Over the past several years, much attention has focused on the role of China’s trade surplus in creating today’s global financial imbalances. But too little attention has been paid to the role of Japan’s policy of near-zero interest rates in contributing to these imbalances. As global financial uncertainty rises, it is time for Japan to change course.
Japan’s ultra-low interest rate policy was initiated in the 1990’s to put a floor under the economy following the bursting of its asset price bubble. However, over time these ultra-low interest rates have promoted a highly speculative financial “carry” trade: speculators borrow yen at low interest rates and then buy dollars and other currencies that are invested in higher-yield assets elsewhere.
There are two key features of this carry trade. First, it contributes to yen depreciation and dollar appreciation as carry traders switch out of yen. Second, it increases global asset demand, generating asset price inflation.
The yen’s depreciation versus the dollar has contributed to continuing large US trade deficits with Japan. It has also pressured other East Asian countries to under-value their exchange rates in order to remain competitive with Japan. Given China’s under-valued currency, East Asia’s two largest economies have thus anchored down exchange rates throughout the region, thereby increasing the region’s trade surplus at the expense of jobs and growth in the rest of the global economy.
Funds switched out of Japan have shifted to other financial markets, with the chase for yield driving up asset prices and lowering interest rates. In the US, this has complicated the Federal Reserve’s task. The Fed has been trying to slow demand growth and cool the housing price bubble to avoid inflation, but carry trade speculators have been easing credit.
Most importantly, the carry trade generates global financial fragility by creating fundamental – and dangerous –mismatches. First, carry traders borrow in yen but invest in dollars and other currencies. Second, carry traders borrow short-term money in Japan but may invest in longer-term assets outside Japan. Unexpected yen appreciation could cause large carry trade exchange rate losses, as could unexpected closing of the interest rate gap with Japan. Such losses, or just the thought of them, have the potential to trigger global contagion as carry traders close positions in US markets to repay loans in Japan.
In addition to the global dangers of the carry trade, the policy of ultra-low interest rates may also be bad for Japan. This is because ultra-low interest rates may hurt Japan’s households and lower consumption, and this effect may be larger than the benefit that a weak yen confers on Japan’s exports.
Higher interest rates can spur consumption if their impact on income outweighs the increased incentive to save. This may well be the case for Japan, which has a rapidly aging population. Current ultra-low interest rates may be scaring people about the adequacy of future income. Raising rates could alleviate those fears, increasing consumer confidence and spending.
Additionally, raising interest rates would be a form of expansionary fiscal policy. This is because Japan has a large public debt, and increasing interest payments on that debt would put extra money in the hands of households.
The policy of ultra-low interest rates was justified in the aftermath of the bursting of Japan’s asset price bubble, but Japan stabilized its economy long ago. At this stage, the policy has become a contributor to global financial fragility, and it may be retarding Japan’s own prosperity by contributing to consumer anxieties. That means Japan should decisively abandon ultra-low interest rates, albeit gradually so as to allow an orderly unwinding of speculative positions.