During the first half of the 20th Century (and for roughly 400 years before that) we had hot wars. Millions died, and sometimes, as with World War II, something useful was accomplished, though we’ll have to leave it to God to decide whether the accomplishments were worth the sacrifices.

Then, from roughly the time I was born until 1989, we had a Cold War. It was cold because the two main combatants, the US and the USSR, possessed nuclear weapons and hence a hot war was unthinkable. In other words, the possession of horrific weapons had the paradoxical effect of making the world vastly safer than it had been for half a millennium, and maybe forever.

Of course, there were mini-hot wars in the midst of the Cold War – Korea, Vietnam, and Afghanistan (the Soviet Union-Afghani War, not the US-Afghani War), among many others. But these were mainly “proxy” wars, limited military conflicts not fought on the land masses of the real combatants-in-interest, but designed to weaken the real combatants’ interests.(1)

Hot wars and cold wars (and proxy wars) are, of course, fought between enemies. But what’s interesting about currency wars is that they are usually fought among friends, or at least among countries that aren’t formally enemies. For years, for example, Congress has complained loudly (and US Administrations more quietly) that the Chinese have been managing their currency to keep Chinese exports competitive. But that was a tempest in a teapot compared to what’s about to happen.

Japan, as everyone knows, has been locked in a deflationary vice-grip for nearly a quarter of a century. Japanese GDP is barely higher today than it was in 1985, while US GDP has roughly doubled over that period. Prices of many consumer items in Japan are actually lower today than they were in 1985.

Of all the economic circumstances a country can find itself in, deflation is one of the worst (think “Great Depression”). During its “lost decades,” Japan refused to restructure its economy to make it more competitive, and also refused to permit immigration, even as its working age population dropped faster than the winter temperature in Hokkaido. Instead, Japan borrowed to maintain its lifestyle, resulting in a level of sovereign debt that even the Japanese themselves now view as utterly unsustainable.(2)

Japan had to do something dramatic to pull its act together before people stopped buying its bonds and it turned into Greece. What it actually did, under current Prime Minister Abe, was more than dramatic – it was positively thrilling. Abe launched the “three arrows” campaign, designed to wrench Japan out of its prolonged malaise.

The three arrows are (a) extremely aggressive monetary easing, by comparison with which Ben Bernanke is a positive piker,(3) (b) a fiscal plan that doesn’t depend almost entirely on more borrowing,(4) and (c) structural reform of the Japanese economy to make it more competitive.

The first arrow – massive QE – has already been fired, and it seems to have hit its target: the yen has fallen roughly 30% against the USD dollar (more against the euro), the Nikkei Index rocketed up more than 80% (before dropping into Bear territory earlier in June), and Japanese GDP growth shot up 4.1% in 1Q13.

But here are the problems, and I believe they are, taken as a whole, insurmountable:

Abe can’t restructure the Japanese economy. No one has been able to accomplish this in the last quarter century, despite horrific deflation, for the simple reason that the Japanese don’t want to restructure. Japan is a very traditional country, and its traditions and customs matter more to it than does something like “outcompeting the US.” The price Japan would have to pay to restructure – becoming mini-Americans – is too high. For economic restructuring to succeed on the scale it needs to succeed at, the Japanese would have to stop being Japanese.

Fiscal reform can’t happen until economic competitiveness improves. As noted, I don’t see serious economic reform in Japan’s future, and until that happens, and Japanese GDP growth takes off and stays high, Japan will have to continue to borrow out the wazoo and hope folks keep buying those bonds. Adding to an already unsustainable debt load isn’t fiscal reform.

Japan isn’t acting in a vacuum.  This is really the crux of the issue. The Paul Krugman-Janet Yellin print-and-spend-‘til-the-cows-come-home brand of economics might actually work if Japan were the only country in the world, or at least the only important one. But, unfortunately for Abenomics, there are three countries in the world more important than Japan(5) and a bunch of countries and regions important enough to matter.(6) Are all these good folks going to sit still for a decade or two while Japan exports its deflation to the rest of the world? Here’s a simple thought experiment designed to illustrate why the correct answer is “No way in hell!”

For Abenomics to work, given the hole Japan has dug for itself, the yen has to fall not from 78 to 100 as it’s already done, but to something like 300 or even 400 to the dollar.(7) At that rate, American car buyers could get a top-of-the-line Toyota Avalon cheaper than they could buy an entry-level Chevy. GM (and Ford and Chrysler and thousands of other American companies) could respond to this by shuttering dozens of factories and laying off thousands of workers, but that seems, shall we say, unlikely. Far more likely will be shrill demands on Washington to make the Japanese stop trashing the yen or to start trashing the dollar in return. The same thing will happen in Germany (the euro), China, Brazil (and the rest of Latin America), India, non-Japan Asia, East Europe, etc., etc. The beggar-thy-neighbor policies that destroyed the global economy in the 1930s and helped precipitate World War II will be front and center again.

Japan, in other words, is a wreck looking for a train. But, for extra credit, here’s question #1:  Since no one can win a currency war, why would Abe start one?(8) And here’s question #2: What happens to investment markets during currency wars?(9)

 

(1) People who ignore the difference between real, all-out wars and proxy wars (me, for example, when I was younger) almost always misunderstand the latter and tend to wear out themselves and everyone else in their zeal to demonstrate moral superiority by disapproving of them. Remind me, some day, to discuss the concept of the “war of detainment.”

(2) Japan’s debt-to-GDP stands just short of 250%.

(3) The scale of Abe’s QE is nearly the same as that in the US, but Japan is only 1/3 our size.

(4) The Japanese government currently spends almost a quarter of its income just to pay the interest on its debt. If rates on Japanese bonds were to rise to Abe’s target of 2%, the Japanese would be spending something like three-quarters of their income on interest payments.

(5) The US, China, and Germany. The last is currently more important than Japan, even though Germany’s GDP is smaller, because Germany holds the key to the future of the Eurozone which, as a whole, is the largest economy in the world.

(6) Non-Japan Asia, Latin America, East Europe.

(7) Japan’s aging population and shrinking workforce mean that its domestic economy can’t possibly grow the country out of its malaise. That puts all the burden on the export economy, which is why Japan needs an exchange rate of something like 400 yen to the dollar.

(8) The correct answer is: Since he can’t restructure the Japanese economy, and since he can’t win a currency war, the only option left was to allow Japan’s standard of living to drop by a third, thereby ensuring that someone else would become prime minister. That’s why we have a currency war.

(9) The correct answer is, cf. 1930 – 1939.

Next up: Submerging Markets? (Part 1)

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.