The Great Unequalizer
The Pandemic Is Compounding Disparities in Income, Wealth, and Opportunity
The unprecedented international imbalances of the first half of the 1980s have fundamentally altered the structure of the world economy. The United States, the creator of the postwar economic system and home of the world’s key currency, has become the largest debtor nation ever known to mankind—and its red ink will continue to flow at least into the 1990s. Japan, widely viewed as a developing country only a generation ago, has become by far the largest creditor—and its massive buildup of foreign assets will continue expanding rapidly as far ahead as one can predict. The actions taken to date to correct these imbalances have gone only about half the distance needed, so there is now no prospect for their early elimination—and very little for steps to cope with the structural transformation they will bring. The forces set in train by these historic changes will dominate the course of global economic events for the next five to ten years, and may go far to influence world politics as well.
The trade deficit of the United States reached about $150 billion in 1986. By the end of this decade the net indebtedness of the United States will substantially exceed half a trillion dollars and the country will be paying tens of billions of dollars to foreign investors in servicing costs. America’s oil imports may again rise sharply, certainly in terms of volume and perhaps price as well. To restore balance the United States therefore must improve the rest of its yearly current-account balance by approximately $200 billion. The vast bulk of this improvement will have to come in trade in manufactured products, the very sector decimated by the overvalued dollar in the first half of the 1980s.
The trade surplus of Japan is running close to $100 billion a year. By the early 1990s, Japan will be a net creditor of at least half a trillion dollars—mirroring to an astonishing degree the American red ink. Japan’s annual investment earnings will grow to between $25 billion and $50 billion within the next five years. Japan must therefore accept a decline of around $100 billion in its annual trade balance (also mainly in manufactured products) to restore reasonable equilibrium.
These shifts will be dramatically different from all previous economic episodes because of the sheer size (and perhaps speed) of the changes required and of the extent of the needed role-reversal between the world’s two largest economies. It is historically and arithmetically certain, however, that adjustments on this order of magnitude will occur. But will the adjustments be made in time to avert severe international economic disruption triggered by a free-fall of the dollar, a massive outbreak of American protectionism or a deep global recession—or all three? Will they occur constructively, by a speedup of growth abroad and further orderly changes in exchange rates, or instead by an American recession, which could drag down the world economy and reignite the debt crisis of the Third World?
Unprecedented geopolitical questions arise. Can the world’s largest debtor nation remain the world’s leading power? Can a small island nation that is now militarily insignificant and far-removed from the traditional power centers provide at least some of the needed global leadership? Can the United States continue to lead its alliance systems as it goes increasingly into debt to the countries that are supposed to be its followers? Can it push those countries hard in pursuit of its economic imperatives while insisting on their allegiance on issues of global strategy? If the United States turns increasingly protectionist and thereby disrupts the trading system, can it hold its allies together in managing the security system?
There may be political pressures within the United States for the nation to turn its back on a continuing global security role—as happened with the proposed Mansfield Amendment to reduce troops in Europe in the early 1970s—if the allies resist facilitating the essential correction of America’s economic imbalances or seek to turn the weakened U.S. position to their advantage. Questions will be raised as to why America should pay to defend countries that are now, at least according to the published statistics, richer than it is. This could turn out to be true particularly in the case of Japan, toward which historical and even racist resentments have been revived by the economic disputes.
The United States could decide to condition the continued American protection of its European and Asian allies on a display of economic cooperation far greater than any they have shown to date—rejecting the compartmentalization of security and economic matters that has facilitated the management of both concerns for a generation, and the primacy always heretofore accorded to security when that compartmentalization broke down. Or the United States could pursue the massive cuts in strategic forces discussed at the superpower summit at Reykjavik—sharply enhancing the importance of conventional forces, which the Europeans would largely have to provide and pay for themselves.
Moreover, there will be enormous psychological effects in both the United States and Japan, going far beyond the economics of the situation. The United States is the world’s largest debtor but it continues to think like a creditor—dispensing advice to the rest of the world (particularly the other, mainly Latin American, debtors) while its own budget remains in huge deficit, and, in the recent past, propelling its currency to levels that priced U.S. industry and agriculture out of world markets. Japan is the world’s largest creditor but continues to think like a debtor, seeing itself as a vulnerable island nation with few global responsibilities. The implications for world leadership, or lack thereof, are profound and far-reaching.
It is obvious that the United States can no longer play the role of global economic benefactor. It is unclear whether America’s present political leadership position can be sustained in an environment so radically different from that on which the postwar order was founded. The development of a new means of pluralistic security leadership, as well as of a more cooperative economic leadership, may finally be made inevitable by the massive economic shifts of the 1980s.
