“If you wish to destroy a nation you must first corrupt its currency. Thus sound money must be the first bastion of a society’s defence.” – Adam Ferguson (Historian)

The Yen is crashing again. This is extremely bullish, we are told, because of a novel economic theory that has taken hold. The theory goes as follows:

1) Japan announces yet another unprecedented measure to crash their currency.

2) The market buys the news, the Nikkei explodes higher, pushing up other global markets in sympathy.

3) Since short-term stock price movements are never wrong, this must be good policy.

While I’m prone to hyperbole at times, the above theory is not far off from the truth. If you turned on financial television last Friday, this is precisely what you heard. You heard nothing about whether the policy is fundamentally sound and everything about how the day’s stock market gains were validation that the policy was to be lauded.

(Note: Importantly, you also likely heard nothing about how intermarket action was not confirming the belief that this latest initiative was likely to stimulate inflation expectations, with defensive sectors and long duration Treasuries continuing to lead after the announcement. At Pension Partners, we remain defensively positioned in our mutual funds and separate accounts.)

But is Japan really rewriting economic theory? Should we simply accept the prevailing notion that crashing your currency is bullish for all because stock prices are higher? Perhaps, but the story is here is far from that simple.

Debasing Your Way to Prosperity

First, history has not been kind to countries attempting to debase their way to prosperity. If it were an effective means to grow your wealth, Zimbabwe would be the world’s richest. A little devaluation may be a good thing as a short-term boost to exports, but a massive devaluation is an entirely different situation.

What the Bank of Japan is attempting to do here is just that and beyond unprecedented. They already had the largest quantitative easing program in existence with central bank assets at over 57% of GDP (see chart below). But this level apparently was not good enough and they upped the ante to 80 trillion yen per year (from 60-70 trillion) with an increase in direct purchases of equities through exchange-traded funds (ETFs).

Not to be outdone, hours after the BoJ announcement, Japan’s $1.2 trillion Government Pension Investment Fund announced that they will double their holdings of domestic and foreign stocks.

Collectively, these measures drove the Yen to its lowest levels in seven years and the Nikkei to new highs. The Yen has now lost over a third of its value against the dollar since late 2011 and as can be observed in the chart below, much or all of the stock market gains since then have been dependent on Yen weakness.

From this chart, analysts and pundits have concluded that Japan’s measures are “working.” They are accomplishing their goal of a higher stock market and weaker currency and that must be good news for the Japanese economy.

The Stock Market is Not the Economy

Unfortunately, as we have learned here in the U.S., the stock market is not the economy. Like Ben Bernanke and Janet Yellen, Haruhiko Kuroda (Bank of Japan Governor) has made the case of a virtuous cycle whereby higher stock prices will increase inflation expectations and bring about higher investment and wages. The problem is this “wealth effect” theory has yet to become a reality.

In the U.S., we have experienced the slowest growth recovery in history both in terms of real GDP and real wages. In Japan, things are far worse, with some arguing they are already slipping back into recession (they were in contraction as recently as 2013) after GDP fell 7.1% in the 2nd quarter with consumption falling 5.1%. Given this backdrop, it is difficult to argue that rising stock prices are trickling down to consumer spending.

As for generating inflation, what everyone seems to miss is that rising prices are not in and of themselves beneficial; they are only a positive if outpaced by wage gains. On that front, nominal compensation grew 1.6% in the second quarter but was far outweighed by a 3.4% rise in consumer prices.

Far from being swayed by this evidence, Kuroda is doubling down. For as any good central banker knows, you never admit that you were wrong but simply argue that you have to do more for your policies to take effect. They are also pointing to the rising stock market as evidence that it is indeed working, but again, read about Zimbabwe if you believe that the stock market is an arbiter of the health of an economy that is printing massive amounts of money.

Zero-Sum Game of Currency Debasement

Even if we accept that Japan’s unprecedented measures will eventually be a boon for its own economy, does that mean we should assume that it will boost output in the U.S., Europe, and elsewhere? Of course not but this is the message that the financial media is sending. By definition currency debasement is a zero-sum game. If you are crashing your currency to increase your exports, exports in one of your competitors will decline. Unless you believe that crashing your currency can actually increase global growth (the pie), this is mathematical fact.

If Japan wins by increasing its exports, all of its competitors are losing. A two-year chart comparing the Nikkei to that of its closest competitor, South Korea (Kospi Index) should make this abundantly clear. South Korean leaders have been increasingly vocal about the negative impact of a depreciating Yen and one should only expect this to intensify in the months to come.

What is the End Game?

With global growth slowing, currency debasement has become an increasingly important factor for markets and economies as there is little organic growth. The economic strategy for weaker countries has shifted from focusing on increasing this organic growth to trying to take a bigger slice of the pie; this is the equivalent of trying to take market share by lowering prices in a declining industry.

But of course, these tactics are not going unnoticed by competitors. It is only a matter of time before other countries retaliate by depreciating their own currencies. We’re already seeing various forms of this with central banks around the world moving to zero and negative interest rate policy and their own forms of QE. It is a race to the bottom so to speak with seemingly little end in sight. The most benign end game is that we see continued currency wars in the years to come but given its increasing role in the global economy we should not be surprised to see military conflicts from these currency manipulations as well.

As for the effect on financial markets, expect to see extreme volatility in major currencies which should translate into increased volatility in other markets as well. When you have the third largest nation in the world in terms of GDP (Japan) blatantly attempting to crash its currency, it is going to have ripple effects around the world.

How long will a crashing Yen will be perceived as bullish for all? That is a more difficult question to answer as it comes down to investor psychology. For now, the prevailing psychology is undeniably euphoric, focusing on the short-term gains in the stock market and assuming this will continue ad infinitum. Perhaps, but as we know, psychology can change in an instant and sentiment within Japan is now highly divided over the current policy. At a certain point, confidence in a crashing currency will erode and investors will begin to question whether the BoJ is unable to solve Japan’s structural issues through printing money. Or worse still, they will begin to realize the many unintended negative consequences that corrupting one’s currency brings.