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Japan is on an unsustainable path of a strong yen and deflation. The unprofitability of Japan's major exporters and emerging trade deficits suggest that the end of this path is in sight. The transition from a strong to weak yen will likely be abrupt, involving a sudden and big devaluation of 30 to 40 percent. It will be a big shock to Japan's neighbors and its distant competitors like Germany. The yen's devaluation in 1996 was a main factor in triggering the Asian Financial Crisis. Japan's neighbors must have a strong banking system to withstand a bigger devaluation of the yen. Self-inflicted Deflation
Japan's nominal GDP contracted 8 percent in the four years to the third quarter of 2011, and six percentage points of that was due to deflation. Without increased government expenditure, the contraction will be one percentage point more. Japan has not seen this kind of sustained deflation since the 1930s. Without government deficits, Japan's economy will decline much more. Central government bonds and borrowings plus its guaranteed debts rose by 116.3 trillion yen during the period, equivalent to one-fourth of the level of the nominal GDP in the third quarter of 2011. If Japan had adopted balanced budgets, its economy would have contracted two to three times more. This will lead to a debt crisis in its private sector. A strong yen, deflation and rising government debt form a short-term equilibrium that lasts as long as the market believes it is sustainable. The yen has seen a relentless upward trend since it depegged from the dollar in 1971, up to 83.4 from 360 again to the dollar. When wages and asset prices rise, a strong currency can be justified. When wages and asset prices fall, a strong currency is suicide. Japan's nominal GDP peaked in 1997 and its nominal wages did too. Its property prices have declined every year since. The Nikkei rose in only four out of the last fifteen years and is still close to a three-decade low. Japanese policymakers, businesses, academics, currency traders and the average Mrs. Watanabe all believe in a strong yen. This belief is wrong but self-fulfilling. It has lasted so long because the Japanese government adopts policies to offset the destabilizing effects of deflation due to a strong yen. Hence, Japan's national debt has marched upwards along with the value of yen. It is expected to top yen 1,000 trillion in 2012, 215 percent of GDP, 7.8 million yen (or roughly US$ 94,000) per person, and about half of net household wealth per capita. The sustainability of Japan's deflationary path depends on the market's confidence in Japan's debt market. As Japanese institutions and households hold almost all of the government's debts, their faith in the government's creditworthiness is the mojo for Japan's seemingly harmless deflationary spiral.
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