After half a decade of permitting the imbalances to build, with only inadequate rearguard actions taken in response, the world thus faces a set of interconnected watersheds: economic; political, both domestically and internationally; and psychological. A new structure of economic relationships and power positions is rapidly emerging, and may be ushering in deep political and security changes as well. A series of immediate measures is needed to avert the risk of severe crisis, and I will address these first. The systemic implications of the situation may be even more profound and difficult, and these will be the focus of the latter part of my analysis.
The objectives of international economic policy in the short run must be two-fold. First, the world must avoid an outbreak of trade protectionism of such severity that it would disrupt the entire global economy, intensify the Third World debt crisis and jeopardize the alliances of the non-communist world as well. Second, it must avoid a dollar collapse that would ignite global financial instability and renewed inflation. Either of these developments, which could occur separately or in tandem, could in turn trigger a world recession or worse.
To prevent such an outcome, it is essential to achieve a sharp and sustained decline in, and perhaps the eventual elimination of, the American trade deficit. The postwar history of American trade policy shows that the exchange rate of the dollar and the level of the balance of trade are the best leading indicators of protectionist pressures, a correlation that was never stronger than over the past few years.
The test is not solely, or even primarily, whether the Congress ultimately passes "protectionist" legislation—though its doing so could trigger a global crisis. This Administration, like its predecessors, has done most of the dirty work already by adding new trade barriers under the threat of such congressional action. The continued granting of sector-by-sector restrictions, which has substantially accelerated the retreat from free trade, could at some point set off a full-scale trade war.
It would be absurd for the United States to prompt such an outcome just when the fall in the dollar has begun to restore American international competitiveness, and thus when other countries can be expected to experience intensified protectionist impulses. Fortunately, the debate, both in Congress and among the public, seems to be moving toward a focus on strengthening American competitiveness rather than blocking the access of foreign goods to U.S. markets. But any of several developments could ignite a highly destructive and perhaps irreversible trade disruption: a few months of bad trade figures; a failure to discover effective ways to buttress the underlying ability of the United States to sell abroad; continued political unwillingness to deal with the budget problem, which lies at the heart of the trade deficit; an effort to deal with both deficits by taxing foreign exporters through a new "revenue tariff (i.e., an import surcharge); or a foul-up, either at home or abroad, in managing the growing number of sector-specific trade conflicts. The race between constructive adjustment and such a disaster remains to be won.
Foreign investors could begin to forsake the dollar unless the trade deficit is decisively reduced. In that event, the currency markets could push the dollar down much further, and perhaps much faster, and the United States might have to raise interest rates sharply to finance the deficit. Such a financial crunch could revive rapid inflation in the United States for a while and push up inflationary expectations even more, thereby reinforcing the rise in interest rates, and simultaneously create a recession, perhaps of fairly great magnitude.
In essence, America must aim for export-led growth for the rest of this decade and into the early 1990s. Most economic forecasts for 1987 and 1988 are already relying on a substantial improvement in the U.S. trade balance to avoid recession. But it will take at least five years of trade gains to halt the deterioration of America’s international financial position. It must be a central goal of the national agenda—for foreign policy reasons as well as economic ones—to achieve such an outcome.
I believe that the American trade deficit will decline substantially in 1987 and 1988, perhaps on the order of $30 billion in each year. By early 1987 the dollar had fallen by about 35 percent against the currencies of Japan and Western Europe—the surplus countries whose trade deterioration must mirror the bulk of the American correction. (The South Korean won and, especially, the Taiwanese dollar, were also on the way up—but not until quite recently and to a limited extent, so without yet much impact on trade flows.) It normally takes 12 to 18 months for currency changes to produce improvements in recorded trade balances, and the lag could be even longer this time because the dollar was so overvalued at its peak that foreign firms built enormous profit margins and did not have to raise their prices for some time. The economic adjustment to the dollar’s fall began only after the Group of Five leading industrial nations (G-5) announced, at the Plaza Hotel in New York, their intention to bring the dollar down, substantially and to stay. Since this Plaza agreement was not realized until September 1985, no one should have expected much improvement in the trade balance until 1987.
Indeed, the flattening of the deficit throughout 1986—compared with a trajectory heading toward $200 billion or more —already represented substantial progress. Real net exports began to improve in the fourth quarter of 1986, accounting for all of the meager expansion of total GNP in that period. The United States achieved export-led growth between 1978 and 1980—with exports growing twice as fast as world trade and the current-account balance improving by over $50 billion (excluding the adverse price effect of the second oil shock)—so, clearly, it can be done.
