Widespread market comments that a 5.3 percentage points interest rate differential favoring dollar assets is the main source of the yen’s intractable weakness is a typical simplification of Japan’s enduring and deep-rooted economic problems.

The first symptoms of Japan’s deteriorating economic outlook emerged when its public debt as a share of GDP doubled to 80% during the decade of 1980s. Since that time, the public debt continued to accelerate, unchecked, to 239% of GDP at the end of last year.

Predictably, that growing avalanche of government liabilities has been systematically monetized, leading to distorted interest rates, unbalanced product and labor markets, and a neglect of structural social and human capital policies.

Those are the underlying fundamentals driving the value of yen-denominated assets.

And the current economic indicators are equally worrying.

A volatile inflation rate came in at 2.7% in March, the budget deficit is optimistically estimated at 4% of GDP, and the growth rate of the economy slowed down from an annual rate of 2.6% at the beginning of 2023 to 1.2% during the final three months of last year.

That is a weakening economy in need of help that monetary and fiscal policies cannot provide without further destabilizing an already precarious policy posture.

Normalize demand management policies

Overextended public finances – with a high budget deficit and a huge public debt – offer little to no room at all for any support to demand and employment.

The monetary policy is also excessively easy. With an inflation rate well above the 2% policy target, the current credit stance needs tightening. But what one observes now is exactly the opposite. The real policy interest rate is a negative 2.7% (0% nominal policy interest rate minus a 2.7% inflation). And the weak yen is just reflecting an excess supply of Japanese currency finding buyers at a low and declining price to the U.S. dollar.

Since the beginning of the year, the overhang of yen liquidity, and the worsening growth outlook, have led to a 10.4% decline of the Japanese unit against the dollar.

The way forward is clear: If Tokyo does not substantially, and credibly, reduce its money supply, the relative price of the yen will continue to sink.

And the key question is: Will Japan do that?

The answer is no -- because that would worsen an already weak and unbalanced economy.

To see that, here is a quick look at the current state of Japan’s economic activity.

The latest data on demand and output during the fourth quarter of last year indicate that growth was driven by a 1.4% increase in net exports. But the domestic demand, depressed by a 0.5% decline of household consumption (accounting for 54% of GDP), fell 0.2% to bring the economy’s growth down to 1.2%.

Exports increased 3.5% on strong external demand for Japan’s products and services, while imports continued their free fall since the middle of last year owing to a sharply declining private and government spending.

Better Asian ties would support exports

The principal conclusion one can draw from this data is that household consumption and residential investments – interest rate sensitive components of aggregate demand representing about 60% of the economy – are not responding to extremely low credit costs.

What’s left to drive demand and employment are exports, government spending and government financed incentives to private and public investments for an accelerated transition toward Japan’s green and digital economy.

And that means that Tokyo will have to continue running big budget deficits in a sea of public debt that is two-and-a-half times larger than the country’s total demand and output.

That must change. Fiscal and monetary policies need to be set on a course of gradual and sustained normalization, with public spending focusing on welfare reforms to stop and reverse the population decline, and to increase the stock and quality of human capital through education and science.

Meanwhile, exports can serve as the mainstay of economic activity, a pillar of technological innovation and of Japan’s leading position in world economy.

More than 80% of Japan’s exports go to Asia, United States and European Union – in that order of importance. Trade and finance relations with the U.S. and the E.U. are in good order, but Tokyo has some work to do to straighten out its commercial and political ties with East Asian neighbors like China and South Korea. Asia, after all, accounts for more than half of Japan’s total export trades.

Japan cannot stabilize and enhance the appeal of yen assets without (1) a credible commitment to normalize demand management policies, and (2) an equally firm determination to implement family supporting welfare and labor market reforms.