by Krassimir Petrov, PhD & Vahan Nahapetyan
The American University in Bulgaria & KMPG, Armenia. September 19, 2007
Nowadays governments fight increasingly over control of financial markets. The key battlefield of this war is the market for foreign currencies, the FOREX. Lately the biggest economies in the world are in constant competition in the FOREX market. The U.S. Dollar, so far the uncontested leader in the FOREX market, is now seriously under attack by other currencies, especially the Euro and the Yen. Currently all major governments are trying to promote their currencies to the status of reserve currency; even Putin recently declared quite openly that he wants to accomplish this for the Russian Ruble, first by making it convertible, and later required for purchasing Russian oil and gas.
A reserve currency is a currency that is held by many foreign governments or institutions as part of their general reserves. It usually becomes the pricing currency of internationally traded goods, for example oil. Once a currency gains the status of a reserve currency, its issuing government derives tremendous financial benefits, including seigniorage and significant leverage over both domestic and foreign markets. Reserve currencies are ordinarily chosen by the central bank and the banking sector of a particular economy, rather than by the private sector. The fundamental reasons behind this choice involve the size, the stability, and the strength of the underlying economy, as well as the liquidity of the given currency on the FOREX market.
Currently, the Japanese Yen ranks third amongst reserve fiat currencies. It lags behind its main contender, the U.S. dollar, and the uprising Euro. The U.S. dollar has dominated reserve currencies for the last half a century and is currently way ahead of the Euro and the Yen, contributing roughly 2/3 of worldwide central banks' reserves. However, due to multi-decadal developments in the U. S. economy, most importantly the rise of the welfare-warfare state with its concomitant twin deficits, the dollar's value has been steadily eroding and its usage as a reserve currency diminishing, which opens up opportunities for the Euro and the Yen. Currently, there is a strong economic growth in East Asia, which gives the Japanese Yen a perfect window of opportunity to extend its status as a reserve currency, especially among the East Asian economies.
Understanding the motives of a country to extend the reserve status of its currency requires understanding of the advantages that the reserve status confers. First of all, it allows the issuing country to purchase foreign traded goods at slightly lower cost than other countries, because it saves the transaction costs of exchanging its currency for foreign currencies and the cost of hedging against currency volatility. A second advantage to the issuing country is the ability to borrow money at better rates than other nations; even today, the U.S real interest rate is much better (lower) than the Japanese interest rate, once we factor in the higher underreported U.S. inflation rate. A third advantage of the reserve status is that demand for the given currency is substantially increased, which adds further value to the currency. From this follows yet another important advantage: the opportunity to inflate the currency and export it in exchange for real goods, which allows the reserve economy to run "sustainable" huge trade and budget deficits, i.e., the proverbial "deficits without tears", seemingly at no cost and without deteriorating effects on the economy. The most important benefit, however, is the ability of the issuing government to export some of its inflation abroad, and as it inflates and devalues its currency, to impose an "inflation tax" on other economies.
In the world of fiat currencies, the ability of one country to impose an inflation tax on another represents a de facto imperial tax. For a simple introduction to "Economics of Empires", we refer the reader to the first section of the article "The Proposed Iranian Oil Bourse". In essence, by imposing the U.S. Dollar as a reserve currency on the rest of the world, the United States extracts an imperial tax from dollar holders, that is to say, from those countries that hold U.S. dollars as reserves, including U.S. government bonds. In this sense, from an economic point of view, over the last 3-4 decades, Japan has been the �best� American vassal that has cumulatively contributed probably the largest amount of tribute into the American coffers. If the Japanese themselves were able to raise the status of the Japanese Yen to a major reserve currency of the world and reduce or remove the dollar as their reserve currency, then they will be able to transform themselves from an American vassal into an empire, a Yen Empire with all the benefits and privileges that an empire confers. This is not to say that Japan will create the most powerful empire in the world, for this is China's destiny, but it is nevertheless far better to extract tribute from others instead of paying them.
Economic Decline of the American Empire
Of course, there is no such thing as a free lunch, for in this case the rest of the world actually pays for that seemingly free lunch; in essence, the free lunch that the empire enjoys is simply the imperial tax that the rest of the world pays in the form of inflation tax. Naturally, when the issuing country tries to have too many of those free lunches, that is, to abuse its subjects by overtaxing them, it ultimately risks collapsing the exchange value of its own currency, for subjects will sooner or later get sick and tired of paying those taxes. The slide begins when private foreigners move out of the currency; the collapse occurs when foreign governments and central banks start dumping the currency from their reserves, forcing the value of the currency significantly lower. The dumping may be triggered for reasons of political or financial nature.
Such an example of political nature is Iran's recent diversification out of dollars. Due to the Iranians' hostile attitude towards the United States, including the recent nuclear standoff, Iran decided and completely dumped its dollar holdings in late 2005. Another country that has for similar political reasons completely dumped its dollar holdings in early 2006 is the other prominent member of Bush's Axis of Evil; Syria. These diversifications are based on political considerations. On the other hand, some European countries have diversified out of dollars for purely economic reasons; one recent example is Norway. However, the economically and politically strong countries base their decisions neither on politics alone, nor on economics alone, but always both on economics and politics; Japan, China, and Russia would fall in this category.