Such an improvement in the American trade balance should help reduce the pressures for irrational trade actions and a precipitate decline in the dollar. However, my estimates are admittedly on the optimistic end of the spectrum and some experienced observers, including the economists of the International Monetary Fund and the Organization for Economic Cooperation and Development, foresee very little improvement in the American position coming from the adjustment actions taken so far. Even on my forecast the deficit would still be close to $100 billion. And it is unclear whether trade politics and the currency markets will be dominated by a declining trend in the U.S. trade deficit or by a level that remains huge by historical standards. Timing is also crucial: Will the decline in the trade imbalance, even if it does occur, arrive in time to produce a significantly better environment before the dams break?
These uncertainties underscore the need to correct the imbalances as rapidly as possible. The United States could conceivably borrow new funds abroad to service its escalating foreign debt for a while, as many Third World debtors have done. But this would simply build up the debt and its servicing costs further, and increase the magnitude of the required adjustment. Considerations of economic and foreign policy, even of national security, strongly suggest making every effort to avoid such a predicament.
Both the United States and its friends and allies abroad have an enormous interest in constructive resolution of these problems. In the absence of such a response, the entire world economy could be badly shaken—with substantial costs to all countries, particularly those more dependent on trade than is the United States. As noted, fundamental security structures could be jeopardized—again, with high costs to all involved but with the highest costs to those nations that are most exposed. It would appear that all countries, at least all those outside the communist world, must share these objectives and cooperate in achieving them. But this seeming imperative clashes directly with the unwillingness, or political inability, of the major countries to take, to date at least, any of the required actions to anything approaching the needed degree.
By following its present policies the United States will continue to run the huge deficit in its federal budget that, as I have mentioned, lies at the heart of its trade imbalance. It was the enormous growth in the budget deficit in the first half of the 1980s, coupled with normal levels of private demand and savings, that produced the present situation, in which Americans are spending far more than they produce and hence running a gargantuan trade deficit. Because the government deficit soaked up a large share of America’s paltry private savings, the excess spending had to be financed from abroad—the capital inflow that quickly turned the United States into a debtor country. Indeed, the source of the "miracle" of supply-side economics has now been revealed: foreigners supplied many of the goods and most of the money. If the policies of the 1960s and 1970s were "spend and tax," the policies of the 1980s were "spend and borrow."
The budget deficit and trade deficit are both likely to fall by about $30 billion in 1987. Hence the United States may enjoy an optimum balance this year between internal and external adjustment. But the budget imbalance could rise again in future years unless the President and Congress soon settle their differences on how to reduce it. If they do not, a cut in the trade deficit of anything like the magnitude needed, because it would reduce the associated capital inflow by a like amount, could occur only with very sharp cuts in consumption and investment by private Americans. The goal should be to cut the budget gap by at least another $100 billion by the early 1990s to make room for the needed gains in the trade balance without "crowding out" the private sector. Such crowding out would be an ironic legacy of Reaganomics.
From the surplus side, Japan and West Germany (as the proxy for Western Europe as a whole, since the entire region’s growth performance depends heavily on Germany’s) do not look any more promising. Each country appears to be growing at a sluggish annual rate of two percent or even less. Neither has had the growth spurt that, according to the normal pattern, should have followed the world recession of 1982; only the United States experienced such a spurt, growing at over six percent for 18 months in 1983 and 1984—thereby providing welcome impetus to the world economy but adding further to its own trade deficit in the process. As a result, unemployment remains at unprecedented levels throughout Europe and has reached a postwar high in Japan. Yet both countries resist providing significant new stimulus.
In both Japan and Europe the goal should be a further expansion of domestic demand by about two percentage points per year for a couple of years. This would permit the essential international adjustment to take place in an environment of renewed growth rather than recession. When completed, it would also promote an improvement of about $40 billion annually in the American trade position.
Tax cuts are probably the best way to achieve the bulk of this growth. In Japan this could be engineered by deferring for a couple of years the planned value-added tax (VAT) included in the government’s new tax reform program—which could thereby couple reform and stimulus. (The stimulus to be derived by deferring the VAT would be especially great, as spending would undoubtedly be accelerated by a consumer desire to make purchases before the imposition of the tax.) Germany should both bring forward and substantially expand its tax reduction scheduled for early 1988. Neither country would suffer adverse effects from such efforts, as their inflation rates are virtually zero and their high national rates of savings can easily finance any temporary negative impact on the budget. Nevertheless, little action appears in the cards. If changes along these lines in the "fundamentals" do not transpire, the only alternative is further—perhaps substantial—change in the exchange rates, in spite of any efforts that the G-5 may take to stabilize them.
However, assuming American movement on the budget and action abroad along the lines just indicated, the exchange rates of early 1987—the dollar at about 1.80 West German marks and 150 Japanese yen—are nearly correct for now (although the yen, at least, will probably have to continue appreciating over the foreseeable future). Without such steps, the yen would need to rise beyond 140 to the dollar, and the mark to perhaps 1.60 to the dollar, in the near future. Such currency movements would risk triggering a precipitate plunge of the dollar.
