Japan is a risk for the world economy. Although Prime Minister Junichiro Koizumi’s reform plans are vague and offer no guarantee of results, Japan, and the world as well, depend on the success of the reforms for their prosperity.
At the recent summit of the Group of Eight industrialized nations, Koizumi and U.S. President George W. Bush agreed to create bilateral panels on fiscal and monetary policy, direct investment, trade and deregulation. The Bush administration proposed setting up the panels, and I believe Washington will use them to check up on Japan’s economic policies that hopefully will put the nation back on a recovery track.
One concern I have about Koizumi’s reform programs stems from their largely ignoring the risks of excessive currency fluctuations. Granted, some market experts, scholars and bureaucrats contend that currency stability is no longer as important as it used to be, since the manufacturing industries are less important in today’s economy. I believe, however, that currency stability is a prerequisite for self-sustained economic recovery. An overshooting of the yen’s value could ruin Koizumi’s reforms.
Koichi Hamada, chief of the Economic and Social Research Institute, the Cabinet Office, presented an interesting hypothesis at a Japanese economists’ conference in May. He suspects that the yen’s surge in the 1980s, which seriously damaged the Japanese economy, occurred when Washington as leader of the world system manipulated Tokyo under the pretext of policy cooperation. He noted that Japan expanded its money supply under the U.S. pressure of 1986-88 more than the United States did. Many economists who are unable to explain the reasons for currency volatility fail to take such political dynamics into account.
The U.S. dollar plunged in the late l980s and in the early 1990s when the market overreacted in panicky trading to the policies of the Reagan and Clinton administrations aimed at bringing down the value of the currency.
An executive with a major Japanese electronics manufacturer says if the exchange rate had remained at the level of 80 yen to the dollar, the prevailing rate in April 1995, his company might have gone bankrupt. His company has moved production plants to countries where costs are decisively low, on the assumption that the rate could hit 80 yen again.
Some experts say a lower value for the yen should be engineered by the Bank of Japan’s intervention to help boost economic recovery. In the short term, it could stimulate the economy but could cause a wild rebound in the yen’s value in the long term. The exchange rate, per se, should not be the sole concern. What is more important is that Japan lacks a system to stem excessive currency fluctuations. That, combined with high costs, makes Japan less attractive as an investment location.
At a time when the economy is in the doldrums due to sluggish private demand, Japan faces a steady outflow of business investment and jobs. Export-oriented industries, such as electronics, have moved overseas their production facilities, which also handle research and development for new products. Even smaller Japanese companies and agribusinesses that sell their products mostly in Japan have moved production bases to low-cost countries.
All of this has undermined Japan’s economic base, and it is becoming difficult for the nation to provide jobs for its 66 million workers. A fresh surge in the yen’s value could occur if Koizumi’s reforms succeed and signs of economic recovery cause a sharp rise in capital inflow — and if the value of the dollar, now overvalued as a result of the U.S. strong dollar policy, is over-corrected and tumbles.
The U.S. business world is already seeking a correction to the dollar’s appreciation. The U.S. suffers from a current account deficit of $400 billion a year and is saddled with $1.3 trillion worth of net foreign debts. The market could view this situation as untenable. The fate of the world economy is considered dependent on the whims of U.S. consumers, whose savings rate is almost zero, but we should not assume that this situation will continue indefinitely.
If the two scenarios mentioned above were to occur simultaneously, the Ministry of Finance’s buying support of the dollar would not be enough to stem the currency’s free fall. The yen would spurt and Koizumi’s reforms would fizzle out despite early signs of success. The Japanese would be greatly disappointed.
The Americans would not want to see such an event either, because a sharp fall by the dollar would mean an outflow of much needed foreign capital. What would happen to U.S. financial markets is not difficult to imagine. The question is, would it be technically and politically feasible to create a framework for preventing currency volatility of that magnitude?
Let me point out that financial markets are sensitive to comments by U.S. officials. Whenever White House economic adviser Lawrence Lindsey says the U.S. would tolerate a cheaper yen, the currency’s value falls. Whenever Bush says a strong dollar facilitates a capital inflow but tends to curb exports, the yen’s value spurts.
Ronald McKinnon, professor at Stanford University, has long advocated a Japan-U.S. monetary program that would eliminate the expectation of an ever-higher yen, which he believes is the basic cause of a lower level of private investment in Japan. C. Fred Bergsten, director of the Washington-based Institute for International Economics, has proposed a flex target zone, which reflects changes in economic fundamentals.
These proposals are unpopular among Japanese foreign-exchange authorities and economists, probably because Japanese government officials realize they have no way of influencing U.S. politics, and many Japanese economists believe firmly in the principles of the market economy alone. In Japan, bureaucrats tend to play a leading role in currency stability, but this responsibility should lie with political leaders. Some politicians understand this.
Sony Corp. Chairman Nobuyuki Idei once reportedly asked Koichi Kato, a dissident in the ruling Liberal Democratic Party, to help stabilize the yen-dollar exchange rate. Kato said political leadership should deal with the issue, because it is ultimately linked to the Japan-U.S. security system. The proposed Japan-U.S. economic panels will provide Japan with a rare opportunity to propose the establishment of a mechanism for preventing excessive currency fluctuations.
Washington is loath to having policy freedom restricted under an international agreement. Even with some governmental agreements that do not require ratification, it will be difficult for the government to ignore the will of Congress. Even if Washington hoped to avoid a currency crisis and see Koizumi’s reforms succeed, it would not be easy for Tokyo to persuade Washington to accept its proposals for avoiding currency turmoil.
Whether a mechanism for controlling a currency crisis could be created depends, first of all, on Koizumi’s political will and ability to present a credible reform program — of which an agreement on currency stability is an integral part — and a convincing arguments to persuade U.S. officials at the highest political level.