Japan, China, and the U.S. current account deficit.

• Author: Clarida, Richard H.

Exchange rate protectionism is a subject much in the news these days especially in regard to the actions of Japan and China in foreign exchange markets and in the financing of the U.S. current account deficit. I will discuss each of these issues in turn.

Japan's Rebound

I remain encouraged by the balance of evidence that Japan appears to be emerging from a decade in which a deflation spiral was a serious concern. This reflects well on policies pursued by the Bank of Japan under Governor Fukui's leadership, but there is no doubt Japan has also benefited substantially from the expansion in greater Asia, and not just China. As for currency policy, I believe that the major goal of BOJ policy must be to reflate the Japanese economy. Given the low level of interest rates, all tools at the BOJ's disposal, including non-sterilized intervention should be deployed. I would in fact favor, as an interim measure, an explicit price level target for Japan consistent with inflation in the range of 1.5 to 2 percent. If this target were implemented, the yen might weaken, but this would not be evidence of a beggar-thy-neighbor policy but rather--as emphasized by Lars Svensson (2003) at Princeton--as part of an effort to anchor expectations in a way consistent with reflation. And of course, if the reflation does continue, a weakening of the nominal exchange rate need not translate into a depreciation of the real exchange rate. As the yen has weakened in tandem with slower growth in recent months, the BOJ appears to have scaled back significantly in its intervention activities. I would support aggressive additional quantitative easing measures going forward if the goal of reflating the Japanese economy appears to be in jeopardy.

Financing the U.S. Current Account Deficit

The United States runs a current account deficit of more than $600 billion per year. In recent years, foreign central banks, especially those in Asia, have made substantial purchases of U.S. government bonds to add to their foreign exchange reserves. It is argued that because of this intervention, the current deficit continues to widen and the necessary adjustment is being delayed. It is important to appreciate that the U.S. current account deficit is a general equilibrium phenomenon and is, in part, a reflection of a global excess of saving relative to profitable investment opportunities in the post-bubble world. When I was at Treasury, I published an op-ed in the Financial Times in October...