In political terms, the short-run problem comprises three conflicts. First is the American Congress versus the Reagan Administration: the former may well "go protectionist," or force the latter to do so, if the Administration cannot come up with an effective alternative to reduce the trade deficit. Second is the Administration versus the Federal Reserve Board: the Fed does not want the dollar to drop too far too fast, so the Treasury must look for alternative ways to achieve much of the adjustment. Third is the United States versus the surplus countries; they are pressed to increase domestic demand to take pressure off the currency markets and defuse congressional temptations to impose restrictive trade legislation.
The obvious political solution is for each of the actors to make a contribution. The Administration and the Congress must together get the federal budget under control, trimming further the growth in both defense expenditures and entitlement programs while raising revenues as well. The Federal Reserve may have to allow a further fall in the dollar, while carefully managing such an adjustment to keep it orderly. Japan and Germany, providing an example and an incentive for the rest of Europe, must cut taxes and foster more growth. In the absence of such a package, either worldwide trade protectionism or a collapse of the dollar would occur within the next couple of years—probably pushing the world into recession.
The international effort to deal with the huge trade imbalances—launched at the Plaza in 1985—has thus gone only about half the needed distance. In this sense, it bears an ominous similarity to the Smithsonian agreement of December 1971, which sought to resolve the most serious international monetary crisis experienced in the postwar period until now. In August 1971, President Nixon shocked the world by imposing an import surcharge and declaring that dollars held by foreign central banks would no longer be convertible into gold—in essence, floating the dollar. Currencies were then realigned in an attempt to resolve the problem—centering, like today, on a huge (for the time) American external deficit and corresponding Japanese and German trade surpluses. Mr. Nixon labeled the outcome "the most significant monetary agreement in the history of the world."
However, the Smithsonian agreement collapsed in just over a year because the countries went only half the distance needed to correct the imbalances. They had agreed to devalue the dollar by ten percent; but by early 1973 it became necessary to double that realignment to restore balance in the international accounts and to stave off renewed currency runs and protectionist pressures in the Congress. One consequence was the final discrediting of the Bretton Woods system of fixed parities and its replacement by floating exchange rates.
The parallels between conditions in 1971-73 and today are extensive and disturbing. The American trade deficit—even if my relatively optimistic forecast is correct—will, if present policies are continued, be cut by less than half and will remain uncomfortably near $100 billion. The Japanese surplus will remain well above $50 billion (although declining by more in yen and volume terms). Hence the adjustment actions adopted so far to deal with the imbalances of the mid-1980s have also gone only about half way. Failure to take further action could bring on the crises that were so narrowly averted in the early 1970s, and—again—a demise of the existing international monetary system.
But complacency and inaction seem to have set in. The Plaza agreement appeared to replace the belligerent noncooperation policy of the first Reagan Administration with a return to the international economic cooperation that was common in the 1960s and 1970s. Within a few months, however, the Plaza spirit of collaboration evaporated. The G-5 countries had been able to agree in September 1985 that the dollar was too high and had to decline, but they quickly proved unable to agree on (1) how far it should fall and (2) what complementary measures should be adopted to limit the extent of the dollar’s fall, and enable it to fall in an orderly way.
Anti-Plaza conflict soon emerged. American officials continued to talk the dollar down, while central banks in Japan and Europe bid it up. Clashes over national economic policies deteriorated into public shouting matches among the major countries, jolting the markets and conveying a specter of total disharmony. At the meeting of the G-5 in February 1987 an atmosphere of cordiality returned, but without much substance—and even the United States seemed resigned to the inadequate results of the efforts of the previous 17 months.
The outlook is therefore discouraging, even for the short run. Continuing huge American trade deficits, even if reduced considerably from the level of 1986, will provide fertile soil for trade protectionism and will be a steady source of potential disruption of the entire trading system. As long as the United States needs to borrow $100 billion or so annually to finance those deficits, international monetary instability will threaten, and a sharp fall of the dollar could precipitate a financial crunch at any time. Most Japanese forecasts envisage continued large surpluses for Japan, and some see its creditor position rising to more than $1 trillion by the year 2000. Policy conflict among the major countries is likely to persist, further eroding the fabric of international economic cooperation that has been crucial to building postwar prosperity and avoiding a return of the economic warfare of the 1930s. Global security arrangements, already jolted in their NATO dimension by the Reykjavik summit and discord over arms control, would inevitably erode as a result of such economic disharmony.
