The role of Japan's near-zero interest rate policy


Chih Kwan Chen

(July 17, 2014)


Reagan’s junk-bond-bubble took four long years to unwind. During the first phase of the runaway U. S. trade deficit in Reagan era, the trade deficits with Japan dominated the scene. In early 1985, major industrial nations reached an agreement to bring down the exchange rate of U. S. Dollar vs. Japanese Yen to reduce the U. S. trade deficit with Japan. Thus Dollar tumbled down quickly from $1.00 = 220 Yen level to around $1.00 = 125 Yen. With the usual 2 to 3 year delay for a major trend change in the exchange rate to be reflected on the actual trade balance1, the runaway U. S. trade deficit reached the peak by late 1987. Seeing no more increase in the financing of the junk-bond-bubble through U. S. trade deficit, institutional investors switched on the newly fashionable trading software of “dynamic hedging”. The result was the rush to the exit door at once by big boys in the market, triggering the infamous 1987 stock market crash.

At the same conference of major industrial nations at early 1985 when the devaluation of Dollar vs. Japanese Yen was agreed upon, Japan had promised to stimulate its domestic economy to divert more of its products away from exports and into domestic consumption. At the same time Japan will increase its imports. By the time of 1987 stock market crash, Japanese economy boomed into a bubble. With the help of sharply devalued Dollar and increased demand from Japan, U. S. manufacturers rebounded and carried the U. S. economic growth throw 1988 and 1989.

Junk bonds issued in Reagan era matured typically in 5 years. At the time of 1987 stock market crash, most of the junk bonds were still 4 years away from the maturity. This meant that those companies funded by the junk bonds could have operated another 4 years in spite of the stock market crash. On the trade deficit front, from the end of 1987 U. S. trade deficit kept falling to a very low level by 1991. When a large number of junk bonds must be refinanced in 1991, the financing was not available due to vastly shrunk U. S. trade deficit. Massive default and bankruptcy of those junk financed entities followed, triggering the 1991 recession. Across the Pacific Ocean, by 1990 Japanese Government had started to rein in the overstimulated bubble.

The 1991 recession forced many businesses to undergo massive restructuring. In order to cut costs many experienced workers were laid off, replaced by inexperienced young workers. A fashionable phrase of that time was, “the career of a computer scientist ends at age 40.” This kind of folly, of course, cut into the strength of the U. S. industrial might. It was the first sign how the evil scheme to hook the U. S. on to the runaway trade deficits is destroying an industrial giant. In this section, we will see how the suicide of an industrial giant evolves further. In the next section we will witness the final phase of this suicide under the beautiful name of “globalization”.

A short taste of the power of a free currency market

The painful restructuring during the 1991 recession had left many U. S. businesses lean and could move quickly once the recovery started in 1992, though such advantage was achieved by cutting off own muscles, bones and brains essential to the long term healthy growth. As the U. S. had emerged from the recession, consumer demands rose, and the trade deficit with Japan had started to expand again. From 1992 to 1995 there were no noticeable manipulation of Yen-Dollar exchange rate in the currency market by governments, so the vigilante mechanism of the free currency market to prevent the run away trade imbalance worked. Let us follow the data shown in Fig. 8-1 at the right to trace how this vigilante mechanism was in action.

In Fig. 8-1 the purple line is for the Yen/Dollar exchange rate plotted in monthly intervals. The black dots are 12 month moving sum of total U. S. merchandise trade deficit in quarterly intervals. The red dots are 12 month moving sum of U. S. merchandise trade deficit with Japan, also in quarterly intervals. It is worth to point out that 12 month moving sum should be read as 6 month delayed statistics. For example, the red U. S. merchandise trade deficit with Japan had started to form a broad bottom from the fourth quarter of 1990, but the actual situation is that the bottom had started to form from the end of the second quarter of 1990 since the moving sum of the fourth quarter of 1990 is the sum of the first quarter to the fourth quarter of 1990 with the center at the boundary between the second and the third quarters.

