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Government Intervention into International Currency Exchange Rates: Japan as a Case Study

Posted by M. C. on September 18, 2022

However, monetary policy interventions introduce other distortions into the economy which can have severe economic consequences, as illustrated by Japan’s lost decades after the Plaza Accord.

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Mihai Macovei

The recent hefty depreciation of the yen to a twenty-four-year low against the dollar has raised eyebrows due to the yen’s traditional safe haven role in times of turmoil, such as the war in Ukraine. The yen’s decline had already started when major central banks signaled a tightening of monetary policy to fight inflation while the Bank of Japan (BoJ) doubled down on its loose monetary policy and zero target for ten-year bond yields. The depreciation accelerated further when oil and gas prices surged, weakening Japan’s terms of trade.

Mainstream analysts got wary about the yen’s tumble and its negative impact on import prices and consumption, but recommended the BoJ to continue its ultraloose monetary policy in order to reflate the economy and support growth. What these analysts fail to grasp is that in a longer-term perspective, the yen’s value relative to other currencies is anchored in economic fundamentals driven by monetary developments and its purchasing power.

Since the sharp appreciation of the yen following the Plaza Accord in 1985, the currency has preserved its relative strength versus the dollar despite Japan’s ultraloose fiscal and monetary policies. This is because money creation has run at a slower pace in Japan than in the US, as the Plaza agreement ushered in Japan’s lost decades, illustrating well how disruptive government interventions in foreign exchange markets can be.

The Plaza Accord

For more than three decades, following its sudden appreciation as a result of the 1985 Plaza Accord (graph 1), the yen has followed a steady path versus the dollar. The Plaza agreement between G-5 countries—the United States, West Germany, France, Japan, and the United Kingdom—marked the first large experiment in international monetary cooperation to revalue the exchange rate system.

At the behest of the United States, which wanted to devalue the dollar and reduce the trade deficit, the five central banks agreed to intervene in currency markets to rebalance international trade and growth. The perceived overvaluation of the US dollar was the result of relatively high interest rates promoted by the Fed during 1980–82 to quell inflation, combined with Ronald Reagan’s expansionary fiscal policy during 1981–84, which caused capital inflows and an appreciation of the dollar.

High budget deficits together with buoyant domestic demand swelled the trade deficit, producing the famous 1980s “twin deficits.” In reality, the exchange rate was not the problem, but US fiscal profligacy and excessive money supply expansion, which exceeded 12 percent in 1983. Instead of fixing domestic policies, the US government talked Japan and Germany into manipulating their exchange rates and increasing domestic demand. As Ludwig von Mises put it so aptly: “What governments call international monetary cooperation is concerted action for the sake of credit expansion.”

Graph 1: Japanese yen to US dollar spot exchange rate


Macovei 1

Following concerted interventions by central banks, the yen appreciated from about 240 units per dollar in September 1985 to 153 units in 1986. By 1988, the yen had almost doubled in value to an exchange rate of 120 units per dollar. Many analyses, including International Monetary Fund reports, concur that the significant government-driven appreciation of the yen sowed the seeds for Japan’s subsequent long-lasting economic debacle.

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