How Japan Fuels Global Financial Instability

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.

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.

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