JPRI Critique , Vol. XV, No. 1 (February 2009)
Japan - Land of the Setting Sun?
by Marshall Auerback

Asia may have the cleanest-looking domestic and international financial statements, but on the real economy side, they have something much messier: the most cyclical and most capital intensive industries.

Investors tend to focus on the statements and forget about the rest, thereby unwisely assuming the region is immune to depressionary outcomes. The data now coming out of Japan seems to suggest they should be paying close attention to both aspects. In many respects, Japan is the new Detroit writ large. It may be time for investors and for Tokyo's monetary and financial authorities to realize that we are all entering a global depression that will require a much larger role for the government in directing or coordinating production and finance if we are to reduce the unfolding human tragedy. Otherwise, we are all in Iceland.

The economic data coming out of Japan have been extraordinarily bad - worse, in some respects, than the USA in the early stage of the Great Depression. And every week it gets worse and worse. Employment is very weak, retail sales are very weak, household spending is very weak. The results of the last Tankan survey showed the worst decline in business sentiment in decades. The 27% decline in Korean exports to China, the 24% decline in Taiwanese exports to China, and the 18% decline in Chinese imports: all this data (reported for November on a year over year basis) point to Japanese exports, long the engine of economic growth, falling off a cliff.

We are literally looking at the unimaginable. Japan has slid into a depression already, pure and simple.

Irrational Exuberance
Yet, even as the Japanese economic data progressively spells out depression for Japan, the yen remains super strong. For all the talk about an incipient bond bubble, the biggest bubble to me right now looks like the Japanese yen itself. In the bubble years starting in 1995 investors and speculators were forced by bubble dynamics to be completely detached from investment fundamentals. It was the only way to prosper and not perish amidst the bubble madness. As a result, attention to the witchcraft of charts and all other manner of technical divining has become the principal preoccupation of today's market participants. Fundamentals are studiously ignored because they take one away from the witchcraft that works.

But financial markets have only one rationale in economic theory: to sift through all of the fundamental information that has a bearing on prospective returns to investments and thereby establish the set of "right" prices that will lead to an optimal allocation of real resources. Because of uncertainty and imperfect information, an optimum allocation will never be reached, but a second best allocation can.

There is no other "social" rationale for financial markets. When financial markets become nothing more than a casino, as they did during the bubble period and again today, and market participants flee fundamentals for the witchcraft of technical analysis and other divining of market dynamics, market participants will send prices flying about in ways that have nothing to do with prospective returns to real investments. The result will be a serious misallocation of real resources. When bubble markets go from a mere speculative casino to a casino in which pivotal players are driven only by the pursuit of short-run fee income, you get a more willful proliferation of "false" prices and an even worse misallocation of resources.

This is what has happened over the last ten years. The result is what economic theory says it should be: today's global financial, economic, and social catastrophe. The ruling maxim in such a regime seems to be that market participants will push prices to the point where they do the maximum financial, economic and social damage. I believe that, despite the massive losses to market participants that such behavior has now brought them, their behavior has not changed. Half a generation is enough to breed a cohort among market participants that knows of no other way. This cohort has been hurt and has had its wings clipped, but it still runs the show.

The Japanese Yen
Let us now apply this to the Japanese yen. According to the most recent economic data the land of the rising sun apparently risks falling off the face of the earth in terms of economic fundamentals. Nonetheless, the Japanese yen soars. We hear the ludicrous mantra from all the investment banks and all of their speculator clients that the yen is a safe haven amidst the global chaos. To my mind the real reason why the yen soars is because it soars: an inherently unsustainable investment tautology.

Except for a brief interlude in the mid-1990s the Japanese yen has been bounded on the upside by a round number - 100 yen to the dollar . It bumped against that ceiling time and again. In recent months the unwinding of massive yen-financed carry trades caused a powerful, though transitory, impetus on the part of panicked yen debtors to purchase yen. This impetus broke the yen through its magic barrier of 100. Since everyone now ignores fundamentals and only looks at the witchcraft of charts and technical tools they now have focused on the next technical objective of 79 yen to the dollar. That was the spike high in yen in that it briefly reached in the mid-1990s. Against an extraordinarily grim economic backdrop, we now have "investors" placing bets on further yen appreciation on the basis of historical chart patterns which are divorced from today's economic context. It is a recipe for disaster.  