The massive devaluation of U. S. Dollar against Japanese Yen started in early 1985 and continued until 1987. Since a significant trend change in exchange rates takes two to three years to be reflected on the actual trade balance1, the U. S. trade deficit with Japan peaked in 1987 and declined until early 1990. Matching with the declining trade deficit with Japan, the free currency market pushed up the value of Dollar vs. Yen, creating the peak in the purple Yen/$ curve in Fig. 8-1 at early 1990. As the effect of the massive Dollar decline of 1985 to 1987 dissipated by early 1990, U. S. trade deficit with Japan turned to sideways, and then started to rise as the U. S. economy started to recover from the recession. Seeing this sea change, the free currency market started to push U. S. Dollar lower vs. Japanese Yen in order to curb the rising U. S. trade deficit with Japan. This effort to push down U. S. Dollar to curb U. S. trade deficit is shown in the steep drop of the purple curve in Fig. 8-1 from 1990. However, at that time period, Japan's mighty bubble of late 1980s had burst already, directing Japanese industries to turn their attention to export again. Japan was still in the stage of vibrant innovation and productivity gain so the expanding U. S. trade deficit with Japan was not easy to slow down. It took fully three years for the massive devaluation of Dollar vs. Yen to make the trade deficit to flatten out in 1993, and another two years, in early 1995 for the deficit to decline; by that time Dollar had been devalued to 80 Yen/Dollar already. As the trade deficit with Japan rounding down, U. S. economic expansion had also slowed down, causing panic to both Clinton Administration and Japanese Government. Thus the stage was set to the following era of disastrous monetary policy.

Currency Manipulation of the Second Kind: Japan's near zero interest rate policy

Japan is poor of natural resources. She must export manufactured goods to get the hard currency to cover the cost of importing raw materials. During 1950s and 1960s, any time when her economy boomed, the robust domestic consumption caused increased imports and the trade deficit so the economy needed to be slowed down and a recession followed. Gradually people of Japan developed the merchatilism-like tendency to treasure trade surplus, larger the better. After the burst of Japan's gigantic bubble at the turn of 1980s to 1990s, Japanese industries turned their attention to exports again and were rejoiced as the trade surplus started to rise. Then as described in the previous subsection, the vigilante mechanism of the free currency market set in, pushing Japanese Yen steadily higher, eventually to 80 Yen/Dollar from the level of 125 Yen/Dollar, in order to rein in the Japan's expanding trade surplus against the U. S.. Japanese Government must have disappointed to see the free currency market had dashed her hope to use trade surplus to reinvigorate Japanese economy so decided to use near-zero interest rate policy to achieve her goal. The scheme works as follows: Near-zero interest rate will induce international speculators to engage in yen-carry trades. A yen-carry trade is for a speculator to borrow Yen at near-zero interest rate, sell the borrowed Yen for Dollar, and invest the dollar proceeds in high yielding Dollar denominated instruments. It is at the process of selling borrowed Yen for Dollar that pushes Yen down vs. Dollar. This scheme was apparently approved by the Clinton Administration, since when Japan's near-zero interest rate policy was put into action at the middle of 1995 and Dollar flew higher vs. Yen as the purple curve in Fig. 8-1 shows, Clinton Administration immediately came out with the slogan of "Strong Dollar Policy" to praise the rapidly climbing Dollar. To use near-zero interest rate to devaluate a currency, like Japan did in 1995, is a kind of blatant currency market manipulation that we call "The Currency Market Manipulation of the Second Kind".

Around 1995 Japanese manufacturing capacity was not fully utilized due to the lingering effect of the burst of the late 1980s' bubble and the strong Yen that curbed the exports. When the near-zero interest rate policy was introduced and Yen started to drop sharply vs. Dollar, those idled manufacturing capacity was quickly thrown back into churning out exportable goods. Thus Japan's declining trade surplus against the U. S. was arrested in 1996 and started to turn up again. Along with the climbing U. S. trade deficit with Japan, so was the overall U. S. merchandise trade deficit since many developing countries were surrogate exporters of Japan in the low cost-low technology products. The sharply elevated trade deficit then stimulated the Clinton Dot-com bubble2.

