Thursday, November 30, 2006

Euro-Yen at the Eleventh & a Half Hour

What are nation-states to do when markets imperfectly reflect the state of the world consistent with longer-term equilibrium? Witness the Japanese Yen vs. The Euro in the accompanying graph. What are we to make of it?

The market, according to pundits far and wide, ostensibly is focused on "interest rate differentials", and the forecasted rate of change thereof in the immediate period. Employing this line of reasoning, it would seem that the market is "acting rationally" eschewing Yen in favour of Euro's. In earlier days this might be wholly understandable since cycles might be distinctly out of phase. But globalization has changed this, increasing economic correlation and business cycle synchronization. Sure fiscal policies differ, and demographics might be divergent. But the logical question to ask is: Why might the European Central Bankers believe that 4% rate of interest is imminently appropriate, whilst the BoJapan's boffins (& MoFo's) believe 1% is too high?

Japanese asset prices are rising smartly - both property (commercial & residential)and shares. Corporate profits are surging. Capital investment increasing. Orders robust. Exports surging. Unemployment low. Government deficits large (>5%GDP). All the above are sure signs that things are pretty damn alright, irrespective of 0.5% core CPI still apparently deemed too low. Europe on the other hand, has less than 3% GDP fiscal deficits, much higher, but decreasing unemployment, surging asset markets, especially commercial and residential property (making some believe there is a bubble), growing private-sector debt, growing capex, roughly balanced trade accounts, and inflation that when incorporating asset prices, is growing and too high for policy makers to countenance.

So why with all this slack in employment, is inflation rearing up in Europe, but not Japan? Why are the Europeans more concerned about inflation or the Japanese with >5% fiscal gaps and near-ZIRP, not more puzzled by why with loose fiscal and loose monetary policy and rollicking asset markets, they are not generating more inflation at home? And if THAT combination of events is not generating goods-price inflation at home, would tighter monetary and fiscal policy really have a negative impact? And, if so, would this be bad for a nation that is is generating incredible dollops of income on overseas assets and FDI?

I think that what markets are not expressing, (rightfully since pissing in the wind is unpleasant in the best of times)) is that betting against the central bank and authorities of the world's second largest economy is a "mugs game". For the the world's central banks - at the moment - are working at different purposes. The US FRB is spinelessly schizo from dual irreconciliable mandates, erring on the side of soft money. The ECB is independently pursuing its mandate, it too erring on the side of soft money, though helped enormously by the saner fiscal policies, forward-thinking energy policy & taxes, and thankfully more balanced trade account, and manufacturing sectors. The BoJ, however, sits alone at the opposite pole to the ECB: politically compromised to TeamJapan, cynically selfish global citizen insofar as they maintain a ZIRP policy that matters not in the least to Japanese demand for credit, but which insures the YEN will be the global funding currency of choice to offset their surplusses and insure that TeamJapan losses not an iota of competitiveness to their Asian peers and would-be competitors. THAT is why the yen has deteriorated over the course of the past four years. THAT is why I loathe the BoJ's inaction, and the MoF's continued demaoguery regarding the impact of higher rates, for the only real impact of higher rates would be prevent the YEN from being the financing currency of choice for global carry, resulting in a higher Yen, resulting in lower corporate profits and potentially deflation of the benign adn unpernicious kind that results from productivity gains, plateuing demographics, and a geographical location adjacent to the largest deflationary force the world has ever seen.

China bears some blame here. For China, rather than be accumulating dollars, should be selling dollars and buying Yen, driving the Yen/Euro and Yen /dollar towards equilibruim amongst the crosses, and preparing for what the eventual acscent of the RMB (and the GCC currencies) relative to the entire OECD currency panpoly.

5 comments:

Aaron Krowne said...

Japan's conditions look eerily like those in the US in the 19th century: gradual deflation which is not to the detriment of gradual economic progress (and indeed, is evidence of it), with minimal if any "frothing" (financial bubbles).

