Japan and the United States in the World Economy
Speech given for a conference on "Wisconsin - United States - Japan Economic Development" Sponsored by Kikkoman Foods Lake Geneva, Wisconsin
© Institute for International Economics.
The Structural Foundation
The United States and Japan are the two largest national economies in the world. The United States is the world's largest deficit and debtor country. Japan is the world's largest surplus and creditor country. The exchange rate between the dollar and yen has fluctuated violently, strengthening from 360:1 as recently as 1971 to 80:1 in early 1995 before weakening again to about 130:1 at present. Trade frictions over the past thirty years, leading to such extreme measures as America's import surcharge in 1971 and Japan's acceptance of "voluntary export restraints" in a wide range of industries in the 1980s, have threatened the stability of the global trading system. Hence the course of economic relations between the United States and Japan plays a critical role in the world economy as well as a central role in overall relations between the two countries.
The economic positions of Japan and the United States have reversed dramatically over the past decade. In the late 1980s, most Japanese and many Americans believed that Japan was on its way to becoming the dominant economy in the world - if it had not already achieved that position. Most Americans and many Japanese believed there had been an fundamental deterioration in the competitive position of the United States. Japanese investors were making huge investments at the United States (at what often turned out to be vastly inflated prices). American companies were emulating key Japanese management practices as they struggled to restore their own strength.
All this has changed over the past decade. The United States is now in its eighth consecutive year of economic expansion. America has created over fifty million new jobs since 1970, twelve million alone since 1993. Unemployment is at its lowest level in almost thirty years. Prices are more stable than at any time since the first oil shock in 1973. Indeed, except for a short recession in 1990-91, the United States has grown steadily since 1982. The "American model" looks increasingly successful and is itself being widely emulated around the world.
By contrast, Japan has been the "sick man" of both the industrial countries and East Asia since the early 1990s. This performance represents a strange paradox. Until the outbreak of the recent Asian crisis, Japan had been living in the fastest growing region of the world economy. It has implemented fiscal stimulus programs, even prior to the latest initiatives, that cumulated to more than $600 billion in recent years. Interest rates have been virtually zero for some time. The trade surplus is the highest in the world and has again been rising significantly.
Yet there has been virtually no growth in Japan for more than six years. Something fundamental seems to be wrong. Deregulation and liberalization are clearly needed in many sectors, especially as other countries move rapidly to open their own economies. Most important is the weakness of the financial system; recovery seems highly unlikely without fundamental reform in that sector.
The Present Debate
Relations between the United States and Japan also represent a paradox at the present moment. On the one hand, overall ties between the two countries are extremely strong. Recent agreements to update and improve security arrangements have indeed strengthened a crucial, and frequently contentious, element of the nexus. On the other hand, the frequency and intensity of disagreement over economic issues - especially the appropriateness, and degree of urgency, of Japanese policy in this area - have reached record levels. Their continuation could jeopardize the entire relationship despite all the progress on other topics.
Moreover, the current economic debate is of a somewhat different nature than in the past. Macroeconomic policy and exchange rates have been an element in previous squabbles, to be sure, especially in the early and late 1970s. But the traditional focus of US concerns has been on Japanese trade barriers, "unfair" export surges (ranging from textiles in the 1960s to automobiles in the 1980s) and "structural impediments" to open trade between the two countries. These traditional sources of friction, while not absent from the current fracas, are distinctly secondary. The present focus is almost wholly on Japan's macroeconomic policy and especially the call for Japan to (1) restore much more rapid growth (2) that is led by domestic demand rather than a renewed expansion in the trade surplus.
The United States has two main motives for pushing Japan so hard on these fronts. First, it is virtually impossible to resolve the Asian economic (and increasingly political) crisis satisfactorily without a substantial pickup in Japanese growth. Japan accounts for two thirds of the entire economy of Asia. Hence the problem countries in the region, ranging from Korea to Indonesia, simply cannot achieve the export increases required for them to recover - even if they do everything right themselves - as long as Japan is in recession. There are enormous risks to the world economy as long as Asia festers and the United States correctly sees Japanese recovery as a necessary component of resolving that key problem.1
Second, Japan's current economic position and outlook will generate substantial costs to the economy of the United States itself and hence to the overall relationship between the two countries. To be sure, in light of the strong performance of the American economy, there have been short-run benefits to the United States from the sharp rise in the value of the dollar and the expansion of our trade deficit. These developments have helped dampen inflationatory pressures, permitting us to reduce unemployment for far below the level that most economists had believed was acceptable with price stability. In this sense, the deterioration in our external position has provided something of a "safety valve" for the present expansion.