Asian Financial Crises, the trigger of bursting Clinton Dot-com Bubble

Japan's near-zero interest rate policy has generated severe consequences both in the domestic front and in the international front instead of pushing Japan's economic prosperity through the devaluation of Yen and increased trade surplus. On the domestic front, the policy has trapped Japan into the prolonged economic stagnation3. At the time of 1995 when the near-zero interest rate policy was introduced, Japanese worker's average retirement age was about 55 and Japan's social security system was far from adequate to support such a young-age retirement. Average citizens of Japan need to save a substantial portion of income as retirement nest eggs. Since the retirement saving depends heavily on the interest compounding, near-zero interest rate policy cut down the retirement saving substantially. The response of Japanese workers to the unexpected adverse effect on the build-up of retirement nest eggs was to cut back their consumption and to save more. The chain reaction of more saving, less consumption, shrinking business sales, pressure on wages and salaries, more saving and so on, has pushed Japan into a self generated trap of the great stagnation.

The favorite vehicle for retirement saving in Japan was 3 to 5 years saving certificates issued by government sponsored post offices and private banks. At the beginning of the near-zero interest rate policy the pain to the private saving was not immediately felt. The near-zero interest rate policy naturally meant more money creation to stimulate the economy. Thus for a short while the stimulant plus the increased exports seemed to have lifted Japanese economy, but soon the bad impact of the near-zero interest rate policy on the international front boomeranged to hit Japan at the time of above mentioned domestic chain reaction took place to force Japan into the stagnation for more than 15 years. The international chain reaction started from The Asian Financial Crises as will be discussed below.

As Japan becomes the power house of manufacturing consumer goods, the average wage in Japan rose rapidly to make the manufacturing of labor intensive products not economical within Japan. Starting from 1960s, more and more Japanese manufacturers have tried to outsource labor intensive productions to low labor cost developing countries around Asia. Before the globalization of 1980s, the existing tariff barriers limited the scope of such outsourcing. The first target of Japanese outsourcing was Taiwan. As a former colony of Japan, but not like Korea, many in Taiwan are friendly to Japanese. Under the strong authoritarian control there were neither labor disputes nor environmental movements in Taiwan at that time. Those conditions attracted many Japanese manufacturers to Taiwan. Idled labor resource in Taiwan was utilized and Taiwan steadily climbed the economic ladder. We call such a development model "Taiwan Model4". Once the era of globalization dawned in 1980s, the Taiwan Model really shined; the consumer market in the U. S. was flooded by "made in Taiwan" inexpensive consumer goods.

By the latter half of 1980s, the average wage in Taiwan had also increased quite a lot, and the general public of Taiwan has started to pay more attention to the environmental pollution by industries. However, under the strong authoritarian regime of Chang Ching-kuo, the son of General Chang Kai-shek, that regarded Communist China as the arch enemy, not many Taiwan merchants dared to relocate into China, so some of them had outsourced their factories to other Southeast Asian countries. Also Japanese manufacturers have started to outsource their factories to various Southeast Asian countries instead of Taiwan. Naturally "Taiwan Model" is widely copied in those places, too. In Eastern Asia, South Korea has not strictly copied "Taiwan Model". As a former colony of Japan Korean dislikes Japanese and direct investments from Japan are not welcomed. Instead South Korea borrowed heavily from Japanese banks to buy the technology and manufactured the inexpensive consumer goods by herself. Thus all the East and Southeast Asian countries followed "Taiwan Model" one way or the other, and they have advanced economically based on Japanese outsourcing of labor intensive manufacturing. They exported their products mainly to the U. S. and improved their balance of payments until 1995.

