Over the years we have read many times that the Bank of Japan (BOJ) has rapidly inflated the supply of Yen. The 'pundits' who made such statements were obviously swayed by the numerous announcements of QE programs emanating from Japanese officialdom, but they should have done a little research rather than blindly assume that these QE programs led to large increases in the economy-wide Yen supply. If they had done the appropriate research they would have discovered that over the past 20 years the annual rate of growth in the Yen supply (Japan's monetary inflation rate) has oscillated in a narrow range around an average of only 2%, and that it is presently near this long-term average. This is illustrated by the following chart. The fact is that of the major currencies, the Yen has had by far the slowest rate of supply growth over the past two decades. That's why the Yen has maintained its purchasing power and why it has been a relatively strong currency on a long-term basis despite the many blatant short-term negatives.

On a side note, the following chart shows that Japan's money supply grew at an average rate of around 10%/year during the boom years of the 1980s and that the money-supply growth rate collapsed during 1990-1991. The monetary transition from the bubble world to the post-bubble world is where comparisons between the US and Japan break down. Whereas Japan's monetary inflation rate tanked after its credit bubble burst, the US's monetary inflation rate moved sharply higher. This is an important part of the explanation for why things never got that bad in Japan and why the much-maligned Japanese economy had stronger real growth over the past 10 years than the US economy. The reality is that monetary inflation damages the economy. The more 'success' that the Fed enjoys in its efforts to maintain a high rate of US$ inflation, the worse things will inevitably get for the US economy.

On another side note, it's too bad that Japan's government went on one Keynesian spending binge after another following the bursting of the credit bubble. If it hadn't gone down this path, wasting resources on a grand scale and racking up an enormous debt in the process, Japan's economy would probably now be in very good shape.

As far as currency exchange rates are concerned, the relative monetary inflation rate is the tide. Interest rate differentials, trade balances, equity and commodity price trends, government debt/deficit levels and differences in economic growth rates are waves. The waves can dominate for periods of up to a few years, but the tide will eventually have its way.

As mentioned in our opening paragraph, the tide has been in the Yen's favour for a long time. One result is illustrated by the following weekly chart. Despite the US dollar's interest rate advantage over the Yen during the entire 15-year period covered by the chart, the Yen has been in a long-term bull market relative to the US$.

The US$ has done poorly relative to most major currencies over the past 10-15 years, so let's check the Yen's performance against a strong currency: the Australian Dollar (A$). The following weekly chart shows that there have been some big multi-year swings in the Yen/A$ exchange rate over the past 15 years, but the current level of this rate is the same as it was in 2003 and the same as it was in 1998. During the period covered by this chart the A$ apparently had everything going for it. In particular, the A$ had a large interest rate advantage throughout, the Australian economy was consistently stronger than the Japanese economy, there was a secular bull market in commodities that attracted considerable foreign investment into Australia, and the Australian government ran budget surpluses or small deficits whereas the Japanese government relentlessly ran huge deficits. All of these 'waves' added together constituted a powerful force, but they were counteracted by the tide (Australia's average money-supply growth rate was much higher than Japan's over the period in question).

The past has been characterised by relatively slow growth in the Yen supply and long-term strength in the Yen, but the future could look very different. Japan's government has racked up so much debt that at some point within the next few years it will have to either directly default on a substantial portion of its debt or enlist the help of the central bank (the BOJ). Either way, savers will be hurt. A lot of Japanese savers are invested in government bonds, so a direct default would result in large nominal losses for many members of the voting public. It would be blatantly obvious that the government was to blame for the losses, so the government that took this action would effectively be committing political hara-kiri. That's why it is more likely that the government will enlist the help of the BOJ.

The BOJ could monetise a large slice of the debt. While this wouldn't reduce the total size of the debt burden, it would effect a transfer from the balance sheets of voting investors to the balance sheet of the central bank. The debt could then be defaulted on, with the BOJ taking the loss. Due to the Yen's loss of purchasing power, the cost to savers would be just as great as it would be in the case of a direct default. Moreover, the cost to the overall economy would be greater if the monetisation route were taken due to the distortion of price signals and the mal-investment caused by creating a lot of money out of nothing. However, it would have the political advantage of making it more difficult for the average person to correctly assign blame.

Large-scale debt monetisation will very likely occur in Japan, leading to the Yen becoming a relatively weak currency. The difficult question is: when will the large-scale monetisation begin? We don't know the answer. A year ago we thought it would have begun by now, but clearly it hasn't.

Steve Saville