A New Conjuncture in the U.S.-Japan Economic Relationship

Introduction
Well, it’s a great pleasure to be back in Okinawa today. The last time I was here was at the conclusion of the G8 Summit. I wanted first to thank Miyazato-san for the very kind introduction and also to the Ryukyu Shimpo and the Ryukyu Forum, to all of you for inviting me here, and also to Totoribe-san for arranging my visit.

As Miyazato-san has already indicated, this is a very important place for my family. My daughter took her first swim here with her father. We have a special place in our hearts for Okinawa.

I think it is a real tribute to the Okinawan people that this was the spot chosen for Japan’s hosting of the G8 Summit. By all accounts it was a very successful summit, both in addressing the new challenges associated with information technology and the very old challenges of economic development. I worked for President Clinton for six years, and of all that time one of my most treasured moments was the warm welcome that was given him by the Okinawan people at the Peace Park ceremony. It really stuck in his heart as well.

Realignment in Relative Positions
Over the last twenty years, we have seen two remarkable swings in the relative positions of Japan and the US in the world economy. Today, we are witnessing a third conjuncture. I will briefly compare the current positions of the US and Japanese economies and the policy measures under debate in each case. I will then give my own views what this means for the bilateral economic relationship and cooperation on global priorities more generally.

In the 1980s, Japan was the envy of the world as a manufacturing and exporting powerhouse, while the US was repeatedly chided for its irresponsible public finances. US scholars and management gurus wrote books and articles suggesting that the US adopt a variety of Japanese innovations including government involvement in directing investments among industry and greater reliance on patient bank capital rather than the myopic quarterly time horizon associated with equity financing. The US was chided for having too many lawyers.

But then, only a decade later, all the scholars and the management consultants were saying something very different. Now the US economy was the one to beat with its IT revolution, booming venture capital industry, and skyrocketing stock market. Japan became the subject of much handwringing, and the close link between banks, borrowers and bureaucrats was widely condemned, as asset prices plummeted and loans went bad. Now it was Japan’s turn to look to the US for ideas, and sure enough it was only a matter of time before a report from a Prime Minister’s Commission recommended Japan needed more lawyers!

Today, we find ourselves at a third conjuncture. In the US, the high tech stock index, the NASDAQ has come down from its giddy heights, followed in short order by weakening in the broader stock market, the manufacturing sector and business profitability. Unfortunately, the foundations had not been laid for Japan to take up the slack, and instead Japan’s stagnant economy has turned down as well. And although the US and then Japan have found it difficult to be the weak link in the global economy each in our own time, this is one case where misery does not love company. Far better for all when there is at least one strong engine of growth.

Comparison between Japan and US Downturns
As the U.S. stock market has continued its downward slide, many observers are comparing America’s experience as we enter the first decade of this century and Japan’s experience enter the last decade of the last century. Both Japan and the U.S. ended periods of sustained growth with the development of a run-up or “bubble” in stock prices which was fed by loose monetary policy. And in both cases downturns were ushered in by a very sharp turnaround in the stock market fed by a sharp contraction in the money supply.

But the story from there is quite different. In the case of Japan, there was a general asset price overvaluation that extended throughout the stock market and the real estate market and infected the major banks’ balance sheets. In the US, “irrational exuberance” was much more concentrated in the high tech sector, where venture capital and equity financing dominate. As a result, the relative wealth decline is much more modest so far in the US and the banking system remains largely unscathed:

There is a lively debate whether the current weakening of the US economy is likely to be a brief growth pause or the type of prolonged stagnation Japan has experienced. The debate can be summarized in terms of three letters. Some believe that the downturn is a V shape—that it will be very quick, but that strong consumer confidence and rapid adjustment of inventories will lead to a very quick recovery. Those who point to a U suggest that the downturn will be longer because businesses over-invested in the euphoria of the 1990’s. And it is hard to see why businesses would be rushing to scrap this recent investment so soon, with no new generation of “must have” technology in sight. A third group speculates that the U.S. may, in fact, be entering a long, protracted downturn similar to Japan. And those are the ones who talk about an L, with no recovery in sight. I don’t see the arguments for that right now.

In any scenario, I see three clear differences between the US and Japan:

• In the US, the deflation in asset prices has not infected the banking system and deflationary pressures are not a concern;
• The US entered the downturn in a strong fiscal position, while Japan has little fiscal ammunition in reserve,
• On the other hand, the US entered the downturn with a very large and sustained current account deficit, in sharp contrast to Japan.

Different Problems, Different Policy Debates
So what does this mean for the policy debates in Japan and the US?

In America, there has been a very fierce debate over tax cuts that started when the economy was still strong. Then-candidate George W. Bush argued very strongly for an enormous tax cut because of the big surpluses and the strength of the U.S. economy. Now that the economy is slowing, President George W. Bush is arguing very strongly for the same tax cut because we need fiscal stimulus. In fact, President Bush started talking down the economy in part to provide a compelling rationale for tax cuts. Unfortunately, in an economic environment driven strongly by psychology, this rhetoric may have exacerbated the loss of confidence.