Even if adequate measures are adopted to resolve the immediate problems, the United States, Japan and, to a lesser extent, the European countries must undergo enormous structural changes to maintain international economic stability for the longer haul. For most Americans, the new situation will represent a dramatic reversal of the 1980s. Even after the end of the boom of 1983-84, domestic demand in the United States—for consumer goods, plant and equipment investment, government programs—has risen at a healthy rate of between 3.5 and 4 percent annually. However, domestic production (the gross national product) has only been rising at an annual rate of about 2.5 percent. The remainder of domestic demand has been satisfied by goods and services produced abroad. It is fun while it lasts, but no country can forever live beyond its means as the United States has been doing.
All this must reverse by the 1990s. To run a trade surplus, America will have to produce more than it spends. The United States will have to churn out goods and services for use in other countries rather than at home. To finance the economy with domestic resources, Americans will have to save much more, or cut the budget deficit substantially, or, much less desirably, slash U.S. private investment.
This would be a huge adjustment, even for an economy as large as America’s. The shift of resources into export and import-competing products will amount to between four and five percent of the total U.S. GNP, or about two thirds of the total defense budget. It is a far larger adjustment than that required to meet either oil shock of the 1970s.
Achieving this new state of affairs would in turn require major alterations in the structure of the American economy. Virtually all of the trade improvement must come in the manufacturing sector, since agriculture faces a persistent world glut and the services account (which includes the growing burden of interest payments on the foreign debt) will be worsening. Such a shift would require an expansion of about 30 percent in the capacity of the U.S. manufacturing industry over the next five years, which in turn calls for considerable new investment. The budget deficit must come down to permit funding for such investment without continued reliance on funds from abroad—a reliance that, by definition, would mean that the trade deficit was failing to improve.
These essential structural changes in the American economy will have to be mirrored by changes of at least equal magnitude in the major countries abroad. The most dramatic case is Japan, where there is widespread fear of deindustrialization of the home islands as the yen soars and the newly industrialized countries (NICs) of East Asia seize new markets every day. The "hollowing out" of the Japanese corporation is foreseen, as many world-class Japanese firms move their production abroad and import more and more components—despite the highest unemployment level in postwar Japanese history and growing erosion of the lifetime employment system. Indeed, Japanese labor has begun to complain of an "export of jobs."
During a transition period of four or five years, the growth rate of the Japanese GNP will be reduced by approximately one percent a year due to the decline of its trade balance. The growth rate of the Japanese manufacturing sector will be cut roughly in half. For the long haul, Japan will have to generate enough domestic demand to sustain its economic growth at a politically acceptable level. Doing so will require it to continue cutting its savings rate or, far preferably, to find new sources of domestic investment. Its corporations will have to alter their strategies drastically; most of the Sonys and Nissans will no longer be able to maintain global leadership primarily by selling worldwide from Japan, but will have to re-tool for the home market or, increasingly, produce abroad.
Fortunately, there are enormous sources of pent-up demand within Japan. The average Japanese home is half the size of the average American home, and more than half of Japanese homes do not have modern plumbing. Japan could launch a ten-year housing boom, which would encompass enormous demand for appliances and other household items as well as for the residences themselves. The high price of land is often cited as an insurmountable barrier to such a strategy, but Japanese land prices are largely a function of inefficient land use—rice paddies in major cities due to huge farm subsidies, building codes that limit dwellings to one story to let sun shine on the other side of the street, property taxes with very low or zero effective rates—rather than physical shortages. Indeed a Japanese housing boom could be a major source of world economic growth, as well as an effective way to deploy Japan’s large savings for domestic purposes rather than for the purchase of assets abroad, which promotes a large trade surplus.
The Japanese history of rapid response to external shocks is a source of confidence that, once again, they will be able to do what is necessary. However, the current adjustment will be much more complex than those accomplished in response to the oil shocks of the 1970s—when Japan responded mainly by doing more of what it had been doing already, i.e., exporting. Moreover, many Japanese believe the country has "used up" much or all of its scope for government stimulus due to the huge national debt from large budget deficits in the 1970s.
Japan must therefore make far-reaching changes in its basic economic structure. It could of course enable its exports to continue growing by promoting a dramatic increase in imports of both manufactured and agricultural goods to help satisfy higher levels of domestic consumption. This approach would also require tremendous structural changes, however, since Japan’s import level—contrary to much foreign rhetoric and some analysis—does not appear very different from that of other countries when proper account is taken of its lack of natural resources and distance from world markets.
The financial side of the future trans-Pacific equilibrium is also worthy of note. America’s net foreign debt is now about $250 billion and Japan’s net asset position is almost as large. By the early 1990s America will be a net debtor of at least $500 billion and Japan will be a net creditor of a very similar magnitude. In essence, Japan will own a sizable stake in America and the United States will be significantly in debt to its major Pacific ally.