Why no frothing? Because of the interest rate differential and the carry trade: excess Japanese liquidity tends to be siphoned outside of Japan to speculate elsewhere.

This may be why no one really understands Japan, especially in comparison to the rest of the world: Japan has accidentally stumbled into the 19th century.

This is also why anyone trying to engineer Japan's "recovery" looks so foolish and impotent: if you poured excess liquidity into a 19th-century economy, it would go to savings, not speculation, so you won't be able to generate inflation. Additionally, modify the situation so that savings itself cannot be invested domestically (as if it was going into cash or gold, to complete the 19th century analogy).

As long as Japan has it's special status as a global liquidity source, I'd wager this will keep happening. This sets up a "potential energy well" that Japan would need to extract itself from (rather painfully, for Japan and the whole world) in order to start behaving in the usual, dysfunction 20th-century manner (where inflation is bizarrely considered a good thing).

Cassandra said...

Thanks, Aaron, but I do not think it is hard to wean Japan from either ZIRP or >5% fiscal gaps, just I do no think the world will be imperiled in US Fed Gov raised taxes to other OECDS norms of tax receipts as %GDP. Contractionary? Better to have it "managed" sooner, than spin out of control, unmanaged, later.

Normalization would entail capital inflows, and a much stronger Yen. The Yen should be in the 80's relative to the USD and the Euro, given rate normalization, or some form of capital controls that would limit Yen borrowings by foreigners or inhibit the swaps they undertake into the destination currency. It means the Japanese would simply suck on the same deindustrialization and adjustment lollipop that the rest of OECD nations have been sucking on. It's all contractionary.

Aaron Krowne said...

Perhaps you're right that it won't be difficult -- for Japan. For the rest of the world, it means more of what we saw in May: the havoc wreaked by deleveraging.

I have a pet principle. It's that malinvestment always has an equal (or greater) and opposite adjustment. All of this non-equilibrium policy (and I'm speaking specifically about intervention with respect to liquidity, interest rates, and exchange rates) has brought about malinvestment on a global scale. Someone's going to pay for that.

By the way, the US has higher taxes than generally acknowledged. The first dodge is to avoid counting social security and the unemployment tax. The second is to ignore state, local and sales taxes. The US taxes already quite high relative to what the domestic economy can bear (somewhere in the range of 50% of national income). Further, large swathes of the economy are now propped up by government spending (especially for defense/homeland security).

None of this is sustainable, and I think adds up to an inevitable painful period for the US in the near-term.

By the way I'm not entirely sure it follows that the Yen must appreciate and Japan must deindustrialize. Firstly, I think an interest rate increase could be potentially zero-sum for the Yen's exchange value: the lower global holdings due to the death of the carry trade would be balanced out by higher investment due to a more competitive interset rate (in fact, net global holdings of the Yen may fall, with Japan failing to distinguish itself in any noticeable way).

And inasmuch as Japan's industrial base is not "traditionally-industrial", but rather "post-industrial" (highly-mechanized and hence labor-minimal), outsourced production due to lower labor costs elsewhere is not the inevitable conclusion.

Of course, you know way more about Japan than I do.

Cassandra said...

Death of the carry trade means lots of deals to unwind, which will, as in '98 create meaningfully large point-in-time demand for Yen. Not all is vs. dollars by a longshot, but who will want/buy the dollars?

I agree that Japan's post-industrial landscape is a model to behold. But, there remain pockets that will eventually be sacrificed to globalization. They have undoubtedly ben successful at moving up the value chain rather than simply packing up the cap eqpt and shipping it to China or Vietnam.

Cassandra said...

Death of the carry trade means lots of deals to unwind, which will, as in '98 create meaningfully large point-in-time demand for Yen. Not all is vs. dollars by a longshot, but who will want/buy the dollars?

I agree that Japan's post-industrial landscape is a model to behold. But, there remain pockets that will eventually be sacrificed to globalization. They have undoubtedly ben successful at moving up the value chain rather than simply packing up the cap eqpt and shipping it to China or Vietnam.