International Speculative Bubbles

One of the constant themes in my books is the underlying deflationary nature of capitalism, which has to be put off by various means, such as expansionary monetary or fiscal policy, which often have unforeseen consequences.

Japan has been suffering a slowdown for some time. Very easy monetary policy has been used to keep demand higher. Low Japanese interest rates have caused people to borrow money in Japan, then trade Japanese currency for other currencies, and then finally invested where returns are higher.

This procedure, known as the carry trade, seems to have helped to finance a lot of the recent corporate buyouts, which produce a bubble elsewhere. At the same time, the carry trade tends to reduce the value of the yen, promoting Japanese exports.

How long such imbalances can continue is an open question. What follows is a New York Times article explaining the situation:

if Fackler, Martin. 2007. “Bank of Japan Raises Short-Term Interest Rates.” New York Times (22 February).


“The flow, known as the yen carry trade, is the product of the yawning gap between Japan’s rock-bottom interest rates — at 0.5 percent with Wednesday’s rise in the benchmark overnight funds rate — and the much higher rates in other countries. The gap has driven Japanese to pour money overseas in search of higher returns. Some of the money also comes from foreign investors, who borrow cheaply in Japan to invest in real estate and other markets abroad. Even home buyers around the world are borrowing yen.”

“As this flow of money — potentially uncertain and volatile — out of Japan has grown, so has the fear that something could disrupt it. For now, though, economists said that Wednesday’s rate increase by the Bank of Japan is a baby step toward closing the gap with Europe and the United States, where the benchmark rate is 5.25 percent.”

“This isn’t much different from 0.25 percent,” the bank’s previous benchmark rate, said Masaaki Kanno, an economist for JPMorgan Securities. “The Bank of Japan must raise rates much higher to trigger an unwinding of the carry trade.”

“Economists say this trade has made Japan a source of low-cost capital, pumping money into everything from Wall Street stocks to real estate in South Korea, India and even Eastern Europe. Economists say the risk is that global markets could suffer steep sell-offs, hurting home buyers in Seoul and Bucharest, as well as 401(k) holders in New York, if the trade suddenly dried up — or worse, if Japanese investors started pulling back their money.”

“This has led some economists to begin calling the carry trade a bubble, financed by cheap Japanese credit, that is just waiting to burst.”

“The huge outflows have also driven down the yen as carry-trade investors sell it to buy dollars and euros to invest overseas. This has helped make the yen one of the weakest major currencies, sending it last month to a four-year low of 122.19 yen to the dollar.”

“Yet, despite the carry trade’s importance, no one knows for sure how large it really is. Mr. Kanno estimates that about 7 trillion yen, or about $58.39 billion, flowed overseas last year alone.”

“Another way to measure the trade is by the amount of assets now held overseas by all those involved in the trade since it began in 1999, when the Bank of Japan first cut rates to near zero. Mr. Kanno estimates those holdings are worth about 40 trillion yen, or around $330 billion.”

“However, economists say, the Bank of Japan is unlikely to prick the trade bubble anytime soon. To do that, it would have to raise rates enough to make the trade no longer profitable. Economists say that would require ratcheting the benchmark rate to more than 1 percent or even 2 percent.”

“Economists say additional rate increases are unlikely, at least in the near future. Japan’s economy is showing no signs of inflation, which would normally prompt a tightening. Moreover, most economists forecast sluggish growth rates this year of no more than 2 percent or so in Japan’s overall economy. Japan’s economy grew by 2.2 percent in 2006.”

“It would be difficult for the Bank of Japan to justify any follow-up rate hikes,” said Hiromichi Shirakawa, a Tokyo-based economist for Credit Suisse Securities. “I think their hands are tied in this regard until at least the end of this year.”

“The bank’s governor, Toshihiko Fukui, has said that he wants to raise rates, eventually to at least 1 percent, to take the bank out of the super-loose monetary policy adopted during Japan’s stagnant 1990s. Mr. Fukui faces a delicate balancing act: he aims to temper the risks from an expanding carry trade bubble against choking fragile economic growth. In addition, he needs to manage the possibility of inflation.”

“So far, Japanese central bankers and lawmakers have taken a hands-off attitude toward the carry trade. This may partly be because the weaker yen has proved politically popular here.”

“A declining yen … even enriches the Ministry of Finance, which holds some $800 billion worth of foreign bonds as part of the nation’s foreign currency reserve.”

“Policy makers also seem aware that the carry trade is mostly driven by Japanese individuals trying to improve the return on their savings. Mr. Kanno of JPMorgan estimates that these individuals’ holdings overseas have grown to about 30 trillion yen since 1999, making up about three-quarters of all carry-trade-related investments. Most of the rest is held by foreign investors, he said.”

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