How to create a hypothesis for analyzing currencies Pt I

On Saturday I got asked by two different people about the rate of the Japanese yen to the US dollar.

This site is not supposed to be about currencies, but I have so frequently heard ideas based on dinner party theories, that I must address the profound deficit in scientific thinking in this area.

Firstly (and I am addressing this to the two ladies from Saturday), why do you suppose that a currency would move in value relative to another currency in the first place?

If you say the word “trend”, then you get sent to the back of the class.

Both of you mentioned that an increase in the price of the yen will make Japanese exporters hurt, which should then stop the yen from rising.

This is an illustration of your hypothesis:

Japanese Yen mental model

However, can you see any weaknesses in this model?

If not, you need to add more detail to your thinking.

Your assumptions include:

1. The strong yen will make it unprofitable for exporters to export

2. If it is unprofitable to export, exporters will stop doing so.

3. The decrease in exports relative to imports will be sufficient to push the country into a current account deficit.

Including these elements in your mental model, the new one should look like this:

Yen mental model updated

Now you have for causal links which you can use to analyze your hypothesis.

Yen mental model analysis

Now, go through each of the causal links in the chain, and look into the evidence.

=> Look how much large companies such as Toyota are earning from exports (Toyota produced 1.3 thousand cars in Japan last quarter, and 1.1 outside Japan, while it sold 0.7 thousand in Japan, and 1.6 thousand overseas, and it made money on the operating level in every geographic segment).

=> Look at Japanese companies business targets (mostly looking for market share as opposed to profitability).

Look at what Japanese exporters do when faced with tough competition from China and Korea (they dig in and increase efficiency instead of trying to fundamentally restructure or look for different business models)

=>  Look at what is happening with imports Japan (in fact, Japan currently has a current account deficit, but this is largely due to increased imports due to the need to import extra gas due to nuclear power plant shutdowns, and is likely to be a temporary phenomenon).

This is how to create a hypothesis with which to analyze currencies. Note that if you are interested in the Japanese yen against the US dollar, then you need to run a similar exercise for the US.

I will write about how to think about currencies another time.