The yen solution: why dramatic currency depreciation and the resulting market resurgence are Tokyo's only way out.

• Author: Nakamae, Tadashi

Japan will emerge from its deflationary slump only when the yen is allowed to weaken.

The chief external cause of Japanese deflation is foreign direct investment in China. The chief internal cause is an excess of domestic supply capacity. Depreciation of the yen, if and when it comes, will lead to the reduction of both sources of deflation and to the eventual resolution of Japan's deflationary crisis. The great obstacle to this resolution is a system which, measured by the weight of the public sector in savings and investment, has become even more socialist than was Soviet Russia.

Not only in Japan but also in markets around the world, deflation has arisen as a result of foreign companies relocating production to China. Taiwanese corporations were the first and American corporations have become the biggest investors in China. But it is Japanese producers of exportable goods whose direct investments, driven by the strong yen, are having the most deflationary impact on the global economy. As long as the overvalued yen keeps their domestic operating costs prohibitively high, Japanese producers will increasingly tap deeply into the Chinese labor market, causing consumer-goods markets in Japan and worldwide to continue to be flooded with cheap China-made electronics, textiles, and other products. Thus, until the overvaluation of the yen is corrected, China will be a growing external source of deflation, for the world generally and for Japan particularly.

A more important source of Japanese deflation, however, is excess supply capacity within Japan. This problem is by no means unique to Japan. But after Japan consented to a strong yen in the Plaza Accord of 1985, it became the first country to experience the investment bubble that eventually spread through Asia, the United States, and Europe. As such, Japan has been first to face the deflationary consequences of oversupply.

Japan's economic bubble of the late 1980s was not, as is often thought, primarily a property and equity bubble. It was primarily a capital investment bubble. Three-quarters of debt created during the bubble years stemmed from new investment in supply capacity. Consequently, excess supply capacity in the Japanese economy as a whole has remained at around 30 percent since the capital investment bubble reached its peak in 1991. Japanese manufacturers, after twelve years of attempted adjustment, are still operating at less than 70 percent of capacity. Fundamentally this is not a...