On Japan: Don’t Call It a Bubble

Should you worry about a U.S. “bubble economy”? Over the past year, former Vice Minister of Finance for International Monetary Affairs Eisuke Sakakibara and his successor Haruhiko Kuroda have commented that the situation in the United States is quite similar to that in Japan in the late 1980s and could end with a similar crash. Perhaps they are trying to divert public attention away from the mistakes Ministry of Finance and the Bank of Japan have made over the past 15 years: if the Americans follow the same path, then the Japanese situation might not seem so exceptional or bad. They may also hope that the arrogant Americans get their comeuppance—a feeling with which I certainly sympathize.

The good news is that they are wrong in their characterization of the American economic situation. The bad news is that they had better be wrong because the consequences for Japan of an American crash would undoubtedly be negative. The two economies are tied together closely enough that if the United States were to experience a stock market crash and economic recession, it could easily throw the Japanese economy back into recession, too. The most obvious link is trade. The United States remains the largest market for Japanese exports, absorbing 30 percent of the total. Since exports represent about 10 percent of the economy, this means that about 3.3 percent of total Japanese GDP consists of exports to the United States. That’s not a lot, but it could make a difference in domestic growth if those exports were to fall rather than grow because export industries are closely linked to other parts of the economy.

The United States is also the major destination for Japanese investment—both real (factories and real estate) and financial (stocks and bonds). About 38 percent of total overseas investment is in the United States, amounting to 60 trillion yen. Therefore, what happens to American stock prices, interest rates and the exchange rate affects Japanese investors—including the insurance companies and other financial institutions managing pension funds that are critical for your retirement. A stock market crash or a falling dollar would be a disaster for Japanese investors.

Luckily, the Sakakibara-Kuroda view is wrong. The American situation is not like that in Japan, and there is a good chance that the U.S. economy will achieve a soft landing. The economy has indeed experienced an usual burst of high economic growth, with low inflation and a sharply rising stock market that looks superficially like Japan’s bubble economy. The index of share prices on the New York Stock Exchange has tripled in value since 1993, and real-estate prices have finally begun rising in some urban areas over the past year. But the American experience has been solidly based on the diffusion of new technologies—particularly in the information technology sector—that caused an increase in productivity growth. And higher productivity growth enables higher non-inflationary economic growth. Some optimists believe that the sustainable economic growth rate is now as high as 3.5 percent, a level that could last for several more years as the information-technology revolution continues to create new employment and investment opportunities.

Unfortunately, the actual growth of the economy over the past several years has exceeded the long-run potential. In the last three years, the economy has expanded at a rate of just over four percent annually, and the most recent three quarters have exceeded five percent. This excess has driven unemployment to very low levels. National unemployment is now four percent, and in some hot markets (like the Washington, D.C. metropolitan region), it is two percent or even less. A level this low causes inflation to increase, as firms offer higher wages in order to attract workers.

Meanwhile, high domestic growth has caused the current-account deficit to widen. It could be as high as five percent of GDP this year—an unprecedented level for the U.S. economy and unsustainable for very long. In order for the current-account deficit to shrink, the dollar will have to depreciate against other currencies (making imports more expensive), and the economy must grow more slowly (thereby sucking in fewer imports).

Early signs of inflation and the rising current account deficit have led Alan Greenspan and the Federal Reserve Board to raise interest rates in a series of small steps beginning last year. The most recent step was a half percentage point increase in short-term interest rates in May. The goal of increasing interest rates is to bring the rate of economic growth down to a sustainable level (perhaps two to three percent in 2001) without driving the economy into recession.

Interest rates are now sufficiently high to begin having the desired effect. Commercial-bank lending rates are rising, and banks are tightening their standards for granting loans. As a result, credit will become more expensive and more scarce in coming months. Hopefully, this will cause economic activity to decelerate: consumers will purchase fewer cars or houses that need to be financed with bank loans, and firms will cut back on their investment. Generating a soft landing is tricky because of the lag between the interest rate increase and the point when the data showing the impact on the economy are published. Raising rates too much or too little is a distinct possibility. But the Federal Reserve Board is monitoring the situation very carefully, is aware of the complexities, and will attempt to find the appropriate amount of monetary restraint.

This is quite different from Japan in the 1980s. The acceleration of growth in the second half of the decade was not based on a new wave of technology. Japanese economic growth was aided by distinctive domestic technology advances over the past half century—especially in the field of manufacturing processes that drove down production costs and reduced product defects. But these technologies were not new in the 1980s and had already largely diffused through the economy. In fact, with the economy coming to the end of the “catch-up” phase of its development, growth should have decelerated.

Instead, the economy expanded rapidly. This surprising burst of growth was caused by a mistake in monetary policy: reducing interest rates too low and encouraging the money supply to grow too rapidly. Real-estate and stock prices rose, but this rise was not justified by any change in economic fundamentals. Companies were profitable, but mainly from gains in real estate transactions or the stock market rather than from improvements in their core business operations. This situation was unstable and unsustainable. When the Bank of Japan eventually raised interest rates and restrained credit from 1989, its response was late and slow. Eventually it overreacted and produced the disastrous crash in both real estate and the stock market.

There is no guarantee that the members of the Federal Reserve Board will give the U.S. economy the soft landing everyone wants. But they confront an easier task than that faced by the Bank of Japan in 1989. If they succeed, the already high reputation of FRB Chairman Alan Greenspan will soar even higher. If they fail, let us all hope the monetary policy mistakes are small and quickly corrected. Otherwise it’s recession time for the United States and “sayonara” to Japanese economic recovery.