A crucial question is how their creditor-debtor relationship will affect overall relations between these two largest economies in the world. Paradoxically, the huge debtor position of the United States provides it with added leverage in an extreme crisis. If Japan owned half a trillion dollars’ worth of investments in the United States, an American default or freeze of Japanese assets would be acutely damaging to Japan. A large depreciation of the dollar could also cause the Japanese economy considerable pain (although, in the case of the dollar’s recent decline, sophisticated hedging techniques, Japanese accounting rules and relatively higher American interest rates have limited the impact on Japanese institutional investors).
Such action, while remote from daily financial activity, should not be regarded as unthinkable. President Nixon partially defaulted on more than $100 billion held by foreign central banks in 1971 when he declared those assets inconvertible into American gold after almost four decades of promises to the contrary. Mexico and Brazil never shrink from reminding their creditors that ultimate power lies with the large debtor, and they extract numerous concessions as a result. Any Japanese political or financial leader pondering a major policy change that would run against American interests, such as a reversal of alliances or a sudden move out of dollar investments and into other currencies, would have to take account of the risk of triggering such a reaction—as Arab dollar holders evidently have done, particularly after observing the American freeze of Iranian assets in 1979.
In the course of normal economic activity, however, the creditor holds the greater leverage. The U.S. Treasury has already had to adjust to Japanese sensitivities in structuring its auctions of American government securities, and the risk of a Japanese investment pullout has reinforced at least some U.S. authorities’ reticence to let the dollar fall too far or too fast. As the stock of Japanese holdings of dollar securities of all types rises, such catering to their concerns—and those of other foreign investors—will rise at least proportionately.
There is a possibility of steady downward pressure on the dollar resulting from the concern of foreign creditors over the huge debtor position that Americans will face in the 1990s and beyond. More likely, though, debtor status will not constrain U.S. policies if the American external position is in rough balance and international confidence is maintained in underlying U.S. policies. The problem is that every country inevitably experiences periods of external imbalance and unsatisfactory domestic performance, and that the huge debtor position will then add considerably to the impact of a loss of confidence abroad. In fact, the United States experienced just such pressures in 1978-79 when it was still a net creditor, and Germany had to cope with a decline of foreign mark balances in 1980. In essence, the "dollar overhang" issue will return, perhaps with a vengeance. America’s economic policy, and perhaps its foreign policy as well, may thus be increasingly constrained by the need to take its creditors’ views into constant account.
The most important implication of this deep Japanese financial penetration of America, however, will be a further increase in the interdependence of the two countries. Japan will become as hooked on its American investments as it has already become on the American market, and as the United States has become on Japanese financing for its twin deficits. As with mutual nuclear deterrence, each country will be able to inflict severe damage on the other—though only at huge cost to itself. The two nations, so different in so many ways, will thus be forced by economic imperatives to learn to live together more harmoniously if they wish to avoid major conflict.
The other structural change that is needed for the longer run involves the international monetary system itself. The events of the 1980s make clear the failure of unmanaged flexibility of exchange rates. The unprecedented magnitude of the exchange-rate imbalances and the required adjustments indicates how inadequate the system has become in achieving its central objective of a stable and balanced world economy.
The Bretton Woods system of fixed exchange rates collapsed in 1971-73 because it had permitted the dollar to become overvalued by about 20 percent. The floating rate system that followed, however, permitted the dollar to become overvalued by more than 40 percent. This result alone is a fatal indictment of the present regime, the source of spreading dissatisfaction throughout the world and a spur to the search for a better alternative. Indeed, the finance ministers of the G-5 nations admitted at the Plaza in 1985 that convergence of national economic performances had not achieved international monetary stability, as they had been promising it would, and that direct governmental intervention was required.
The monetary system has also failed to defend an open system for world trade. Protectionism has been on the rise for at least five years and constantly threatens to erupt in a manner that could destroy the existing framework. The launching of the Uruguay Round in the General Agreement on Tariffs and Trade (GATT) could help to reverse this momentum, but a definitive resumption of the postwar movement toward free trade can be restored only with a lasting return of accurate currency relationships and monetary stability.
It is a paradox of the 1980s that international capital flows have been increasingly liberalized while international trade has been increasingly protected. There would seem to be a causal link between the two trends: the added scope for capital flows accelerates the fluctuation of exchange rates, often driving currencies away from levels that would tend to restore trade to equilibrium, thus bringing on the huge trade imbalances that intensify protectionism. It would be far better to reform the monetary system than to reverse the liberalization of capital flows, but one of these two courses will be necessary to avoid continued movement away from open trade.
The third criticism of the current monetary system is its failure to affect economic policy in the major countries. Some observers absolve the system, charging that it is faulty national policies that have caused the imbalances of the 1980s. Some go further, arguing that no system could have withstood the pressures created by the opposite movement of fiscal policies in the major countries (into massive deficit in the United States, sharply lower deficits in Japan and Germany) and those countries’ neglect of the international impact of their actions.
