Yen Faces Long Climb to True Value

A year ago the dollar bought 250 yen. Today the Prime Minister of Japan calls the dollar outrageously low at an exchange rate of 170 yen, while the U.S. Treasury Secretary reportedly says that the dollar could fall to 150 yen. The issue is certain to arise at the economic summit in Tokyo this week. What do the economic fundamentals suggest as an appropriate exchange rate?

A comparison of the growth of productivity in the U.S. and Japanese economies since the end of World War II suggests a rate in the range of 75 to 100 yen to the dollar as one reflecting the relative international competitiveness of Japan and the United States.

Such a rate causes speechlessness in Japan where for more than 30 years the dollar has been two to three times as high. Few Americans and even fewer foreigners remember how exchange rates were originally fixed after World War II when the International Monetary Fund first opened for business.

The Bretton Woods Agreements of 1945 had established that the postwar international financial system would be based on fixed exchange rates to be monitored by the IMF, and the first chore of that fledgling agency was to determine what exchange rates would be appropriate in the chaotic world economy of the late 1940s.

Much of the industrial plant of Europe and Japan had been demolished. Estimating how competitive those economies would be after the war damage had been reversed was a daunting task. The only guide was their pre-war performance, but how applicable that might be in the 1950s and 1960s was at best a guess.

In determining the level of the original postwar exchange rates, it was U.S. policy to deliberately overvalue the dollar and to undervalue European and Japanese currencies for political reasons. Undervalued currencies, it was reasoned, would induce the war-devastated countries to take an outward orientation in their international policies, rather than turning inward toward isolationism. It would induce them to expand exports, and thereby contribute toward prosperity which, it was believed, was essential for a stable world peace.

No one will ever know to what degree that 1949 policy was successful. What is known is that the policy was never consciously reversed. The yen was set at 360 to the dollar and remained fixed at that rate for nearly a quarter of a century.

Consider the change in the Japanese economy between 1949 and 1973. Productivity grew at an average annual rate of 4.7%; every year for 24 years the productivity of Japanese labor and capital was nearly 5% higher than the year before. The figure represents the productivity growth of the entire economy, not just of labor.) Productivity in Japan grew on the average at more than twice that of the United States, which expanded at 2.2% annually.

If over those years the exchange rate had been adjusted to reflect the changing competitiveness of the two economies (as reflected in their relative productivity growth), in 1973 the exchange rate would have been 170 yen to the dollar.

In fact, in 1973 the dollar was finally depreciated to 280 yen--still a gross overvaluation of the dollar. This arithmetic, moreover, assumes that the original 360 rate for the yen in 1949 was an adequate reflection of competitiveness in 1949, not an undervaluation of the yen.

Extending the arithmetic from 1973 to 1985 on the basis of available information suggests an appropriate rate for early 1986 of 75-100 yen to the dollar.

The yen was able to remain undervalued for so long because Japanese financial markets were tightly controlled and shut off from foreign influences. It was not until the late 1970s that Japan began to loosen government controls over its financial sector and then only at the infinitely slow pace that characterizes all such Japanese moves. Market forces, in brief, were not allowed to correct the undervalued yen.

Even today the Japanese financial sector is only partially open to market forces. Internal economic developments within Japan, however, are working toward a further removal of financial controls. Unless these market pressures are resisted by government intervention, the yen will continue to appreciate.

The U.S. policy of the late 1940s of undervaluing the yen and overvaluing the dollar was politically sound and economically salutary for the time. By 1960, however, when the postwar reconstruction was completed, it should have been corrected. It was not.

Competitiveness is a matter of price. Japanese goods have a reputation for high quality and low price in world markets because the yen has been consistently undervalued on the foreign exchanges. The Japanese are hard-working, exceptionally able people, but even the nationalistic Japanese consumer may begin to see merit in foreign goods when it takes only 100 yen or less to buy one dollar.

The adjustment will not be easy for the Japanese, but neither has it been easy for the U.S. economy to operate with a dollar overvalued by 100%. Market forces are finally being allowed to restore the competitiveness of the American economy.