Stabilizing the Yen: A Concluding Note

Japan is many years away from working itself out of its deflationary trap without relying on "excessive" export expansion. But a necessary first step would be to reduce the foreign exchange risk that causes the low-interest-rate liquidity trap and undermines the ability of the BoJ to expand the domestic economy, and causes international financial intermediation to finance Japan's current-account surpluses to be excessively volatile.

Counterintuitive as it may seem from today's low real valuation of the yen, stabilizing the nominal dollar value of the yen is the preferred strategy. If the yen is credibly fixed within a narrow band over the long run, Japanese nominal interest rates must rise to American levels as the negative risk premium vanishes and fear of future deflation erodes. The dollar exchange rate would again be the nominal anchor-as in the 1950s and 60s. Moderately higher nominal interest rates need not have a deflationary impact if risks in capital and labor markets are reduced, and if fears of future deflation are eliminated. Once Japanese employers became more confident that that the yen would not again ratchet upwards, they would feel freer to grant more generous wage settlements (McKinnon and Schnabl, 2006). Then, private consumption could well increase more generally along with personal disposable income and residential construction.

Credibly fixing the yen dollar rate, with the BoJ allowing domestic nominal interest rates to rise, would spring the liquidity trap and restore some-albeit limited-power to the central bank. The yen carry trade would disappear and be replaced by a more normal international financial intermediation: private purchases of overseas financial assets by Japanese insurance companies, banks, and pension funds would increase, while the government's role in acquiring foreign exchange reserves would diminish. With surplus saving even if somewhat lessened by greater private consumption, Japan would remain a large international creditor. But once foreigners knew that the yen could not ratchet up, they would become more willing to borrow in yen, and would complain less once the BoJ stopped accumulating dollar reserves.

While technically feasible, a credible stabilization of the yen/dollar rate presents a major political problem. It conflicts with recent calls in both Europe and the United States to appreciate the yen-either directly by the BoJ selling dollars to buy yen in the foreign exchange markets, or indirectly by raising domestic interest rates to attract more foreign capital. But officially induced nominal yen appreciations with the fear of more to come would accentuate the deflationary pressure that Japan now faces. As in the 1980s and 1990s, declines in domestic wages and prices would eventually offset any nominal appreciation in its effect on international competitiveness, and Japan would become more deeply mired in its deflationary trap.

To be credible, however, a new policy to stabilize the yen would require explicit cooperation with the United States. How it could work was described 10 years ago in McKinnon and Ohno (1997, chs 10 and 11). The prescription developed there is also relevant today for the PRC's current exchange rate dilemma. But those who do not learn from history are condemned to repeat it.

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