My recent post on the yen triggered a number of interesting comments. For instance, Miguel Sanchez responded to my claim “For those who don’t follow the yen closely, 77 is an insanely high level” with the following:
Aptly worded, though probably not in the way you intended. For those who do follow the yen closely, the real effective exchange rate is historically quite low, though it’s been off its all-time lows since the financial crisis.
I know there’s a huge and ongoing debate about how to gauge "fair" value, but I would’ve thought the very basic test of whether a currency is overvalued is whether the country is running a trade deficit. Japan has and continues to run a massive trade surplus.
This is a widespread view, but it contains two misconceptions. First, there is an implicit assumption that trade accounts should balance. In fact, countries with good demographics (like Australia) would be expected to run current account deficits, and countries with bad demographics (like Japan and Germany) would be expected to run a surplus. And that’s exactly what happened. Indeed, with optimal fiscal policy, Japan’s surplus might well be much larger.
The second mistake is to assume that the real exchange rate is the correct variable for my analysis. Monetary policy affects nominal exchange rates, and has no long run effect on real exchange rates. The way to tell if a currency is under or over-valued is not to look at trade balances, but rather NGDP. By that measure, monetary policy in Japan is too tight and the yen is too strong in nominal terms.
Miguel didn’t say this, but some proponents of “fairly valued” exchange rates claim that a weak yen actually hurts the rest of the world, by stealing jobs from others. But as we saw, the rest of the world actually gains from a weaker yen, at least when a strong yen is severely hurting the Japanese economy.
Asian markets posted gains and European shares were headed higher Friday as the yen retreated from historic highs after the world’s seven leading industrial nations pledged to rein in the currency to help earthquake-stricken Japan.
This market response supports my “monetary view” of the overvalued yen, and goes against the “trade surplus view,” which implies the yen was undervalued even before the recent steps taken to depreciate it further. As with China’s policy of fixing the yuan in late 2008 and 2009, an expansionary monetary policy during a worldwide recession helps all countries. Macro is not a zero sum game.