by C. Fred Bergsten, Peterson Institute for International Economics
© Institute for International Economics
This paper updates and draws extensively on the analysis in C. Fred Bergsten, Takatoshi Ito, and Marcus Noland, No More Bashing: Building a New Japan-United States Economic Relationship, Washington: Institute for International Economics, October 2001.
The United States and Japan are the two largest national economies in the world. Since the early 1990s, they have been moving in opposite directions. The United States enjoyed an expansion of record duration from the end of the Gulf War in 1991 until early 2001, growing much faster than any other G-7 country and much faster than it had at any time since the Second World War. Japan's economy, by contrast, has been virtually stagnant since its financial bubble burst in the early 1990s and has clearly experienced its worst performance since its recovery from the ravages of the Pacific War.
Two factors temper this otherwise sharp distinction between the recent performance of the two countries, however. The more immediate is that the United States dropped into recession in 2001 and, despite a fairly robust rebound in 2002, has clearly not yet fully recovered from the bursting of its own financial bubble (in the stock market), its corporate governance scandals and the uncertainties generated by the terrorist attacks of 9/11 and the Iraq war. There remains considerable disagreement over the prospects for the American economy for the coming months and next few years.
The more lasting caveat is the continuing sharp disparity, in Japan's favor, between the international economic position of the two countries. Japan continues to run the world's largest trade and current account surpluses, running well in excess of $100 billion (about 3 percent of GDP) per year, and remains by far the world's leading creditor country with a net international creditor position of more than $1.5 trillion. The United States, by sharp contrast, is running annual trade and current account deficits of more than $500 billion (5 percent of GDP) and is by far the world's largest debtor country at more than $3 trillion (30 percent of GDP).
The Economic Reversal
As recently as the late 1980s, or even the early 1990s, most Japanese and many Americans (and others around the world) believed that Japan was becoming the dominant economy in the world and that the United States had lost its competitiveness. Both economies have experienced stunning turnarounds since that time.
The positive swing has of course come in the United States. Productivity growth, which is the underlying source of a country's economic performance, had been extremely poor in the United States throughout the 1970s and 1980s, averaging only about 1 percent per year. With the labor force growing at about 1 percent annually, this meant that output potential was expanding by only 2 percent per annum. But productivity growth doubled or tripled (depending on one's measure) in the United States during the mid-1990s and, with the labor force expanding at the same rate, took potential output growth to 3 1/2 to 4 percent. This is an extremely rapid pace for a mature, high-income country like the United States and sets it well above all other G-7 countries.
Actual US growth was even faster in the late 1990s, running at an unsustainably high 5 to 6 percent for several years. Productivity growth has continued to expand rapidly through the recession, as well as during the recovery of 2002-early 2003. Hence it appears that the medium to long-run prospects for the US economy, despite the recent problems and current uncertain outlook, are very strong.
In Japan, by sharp contrast, productivity growth dropped by more than 50 percent in the 1990s. Its double-digit economic expansion of the 1960s and 1970s was long forgotten. Three or four recessions (depending on definition) occurred during the past decade, including at times when the rest of the world was expanding rapidly. Financial crises threatened repeatedly and were near-misses on several occasions. Other countries, including the United States, came to fear that Japan's weakness would plunge the world economy into crisis rather than that its strength would overpower them.
Three central questions emerge from this brief review of the recent past and current situation:
The Agenda for Japan
Japan's outlook continues to be clouded by the four major sources of its difficulties over the past decade. All four will have to be addressed to revitalize its prospects.
First, as much as half of Japan's banking system is probably insolvent. The huge level of nonperforming loans (more than $1 trillion, 20 percent of GDP) continues to grow faster than the banks are able to provision for them. Thus the banks are unable to lend more, despite the ample liquidity provided by the Bank of Japan, and little new investment takes place. The financial intermediation that is so central to any modern economy, and that has traditionally been provided in Japan almost wholly by the banking system, has largely dried up.
Confidence in a country's financial system is crucial to successful economic performance. Hence the demise of Japan's banks is at the heart of the country's overall economic problem. Neither consumer demand nor private investment is likely to resume at anything like a satisfactory rate until the banking system is fundamentally reformed.
Japan's authorities have continued to dither on this central issue, however. Unwillingness to risk a "hard landing," or even to force "zombie companies" or insolvent banks themselves into bankruptcy, has precluded any prospect for a serious turnaround. A possible solution emerged last fall, when Prime Minister Koizumi appeared to accept the far-reaching proposals of new FSA Minister Heizo Takenaka to dramatically restructure the banks, but the LDP leadership and business community (largely via the Keidanren) rejected the necessary adjustment. Piecemeal measures have thus become the norm once again and Japan is exhibiting its traditional tendency to "muddle through" rather than confront the problem.
