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When I joined the Richmond Fed in 1968 as an international economist, it took 360 yen to purchase one dollar. Yesterday, it took fewer than 80.

I can’t explain why the immediate reaction to the Japanese tragedy, which will cripple its economy for some time to come and will likely curb Japanese exports more than imports for a long time as well, would be a stronger yen. The knee-jerk explanation that the Japanese were repatriating money held offshore to Japan for reconstruction didn’t sound plausible to me. For one thing, it was too quick. That explanation would make more sense in coming weeks and months than immediately in the wake of the disaster.

The enormity of the disaster and size of the move up by the yen does put into greater relief what I consider a common misconception about the relationship between the strength of a country’s economy and the strength of its currency. The conventional wisdom seems to be that a strong economy produces a strong currency, and that a strong currency produces a strong economy. Not only does this week’s Japanese example run counter to that simplistic notion, but so does the Japanese example over the past two “lost decades” when the yen nevertheless remained strong.

The United States experience highlights the other side of that misconception. Our economy has performed much better than Japan’s over that period, yet the dollar went from weak to weaker. After the initial shakedown period, and until recently, the new euro seemed to draw strength from an underperforming European economy.

I don’t consider these examples exceptions to the rule; I just think the rule is wrong. It is certainly not the way I learned it when I studied exchange rates in school. In the first place, the demand for the dollar, for example, is reflected in credits in the U.S. balance of payments (above the line). The supply of dollars on the foreign exchange market is reflected in debits (above the line) in the balance of payments. The exchange rate is determined by the balance of these debits and credits.

I mention this obvious point to call your attention to the fact that exchange rates are discussed on cable TV without any reference to the balance of trade, the current account balance, or the overall balance of payments. It’s like trade and investment relationships are irrelevant to exchange rates. The level of interest rates compared to that of our trading partners is about all that is mentioned.

Many factors affect exchange rates, but I learned that the most important factor was relative rates of income growth. Domestic growth adds to our demand for imports; foreign growth adds to their demand for our exports. Therefore, other things equal, if we grow faster than our trading partners, it weakens our currency. If foreign growth is greater, it strengthens our currency. This is the exact opposite of what we usually hear, which is a positive relationship between growth and currency strength.

Foreign exchange markets are very efficient, so that current exchange rates pretty much reflect all there is to know about the factors that would influence them. That makes trying to outguess the market a crap shoot in most cases. There are still remnants of fixed-change rates, however, that still offer some pretty-sure bets. Chinese yuan pegging (or semi-pegging), along with the continued deficit in the U.S. current account, suggests to me that a dollar bet on yuan appreciation is a good bet, if you can get the timing right — a big if.

Anyway, my main point is that the recent behavior of the yen is a reminder that what we think we know about exchange rates is wrong. Of course, we still don’t know what we don’t know.

Source: Yen Confusion: A Teaching Moment