On 2013-01-24, at 6:07 AM, SSJ-Forum Moderator
wrote:

Keep in mind that we're both 90% in agreement that this would only buy time for Japan, and that we disagree on whether it could work at all. Your counterarguments are
threefold:

1. The markets are too large and would overwhelm the intervention.

2. Other countries would not permit it.

3. Japan has lower inflation than other countries, so the Yen will slowly appreciate anyway.

On the first point:

From: Richard Katz (rbkatz@ix.netcom.com)
Date: 2013/01/24
But, in any case, it held during the 15 months from January 2003 to March 2004 when the government of Japan spent Y35 trillion (7% of GDP) on intervention and yet the nominal yen APPRECIATED 8% from Y119/$ to Y109. [.]

So, why can't Japan do what Switzerland did? Because Japan is not Switzerland. [..'] Switzerland is much smaller and less important in global trade and capital flows and in daily trades on global forex markets.

That would only make it easier for speculators to undermine the Swiss policy, because the market could "overwhelm" such an attempt much more easily for a smaller country. But it's conceptually wrong. The market can always overwhelm a country that wants to keep its currency overvalued, or e.g. pegged to a strong currency and overvalued. You cannot successfully fight a central bank determined to keep its currency undervalued by selling unlimited amounts of its own currency, unless the central bank can no longer sterilize the capital inflows (see below). The key here is "potentially unlimited", not a limited forex purchase like in the cases of Japan you cited. It's still true what Keynes wrote in 1941 in his call for an international clearing union: "For whilst a country's reserve cannot fall below zero, there is no ceiling which sets an upper limit." If you can show an empirical example of the contrary, I'd be very interested in seeing that, as would probably every forex trader in London or New York.

Suppose the MOF tries to fix the yen around Y100/$ when the market thinks it should be Y90. So, speculators use dollars to buy yen get Y100 for each dollar. Their purchases push the yen upward a bit, let's say to Y98/$. In that case they sell their 100 yen in the forex markets and get $1.02. They've made a 2% profit in just a few minutes, or hours or days. And then the MOF pushes back and the whole process starts all over again. The MOF has simply made speculators rich without affecting the yen rate. Look at the massive private capita flows into Japan during the period of intervention that simply neutralized the MOF actions.

Yes. But it's not Japan who pays for the 2% profit, rather speculators who bet the other way. And massive private capital inflows into Japan with a targeted exchange rate would only increase the money supply in Japan, which presumably isn't a bad thing if we want to beat deflation.

On the second point:

As far as I know, the EU did not
flip its wig when the Swiss National Bank put in the ceiling. The US Treasury and EU and China and other Asian would do so if Tokyo made a similar move. Knowing this, currency speculators would bet against the MOF/BOJ being able to sustain the policy, just as they did in the fixed currency system. If the speculators expect the MOF to fail, then they will take actions that will make it fail--in a self-fulfilling prophecy.
If speculators believe that the EU will tolerate the Swiss policy, then they won't necessarily fight against it.

It is a separate argument to say that the forex rate is purely set by the market (which the Swiss have shown not be the case) and to argue that other countries won't permit targeted depreciation by the second-biggest economy in the world. The only way for other countries to prevent Japan from succeeding would be to also devaluate their currencies. That's a systemic challenge, but not a matter of whether it conceptually works.

On the third point:

Also, keep this in mind. With Japan having deflation and the rest of the world having inflation, the nominal yen has to rise a few percent per year just to keep the real (Price-adjusted) yen from becoming undervalued.
So, even if the rate that the MOF set today were market-conforming, in a few years, it would be out of whack with fundamentals. Speculators know this.

First, with the inflation differential being around 2-3%, that would just imply that the forex purchases would have to grow by that percentage every year.
Second, when accumulating forex reserves, the BoJ would either have to sterilize these, or generate inflation in Japan. So the first point is moot.

Sterilization could take two forms: sell more bonds at home, for which there probably isn't quite enough demand at this scale, or create a sovereign wealth fund and invest overseas. I think the latter wouldn't be such a bad idea for a country with Japan's demographic profile. But conveniently, the increase in the money supply after converting forex to Yen domestically would create inflation.

Finally, as to the theory in the article that you
cited: a number "rational expectations" monetary economists buy this notion despite all the evidence against it.

etc

This seems to be more a case of Taylor not understanding the root of Japan's problems, which have little to do with an output gap in the Keynesian sense, but you have explained that yourself already. I don't think it invalidates rational expectations in general.
In fact, that the Swiss intervention worked or that Draghi managed to buy time for the Eurozone is a point in favour of rational expectations.

Again, this would only buy time, it wouldn't solve the problem of structural reforms and do nothing for the demographics of course, and the US might not permit such a policy. But it would work.

--Mark

Mark S. Manger
Assistant Professor
Munk School of Global Affairs | University of Toronto Observatory Site | 315 Bloor Street West | Room 212
Toronto, ON M5S 0A7
mark.manger[at]utoronto.ca
www.munkschool.utoronto.ca/mga

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