The last time the dollar dropped below the levels it reached Wednesday against the yen, the Bank of Japan and the Federal Reserve jointly intervened to push it higher. That was in July 1995.

No wonder currency traders got a bit nervous Thursday when Japanese officials complained about the strength of their currency amid the latest bout of market turmoil. But the chances of any joint intervention this time are highly remote. Why? Because the Japan-U.S. trading relationship is nowhere near as important as the U.S.-China relationship.

In fact, the politically sensitive distortions that an undervalued Chinese yuan imposes on the latter relationship are a key reason why we seem to be sliding back into an economic crisis. The China-U.S. imbalance is the 800-pound gorilla in the room and a big reason why policymakers seem so bereft of deflation-fighting tools, including being unable to intervene in currency markets.

In isolation, it might make sense for the Fed to help out the Bank of Japan. One admittedly ill-defined test that officials typically use when considering intervention–whether the market has gotten out of touch with “fundamentals”–could arguably apply in this case.

The zero-yielding currency of a heavily indebted, liquidity- and deflation-trapped economy should hardly be the go-to currency of the world. It is pure fear and risk aversion, not fundamental economics, that has driven people back to a cheap currency in which they had borrowed when risk appetites were stronger.

The problem is any U.S.-endorsed intervention would be interpreted in Beijing as hypocrisy. How can the U.S. criticize China for intervening in support of a weaker currency, Chinese officials would ask, while it does so itself in support of a weaker yen?

There are many perfectly good retorts to that, the most compelling being that for all intents and purposes Japan manages a flexible exchange-rate regime that is nothing like China’s. But such semantics are irrelevant in the delicate dance of international politics.

Indeed, that dance became more complicated this week as China responded to the dollar’s concomitant surge against the euro during Wednesday’s turmoil by letting the yuan fix to a level 0.24% lower against the dollar. It was the biggest one-day decline ever in the Peoples’ Bank of China’s daily fixing and it virtually erased all gains that the Chinese currency had made against the dollar after the PBOC shifted to more flexible currency regime in late June. The yuan fell further in overnight trade Friday.

China earned some goodwill in the U.S. when it announced that regime change, which was assumed to signify an appreciation in the yuan. But with the news of a surge in China’s trade surplus with the U.S., that goodwill has now all but disappeared. Protectionist pressure in Congress will grow.

And as Brown Brothers Harriman currency strategist Marc Chandler points out, these perennial trade and currency concerns are coming amid tensions over security issues. He notes that Washington’s newly expressed opposition to China’s territorial interests in the South China Sea has put next month’s visit to the U.S. by President Hu Jintao in doubt.

These political concerns are of far bigger importance to the U.S. than is a strong yen, even though its corollary–a weaker euro–is damaging to U.S. export interests in Europe.

After all, whereas Japan’s monthly trade surplus with the U.S. has merely gone from $4.2 billion 15 years ago to $5 billion now, China’s has exploded from $3.9 billion to $26.2 billion.

Japan still matters to the U.S., as evident in its dollar-based reserves, which have risen from $200 billion to $1 trillion over that time. But look at China’s reserves. They’ve gone from $30 billion 15 years ago to $2.4 trillion now.

Those numbers reflect a giant distortion in the global economy, one that reflects an overdependence on the U.S. consumer at a time when the world can’t afford it. This imbalance can only be fixed through policy actions aimed at adjusting China’s exchange rate and boosting U.S. savings.

It’s a great pity that the failure to address this on both sides has meant that other possible policy options for overcoming the world’s deflation threat are also off the table.

By MICHAEL CASEY

Tags: bank of china, bank of japan, economic crisis, economy, Federal Reserve, financial markets, financial system, us consumers, us economic

This entry was posted on Friday, August 13th, 2010 at 11:26 am and is filed under Asian Finance, Chinese Finance, Global Economy, Global Financial, Japan Finance, Market Finance, US Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.