My personal recommendation is that Japan emulate President Franklin Delano Roosevelt in 1933: declare a "bank holiday," closing the banking system for as many days (ten in Roosevelt's case, probably much fewer in Japan today) as necessary to reform it fundamentally. This would include shutting down the many banks that are clearly insolvent, forcing mergers of many of those that remain, clearing their bad loans into a government institution that would then sell them back into the economy at a deep discount, and essentially starting afresh.
There would clearly be a short-term rise in unemployment from such an initiative as workers in failed banks and companies lost their jobs. However, the markets should respond quite positively at the prospect (finally) of a recovery from the "lost decade." In light of the huge output gap that has developed in Japan over that decade, perhaps as much as 10 percent of GDP, the recovery could be quite sharp with annual expansion perhaps reaching 3 to 4 percent during several years of "catch-up growth." With or without a bank holiday, fundamental reform of the banking system is central to restoring confidence and thus economic prosperity in Japan.
Second, Japanese monetary policy needs to be strongly supportive of such reform. Interest rates have been held at zero for over four years. The Bank of Japan, by any traditional measure, is pumping huge amounts of liquidity into the economy. Yet deflation has continued for four years, the first extended experience of this type in any industrial country since the Great Depression; this deepens the debt problem of the banks (and government, see below), discourages consumption as households wait for lower prices and further saps public confidence.
The Bank of Japan made a huge error in letting deflation take hold because monetary policy, being unable to set nominal interest rates below zero, then loses most of its effectiveness. (The Federal Reserve has studied this experience carefully and has thus continued to ease monetary policy aggressively to preclude any risk that the United States will fall into deflation.) The BoJ has tried to cope with a series of unorthodox measures, including the purchase of equities from the banks (also intended to strengthen their balance sheets) as well as continuing massive purchases of government securities. Absent reform of the banking system, however, there is unfortunately little they can do on their own to remedy the current malaise.
As part of a comprehensive reform program, however, the Bank of Japan should adopt a regime of "inflation targeting" to both counter further risks of deflation and to avoid any excessively inflationary impact from a renewed growth surge. Like many other countries, the BoJ would adopt a target of 1 to 3 percent for annual increases in the price level. Properly conducted, this should inspire confidence that prices will be stable in a symmetrical manner-neither rising nor falling at rates that would disrupt the economy.
Third, Japan must adopt a truly expansionary fiscal policy in the short run and then consolidate the huge public deficits and debt once recovery is underway. Over 80 percent of the buildup in public debt has been due to the sluggishness of Japan's economy over the past decade rather than increased government stimulus. Indeed, Japan's fiscal policy has been rather tight through much of this period: taxes were raised sharply in 1997, cutting short a nascent recovery, and public investment has been cut steadily for the last three years and is now lower than in 1998.
As noted above, the necessary restructuring of the banking system will probably trigger a short, though perhaps sharp, further contraction of the economy. Real fiscal stimulus, preferably implemented for the most part through tax cuts that will further encourage consumers to resume more aggressive spending, will need to be part of the recovery program. The wasteful public expenditures of the past, or "roads and bridges to nowhere," need to be avoided.
Once growth resumes, fiscal policy will tighten due to the "automatic stabilizers" of higher tax revenues and lower social spending. But further cutbacks in wasteful government spending will be needed to bring down the outsized debt/GDP ratio and restore policy flexibility for the future. The fiscal policy side of the reform program, given the delicacy of its timing, will in fact be one of the trickiest parts of the overall revitalization program.
The fourth element in the picture is deregulation. Japan's internationally oriented companies, the Sonys and Toyotas and Kikkomans, remain among the most competitive in the world but the export sector is simply too small to carry the entire economy (which is why weakening the yen is of little help). But 80 to 85 percent of the Japanese economy—particularly service sectors such as construction, retail, and transportation—is grossly inefficient. Companies in these sectors are shielded from competition by a host of government regulations, tight government-business connections and corporate boards of insiders with extensive cross-shareholdings. Far-ranging deregulation, and much more aggressive competition policies, will be needed to achieve a more competitive, and thus more economically dynamic, Japan for the longer run.
Japan's economic problem is thus multifaceted and deep-seated. It will require an equally comprehensive reform program to achieve revitalization. That program must include four major parts:
As noted above, the results of implementing such a program could be surprisingly positive. The "lost decade" has produced a large amount of pent-up demand in Japan, for consumer spending but probably even more so for private investment. A restoration of confidence could thus produce several years of rapid "catch-up growth."
The crucial issue is of course the prospect for achieving such reform. Japan's "high-level stagnation" seems to have bred complacency as well as stagnation, so there is relatively little public pressure for reform and willingness to accept the necessary pain that would inevitably accompany it. Hence the situation may have to get worse before it gets better. Japan may even have to undergo a severe financial crisis including runs on the banks, capital flight from the country, forced bankruptcies, and unemployment. The last section below will suggest some less draconian possibilities for achieving the needed changes.
