Reality and Illusion

U.S. Senators and Representatives have urged President Obama to place the issue of currency manipulation on the agenda for the negotiations for the Trans-Pacific Partnership, a trade pact (see here). The lawmakers claim that China and Japan manipulate their exchange rates in order to boost exports at the expense of U.S. firms. In the current political environment, this may be the only issue on which there is bipartisan agreement.

The charge that China manipulates its exchange rate is less relevant today than it was several years ago. The Chinese currency has appreciated against the dollar since 2005, although the pace of this rise has moderated. Moreover, the Chinese have made clear that they will not accept linking exchange rates to trade talks. Blaming the Japanese for currency manipulation revives memories of the 1970s and 1980s when concerns about Japan’s economic might were common. The subsequent decline in Japan’s relative fortunes might give pause to those who fear Chinese predominance.

The fall in the value of the yen is due to “Abenomics,” the economic policies introduced by Japan’s Prime Minister Shinzo Abe after his election in December 2012 to stimulate the Japanese economy. These include aggressive monetary expansion by the Bank of Japan, which raised its inflation target to 2% and promised to double the size of the monetary base over a two-year period. Not surprisingly, this has led to a 25% depreciation of the yen against the dollar.

The U.S. lawmakers are responding to those developments. But they should be careful in their finger-pointing. The Federal Reserve’s Quantitative Easing 1, 2 and 3, which were implemented to stimulate the U.S. economy, led to charges of “currency wars” by foreign finance ministers. Barry Eichengreen, however, has pointed out that these policies were not implemented to depreciate the dollar but to stimulate the U.S. economy, and will have positive externalities for other nations. This differs from intervention in the foreign currency market undertaken to keep an exchange rate undervalued to boost exports. Bergsten and Gagnon claim that more than 20 countries manipulate their economies in this manner.

There is another interesting aspect of the U.S criticism. The prices of Japanese goods in the U.S. are determined by the real exchange rate, i.e., the nominal rate adjusted by the U.S. and Japanese price levels. Japanese prices have fallen in recent years, which by itself would result in a depreciation of the yen’s real exchange rate. The five-year averages of the annual rates of change in the Japanese and U.S. GDP deflators show this trend very clearly:

% GDP Deflator Japan U.S.
1998-2002 -1.06 1.78
2003-2007 -1.27 2.87
2008-2012 -1.34 1.78

The causes of Japanese deflation have been the subject of much research (and dispute): see, for example, here and here. Ito and Mishkin hold the Bank of Japan’s monetary policy largely responsible for the fall in prices during this period. The increase in the Bank of Japan’s targeted inflation rate is intended to break that trend.

But why didn’t U.S. officials criticize this aspect of Japanese monetary policy? Perhaps because the yen was appreciating in nominal terms, which partly offset the cumulative impact of the decline in Japanese prices on U.S.-Japanese trade (and was hardly evidence of a currency manipulator). But this may also be an example of the “money illusion” that exists with respect to exchange rates. Observers often overlook the distinction of real and nominal rates. The impact of Chinese inflation on the real exchange value of its currency, for example, is usually ignored or not understood (but see here). U.S. policymakers who confuse the two should not be surprised when their indignation is not met with a respectful response.

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2 thoughts on “Reality and Illusion

  1. gv

    I guess your anbalysis is just another US centric view. When one looks at long term charts, one gets a different idea. The US has been debasing its currency for a long time.
    The EUR/USD rate is still way above the average long term rate and has moved a lot higher since the inception of the EUR. The average is about 1,1-1,2 (0,90 was due to excessive Euro optimism). Oh gosh, and when the EUR dropped to 1,2 the Eurozone was going to disappear, yes?
    The average for the USD/Yen rate must be around 110-115, not that far away from today’s exchange rate and that while Japan has lived through two lost decades and the US has known booming nineties.
    And let us not talk about the CAD, AUD, …
    Both Japan and the US have applied aggressive monetary policies to debase their currencies (that’s why their rate is close to the average) and Barry Eichengreen listens too much to what the FED says, and forgets to read the strategy behind it. QE doesn’t work? Oh yes it does when you focus on the real issue and that is what keeps it going.
    Always watch the one that shouts the loudest, he usually has something to hide.

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  2. Kevin Gallagher

    Very good. Indeed the US best not look in the mirror when it points its finger at TPP countries. What is even more egregious is that the US is currently not letting in on Chile and Malaysia’s requests to have a safeguard in the TPP that would allow for temporary regulations on the inflow and outflow of capital. See the following for more discussion:

    http://www.bu.edu/pardee/financial-stability-and-the-trans-pacific-partnership-lessons-from-chile-and-malaysia/

    http://www.bu.edu/pardee/publications-library/iib-global-trade-reform/

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