The Dollar/yen Puzzle
Jude Wanniski
May 3, 1994


In The New York Times today, Thomas L. Friedman reports on the "Puzzling Currency Move" of the dollar, which was "supposed to rise" when the Fed hiked interest rates, but instead fell against the yen and the DM. The theory is that investors will be attracted to higher interest rates, selling yen bonds and buying dollar bonds. There are, though, two reasons why investors will buy bonds, for yield and for capital gains. If the purchasing power of the yen rises even as the spread with dollar assets widens, investors will sell dollar bonds and buy yen bonds. They will forgo the interest and take the capital gain. Friedman, among the Times's best reporters, but new to the financial pages, raises a lot of interesting questions. Ultimately, however, he becomes frustrated with the answers he gets from people such as Henry Kaufman and anonymous U.S. officials, who offer various speculations about why the yen got stronger and the dollar weaker. You have to act "massively, with a good deal of conviction," says Kaufman. Hmmm.

The closest the Times reporter gets is in probing the political problems between the U.S. and Japan arising from the U.S. trade deficit. The new government in Tokyo of Tsutomu Hata "is so fragile that many expect to count its life in weeks, not years or even months." It is so weak, it will be unable to respond to U.S. demands that it alter fiscal policy to reduce its trade surplus, "and the United States will continue trying to force Japan to open markets by keeping the dollar weak and the yen strong." Then why did Treasury ask the Fed to intervene last Friday to support the dollar against the yen? And why did the intervention have so little effect? Hmmm.

If the Times had asked us: First we would note that in the last six months, the dollar price of gold increased by roughly 10%, to $385 from $350, at the same time the yen price of gold was decreasing by 10%, to Y40,000 from Y44,000. We can say the dollar has been experiencing an incipient inflation, as the rising gold price indicates a surplus of bank reserves at stable prices. If gold stays high, eventually all other prices will follow it to a new equilibrium, and dollar bonds will have lost 10% of their purchasing power. On the other hand, the yen has been experiencing an incipient deflation, as the economy is being starved of liquidity, revealed by the declining gold price. The answer to this puzzle is to have the Federal Reserve drain liquidity from the banking system until gold is once again at $350 while the Bank of Japan adds liquidity until gold is again at Y44,000. Because gold has come off in dollars somewhat, to $375, it would not take much to do the job. By raising the fed funds rate in three small steps, to 3.75% from 3%, the Fed has not been tightening per se, in that it has not been draining reserves from the banking system. It merely has been adding reserves at a slightly slower rate. In Japan, the mechanism should not be to lower short-term interest rates, but to add liquidity to the banking system through the outright purchase of government bonds! In both the U.S. and Japan, the yield curves would immediately tend to return to where they were six months ago. 

We have to understand this if we want to know what's going on in this international currency puzzle. The plain fact that the Fed, the Bank of Japan, and the Bundesbank are refusing to target gold at the moment is not important to our understanding of how and why the markets are moving about. Once we accept the idea that the world financial markets have never left a gold standard, measuring the performance of government debt management against that standard, we can solve currency puzzles a bit more easily than those who do not. Fed Chairman Alan Greenspan would like to be targeting gold explicitly, I think. However, as he does not know how to get there from here, he is stuck with the current interest-rate standard. This is where the Fed was from 1971, when it left gold, to October 1979, when the Volcker Fed shifted to a monetary aggregate standard. The interest-rate standard is superior to the M standard as a guide to the market's demand for liquidity, which is why we are back to it. It's not as good as gold, though. With gold, you aim at the target directly. Targeting interest rates to move gold is a trick shot, bouncing your fire off one target to hit another. It is crude and inefficient.

If Greenspan were to drain bank reserves to get gold to $350, what would happen to the fed funds rate? Would it rise or fall? From our perspective, in the process of draining reserves the market's demand for liquidity would increase, the dollar would strengthen, and so would the value of all dollar assets. As the gold price fell below $350, the Fed would have to add reserves to stop gold's fall. We would expect to see a bidding up of the price of notes, bills and bonds. As Greenspan is not in a position to do this, he must keep his fingers crossed and hope that his trick shots do the trick. This requires an increased dollar liquidity sufficient to put downward pressure on the gold price. As we have pointed out recently, the best prospect would be an alleviation of trade tensions with Japan. If the cloud over Tokyo were to recede, demand for dollar liquidity would tend to rise. The single best solution to the problem would be a modest reflation by the Bank of Japan, which unfortunately nobody is talking about in Washington. 

Treasury's request to the Fed to support the dollar against the yen was a nod in that direction, but nodding is even less effective than a trick shot. Because the Fed is targeting the fed funds rate at 3.75%, the dollars it takes off the international market are replaced almost immediately by dollars it adds to the open market in New York -- the process called sterilization. Secretary Lloyd Bentsen is also encouraging the Japanese to cut income tax rates, to spur consumer demand as a way of cutting their trade surplus. Alas, in this situation, a tax cut is also like a trick shot, in that it would increase the demand for yen in an economy that is already starved for liquidity. The yen would rise faster in value against both gold and the dollar. This is the kind of process we observed in 1981-82 here at home, when the Reagan tax cuts ran smack into Paul Volcker's M standard, which was deflating the economy. Gold fell from $625 in November 1980 to below $300 in early 1982, amidst widespread bankruptcies and the worst recession since the 1930s. When Volcker finally took his foot off the brake, the economy leaped into action -- preceded of course by an enormous rally in stocks and bonds that completely confounded the monetarists, who had predicted the opposite.

What would happen to interest rates in Japan if the Bank of Tokyo bought government yen bonds until gold were back at Y44,000 per ounce? Short-term rates are already very low, at 2.3%, and we would not expect that to change much at all. The added liquidity would, after running up gold, spill over into the financing of all kinds of promising economic enterprises that are now denied credit because of the crunch. The Nikkei would run up, the yen would fall against the dollar, and contrary to predictions by the Keynesians, Japan's trade surplus with the United States and the rest of the world would diminish. Hooray! Puzzle solved!

Will any of this happen anytime soon? It will happen sooner or later, I think. The people who count are at least leaning and nodding in this direction, and it certainly helps that a few of us have figured it out. When it happens, it won't produce the kind of exuberant bull market we experienced in 1982-83, but remember, we don't have Ronald Reagan in the White House. All we can really accomplish in the near term, before the voters select a new Congress next year, is to get back on the monetary track we were on before Chairman Greenspan slipped. That still would be a lot to accomplish, and we certainly wouldn't sneeze at a Wall Street rally that got us back to where we were last October.

THE MANDELA CURVE? Notice in yesterday's Wall Street Journal that Nelson Mandela is now talking about financing the $11 billion in public works projects he promised in the elections largely with existing funds, in particular by slashing the defense budget. For the first time he is quoted as saying "a low tax rate will attract investment much more than raising taxes." This concept is nowhere to be found in the agenda of the African National Congress, which has promised to tax the rich white folks to share the wealth with the blacks. We are encouraging our friends in the Congressional Black Caucus to steer Mandela toward the promising side of the Laffer Curve. If Mandela gets it right from the start, we would soon see supply-siders galloping throughout Africa.