The Agenda for the United States
The agenda for the United States is naturally much shorter than that for Japan in light of the far better performance of its economy over the past decade. Even the recession of 2001 was quite short and quite modest, with growth in domestic demand (which is what counts for the world economy) recovering to 4 percent in 2002 and looking likely to recover to at least 3 to 4 percent in the second half of 2003 and 2004. That outlook is based on several sources of strong stimulus to demand as well as the continued strong growth of productivity on the supply side: the sharp fall in world energy prices, which is likely to go much further; the tax cuts already in place and the future cuts that have now been voted by Congress in the next few months; and the continuing extremely low level of interest rates, the lowest in the United States in 40 years, that provide enormous support for the interest-sensitive sectors of the US economy (notably homebuilding, automobiles, and other consumer durables).
The main challenge for the US economy is to maintain, or even increase further, the dramatic increase in productivity growth that occurred in the 1990s as described above. Both fiscal and monetary policy, as noted, are clearly supportive. So is the continued globalization of the American economy: the share of trade in total US output has tripled over the past generation, adding greatly to the competitive pressures on American firms and workers and thus forcing them to improve their productivity to compete. (The trade share in the US economy is now far higher than in the Japanese economy, where it has actually declined over the past 20 years rather than growing steadily as in the United States.)
The central policy problem for the United States is how to increase the low rate of national savings, which is clearly inadequate to finance the level of investment needed to grow the economy at 3 to 4 percent. This is of course the underlying cause of the huge and growing trade deficit, since the resulting shortfall must be filled by foreign capital, whose inflow drives up the exchange rate of the dollar, pricing American products out of world markets and producing the external imbalance.
The chief policy tool to increase national savings is the federal budget. Indeed, its dramatic swing from a deficit of 6 percent of GDP in 1993 to a surplus of 2 percent in 2001 was a major source of the improved US economic performance of the 1990s. It also gave the government the flexibility needed to respond promptly to the recession of 2001 with renewed stimulus. But the budget outlook has again become quite worrisome with the huge tax cuts of 2001, the further cuts just enacted, the additional spending required by the war on terrorism and now in Iraq, and the ageing of the population with its attendant cost increases for Social Security and Medicare. The president's tax cut proposals were fortunately rolled back substantially by the Congress but spending growth must be brought under increased control as it was in the middle 1990s.
Correction of the trade deficit, which is the other major imbalance in the US economy today, will require as well a substantial further decline in the exchange rate of the dollar. The dollar rose by 30 to 50 percent, depending on which index is used, from 1995 to early 2002. As a result, the trade deficit grew by almost one percent of GDP in four of the past five years and now exceeds $500 billion. Both the level and growth of these deficits, and of the US international debt position, are clearly unsustainable.
The dollar has thus declined over the past year, in a gradual and orderly manner, but only by about 10 percent on a trade-weighted average. It will probably need to fall by another 10 to 15 percent, on average against its major trading partners, to cut the external deficit in half and thus restore a sustainable relationship between the country's net foreign debt and GDP (in the 30 to 35 percent range). This will probably require another year or so of gradual decline like that of the past sixteen months. As part of this process, the yen will probably need to strengthen further against the dollar, to at least 110:1, but will correspondingly weaken against the euro and other currencies so that its trade-weighted exchange rate will not change very much.
A Cooperative Agenda?
A final question is whether there are ways in which the United States and Japan can work together to help resolve the problems identified above.
One obvious avenue relates to the trade imbalances. It is counterproductive for Japan (or anybody else) to intervene in the currency markets to weaken the yen against the dollar when the United States, and the world economy as a whole, need a weaker dollar to promote correction of the outsized US trade deficit. The US authorities have recently made clear their disapproval of Japanese intervention but intervention has apparently continued, and even accelerated, so it is not at all clear that the issue has been resolved.
On the more fundamental issues, of America's need for renewed budgetary correction and Japan's need for the four-part program outlined above, the upcoming G-8 summit in Evian offers a possible modality for cooperation. The summit will be the first post-Iraq meeting of the G-8 heads of state and government, several of whom have quarreled bitterly over both the war and the postwar planning. Hence it is imperative that the countries use the summit to pursue reconciliation, including through the adoption of a new Global Growth Strategy to stimulate the world economy via a coordinated recovery program.
Such a program would commit each of the G-8 members to implement new policy initiatives to get their economies going. The leaders could then use the international compact to help overcome domestic resistance to reform, for example, to bank restructuring in Japan. As in the past, reform-minded political leaders could employ such international agreements to strengthen their positions in their internal debates and achieve policy outcomes that were previously blocked. The urgency of restoring traditional alliance relationships, especially between the United States and several of the continental European countries (notably France and Germany), make it imperative that the Evian summit promote reconciliation. There could be no better way to do so than via a new consolidated growth strategy, to which all G-8 countries make a major contribution.