Shinzo Abe, Japan's newly elected prime minister who's probably best known for ignoring corruption in his first term and his ongoing insensitivity (euphemism intended) to Japanese war atrocities, is about to make history. He's on a tear about the need to inflate Japan out of its fifth recession in 15 years—to my mind, not a bad thing. And he's muscled the Bank of Japan into setting a 2 percent inflation target, an unprecedented move for the ultraconservative central bank. But lurking just under the surface is a more problematic goal that could have major implications for emerging markets in general and China in particular.
Abe is apparently eager to drive down the exchange value of the yen, a policy that would both stimulate lagging demand for Japanese products and please industrial supporters of his Liberal Democratic Party. Indeed, the yen has already depreciated by 10 percent against the dollar, leaving it as weak as it's been since June 2010. And with Europe looking in this same direction for a boost in demand, it could mean big trouble for export-led emerging market economies. Listen carefully, and you may just hear the words "currency wars" being whispered in the wind.
Japan has had mixed success at best in sustaining economic growth since reality caught up with Japan Inc in the late 1980s. The 1990s were dubbed the "lost decade," with the government seemingly unable to muscle its way past interest groups unwilling to realize losses in the wake of the real estate and stock market fizzles and start afresh. And while the economy did reasonably well thereafter—in the first decade of the 21st century, per capita income grew as rapidly in Japan as in the United States—Japan never got its mojo back after the dislocations created by the Tohoku earthquake/tsunami.
Abe's prescription for a return to growth, a fiercely expansionary monetary policy that works by generating expectations of future inflation and thus makes it possible to push real interest rates into negative territory, is just what serious Keynesians (notably Paul Krugman) would like to see happen. There's a catch, though: The policy is also likely to work indirectly by reducing the exchange value of the yen as wealth holders switch to other currencies in anticipation of a rise in the Japan's cost of living.
By no coincidence, currency depreciation is also on the minds of influential Europeans trapped in a no-growth environment. By their reckoning, the euro is overvalued, at least in the sense that most members of the eurozone badly need a boost in competitiveness in global export markets.
The problem is that everybody can't play the depreciation game at the same time: One country's advantage is the others' disadvantage. And when the game becomes popular—as it did with a vengeance during the Great Depression—it is self-defeating, leading to reduced trade as countries defend their domestic producers with one sort of protectionism or another. Today, the most vulnerable countries are emerging market economies, from Vietnam to Chile to Egypt, that depend on export-led growth. China, of course, is has been most aggressive on this score, leaning on export industries to absorb surplus labor and buying foreign currency at a ferocious rate to prevent the renminbi from appreciating.
The anger created by currency manipulation has been brewing for years, generating a lot complaints but little retaliation on the part of the advanced industrialized world. What's different now is that Europe seems trapped in recession and Japan is rediscovering its inner xenophobe, while the U.S. economy languishes in slow growth. And for the first time in a long time, some sober mainstream policy nerds are openly discussing ways to counter what were called "beggar-thy-neighbor" currency policies during the Depression. See, for example, this new piece by Joseph Gagnon of the Peterson Institute, which offers a whole menu of policy alternatives.
Abe's aggressiveness may yet come to naught—Japan's hard-money financial bureaucracy has a way of pushing back. But, with hindsight, Japan's change in monetary stance may stand as the moment currency aggression gained global policy traction. Ideally, Europe and the United States will reassert their global leadership, using fiscal stimulus to restore their roles as the locomotives of growth and shoving currency antics to the back burner. But don't count on it.