In 1989, the eminent American economist Charles Kindleberger delivered a series of four lectures on the subject of economic laws and economic history. Among the four was the law of one price. As its names implies, the law holds that equivalent commodities must trade for the same price. If not, an arbitrage exists in which one could buy the good (from the cheapest supplier) and in turn sell it at a higher price to earn a riskless profit. An arbitrage's existence signals a market is not efficient. Consequently, the ideal of an arbitrage-free world lies at the heart of classical economics with its assumption of all participants having perfect information.
A corollary to the law of one price is the theory that exchange rate (between the currencies of two nations) movements are bounded by the concept of purchasing power parity (PPP). Essentially the PPP concept extends the arbitrage-free ideal to the realm of international trade. One US Dollar should command the same purchasing power (measured in a basket of goods) as one Pound, Euro or Yen. If, to the contrary, one Dollar can buy more goods in the US than the equivalent quantity of Yen in Japan, then the value of the Yen to the Dollar is out of line. In this case, we say the Yen is overvalued to the Dollar.
Now, for all of the concept's theoretical elegance, applying it — in the real world — is a tough slog. One method is to compare long-term inflation rates between the two countries. Over time the currency of the nation with the higher inflation rate should decline (or depreciate) in value versus the currency of the nation with the lower inflation rate. The results obtained mind you are not exact: differences between the prevailing spot rate and the theoretical PPP exchange rate will exist and will persist for long periods.
In the case where one country (Japan in this example) is experiencing persistent deflation pressures while the other (the U.S.) low to moderate price rises, the Yen (the currency of Japan) should over time appreciate against the US Dollar (as shown by the blue line in the chart above).
What about the spot rate? Well, as the red line illustrates, the long-term trend in the ¥/$ exchange rate has also seen the Yen appreciate. Note, as the Yen appreciates in value against the Dollar, one Dollar will buy fewer Yen. Twenty-five years ago, in March 1988, one Dollar bought, on average, ¥127; today, that same Dollar buys just ¥95. So, although the current spot rate appears undervalued to the theoretical PPP price, the spot price for Yen has gained over time versus the US Dollar.
The interesting question is, Why should this be so? Let us forget about the theory for a moment. Which economy is in better shape today? And, which economy has the brighter future prospects? For all of our current problems, it is the United States. Unless Shinzo Abe, Japan's new prime minister, succeeds in his efforts to reinvigorate Japan's economy, his nation's future is far from sunny.
An aging population, anemic population growth, persistent deflation, high government debt levels and torpid economic growth have reduced the government's room to maneuver in its attempts (hitherto unsuccessful) to get Japan moving again, years after the twin property and share bubbles burst in 1991. Remember, if inflation is the debtor's friend, deflation is his nemesis. Sluggish growth means Japan will have a difficult time reducing its mountain of central government debt (approximately 210% of nominal gross domestic product or GDP as of yearend 2012). Slowly going bankrupt is thus a real possibility for Japan.
Pundits accuse Japan to be actively depressing the Yen's value. Yes, using PPP as a test, the Yen seems so. But, knowing Japan may in time face the same fiscal stresses as befell Greece, perhaps, the Yen should be depreciating. No investor would pay a rising price for shares in a soon to be bust firm. This is the illogic — or the absurdum — in the equation.
Notes on Sources and Methods:
Spot exchange rates reflect the average of the daily rates for the month. A monthly purchasing power parity (PPP) rate was computed using consumer price indices for Japan and the United States. The initial value used was the ending spot exchange rate for March 1988.
A consumer price index is used to track the aggregate cost of a basket of goods and services consumed by an average household. The series used are reported by the US and Japan to the Organization for Economic Cooperation and Development (OECD).
The debt to nominal gross domestic product (GDP) ratio is the ratio of a nation's debt issued by the government to the size of its economy. GDP is a widely used measure of the total goods and services produced (consumed) by a nation over a period of time. Nominal GDP reflects the value of the aggregate goods and services at current price levels. The ratio provides a useful gauge of a country's ability to service its government's debt.
(Sources: OECD; Federal Reserve Board; Central Bank of Japan; Japan Cabinet Office; AIFS estimates.)
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