There will no doubt be a large tax cut in the U.S. The real debate now is over how much of it will be focused on the short-term weakening as opposed to longer-term and, secondly, on the distributional effects. In terms of the long-term, although the U.S. looks like it’s in a good fiscal position short-term, we do have to worry very much about the unfunded obligations of our programs for the elderly with an aging of our population.

And just finally, the good news on the U.S. front is that the monetary authorities—although understandably late to start cutting—have been consistent in their easing, helping to soften the downturn. Despite initial concerns, there has not been the kind of finger pointing between the central bank and the financial ministries that Japan has had to endure.

The Policy Debate in Japan
Let me turn to the comparison with Japan and note some of the things that are very striking to an outside observer.

First, some of the same institutional features of the Japanese system that were great strengths in the seventies and eighties have now proven to be key liabilities. For instance, the tight linkages that led to direct lending.

Second, the political system has proven to be a big contributor to the economic morasse in Japan. What one would expect to see right now is a heated political contest between candidates offering the Japanese people the opportunity to pick radically different prescriptions to fix the Japanese economy. As we know from the US, that doesn’t guarantee the people will choose the better economic policy, but it does mean that the winner has a mandate and the election next time around is a verdict on his economic performance.

Right now it seems the central problem in Japan is the banking system, which is broken, and the resulting deflationary pressures. What we have learned from banking crises around the world—in Sweden, in France, in the U.S.—is that they are not difficult to solve intellectually, they are difficult to solve politically. And the sooner the hard reforms are taken, the faster recovery can take place. The measures that were put in place primarily by the Obuchi government are a good first step. But now what is needed is that banks need to declare the market value of their non-performing and problem loans, and the government needs to help get these loans packaged and onto the market so that the bottom can be found in the land market as well as in the stock market. The September 30 deadline for reporting under new international accounting standards should be a powerful driver.

That means three things, all of which are politically difficult: One; some banks will have to be shut down, others will have to be merged. Two; there will need to be an injection of public funds yet again to recapitalize the banks, and third; it means that the economy, unfortunately, will go through more deflationary pressure and unemployment before it turns around.

I think it is a mistake to try to soften the blow with a stock purchase fund. This will simply obscure the reality that the government is letting off the banks easily once again, enabling them to rollover bad loans and prolong the cycle. Much better to have the stock market find its true value, and have an explicit transparent government recapitalization of selected banks pending resale to the private sector.

During that time that this deflationary process continues, it’s critical that money remains easy and that fiscal policy remain stimulative. The kind of brinkmanship that we have seen in Japan between the Bank of Japan, the Ministry of Finance, and the Diet are terrible for market confidence.

And unfortunately, because of continued deflationary pressures, now is not the time for fiscal retrenchment, as was done in 1997 with regrettable consequences. Once growth is solidly established, there will be plenty of time for a steady withdrawal of public stimulus. The only last thing I’ll say on Japanese fiscal policy is it’s too bad that the tax cut debate isn’t taking place here instead of the United States because I think you could really benefit from tax incentives. Why not replace the wasteful public spending with targeted tax cuts, to encourage consumption and encourage homeowners to realize losses?

Implications for Our Common Goals
Now where does this leave us in terms of bilateral relations and on our shared agenda in the world economy more generally?

First, inevitably it points in the direction of yen depreciation. This is an obvious implication of the kind of monetary policy that is required to counter deflationary forces. Nonetheless, it will put strains on our other trade partners in the Asia Pacific, whose economies are already feeling the effects of weaker US demand. And it will make life for the U.S. more difficult. Our current account is at a post-war high—4.5% of GDP—and normally you would expect the dollar to be weakening right now, but in fact the reverse is likely to happen vis-à-vis the yen. Thus, much as the Bush administration would like not to give any advice to Japan, I would bet they will end up having to take a pretty strong position in favor of Japan taking hard steps on banking reform as the implicit price for accepting sustained yen weakening. It would be irresponsible to remain silent in light of Japan’s importance to the world economy.

Second—the WTO round. Right now, with weakening in both economies, the benefits of a global trade round will be even higher than before. But this will require that Japan and the U.S. come to some kind of accommodation on anti-dumping, which will be very difficult on both sides because of the disagreement over steel.

How about the G7/8? In the benign world economic environment that prevailed last year, the US worked to support a very successful Japanese agenda that focused on the challenges of development and the promise of information technology. Japan’s leadership produced a worthy outcome. In an ideal world, this year’s G8 summit would produce agreement on coordinated management of the world economy to revive growth. But I have a rather more pessimistic prediction that the main story surrounding this year’s summit will be tension between the EU and the US on subjects ranging from missile defense to climate change to trade.

And finally—APEC. In the best of all possible worlds APEC would be a great win this year, helping to launch a WTO Round and helping to finalize China’s accession to the WTO. But given tensions in the region right now, it’s very early to make that optimistic a prediction.

Let me simply conclude by saying that I am one of those who believes that Japan and Okinawa have a very bright future. Japan will again become a powerhouse. It has all the necessary attributes to compete and win in the new economy once the banking mess is cleaned up. I look forward to coming back here one day, not in the distant future, when Japan again is the model to study and Okinawa is a vibrant hub in that Japanese economy. Thank you.