According to METI projections, Japan's industrial production may fall by an unheard of 33% in the coming year. Japan just announced a 35% decline in its exports. That was a record rate of decline. Exports are declining faster than imports. Japan has now reported five monthly trade deficits in a row. Until five months ago it had not reported a trade deficit in almost thirty years. Clearly Japan's export collapse is a cause of its industrial collapse. Now this is manifesting itself on the consumption front. Department store sales in January fell 10%, according to Nikikei Telecom 21. Stores reported poor demand for luxury goods and weak consumer response to New Year sales events.  Similarly, January new car sales were down 27.9% to 174,281 units, the sixth consecutive decline. Overall, Japan's GDP most likely shrunk by more than 10% in the final quarter of 2008. And yet currency traders keep pushing the alleged safe haven of the yen higher and higher.

The yen has been strengthening massively against many other currencies. On a trade- weighted basis, it has been by far the strongest currency on the planet. But there are long lags between changes in currencies, exchange rates and trade. The weakness we are seeing in Japanese exports today is in large part derived from aggregate demand weakness from its trading partners. It is also the result of an earlier appreciation in the yen from around 120 yen to the dollar to 110 to the dollar and then 100 to the dollar. And perhaps, most important, it is the result of a secular trend in which Japan's lower wage neighbors in Asia are making inroads - big inroads - into the global markets it has traditionally dominated as an exporter.

When the long lags between the yen exchange rate change and trade and industrial production fully run their course the land of the rising sun may well fall off the face of the earth. And with it will fall all the market participants who refuse to look at fundamentals and have been the big bulls engineering a yen exchange rate that will maximally undermine the markets, economy, and social fabric of Japan.  

We are already starting to see this manifested politically. I have long viewed Japan as a first world economy with a third world colonial-style political system. But there are signs that Japanese politics are changing and becoming more responsive to the deterioration of their social safety net. By the summer of 2009, we may well have a non-LDP government for the first time in over a decade and only the second time since the end of WWII. Ultimately, a competitive political system will be a good thing as it will move the Japanese polity toward a consumer friendly policy and long-required supply side reforms that have precluded a large number of its citizens from participating fully in the country's historic growth.

What about the short term? The first thing that comes to the mind of most people is MOF/BOJ intervention. Both have mentioned they might take this route, but not yet. They have done it in the past. Paul Krugman and Ben Bernanke exhorted the Japanese to do this to effect quantitative easing a decade ago. There is a limit to how much a country can prop up its currency, but there is no limit to how much of its currency it can print to hold or drive it down. In this connection, consider that the Swiss central bank, also faced with "safe haven" speculation inflating its currency, has threatened to intervene without limit to prevent its currency from appreciating further. It seems to me, after the latest Japanese economic data, that the Japanese authorities must be in pure panic. Intervention must come. Traders should be waking up to this. But after the commodity madness of early last year, during which a speculative frenzy caused a near doubling of oil prices despite a rapidly slowing global economy, it is worth noting that blind irrational speculative frenzies can go on longer than one thinks possible.  

However, when I hear so-called "Mr Yen," Eisuke Sakakibara (long a proponent of a stronger currency) now expressing concerns about what the yen's strength is doing to Japan's economy, it seems reasonable to assume that we are fairly close to seeing a significant change in the BOJ's policy of malign neglect of the currency. I have also heard from very good sources in Japan that MOF/BOJ officials have already spoken to Washington about this and have got tacit approval to facilitate a further yen weakening, given that such a massive monetary/fiscal stimulus will enhance global demand. Why hasn't Washington adopted the same attitude toward China, you may well ask? Well, Japan has long played a crucial role in funding America's military aspirations in the Pacific. Sometimes being the 51st state does have its advantages.  

Marshall Auerback writes regularly for JPRI on international finance. His most recent report is JPRI Occasional Paper No. 37, (October 2007), "Risk vs. Uncertainty: the Cause of the Current Financial Crisis."

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