No matter the strict "Taiwan Model" or its variation like adopted by South Korea, one tactic used by all is to peg their currencies to U. S. Dollar. To peg a local currency to Dollar, the local goverment needs to intervene the currency market constantly to keep the exchange rate of the local currency to Dollar stable. Such operations are a kind of blatant currency market manipulation. Since the designers of the globalization scheme and the eager promoters of the scheme, that is, successive U. S. Administrations, never tried to outlaw currency market manipulations, the tactic of "pegging to Dollar" was also overlooked. The motivation of the U. S. not to outlaw currency market manipulation is discussed in length in Sections 1 to 6 of this review article2. The tactic of "pegging to Dollar" and more aggressive blatant manipulation of currencies have been used widely until today.

As a country evolve along Taiwan Model and climbs up the economic ladder, it will start to run trade surpluses. Its exporters will receive dollars for their exports and need to sell the dollars for the domestic currency to pay for their next batch of productions. Its importers need to buy dollars by selling the domestic currency to purchase foreign goods. Running trade surplus means that there are more dollars for sale than the demand for dollars. Under a free currency market without any manipulation, the value of the local currency will go up against Dollar, the cost of production will rise, and the trade surplus will shrink. This is called the vigilante mechanism of the free currency market to prevent the runaway trade imbalance and thus keep the global economy away from the crash. However, the countries embracing "Taiwan Model" naturally do not want to see their string of trade surplus be cut short by the vigilante mechanism of the free currency market. The government will enter the currency market to buy up the surplus dollars with the domestic currency to nullify the vigilante mechanism of the free currency market and keep the domestic currency pegged to Dollar. The domestic currency used to purchase unwanted dollars, of course, is created by the central bank. As the trade surplus increases, more domestic currency is created and the domestic economy will be stimulated to generate bubbles. The real estate bubble is usually the easiest one to pop up. As bubbles lift their uglyheads, the greed of getting richer prompts people to borrow more money to gain more from the bubbles. On the other hand international capitals that anticipate that the "Dollar Pegged" host currency will eventually be forced to appreciate vs. Dollar, and are eager to lend to the ones wanting to borrow in order to establish a foot hole to share the fruit of the bubbles. By 1995 many small Asian economies were in such a bubbling state. However, such unstable bubbling state is very easy to be toppled by an external shock; in this case the external shock was Japan's near-zero interest policy that induced the "Asian Financial Crises".

As has been pointed out in the preceding subsection, Japan's near-zero interest rate policy had unleashed a flood of "Yen carry trades" and boosted the value of U. S. Dollar sharply higher vs. Japanese Yen. Since the currencies of small Asian countries following "Taiwan Model" are pegged to U. S. Dollar, the currencies of those Asian countries also appreciated sharply against Japanese Yen, causing Japanese manufacturers to lose incentive to further outsource their labor intensive operations to those small Asian economies. The trade surpluses of those countries diminished and then turned into trade deficits. The demand of dollars from the importers overwhelmed the supply of dollars from the exporters. The free currency market started to push down the value of the currencies of those small Asian economies. Those Asian governments had no choice but to step into the currency market to buy up their unwanted domestic currencies, using the Dollar reserve accumulated during trade surplus days, otherwise the international capitals would have escaped in drove and the whole economy of those countries collapsed. However, Japan's near-zero interest rate policy with the full endorsement of Clinton Administration persisted, and those small Asian economies soon exhausted their Dollar reserve and collapsed anyway. The first one went down the drain in July, 1997 was Thailand. The collapse of Thailand naturally induced the international capitals to try to exit from other economies in the similar state, and triggered the chain reaction of collapses. The one hit Japanese banks the hardest, of course, was the collapse of South Korea that had generated a large scale banking crises in Japan. Japanese banks cut back loans to small businesses to reduce leverage to save themselves. Many small businesses in Japan failed, further reducing the consumer spending. Under such a condition Japanese monetary authority has been painted into a corner created by itself, not dare to raise interest rate and forced to do quantitative easing after quantitative easing to prolong the near-zero interest rate policy. Thus Japan has entered into the endless stagnation3 that we call as "Japan Syndrome".

