Wednesday, August 3, 2011

Understanding the rise of the yen

This morning in Japan, the yen flirted briefly with—yet failed to reach—a new record intraday high against the dollar (highest value to date is 76.25 on Mar. 17th of this year), thanks to forceful intervention by Japanese authorities. The yen and the Swiss franc have both been the beneficiaries of investors' concerns over the health of the U.S. economy and the prospect that the Fed, with the consent of Treasury, may seek a further depreciation of the dollar (which decline would supposedly boost the economy) by resorting to another round of quantitative easing.

The chart above seeks to put the yen's recent ascent against the dollar into the proper perspective, by comparing the yen/dollar exchange rate to a theoretical purchasing power parity exchange rate (which is calculated to equilibrate prices between the two countries). The reason that both the PPP and the actual value of the yen have been rising vis a vis the dollar is easily explained by the observation that inflation in Japan has been much lower than inflation in the U.S. In fact, Japan's CPI has not changed on net for the past 18 years, while the U.S. CPI has increased by about 56%. This rather large inflation differential would, by itself, explain the entire appreciation of the yen and then some. That's because the yen/dollar exchange rate needs to rise by the same amount as the U.S. - Japanese inflation differential in order to keep prices in the two countries from diverging. Put another way, higher U.S. inflation tends to produce an eventual weakening of the dollar vis a vis the yen, otherwise U.S. prices in dollar terms would rise relative to Japanese prices when converted to dollars.

Relative to its PPP, the yen is "overvalued" by almost 50% against the dollar. That means that the typical American tourist likely will find that prices in Japan tend to be about 50% higher than comparable prices in the U.S. The exchange rate market is willing to pay a premium for the yen in order to enjoy the virtues of its stable purchasing power and escape the ongoing decline in the value of the dollar. By comparison, I calculate that at the current exchange rate of 1.43, the euro is about 25% overvalued against the dollar, as can be appreciated in the chart below. European inflation has been only slightly less than U.S. inflation in the past 18 years, so the euro doesn't merit as much of a premium as the yen. That the euro is still trading at a premium, despite the ongoing and very real threat of a substantial restructuring of PIIGS debt, suggests that the market doesn't believe an ECU sovereign default will threaten the ongoing viability of the euro. By extension, it also suggests that the ongoing viability and purchasing power of the dollar is a risk to be reckoned with.

A weak dollar—which is undervalued on a PPP basis against almost every major currency on the planet, and whose real, inflation-adjusted value against a large basket of currencies is at or near an all-time low—has many unpleasant implications for the U.S. economy. For one, it means that foreigner's desire to invest here is weak, which is another way of saying that capital is expected to be more productive elsewhere. Two, it means that the purchasing power of all U.S. residents has been reduced significantly should a resident venture outside our borders. Third, it tends to put upward pressure on the price of all imported goods and services. Fourth, it encourages U.S. firms to raise the price of their exports, since otherwise they might be very cheap to foreign buyers. Fifth, if higher export prices hold, it then encourages firms here to raise their prices domestically. Sixth, it encourages foreigners to buy goods and services here in the U.S., particularly real estate which happens to be very cheap on its own merits. Finally, if the dollar sustains these low levels for long enough, inflation is bound to rise, thus undermining the purchasing power of all U.S. residents.

Some argue that a weaker dollar would strengthen the U.S. economy, but the arguments in favor of that proposition are notoriously weak. A weaker dollar might provide a temporary boost to export-oriented industries, but it would also tend to provide a more lasting boost to the prices of all imported goods and services, thus raising costs for everyone. Competitive devaluations in the end are a fool's game, and it can be said with some justification that no country has ever devalued its way to prosperity.

As a supply-sider, I have learned that it is very important to pay attention to market-based signals, since they can provide very good and timely information about the fundamentals of our economy and our financial markets. Currently, it's hard to find anything that is pointing in a healthy direction. And that is why I remain optimistic, because the world appears to be uniformly and profoundly pessimistic about the prospects for the U.S. economy, while I still hold out hope for improvement. For example, while the recent debt limit accord was far from perfect, it was a step in the right direction. And while the Tea Party is being painted as "terrorists," I believe they have the country's best interests at heart, and they will undoubtedly redouble their efforts to enforce some degree of fiscal sanity on Washington in next year's elections.


Jeff said...

Yea. What he said.

Foobar said...

"The evil that is in the world almost always comes of ignorance, and good intentions may do as much harm as malevolence if they lack understanding." - ALBERT CAMUS

The world is a very complex place. A very clear indicator that a view is wrong is if the view is extreme. The Tea Baggers are extremists. These people are just as ugly as other extremists that inflicted the world with great evil; all the while preaching, in their view, self righteous good intentions.

