The Problem With Japan's Fight to Curb Yen's Rise

Japan has "Declared War" on a free market

"We will continue to take decisive action if needed" to curb the yen's rise, Prime Minister Naoto Kan said at a meeting of business leaders. His comments came a day after Japan intervened in the currency market by selling yen and buying dollars for the first time since 2004.

Uh huh. It didn't work in 2004 and it didn't work the other times you tried it either.

Of course the bigger issue is that if it does work, you risk collapsing your bond market.

See, JGBs return nothing. Therefore, the only reason to buy them is to use them as collateral for a carry trade, or to earn your return via currency appreciation rather than coupon.

But both playing the carry and the currency appreciation argument only work if, surprise-surprise, the currency appreciates.

Yes, it is true that most of Japan's debt is held internally. But anyone who thinks that the Japanese firms and individuals aren't playing this the same way has rocks in their head. They most-certainly are.

Wednesday night the Japanese Automakers were bleating that they needed the yen north of 90 (that is, weaker by another 5% or more!) in order to "be profitable." So now we have a focused target for speculative attack - and you can bet that bet will be pressed by international players with plenty of money.

Has anyone figured out the damage if someone who's geared 10:1 or more takes a 5% loss on each leg of their trade?

The fundamental problem is that you can't have a sustainable economy that relies on foreign capital flows - whether it be an import/export imbalance or "hot money" flying around "helping" you. All of these things build in instabilities in the economy.

Japan has been playing this game for more than 15 years, with the outcome being a monstrous accumulated debt, now well north of GDP. They have failed to exit their deflationary depression, having chosen instead to paper over it. But now the birdcage liners are turning into a monstrous problem - if there is any sort of upward move in JGB yields the roll on those bonds will destroy the Japanese federal budget.

They didn't paint themselves into a corner, they bricked themselves into a room with no doors! All choices here are bad ones, and some were foreclosed years ago - like withdrawing the stimulus and forcing those who had hidden losses to eat them. Anything that normalizes yields instantaneously detonates the government's funding model - thus, the increasingly-shrill screaming coming from both idiots like Noda and the Japanese corporate interests - both of which are screaming "I have a bomb! I'll use it! I'll kill you!"

About the author: Karl Denninger

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