After the Asian Financial Crises, IMF stepped in and tried to stabilize the currencies of fallen Asian angels with $30 billion injection, but under the condition that those Asian countries rein in government spending and install higher interest rate to help to bring back international capital and to stabilize their own currency. The high interest rate policy put many entities out of business, but had indeed stabilized the currencies. Those fallen angels gradually regained the growth potential. The contagion of such a calamity certainly will not be limited to Asia alone. Russian at that time was the competitor of those Asian economic entities for the manufacturing of inexpensive consumer goods. With sharply devalued Asian currencies, Russia certainly could not have maintained its currency peg to Dollar. In the first half of 1998, Russian currency collapsed, resulting in the Russia default. A large hedge fund sized around $100 billion was caught holding a lot of Russian debt and was near insolvency. From the fear that the failure of that large hedge fund, "Long Term Capital", will shake the whole financial structure, then FED Chairman Greenspan called in Wall Street big shots and pressed them to jointly bail out Long Term Capital. At that juncture, Clinton Administration realized the poisonous nature of its "Strong Dollar Policy". In the summer of 1998 U. S. and Japanese Governments jointly intervened in the currency market to bring down the high flying U. S. Dollar. As the result Dollar fell quickly from the level of 170 Yen/Dollar to the level of 125 Yen/Dollar. By the middle of 1999 the contagion spread further to Latin America, and Dollar fell further to 110 Yen/Dollar level. With the normal delay of 2 to 3 years from the major exchange rate change to the change in trade balance1, around the end of 2000 U. S. trade deficit reached its peak and the dot-com bubble of Clinton started to burst2.

China Raising; is it made in America?

Fig. 8-1 shows that the U. S. trade deficit with China has been growing very rapidly since 1989. The U. S. trade deficit with China was about $6.2 billion versus the U. S. trade deficit with Japan about $50 billion at 1989. By 1995 trade deficit with China had grown to $34 billion vs. $59 billion with Japan. Such rapid growth of Chinese exports to the U. S. market certainly had pressured the exports of other small Asian economies and had intensified the Asian financial crises. Let us see how China has risen so rapidly to become an export dynamo of consumer goods.

Under the leadership of Deng Xiaoping China has started to emerge since 1978 from the disaster of The Great Cultural Revolution of Chairman Mao. The People's Communes in rural area were disbanded to restore vigor in agriculture. Many inefficient national companies were closed. Foreign direct investments were courted to set up factories to produce inexpensive consumer goods for exports, utilizing China's vast under employed cheap labor resource. In other words China has also followed "Taiwan Model" to climb the economic ladder. China seemed to have all the essential conditions required for "Taiwan Model" to work. For example, under the strong control of communist government there were no labor unrest, plenty of under employed workers, no opposition to industrial developments due to the pollution, no one has the right to own land except the government so direct foreign investments can easily get lands needed to build factories, and Chinese Yuan was pegged to the U. S. Dollar. However, U. S. trade deficit with China simply was not visible until 1986. We start from the investigation why China's export oriented economy failed to gather steam during the first half of 1980s.

In Fig. 8-2 posted at the right hand side, the blue curve is the exchange rate of Chinese Yuan to U. S. Dollar, expressed in Yuan/Dollar. Higher the blue dots, weaker the Yuan to Dollar. The blue graph is plotted with monthly intervals. The data of blue dots are the midnoon exchange rate traded at NY currency exchange tabulated by The Federal Reserve Board. Since the actual Chinese currency are not allowed to be traded outside the country until very recently, the quoted prices are the prices of a kind of future instrument, but the prices here reflect closely the actual exchange rate between Chinese Yuan and U. S. Dollar; it is more than enough to serve our purpose in this discussion. The red curve is the 12 month moving average of U. S. trade deficit with China. The red U. S. trade deficit with China dots are plotted using the scale of log-10( billion dollars). It is worth to note again that in a logarithmic curve, the slope of the curve indicates the % change of the data.

