Japan’s Role in Global Imbalances

A good post by Thomas Palley on the not-sufficiently-discussed role of Japan in global economic imbalances (code for “nations with high savings funding our consumption”), which we found courtesy Economist’s View.

One quibble: he talks about the carry trade as if it was strictly an international phenomenon, that is, foreigners borrowing in yen and then investing in instruments in countries that have generally higher yields. As we have discussed, it’s more complicated than that, since Japanese investors themselves are directly investing in oversea assets, and (at least during the last bit of yen appreciation) tend to make even more foreign investments when the yen rises (meaning they sell yen), which offsets panicked buying by traders afraid of currency losses on their borrowings.

From Palley’s “Global Financial Imbalances: The Japan Factor:”

Over the past several years, much attention has focused on the role of China’s trade surplus in creating today’s global financial imbalances. With so much attention devoted to China, little attention has been paid to the role of Japan’s policy of near-zero interest rates that has also contributed to these imbalances. With global financial uncertainty rising, it is time for Japan to decisively abandon this policy.

Japan’s ultra-low interest rate policy was initiated in the 1990s to put a floor under the economy following the bursting of its asset price bubble. However, over time ultra-low rates have promoted a highly speculative financial “carry” trade. This trade involves speculators borrowing yen at low interest rates, and then switching those borrowings into dollars and other currencies that are invested in higher yield assets elsewhere.

There are two critical features to the carry trade. First, it contributes to yen depreciation and dollar appreciation as carry traders switch out of yen. Second, it increases global asset demand, generating asset price inflation.

The yen’s depreciation versus the dollar has contributed to continuing large US trade deficits with Japan. It has also pressured other East Asian countries to under-value their exchange rates to stay competitive with Japan. In tandem with China’s under-valued currency, that means East Asia’s two largest economies have anchored down exchange rates throughout the region. That has increased East Asia’s trade surplus at the expense of jobs and growth in the rest of the global economy.

Funds switched out of Japan have shifted to other financial markets, with the chase for yield driving up asset prices and lowering interest rates. In the US, this has complicated the Federal Reserve’s task. The Fed has been trying to slow demand growth and cool the housing price bubble to avoid inflation, but carry trade speculators have been easing credit.

Most importantly, the carry trade generates global financial fragility by creating fundamental mismatches. One mismatch is that carry traders borrow in yen but invest in dollars and other currencies. A second mismatch is that they borrow short-term money in Japan but may invest in longer-term assets outside Japan.

These mismatches are dangerous. Unexpected yen appreciation could cause large carry trade exchange rate losses, as could unexpected closing of the interest rate gap with Japan. Such losses, or just the thought of them, have the potential to trigger global contagion as carry traders close positions in US markets to repay loans in Japan.

In addition to the global dangers of the carry trade, the policy of ultra-low rates may also be bad for Japan. This is because ultra-low interest rates may hurt Japan’s households and lower consumption, and this effect may be larger than the benefit a weak yen confers on Japan’s exports.

Higher interest rates can spur consumption if their impact on income outweighs the increased incentive to save. This may well be so for Japan, which has a rapidly aging population. Current ultra-low interest rates may be scaring people about adequacy of future income. Raising rates could alleviate those fears, increasing consumer confidence and spending.

Additionally, raising interest rates would be a form of expansionary fiscal policy. This is because Japan has a large public debt, and increasing interest payments on that debt would put extra money in the hands of households.

The policy of ultra-low interest rates was justified in the aftermath of Japan’s asset price bubble, but Japan has long since stabilized. At this stage, the policy has become a contributor to global financial fragility, and it may be retarding Japan’s own prosperity by contributing to consumer anxieties. That means Japan should decisively abandon ultra-low interest rates, albeit gradually so as to allow an orderly unwinding of speculation.

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