The Basic Problem
However, we know from the sad history of the past thirty years that the present situation poses several severe threats to the two countries and to the relationship between them. We are now experiencing a repetition of the currency and trade cycle that has plagued us repeatedly in the past. This currency and trade cycle can be summarized succinctly:
- the yen weakens sharply below its long-term equilibrium level and the dollar rises well above its long-term equilibrium level;
- the Japanese current account surplus and American current account deficit soar;
- the United States (and many other countries) react strongly against Japan, renewing trade frictions and threatening the stability of the global trading system;
- the yen then rises precipitately, severely weakening the Japanese economy (as occurred most recently in 1993 and 1995) and generating inflationary concerns in the United States.
Four complete swings of this cycle have occurred since the early 1970s.2 It has been permitted to occur again over the past three years, with the yen plummeting to 135:1 against the dollar for a total decline of more than 50 percent from its peak of only three years ago.
Some of this yen weakening was a natural rebound from its overshoot to an excessively strong level of 80:1 in early 1995. Some can be explained by the prolonged weakness of the Japanese economy, particularly when compared with the strong performance of the United States over the past five years.
Some, however, was clearly due to a deliberate competitive depreciation of the yen by the Japanese authorities.3 Having tried repeated fiscal stimulus programs and near-zero interest rates, and being unwilling or unable to achieve much structural reform, they apparently could see no way to achieve sustained economic recovery other than renewed growth of the trade surplus. The problem of course is that this represented an effort to export Japan's problems to the rest of the world--and hence was internationally unacceptable and unsustainable.
The competitive depreciation policy, however, pushed the yen to excessively weak levels and produced a substantial backlash in Japan itself as well as from around the world. The spectre of further yen depreciation began to induce investors to move out of Japanese assets. The equity markets began to weaken, raising the risk of a "sell Japan" panic as the declines in the exchange rate and the Nikkei threatened to reinforce each other. The fragile Japanese financial system was thus at considerable risk, posing the possibility of severe repercussions for both Japan itself and the world economy.
In addition, farsighted Japanese saw the folly of excessive yen depreciation and called for its reversal. The Keidanren publicly advocated a return of the yen-dollar rate to a range of 100-110:1 and called for joint efforts between the two countries to stabilize it. Former high officials, including from the Ministry of Finance, echoed that view.
It is clear that the yen is now dramatically undervalued relative to its sustainable long-run equilibrium position. A new study just released by my Institute calculates that Japan's fundamental equilibrium exchange rate is around 90:1 against the dollar,4 a level that was of course maintained for some time as recently as 1995. This suggests that the yen will need to rise in value by about 50 percent to avoid both major distortions to the world economy and severe frictions in Japan's relationship with the United States.
A Program for the Future
Japan can achieve this outcome only by achieving substantial domestic-led growth, further opening Japan's markets, and reforming Japan's financial system. The needed response includes four major components:5
- permanent cuts in both consumption and income taxes;
- real increases in government spending, rather than the traditional announcements of substantial stimulus efforts that turn out in practice to be far smaller;
- comprehensive reform of the financial system; and
- a complementary strategy, based on these changes in the fundamentals and conducted jointly with the United States and perhaps the full G-7, to push the yen-dollar rate back into the range of 100-110:1 and then to stabilize it as called for the Keidanren and other responsible Japanese observers.6
A program of this type provides the only hope for both restoring respectable performance for the Japanese economy and avoiding severe new frictions between Japan and the United States (and the rest of the world). I therefore strongly recommend it. I also recognize there will be several immediate objections. First, some in the Ministry of Finance have argued that the weaker yen would not produce much renewed increase in the Japanese trade surplus because of the substantial outsourcing by Japanese firms over the past few years. There is undoubtedly some truth to this view and we will not know the full impact of the outsourcing trend (and perhaps other structural changes) for at least a few years.
