On August 15 the world's three largest central banks (United States, Japan, and Germany) purchased more than $3 billion of an already resurgent dollar and sent its value up by more than 3 percent. One month short of a decade after the Plaza Accord, in which major central banks acted in concert to depress a highly overvalued dollar, they acted in solidarity to elevate a chronically undervalued dollar. The ultimate result, provided that fundamentals remain constructive for the dollar, will be a dollar worth more than 140 yen and more than 1.65 deutsche marks. These are the levels that produce comparable local currency prices of traded goods in the United States, Japan, and Germany.
For the present, day-to-day currency movements are still largely governed by the intervention of central banks. A stronger dollar and a weaker yen and deutsche mark make fundamental sense and are consistent with policy goals of each of the countries undertaking most of the intervention. The Federal Reserve wants to temper a resurgence of demand growth while Japan desperately needs to stimulate demand growth for its depressed exports. Germany must firm up flagging export sales. A stronger dollar represents a modest tightening of U.S. monetary policy while a weaker yen and deutsche mark represent monetary easings.
The concerted intervention on August 15 was preceded by more modest, yet persistent, official sector actions to keep the dollar moving up. During the six weeks before August 15, coordinated interest rate cuts by the Federal Reserve and the Bank of Japan, buttressed by official dollar buying on both sides of the Pacific, had pushed the dollar up by 12 percent against the yen while the Japanese stock market had risen by 20 percent. That market rose by another 4 percent on August 16 after Japanese investors had witnessed the collaborative dollar buying by the central banks during New York market hours.
Japanese Capitulation to Economic Facts
Japanese stocks did not soar because of the Bank of Japan's interest rate cut. Nor did they respond to the promise of yet another inflated public works program of 10 to 12 trillion yen (about 2 percent of the gross domestic product) due in the fall. Rather, they responded to an open capitulation by the Japanese government that Japan was headed for self-reinforcing deflation and depression unless aggressive steps were taken to reflate the economy. The dollar buying by the Bank of Japan is becoming a central part of Japan's reflation effort.
Absent the ineffectual public works programs that merely added subsidies to Japan's inefficient nontraded goods sector, Japan-ese policy makers possess only two policy instruments to increase demand for Japanese goods: lower interest rates and a weaker yen. Until June Japan's central bank, wary of financial market bubbles, had contented itself with lowering interest rates more slowly than inflation was falling. Rising real interest rates, a strengthening currency, and accelerating deflation resulted.
Early in July the Bank of Japan signaled, along with some help from the Federal Reserve, that it wanted a weaker yen and was prepared to buy whatever quantity of dollars necessary to achieve that goal. Some parallel yen selling (dollar buying) by the Federal Reserve reinforced the idea that the U.S. government was comfortable with a weaker yen.
The Bank of Japan's aggressive dollar buying injects liquidity into the Japanese financial system, but the Bank of Japan is free to offset such injections by sterilizing them through parallel sales of government securities. Japan's effort to reflate will succeed more rapidly, the less the Bank of Japan acts to sterilize the infusions of liquidity into the Japanese financial system that are attendant on its aggressive dollar-buying activity.
The switch by Japanese policy makers from fiscal stimulus and lower market interest rates to yen weakening as a means to stimulate the Japanese economy marked the key capitulation to the need to reverse the deflationary momentum building in the country. Interest rate cuts had become useless because Japanese households and firms, seeing the deflationary momentum, wanted to hold cash and financial assets rather than purchase any goods or capital equipment. In a deflationary environment, the return to cash and financial assets rises as the rate of deflation picks up. This is the famous liquidity trap articulated during the 1930s global depression by John Maynard Keynes.
To jumpstart the economy, it is necessary to induce foreigners to buy more Japanese goods. The natural incentive is a yen weakened so that the price of Japanese goods in world markets falls. Japan must weaken the yen until Japanese investors start to buy Japanese stocks in anticipation of improved earnings for Japan's key export sector.
The process of reflation in Japan was accelerated late in July when a leak about negotiations to bail out an ailing Tokyo credit union, Cosmo Credit Corporation, caused a run by depositors on Cosmo. Before official assurances of a bailout could stop the run, nearly $1 billion worth of deposits (about 20 percent of the total) had been withdrawn. Japanese authorities had to pile stacks of 10,000 yen notes close to the window at Cosmo to reassure panicky depositors that the value of their holdings was guaranteed by the government.
After the late-July run on the credit union, Japan's Ministry of Finance on August 2 announced additional deregulatory measures making it easier for Japanese investors to purchase foreign assets. Though modest, the actual steps created a powerful psychological effect because they underscored the desire of the Japanese government to encourage capital outflows and therefore to continue the pressure for a weaker yen. The actions also stirred memories of the early 1980s when a major deregulation by the Ministry of Finance allowed Japanese investors to invest abroad for the first time. Those measures were followed by a large capital outflow from Japan, which saw the yen depreciate by about 30 percent from 200 to 260 by late 1984 as Japanese investors aggressively purchased U.S. securities.