I certainly concur in the indictment of many recent policies in the major countries. But to segregate national policies from "the system" is to set up a false dichotomy. No international system is worthy of the name unless it has consequential impact on national policies and tilts them in the direction of greater international compatibility—and thus sustainability.
Indeed, many previous and current systems have done so to a significant decree. Under the fixed-rate rules of Bretton Woods, most countries consistently met the obligation to defend their currency parities. (In fact, they did so too well; the system collapsed because of inadequate currency flexibility.) Most of continental Europe does so now under the adjustable-peg requirements of the European Monetary System. Trade policy in almost one hundred countries is determined importantly by their international obligations under GATT and the costs (via compensation or retaliation) of taking trade actions that violate those commitments.
The need for such systemic influence is particularly acute in the United States. As the largest and most self-sufficient national economy, the United States is quite naturally tempted to try to export its internal problems more than most countries—and it usually succeeds for longer periods of time (as in the late 1960s and early 1980s, when foreigners financed the growing U.S. budget and external deficits). But the chickens eventually come home to roost even for the United States, which then—as with the Smithsonian agreement in 1971 and the Plaza agreement in 1985—must seek international action to rectify its external difficulties.
The history of U.S. foreign economic policy over the past generation shows that every administration, Republican or Democratic, has begun with essentially unilateral efforts to impose its macroeconomic and monetary views on the rest of the world. The inevitable failure of these efforts then forces the incumbent administration to a resort to pluralistic cooperation—President Johnson’s to two-tier gold in 1968, Nixon’s to the Smithsonian accord and the negotiated realignment of 1973, Carter’s to the Bonn summit and dollar defense program of 1978, Reagan’s to the Plaza agreement. Once achieved, the focus on international cooperation tends to remain intact for the remainder of that administration. But the successor regime forgets or rejects the lessons of the past, and the dreary cycle is repeated once more. To help forestall this seemingly endemic American pattern of retrogression, and thereby to promote their own vital interest in achieving a more consistent system of effective global cooperation, the other major countries should seize with alacrity recent offers made by the United States to work out more permanent systemic rules via agreed "reference ranges" for currency relationships.
The issue is not whether the United States and other countries will adjust to the realities of global interdependence. Though countries cling jealously to absolute nominal sovereignty, real economic sovereignty has long since eroded substantially. Despite the periodic efforts of governments to play King Canute, they cannot escape from reality. Policies must be internationally compatible to be sustainable, and to avoid levying huge costs on all parties. The only question is one of timing: whether countries will adjust in a reasonably timely and efficient manner, or try to fend off the inevitable for so long that huge costs arise and crises erupt.
One would hope that the international economic crisis of the late 1980s, like that of the early 1970s, will lead inter alia to the creation of a new international monetary regime—and, this time, to one that is more stable and lasting. There is no need to return to fixed parities. There is enormous need to avoid future massive misalignments such as we have seen in the recent past, which carry such heavy costs for surplus and deficit countries alike. The goal should be a synthesis between Bretton Woods, which became too rigid, and the flexibility of the current regime, with its endemic overshooting and misalignments (and, some say, excessive volatility).
There are numerous ways to achieve such a synthesis. The most promising is to adopt a framework of target zones, under which the major countries would agree on targets for their external positions and then set currency margins of perhaps 15 to 20 percent to help achieve such outcomes. For example, if domestic policies of the type I have recommended were adopted, today’s target zones might range between 135:1 and 165:1 for the yen-dollar ratio—compared to a range of between 150:1 and 165:1 suggested by the U.S.-Japan agreement in October 1986—and between 1.60:1 and 2.00:1 for the mark-dollar ratio. The authorities would alter the ranges over time to reflect differential inflation rates, differences in productivity growth, and shocks (such as large oil price changes) which would have different effects on the various currencies. The yen-dollar zone, for example, might move upward to perhaps between 110:1 and 130:1 by 1990 if Japan continued to experience higher productivity growth and lower inflation than the United States, and to compensate for Japan’s growing investment earnings and the growing U.S. interest payments.
Floating would remain the day-to-day norm, but authorities would act whenever rates moved toward the edges of the zone. They could start with Plaza-type jawboning and intervention, and make changes in monetary policy if necessary. Fiscal and other policies would then be adjusted to maintain internal stability. In essence, the world’s economic managers would view the whole array of potential policy instruments through the lens of the exchange rate and use whatever tools were appropriate at a given time to achieve their internal and external economic goals. Once the regime was in place and seen to be working, because governments were prepared to alter policies to defend the zones, private capital flows would become stabilizing—rather than destabilizing, as with the "bandwagon" capital movements under unmanaged floating—and would reduce the need for further official intervention.
