What is an undervalued currency?

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What do people mean by an “undervalued currency?” Is that like when people say the stock market is undervalued? Or does it mean something entirely different?

A recent graph in the Financial Times caught my eye:

There’s one thing that I know for certain. At least 5 out of the 6 measures of “fair value” are wrong. And given Occam’s Razor, it is not unlikely that all six are wrong.

The subjective theory of value favored by Austrian economists suggests that value reflects what people are willing to pay for an asset. That’s also the implication of the Efficient Markets Hypothesis. So why isn’t the current value of the yen “fair”?

As far as I can tell, the FT is mostly describing investor views regarding the likely future path of the yen. In that sense, “undervalued” means “likely to appreciate”:

Favourable fundamentals should help the currency strengthen, according to some analysts. “The market can’t price the yen so far away from fundamentals for a long time,” said Michael Metcalfe, global head of macro strategy at State Street.

But I am more interested in the case where people view undervalued as a moral judgment, not a market prediction.

One of the items on the list is “purchasing power parity”. In plain English, the price level in Japan is estimated to be 40.6% below that of the comparison country (presumably the US.) Why is that fact important? A Big Mac costs much more in San Francisco than in Omaha. Does that mean that California is too expensive to compete with other states? Does this seem like a state that cannot compete:

Companies based in the Golden State have drawn around $366 billion of venture capital since the beginning of the year, according to data provider PitchBook. That’s more than three times the amount of venture funding that has gone into the other 49 states combined, and nearly double California’s previous record, set in 2025. New York state ranks a distant second in venture-capital investment, with $27 billion in deals announced so far this year.

It is interesting that the list of six factors in the FT does not include Japan’s current account surplus. But if you learned that Oklahoma had a trade surplus or deficit with New York, would you assume the dollar was not correctly valued in one of the two states? Switzerland and Norway have some of the world’s most overvalued currencies if you use PPP as the benchmark. And yet both countries have huge trade surpluses. If neither PPP nor trade balances are reliable, then how can we make sense of currencies being “undervalued” or “overvalued”?

Off the top of my head, I can think of a few ways in which we might put some meat on the bone, that is, make “undervalued” mean something:

1. The government might set an official exchange rate that differs from the free market rate. When there is a black market in a currency, it might make sense to speak of the official exchange rate being undervalued or overvalued. That’s not what is happening in the Japanese case.
2. The country might have either too much or too little nominal spending to promote macroeconomic equilibrium. If there is too much spending, then a currency appreciation might improve things. If there is too little spending, then depreciation might improve things. At the moment, Japan does not seem to suffer from either problem, at least to any significant extent. (Things are never perfect.) At 1.9%, Japanese inflation is close to target. But even in cases where there is a macroeconomic disequilibrium, it probably makes more sense to say money is too easy or too tight, not that the currency is under or overvalued.
3. A country might have too much saving for its own best interest, or for the best interest of the world. That sort of “excess saving” might lead to a currency value that is lower that it would be with an optimal level of saving. I’d say two things about that case. First, given Japan’s dire demographic situation, it is hard to argue that the Japanese are saving too much. Second, even if they were, it would be weird to call that an undervalued currency. It would be like characterizing the world’s excessive use of fossil fuels in terms of the price of coal being “wrong”. If you think Japan is saving too much, then just say so.

To summarize, there are three ways in which a currency’s value could be “wrong”. In the first case, the official value isn’t at equilibrium. You see that in places like Venezuela, where there are currency controls. In the second case, the equilibrium nominal value of the yen is not consistent with macroeconomic equilibrium. That problem eventually gets solved due to wage/price adjustments. In the third case, the real value of the yen is not optimal because of too much saving—according to a foreign busybody with no real knowledge of Japan that was taught a now-defunct Keynesian model in college:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

In this case, the academic scribbler is Keynes himself.