The exchange rate of Chinese Yuan to U. S. Dollar was set at 1 to 1 in the era of The Great Cultural Revolution. After 1978 economic reform, the exchange rate was lifted gradually. As Fig. 8-2 shows in 1983 the exchange rate was around 2 Yuan/Dollar. This exchange rate made Chinese labor cost too expensive to lure foreign direct investments. That was why there was nothing to show about the U. S. trade deficit with China during the first half of 1980s. Chinese Government noticed this problem and steadily raised the exchange rate, that is, depreciated Chinese Yuan starting from 1984 to about 3.7 Yuan/$ by 1986. Thus the U. S. trade deficit had expanded rapidly from 1985 as the red curve in the graph shows. The Yuan exchange rate was pegged to Dollar at about 3.7 Yuan/$ from the middle of 1986 to near the end of 1989, then was brought higher and higher (Yuan weaker and weaker) until it hit 5.8 Yuan/$ by the end of 1993. At the beginning of 1994, another massive devaluation of Yuan brought the exchange rate to over 8 Yuan/$. Since then Yuan has been pegged to Dollar at the rate of about 8.3 Yuan/Dollar through the right most end of the graph, that is, year 2001. It was this relentless devaluation of Yuan that had pushed up U. S. trade deficit with China rapidly. As shown in the previous figure, Fig. 8-1, by 2001, the trade deficit with China has exceeded the trade deficit with Japan already.

At around 8.3 Yuan/$, Chinese currency is extremely undervalued versus U. S. Dollar. That was why when Japan's near zero interest rate policy had boosted the value of Dollar, the value of Chinese currency against Japanese Yen was still vastly undervalued. As the consequence foreign direct investments did not slump and the U. S. trade deficit with China just kept expanding through the Asian financial crises. In contrast small Asian economies did not devaluate their currencies as aggressively as China so became the victim of the financial crises as Japan's near-zero interest rate policy was launched in 1995.

When China buys unwanted U. S. Dollar to prevent the appreciation of Yuan or to devaluate Yuan, Chinese Government must use newly created Yuan to buy those dollars. As China's trade surpluses zoomed up, more and more Yuan were created and saturated China's domestic market. Those excessive Yuan then was borrowed by local governments and the parties connected to the powerful ones to start rampant infrastructure and real estate constructions to boost GDP enormously. That was the secret behind the rapid rise of China as prescribed by Taiwan Model.

Some may ask why U. S. Government did not stop China to manipulate the currency to boost its trade surplus so rapidly, otherwise China would not have risen at such an astonishing speed. However, when we understand that the whole purpose of the globalization is nothing more than to let the U. S. run huge trade deficits, the currency manipulation of China to make U. S. trade deficit explode was just what U. S. Government had wanted. In that sense we can say the rise of China is actually made in U. S. A.. As for the reason why U. S. Government wants the U. S. to have such a large trade deficit is discussed in previous sections2 aptly already so will not be repeated here.


The discussion in this section shows vividly that the foundation of the globalization scheme is to unleash "free for all currency market manipulation" in order to create huge U. S. trade deficits to benefit some special interest groups. In the next section we will come to the process of the self destruction of the strange globalization scheme because the U. S. had incurred too much trade deficits.



2. Review Forecast Section 1,   Review Forecast Section 2,   Review Forecast Section 3,   Review Forecast Section 4,   Review Forecast Section 5,   Review Forecast Section 6


4. Comment 39: Taipei has lost its magic "ring" (Feb. 14, 2007, Revised on Feb. 27, 2007, Corrections and Addendum on June 24, 2009)

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