However, our models show that, with a lag of about two years, the Japanese global current account surplus rises by about $3 billion for every depreciation of 1 percent in the trade-weighted average of the yen (and that Japan's bilateral current account surplus with the United States rises by about $1 billion for every weakening of 1 percent in the yen-dollar rate).7 Japan's global and bilateral surpluses have in fact already surged to new record levels in real terms and will continue to rise sharply if the yen (and domestic demand) remain weak.
Nor should one fear that a modest renewed strengthening of the yen will damage Japanese industry and thus add to the woes of the financial system. Virtually all Japanese sectors confirm that they can compete quite effectively with the yen at 100-110:1 (or even stronger). The Keidanren clearly would not call for such a level if they thought it would hurt the Japanese economy.
Second, some may doubt that the authorities could push the yen to 100-110:1 because "the fundamentals favor the dollar." But the United States is by far the world's largest debtor and deficit country, and Japan is by far the world's largest creditor and surplus country. Those long-term fundamentals always ultimately dominate the currency markets, and they clearly call for a much stronger yen. The short-term fundamentals have favored the dollar, to be sure, but the proposed changes in fiscal policy and financial policy would sharply alter the outlook and enable the authorities to push the yen back to a more sustainable level. Japan's huge dollar reserves of more than $200 billion, especially used in tandem with the United States and the rest of the G-7, would be fully adequate to achieve this goal.
Third, higher budget deficits are resisted because of Japan's large debt burden and the fear of long-term budget costs due to the aging of the population. Japan has a relatively modest underlying structural deficit, however, and the large nominal deficit is due primarily to the poor performance of the economy for such a prolonged period. Renewed domestic-led growth is the only way to restore lasting fiscal stability, as well as more immediate progress for the economy and the avoidance of major new tensions between Japan and the United States.
The details of an effective, and seemingly feasible, plan for restoring satisfactory domestic-led growth in Japan are laid out in the attached paper by my colleague Adam Posen, which will be published shortly by my Institute for International Economics. Posen's overview outline summarizes the main conclusions and recommendations that derive from his study, and the larger paper "How Much is Enough for Japan?" represents his chapter on a crucial component of the issue. I totally endorse Posen's findings and proposals, and therefore append them to my own paper to provide an elaboration on some of the central topics that may be of interest to readers who want to delve into them more deeply.
Wisconsin and Japan
The state of Wisconsin has a heavy stake in successful reconciliation of the current economic clash between the United States and Japan. Exports represent about 10 percent of total state output. Japan is Wisconsin's second largest foreign market, and the overall East Asian market - whose future is so closely linked to Japan's, as noted above -accounts for about 20 percent of Wisconsin's foreign sales.
Moreover, Wisconsin's economy is much more oriented toward manufacturing than most American states. Manufacturing jobs account for about one quarter of all jobs in the state, placing Wisconsin fifth in the country in this regard. Since over half of all US manufacturing jobs now produce for export, and since this is by far the fastest growing destination of output from the sector, Wisconsin's future reliance on trade is even more significant than suggested by the aggregate data.
Qualitative considerations underline that conclusion. Export jobs, mainly because of their heavy incidence in manufacturing, pay 15-20 percent more than the average American wage. Export jobs are far more stable than the average job. Productivity is far higher in firms that export and such firms are far less likely to go bankrupt.8 This is why manufacturing wages in Wisconsin are well above the national average, and why continued trade expansion is central to the future well-being of the state.
It is also apparent that Wisconsin is well positioned to take advantage of trade expansion. High levels of education and skills are the primary requirement for all Americans, and for particular locales, to benefit from globalization. Wisconsin's high school graduation rate is well above the US average, and its students in fact ranked first in the nation in ACT college entrance scores in 1997. Hence Wisconsin could suffer substantially if trade levels were restrained by poor economic policies in any of the major countries, notably Japan and the United States itself as the world's two largest economies, and/or by restrictive trade policies here or abroad.
Wisconsin thus has a very high stake in a successful resolution of both the current and longer run economic problems between the United States and Japan. It is highly appropriate that this conference, which seeks to address these issues and to contribute toward such an outcome, is being held here in Lake Geneva. I hope that my paper will both contribute to a better understanding of the problem and offer some helpful ideas for addressing it. I look forward to hearing the views of my good friend Professor Kosai, the distinguished discussants, and questions and comments from the audience.