The Rising Dollar
The 30 percent rise in the dollar during the first Reagan administration defied conventional wisdom, since it came while the U.S. current account went from a surplus of $5 billion in 1981 to a deficit of $125 billion in 1985. The current account deficit measures only the supply of dollars flowing from the United States to foreign exchange markets. If the demand for dollars rises by more than the supply of dollars as it did in the early 1980s, the dollar will appreciate while the U.S. current account rises, in defiance of conventional wisdom that a larger external deficit weakens the currency. If the U.S. economy continues to fulfill the "Golden Age" scenario (see Economic Outlook, May 1995), the next several years may see a repeat of a rising dollar coincident with a rising U.S. current account as global investors buy into the U.S. Golden Age.
Despite the interest rate cuts, coordinated intervention to support the dollar, and deregulation to encourage investment abroad--not to mention the precedent of the early 1980s--Japanese investors remain skeptical. They suspect that the U.S. government will want to cap the dollar's appreciation at about 100 yen per dollar, notwithstanding the concerted dollar buying on August 15 and Treasury Secretary Rubin's public endorsement of a strong dollar, both of which should have been reassuring to them.
Beyond the currency market intervention, the outlook for a stronger U.S. economy during the second half of 1995 means that a stronger dollar is appropriate both as a reflection of the desire of foreign investors to buy U.S. assets and as a means available to the Federal Reserve to allow some monetary tightening through a stronger dollar instead of through politically unpopular higher interest rates. A stronger dollar cuts foreign demand for U.S. goods while reducing the price of imports to U.S. consumers and containing U.S. inflation pressures.
Shifting Global Policy
By deciding to operate with exchange rates instead of interest rates to increase demand growth in Japan and Germany and to stabilize demand growth in the United States, the Federal Reserve and the Bank of Japan, with some help from the German Bundesbank, on August 15 neatly effected a much needed shift in the global policy mixture. The Japanese economy has desperately needed an acceleration of demand growth: the German economy has needed some boost; and the Fed, having seen a pickup in the U.S. economy since its interest rate cut late in June, can use some help through a stronger dollar in tempering the growth of demand for U.S. output.
The Bundesbank's willingness to join in the Japanese-U.S. dollar-support operation suggests that the German central bank is comfortable with some additional stimulus for the German economy. With exports contributing about 25 percent of the German GDP, concern among the country's major exporting companies about an imminent slowdown in Germany apparently registered at the Bundesbank sufficiently to precipitate its participation in a major concerted dollar-strengthening exercise.
Germany's situation is perhaps the reverse of that faced by the Federal Reserve. The German economy is losing momentum, but the Bundesbank is reluctant to cut interest rates too far for fear of risking inflation in 1996, when some fiscal stimulus is due and the impact of higher wage settlements during 1995 will be felt on prices. Encouraging some depreciation of the currency concentrates demand growth on Germany's relatively efficient export sector and amounts to a monetary easing without an overt cut in the interest rate. Beyond that, combined efforts by the American and Japanese authorities to strengthen the dollar without German participation would cause the German currency to appreciate against the yen and thereby would exacerbate the loss of competitiveness already felt by German exporters in view of the significant strengthening of the yen over the past year.
The yen probably needs to--and probably will--depreciate against the dollar more than the deutsche mark. Because the Japanese export sector is only about 8 percent of GDP, or about a third of the size of the German sector, a larger currency move would be required to increase significantly aggregate demand in Japan.
Beyond that, the yen is more overvalued on a fundamental basis. Had the yen followed the rules of purchasing-power parity since 1975 and appreciated in proportion to Japan's lower inflation rate relative to the U.S. inflation rate, the yen would today stand at about 144 yen per dollar, or nearly 50 percent weaker than its current level. Based on the same criterion, the deutsche mark would be at about 167 deutsche marks per dollar, or just 15 percent weaker than its current level.
The operational requirement for the yen to become self-sustaining is for the yen to weaken to a point where Japanese investors, in anticipation of improved earnings for Japanese companies, stop selling Japanese stocks. To accomplish this, the yen must reach about 110 per dollar, a level where a large portion of Japanese companies become profitable again.
Since that level is well below the fundamental equilibrium level of about 140 yen per dollar, neither the Bank of Japan nor the Federal Reserve should be uncomfortable with yen depreciation to 110 or perhaps 120, given the need to help some of Japan's small and medium-size firms that are less competitive than the large international firms such as Toyota. A dollar appreciation to the 110 to 120 range provides the Fed with some additional disinflationary momentum, which should help to keep U.S. interest rates down.
Skillful Intervention
The coordinated intervention begun by Japan and the United States in June and joined by the German central bank in mid-August represents the most successful episode of central bank intervention to affect currencies since the Plaza Accord of September 1985. Nearly a decade after the Plaza Accord, when central banks moved decisively to reinforce a downward move in the dollar that had been underway since early that year, the world's three major central banks moved in August 1995 to reinforce an upward move in the dollar that had been underway for only eight weeks. Both moves were skillfully executed: they represented efforts to correct a fundamental currency misalignment by pushing exchange rates in a direction already acceded to by markets rather than trying to resist fundamentals and market direction.
The concerted intervention to support the dollar will produce a better global allocation of demand growth and a prolonged global economic recovery, which has heretofore been well served by well-balanced growth of output and demand. The constructive reallocation of demand growth will result in a much stronger stock market in Japan and a stronger stock market in Germany. European countries outside of Germany will also benefit from some weakening of their currencies against the dollar and from a stronger German economy.
John H. Makin is a resident scholar at the American Enterprise Institute.