Those that take extreme views tend to also occupy the lower rungs of the social stratum in life because they lacked the intellectual capacity to understand a complex world. Therefore, ironically, these are the people who are more vulnerable to any economic turmoil.

I disagree with Scott's view of the Tea Baggers. I do agree with Scott's earlier suggestion for Boehner and Reid.

brodero said...

Off the subject but did you see
that Moody's Baa yield is at its lowest in 45 years....

Unknown said...

Why mining/steel sector is falling, is this telling us that there is a stronger USD on the horizon, i.e. part of speculative value in commodities should be wiped out?

AV8R said...

Foobar, your name is aptly chosen. Scott, thank you so much for sharing your wisdom in this blog. It has been very helpful to me and my clients. I really appreciate your perspective.

Keeing it real said...

"The fact that we're here today to debate raising America's debt limit is a sign -- is a sign of leadership failure. Leadership means the buck stops here. Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better. I therefore intend to oppose the effort to increase America's debt."- Senator Obama on explaining why he voted against raising the debt limit in 2006.

A terrorist occupying the lower rung of social stratum in life and lacking the intellectual capacity to understand a comlex world?


Benjamin Cole said...

If any laymen out there are throwing towels down on the ground in exasperation, I don't blame them (including myself).

Martin Feldstein, Reagan's top-gun on his Council of Economic Advisers, and Harvard prof, just wrote an op-ed for the WSJ on the glories of a cheaper dollar. Greg Mankiw is talking inflation targets, and conservative economists such Scott Sumner is calling for aggressive monetary expansionism,

Now we have Grannis, also obviously a highly intelligent guy, writing the opposite.

So, like politics, it is always possible to find a respected economist who fits your predisposition, and then cite that economist.

I have to say, inflation has not been a problem in the USA for a long time, and Japan suffers from perma-gloom and deflation. On a GDP deflator basis, 15 percent deflation in last 20 years for Japan. Also, their equities and stocks markets are down 80 percent and still falling (in case of property).

China, btw, has boomed.

Ergo, I opt for a weaker dollar. Love those exports, and inflation seems dead.

Moreover, as George Gilder pointed out, what is more important than inflation is freedom for innovation and entrepreneurship. You ain't going much of either in a perma-recession. Gilder almost exalted in the fact the growth booms and innovations booms were often linked to inflation in his book Wealth and Poverty.

Gilder even chided Milton Friedman for speaking darkly to Commie officials in Russia about the need to "control" the money supply. "The commies don't need to be talked to about control," said Gilder. "They need to be talked to about opening thing up, and less control."

Gilder may be right. Certainly the sad eclipse of Japan is a reminder that control of the money supply can easily become too tight.

More important than championing minute rates of inflation is championing growth, innovation, prosperity and optimism.

Foobar said...

Keeping it real and AV8R,

Let me assuming everyone is being reasonable and are trying to argue to get at the deeper truth. With that assumption, I really don't understand. Maybe you guys can clarify this. First, some background information.

Bush vs. Obama:

1. Take a look at this graphics from NYT

This is the original article

2. The housing bubble and the subprime crisis and the global economic collapse all happened during Bush's 8 year tenure. From the start of Obama's presidency, he's being mopping up a pile of poo a mile high left behind by Bush. Much of Obama's spending was a conseqence of the mop up effort.

I can understand if you argue that Obama's effort is ineffective. However, is it not deeply disingenous to ignore Bush?! Do you look at the magnitude of differences in the data?

Debt Limit

In 2006, the economy is doing quit well and unemployment is low. Today, the economy is in terrible shape and unemployment is a very high 9.2%. In your household finance, when your income is high, should you not save more so that when the time is bad you have more to spend to see you through? Is that not the responsible approach?

Why is it not reasonable for the US to save more when things are going well in 2006 so that it can spend more now when things are going bad? Is it wrong to have the intelligence, the honesty and the flexibility to change as the environment changes?

Many during the Great Depression self rigtheously pushed for fiscal tightening. The end result is a tremendeous suffering for the whole country for a decade. This great evil done in the name of good intention is in many economic history books.

Honestly, I do want to believe most people are reasonable. There are just some really big holes in the many arguments out there. Are the facts consistent with keeping it real? Really?

Scott Grannis said...

