ON JAPAN: Hands Off the Yen

The Japanese government has been trying recently to “talk down” the value of the yen in an attempt to stimulate the economy by expanding exports (and curtailing imports). I sympathize with the desire to help the economy, but this strategy is unworkable for several important reasons.

First of all, exports are not a very large share of the economy. Twenty years, exports constituted around 14 percent of GDP, but today they account for only about 9 percent. That means exports would have to grow a great deal to have much impact on the overall economy. For example, it would take a hefty 25 percent increase in exports to boost GDP by two percent. That impact would be spread over about two years, yielding a roughly one percent annual increase in GDP?hardly enough for a strong economic recovery.

And whether yen depreciation alone will produce even this much expansion of exports is doubtful. Years ago a high export growth rate was possible because Japan was a small country whose industries were just breaking into global markets on the basis of price competitiveness. But that era is gone. Now that Japan’s huge economy has penetrated foreign markets, a weaker yen is less likely to yield a rapid increase in exports.

The problem facing Japanese exports today is not a lack of competitiveness but weak demand abroad. Japanese exports are skewed toward high-tech products, particularly electronics. But the high-tech sectors of the global economy that buy these products have been in a slump for the past year. For instance, while the overall U.S. economy is essentially flat, Japanese exports to the United States are down about 15 percent, reflecting the slump in the U.S. information-technology sector. Even if the U.S. economic recovers this year, most analysts think the IT sector will not rebound until late this year or even next. As a result, Japanese exports may not expand much as the yen sinks.

In addition, the current focus on the exchange rate once again distracts politicians and bureaucrats from the real problems of the economy. The export sector, in fact, is in reasonably good shape, as it represents the most efficient sector of the economy. What is wrong is the rest of the economy?especially the heavy weight of non-performing loans in the real estate sector and large pockets of inefficiency in services and parts of manufacturing outside the export sector. A robust economic recovery requires dealing decisively with non-performing loans and continuing deregulation to bring efficiency and expanded business opportunities in a wide variety of industries. A weaker yen worsens this situation because politicians and bureaucrats will breathe a sigh of relief and slow down their efforts to produce real economic reform. While yen depreciation would have a small positive direct impact on GDP over the next couple of years, it would do so at the cost of slower reform causing weaker economic growth over the next decade?not a good tradeoff.

Finally, deliberately driving down the value of the yen is bad diplomacy. Some Asian countries compete directly with Japanese exports, especially South Korea, Taiwan, the Philippines, Singapore and Malaysia. These countries have all been distraught over yen depreciation. Even China, which does not compete much with Japanese exports (but would certainly like to export more agricultural products to Japan), has been quite vocal about the yen’s decline. Indeed, this was a major topic when Prime Minister Koizumi recently visited Southeast Asia. While the prime minister wanted to talk in positive (though very vague) terms about enhanced cooperation with the region, he got sharp questions from his counterparts about the falling yen. What kind of cooperation is it for the Japanese government deliberately to drive down the yen, to the detriment of its neighbors? The contrast between the Koizumi’s sweet words and the reality of the Japanese government’s “beggar-thy-neighbor” action was all too clear, and badly marred his trip.

Even the U.S. government has been irritated by the effort of the Japanese government to “talk down” the yen, causing Secretary of the Treasury Paul O’Neill to speak rather sharply on the issue when he was in Tokyo. The policy of the U.S. government has been to avoid interference with the operation of exchange rate markets. U.S. officials, therefore, have been very uneasy over what the Japanese government has been doing. This risks undermining the good bilateral relationship pursued by both sides in the past year.

All of this adds up to a simple conclusion: Japan would be better off economically and diplomatically if the government were to stop this effort and went back to a single-minded focus on fixing the domestic problems that lie at the root of economic stagnation. Let the market decide for itself what the exchange rate should be. If the yen still weakens, so be it, but keep the government out of the process.