“I don’t give a fuck about the Lira,” was one of Richard Nixon’s more memorable foreign policy pronouncements. The United States spent $2 billion buying yen last week, in an effort to shore up Japan’s falling currency. What’s the point? Two billion dollars could buy NASA another Space Shuttle. Why should America be spending it on yen?
First, unlike money spent on a space shuttle, money “spent” buying another country’s currency isn’t really gone. The foreign currency is also money. If the intervention succeeds, the foreign currency will stop dropping or even rise, and the “intervention,” as these things are called, could actually make money.
A currency intervention works on the basic principle of supply and demand. The exchange rate is just the price of one currency in terms of another. As of yesterday seven cents bought you 10 yen. By increasing the demand for yen by $4 billion (including $2 billion kicked in by Japan), you hope to force up the price of yen.
“Hope”? How could an increase in demand fail to increase the price? Answer: if supply increases even more. The yen is dropping because speculators are betting against it: that is, they are selling yen and buying dollars. This bet can become a self-fulfilling prophecy as yen-selling itself causes the price to drop. An intervention is essentially a game of chicken between the speculators and the intervening authorities. The speculators are turning yen into dollars, the authorities are turning dollars into yen, and whichever side blinks (or runs out of money) first loses. So far, the authorities are winning. Since last Wednesday’s intervention, the dollar value of the yen increased by 5 percent and then decreased slightly.
But currency speculators and currency interventions can only affect exchange rates in the short term. In the long run, exchange rates have nothing to do with games of chicken. What matters are structural factors, like differing rates of investment return in each country. If a country’s economic prospects change, as Japan’s have gotten worse, its exchange rate will eventually reflect that change. And if Japan’s recently promised economic reforms work, the exchange rate will improve accordingly. The $4 billion intervention is intended as a vote of confidence in the reforms, and to give the reforms a better chance to work by stabilizing the yen sooner rather than later.
But why should anyone who doesn’t happen to own yen–like, for example, virtually all American taxpayers–care? After all, the falling yen has made everything Japan sells 20 percent cheaper for people who do their spending in dollars. One problem is that other countries, like South Korea and China, feel pressure to match this 20-percent discount sale or lose exports. So they devalue. (Currencies with exchange rates set by the government get “devalued”; currencies set by the market “depreciate.” In fact, governments that ostensibly fix their currencies cannot ultimately resist market pressures, like China; while governments that ostensibly leave this to the market cannot ultimately resist the temptation to fiddle, like Japan.)
A variety of nightmare scenarios is available from here. A currency devaluation race among Asian nations could cause investors to flee the region. (A 15 percent profit is a lot less appealing if it’s paid in a currency worth 20 percent less than when you bought it.) This could trigger bank collapses, stock market crashes, etc. Or if the yen keeps falling and other Asian currencies don’t follow, these other countries will sink deeper into depression (economic, not-or, Explainer guesses, in addition to-psychologically). Either case, or variations thereon, might spell trouble for America. How? Least likely but most frightening is the possibility that economic malaise might give rise to dangerous and hostile political leaders, as in the Weimar republic. Bank failures in Japan might trigger bank failures in Latin America and even in the U.S. and Europe. Asian firms, benefiting from high unemployment and favorable exchange rates, could offer low prices that would put American firms out of business. Western economies might erect dangerous protective tariffs.
So, in the view of the U.S. government, a $2 billion currency play–not, remember, money down the drain–is worth it to protect America’s own economy from these risks.
Explainer thanks Professor Ricardo Caballero of MIT.