Foobar: The NYT's graphic is amazingly wrong. So wrong that I can't understand how they came up with those numbers. To begin with, our total debt owed to the public (which is the only measure that counts) is $9.7 trillion, not 14.3 trillion. Second, total revenues under Bush II were $17.2 trillion, and total spending was $19.7 trillion, for a deficit of $2.5 trillion. How they can claim that Bush racked up a deficit of $6.1 is beyond belief.

For that matter, I calculate that through June of this year, Obama's revenues are $5.2 trillion, spending $8.5 trillion, for a $3.3 trillion deficit. That's one third more than Bush in one third the time.

Foobar said...

Thanks you Scott for your thoughts.

Here is my situation and I am not trying to be argumentative. I have two data sources that I respect: one from you and one from NYT. Unfortunately, I lack the skill to judge which is more acurate. The NYT graphic was referenced by respected econ blogs (e.g. Certainly, your input does mean that I will not take NYT's data at face value.

Given the difference in the numbers, it still doesn't change some of the facts. When the economy was going well, Bush could have and more importantly should have saved a lot more but he did not. Furthermore, it is not fair to blame Obama for increasing the deficit by one third more than Bush in one third the time. This is for the same reason I would not blame Bush for some of the additional spending after the tech bubble burst and 9/11.

Scott Grannis said...

My numbers come directly from Treasury: monthly data on federal revenues and outlays. I am counting each president's term as beginning in February and ending in January. It's simple addition and subtraction, I'm not making any assumptions.

I know Bush left Obama with a lot of emergency spending and a sharply rising deficit, but Obama went ahead and spent another trillion and then rammed through the hugely budget-busting healthcare "reform." Then you have the Democratic Senate which has not passed a budget in over two years (because the numbers were too horrible to commit to print), and Obama's budget earlier this year which was so absurd that not a single Democrat voted for it. Obama didn't have to spend money like a drunken sailor just because Bush upped the ante.

AV8R said...

Foobar says..."Let me assuming everyone is being reasonable and are trying to argue to get at the deeper truth.".

You sound like father Barak talking down to the rest of us ignorant Americans. Using your rhetoric you'd probably label the Founders "Tea Baggers"/extremists. Here's hoping the socialists never get their way on American soil. Let's keep it to economics/market discussions and try to avoid calling names.

Foobar said...

Hi Scott,

I've figured out how to reconcile your numbers with NYT. Please let me know if there is a flaw in my logic below.

Scott, you accounted for the debt caused by Bush = total revenue (17.2) - total spending (19.7).

Your math is wrong.

The equation failed to account for the baseline performance of the country before Bush became the president. Bush inherited a country that was generating a surplus and was working down its debt. If Bush had kept everything as he inherited, NYT is saying the country should have reduced its total debt by 3.6 trillion instead of increasing its debt by $2.5 trillion (a total swing of 6.1 trillion).

Your equation attributed the positive baseline performance of the country to Bush at the start of his presidency. However, the baseline performance was established before Bush took office! For the type of analysis we are doing, we should be looking at the delta from the baseline.

Looking over the big line items in the NYT diagram, I believe these items can be reasonably estimated by the government sources list by NYT. Summing up the cost is basic math. The NYT numbers seemed solid.

Actually, I am a bit upset with you now that I realize this error. I am not an economist or an accountant by training. I do however expect the idea of analyzing the delta from the baseline to be a fundamental one that is broadly used in many situations.

Perhaps my logic is off the mark. If so, I apologize.

Scott Grannis said...

I don't subscribe to baseline budgeting, as I think it's one of the worst things ever invented.

Foobar said...


Our discussion was never about the merit of baseline budgeting.

Your earlier message was arguing Obama was much more irresponsible than Bush. You argued that Obama increased the national debt more than Bush.

You ignored the fact that Bush inherited a nation that was generating an anual surplus that was projected to eventually wipe out the national debt. Whereas, Obama inherited a nation that had a rapidly growing annual deficit that started under Bush's watch.

You ignore the fact that Bush squandered all the surplus and 2.5 trillion more. He put the country in a much poorer fiscal position going into this recession.

This is like having Bush and Obama in a 100 yard race where Bush gets a 50 yard head start.

Is this a high quality analysis? Is this fair?

Our debate was about who is more fiscally irresponsible: Bush vs. Obama. Last night, I wondered why you didn't consider the simple idea of a baseline, the starting line if you prefer. I really wanted to believe it was a simple math mistake.

Unfortunately, your reply today completely twisted our meaningful discussion up to that point.

I do want to believe most people are reasonable. There are just some really big holes in the many illogical arguments and poor analysis. Most people, including the Tea Party, the Democrates, and the Repulicans prefers to twist the issues to suit their ideology. In the process deepen the national divide while the country is going through huge turmoil.