The history of the rise of King Dollar might serve as a guide for the Japanese government. During the 20th Century, the United States transitioned from gold and silver, to gold and silver backed currency, to strictly fiat money. This means that the dollar is no longer backed by any hard assets; even worse, today the dollar is not backed even by other fiat currencies, for the U.S. Federal Reserve keeps only a symbolic amount of foreign reserves; in essence, the Federal Reserve has for all practical purposes no foreign reserves given that 95% of its assets are its own government bonds, which can be legitimately counted as domestic reserves, but not as foreign reserves. This transition to fiat currency meant that United States government could inflate at will; its reserve status meant that it could export its inflation to those countries that held its currency as a reserve. During 1960s, the United States was world's predominant economic superpower; international transactions were conducted mostly with dollars, which solidified the dollar's status of world reserve currency.
At the same time, since the late 1960s, and especially in the 2000s, the U.S. economy is in decline. Its stock market bubble has burst in 2000-2002. Its real estate bubble began bursting in 2006-2007. The mortgage fallout is spreading throughout the economy. The twin deficits are at epic proportions. Its military overstretched in Afghanistan, in Iraq, and all over the world. The "War on Terror" promises even more military expenditures in the future. The Baby Boomers face a 55 trillion dollar abyss. Its national savings rate is now officially negative. As a result, its economy has lost competitiveness on international markets and countries all over the world are steadily losing faith in the dollar and "diversifying" out of it.
The dollar began to face some competition from Japanese yen in late 1980s. At the time, the Japanese economy experienced phenomenal growth, powered by technological innovation and investment, which in turn was fuelled by extraordinary credit expansion, speculative frenzy in stocks and real estate, and massive foreign capital inflows. The 1990s led to a decrease in the usage of yen due to a painful stagnation of the Japanese economy as a result of bursting bubbles, crashing stock market and real estate; overwhelming deflationary forces choked the economy. During the decade of the 2000s, the Japanese economy is once again strengthening due to rectifying many of its structural problems, although the restructuring process is not yet complete.
Today Japan has the third largest economy in the world, currently lagging behind only the United States and China. Its economy is relatively efficient and competitive in areas related to international trade, but productivity is lower in areas such as agriculture, distribution, and services. Japan has been specializing in such goods as cars, electronic devices and computers. A quarter of its exports are being consumed by United States; other main major partners in trade include Taiwan, Hong Kong, South Korea, China and Singapore. Japan was able to achieve such extraordinary results due to its work ethics and superb educational system, as well as technological innovation and productive investments.
Thus, with the Japanese economy on the rise and the American economy and the U.S. dollar on decline, the Japanese Yen has a unique window of opportunity to regain its momentum as a world reserve currency. However, today its task is substantially complicated by the strong competition from the Euro. Governments around the world already hold 13-14% percent in their reserves in Euro and some 6-7% in Japanese Yen. The challenge is formidable and the Japanese government must resolve a number of challenges in order to build the Yen Empire.
The first challenge that the Japanese economy faces today is the completion of the restructuring of its economy that started with the bust of 1990. It constantly makes aggressive moves in order to restructure its economy, however the process is far from complete. It is a common myth amongst mainstream economists that the 17-year slump in Japan has been finally overcome. In reality, the Japanese government has been able to postpone the bust. A series of policy measures, mostly reflationary in nature, were undertaken to supposedly smooth out the economy, which proved to be temporary. The Japanese banking crisis has not been fully cured, as bad debt still lingers on banks' balance sheets. This problem has been postponed successfully for 17 years, but the bitter pill of writing off bad debt must at some point be swallowed in order to force the necessary restructuring in the rest of the economy. This will likely require a genuine deflationary policy as purging bad debt shrinks the money supply.
The second problem that the Japanese must resolve is intimately related to the previous problem: the Weak Yen policy. A reserve currency status can never be accomplished with a weak and constantly weakening currency. Weakness is accomplished via ultra-low interest rates, which in turn fuel the Yen Carry Trade. The weak currency "stimulates" exports, but it hurts Japanese importers, Japanese consumers, and holders of Japanese Yen. The solution is to let interest rates rise, permit the Yen to rise, and allow the Yen Carry Trade to unwind. This will in turn cause substantial pain in the short term, as some Japanese banks may fall, as exporters get hurt, and as the economy falls into recession, but this will force the complete restructuring of the economy. This, no doubt, will have profound effect on the international monetary system and on financial markets worldwide, but its ultimate outcome will be the establishment of the Yen as a world reserve currency.
The Japanese face today a historic opportunity to resurrect their currency to "imperial" status and build their Yen Empire. However, they also face major challenges that require substantial sacrifices and pain in the short-run for the benefit of healthy economy and prosperity in the long-run.
For 17 years politicians have not had the courage to rise to the challenge. However, the cost of prolonging the inevitable is rising. The Japanese face the possibility of another lost decade for the Japanese nation. Even worse, with mounting U.S. dollar reserves, the ultimate losses due to the inevitable dollar devaluation rise progressively. Finally, the Japanese face the grim possibility of even another recession in the not too distant future. Time will tell whether the politicians will do what's right or whether they will opt for what's expedient.
© 2007 Krassimir Petrov, Ph.D.