This last possibility became real with the recent weakness of the yen, prompted by many factors including rises in US interest rates in the wake of the post-pandemic inflationary tide, the requirements of the carry trade – borrowing cheaply in yen to engage in leveraged speculation on US markets, which requires yen to remain cheap even after Japan transitioned to positive interest rates – and by rising inflation making critical Japanese imports more expensive, a problem sharply exacerbated by the US-Israeli war on Iran.
Japan is particularly badly placed to tolerate yen weakness. With inflation already biting Japanese families and businesses used to stable or even declining prices for decades, a weak yen can only worsen things further. If the situation is to be addressed, there are two options. Both have monumentally adverse implications for the dollar.
One is intervention in currency markets. The Bank of Japan could use its dollar reserves usually held in US treasuries – and remember, today, Japan is the world’s largest single foreign holder of US treasuries – to buy yen and thus support the currency. However, this is precisely what the US would wish to avoid. Such an action would only throw more dollar assets onto a market that seems to have had its fill of them and, on top of that, is facing a torrent of new assets being offered it. They include higher borrowing that higher US deficits that Trump is piling up with his penchant for tax cuts and his half a trillion dollar increase in the military budget, which will result in higher issuance of US treasuries which the market must find the will to buy. They will also include the additional issuance that will be necessitated by higher interest costs as the US has been forced to increase interest rates to combat inflation, so far unsuccessfully. Finally, the torrent of assets on its way to find buyers on markets also includes new equity and debt issuance spurred by the bubble of US AI investment. All this would put too much strain on markets for US dollar-denominated assets, the foundation of the dollar system.
The second way the Japanese could deal with the problem of a lower yen is by raising Japanese interest rates. It is true that Prime Minister Sanae Takaichi does not favour this option and nor does the considerable political and business lobby behind her reflationary agenda. However, difficult though this choice may be, they may yet have to make it. What is more important from our point of view is that it is worse for the dollar system than for Japan on at least two counts. First, higher Japanese interest rates would set back the carry trade through which low-cost borrowing in Japan has facilitated the leveraged trading that has been so important in keeping up prices of dollar denominated assets on which the influx of money into the dollar system ultimately depends. Secondly, higher interest rates in Japan will also set back demand for US dollar-denominated assets more directly, as money pours into higher yeilding Japanese bonds.
This is why the US government intervened in currency markets to ‘save the yen’. It is noteworthy that the US did not buy yen and sell dollars but bought yen and sold euros, that too within informing the European Central Bank first. Another demonstration that the US’s allies are now required to be vassals.
In addition to these long-standing problems maturing, the credibility of the Federal Reserve has been thrown into question by many recent developments. There is, first, the Federal Reserve’s support for asset markets through Quantitative Easing after 2008 as well as, more recently, former Federal Reserve Chair Jay Powell’s tardy response to inflation. And in office, Trump has unusually and dangerously interfering in the policies of the ‘independent’ Federal Reserve, demanding lower interest rates. His Treasury Secretary, Scott Bessent has openly accepted, indeed boasted about, the political nature of Federal Reserve decisions. And now new questions about the strategy and competence of the new Federal Reserve Chair, Kevin Warsh, just appointed by the Trump administration, are already being aired.
It is therefore not a surprise that even a scholar as Barry Eichengreen, who has long talked up the dollar believes that the most important lesson of the yen intervention is that it is pushing the dollar system to the brink: ‘The bottom line is that Washington, fearing the consequences for US financial markets, is reluctant to see foreign central banks use their dollar reserves. This is telling us that the dollar is not the attractive reserve currency it once was. When this message sinks in, other countries will redouble their search for more attractive, readily usable alternatives. Reserve diversification is apt to gather steam.’
Well, there you have it, from the horses’ mouth. And the worst of it is that the intervention has not been particularly successful: the yen lost half its gains a couple of days later. It’s going to be a rocky rise for the dollar and the dollar system from here on.
The Valdai Discussion Club was established in 2004. It is named after Lake Valdai, which is located close to Veliky Novgorod, where the Club’s first meeting took place.
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