A second major issue will affect the future functioning of the international monetary system: the respective roles of the dollar and yen in light of the huge structural changes in the international economic positions of the United States and Japan. The dollar has remained supreme, despite repeated bouts of American economic instability and external deficits over the past 30 years, primarily because of the lack of competition. The mark substantially increased its role in the late 1970s, but Germany, which has only recently begun to liberalize its relatively small financial markets, is so dependent on exports that it could never tolerate currency overvaluation, is hampered from taking on global responsibilities by its membership in the European Monetary System, and is much smaller than the United States and strategically vulnerable in any event.
The yen, however, could offer a real alternative to the dollar in the 1990s. Japan’s economy is already at least half the size of the United States’ and will probably continue to catch up. Its per capita income, at least statistically, equals America’s and will move increasingly ahead if the yen continues to appreciate. Japan’s foreign-exchange reserves are far greater. The Tokyo market and Japanese financial firms are rising to global prominence with breathtaking speed. Behind all this lies Japan’s enormous creditor strength.
The yen will certainly not replace the dollar, but it will probably soon pass the mark as the second key currency. The new "multiple currency system" may largely amount to a bipolar financial world centered on New York and Tokyo. The major risk implied by such a prospect is greater exchange-rate instability, as it becomes ever easier to move from one key currency to another. The growing financial interdependence between the United States and Japan thus adds enormously to the need for adoption of new international arrangements—particularly between the United States and Japan—to avoid recurrent monetary problems, and the trade and economic difficulties that demonstrably accompany them.
Politics are obviously central to the adjustments needed to avoid short-term economic crises, to meet the changing structural requirements of the world economy and to improve the functioning of the system itself. The postwar norm for economic negotiations has been multilateralism: major decisions have been made by groups of countries, either within the framework of international organizations (i.e., the International Monetary Fund, GATT and the World Bank) or within limited groupings (the Group of Five, the Group of Ten, etc.). This remains the preferred approach, for reasons of both economic coverage and political comity. But the present-day institutions are not working well and some countries are not pulling their weight. Alternatives must be examined.
The question thus arises as to whether a bilateral U.S.-Japan "Group of Two," as launched in embryonic form by U.S. Treasury Secretary James Baker and Japanese Finance Minister Kiichi Miyazawa on October 31, 1986, should attempt to provide new leadership of world economic affairs. Any such effort would of course be informal and remain open to the participation of nations willing to make comparable contributions, as was explicitly the case with the initial Baker-Miyazawa accord. The two countries would make clear, however, that they were prepared to proceed on their own if others would not come along.
The case for a G-2 lies in hard economic realities. As noted, the United States and Japan are the two largest economies in the world and have the two most important currencies. They share by far the largest two-way trade of any major trading pair. (The United States and Canada trade about the same amount, but this is due largely to geography, and the Canadian economy is only one fifth the size of Japan’s.) They are now the two largest shareholders in the World Bank, and may soon be in the International Monetary Fund.
The United States and Japan are also highly interdependent. On the one hand, they are often each other’s main rivals for industrial leadership, especially in the high-technology and services sectors which are at the cutting edge of global business and finance. On the other hand, Japan depends heavily on American markets for its economic growth, and on the United States for its national security. America depends heavily on Japanese financing for its trade and budget deficits. And much of the necessary improvement of the U.S. trade balance must come at Japan’s expense. The American deficit and debtor position and the Japanese surplus and creditor position are mirror images of each other to a considerable extent.
As a result, the United States and Japan must either learn to work closely together or they will continually square off in hostile confrontations—as they have in fact done with growing frequency in recent years. Each obviously has a major interest in the cooperative outcome, which may require a quantum leap, such as G-2, to succeed.
Moreover, the United States and Japan bear major responsibilities for fostering progress and maintaining stability for the world economy as a whole. The "Pax Americana" will obviously not be replaced by a "Pax Nipponica," despite the musings of some pundits on that theme. But "bigemony" between the United States and Japan—to replace American hegemony—seems quite feasible. And it is obviously easier for two countries to cooperate more effectively than it is for a larger number, as well as to avoid the problems of supporting free riders and evasion of leadership responsibilities.
The history of the past 15 years illustrates both the risks inherent in U.S.-Japan disharmony and the potential for the two to work closely together to promote their own interests and those of the world as a whole. During that period, intense trade frictions have erupted between the two countries on three occasions: in 1969-71, 1977-78 and currently. In each instance America has raised substantial barriers against Japan, and both the global trading system and the U.S.-Japan relationship have been severely threatened.
In retrospect it is clear that each of these three crises drew much of its intensity from a sharp rise, to previously unimagined levels, in the U.S.-Japan trade imbalance. In turn, much of that imbalance stemmed from an overvaluation of the exchange rate of the dollar and an undervaluation of the yen. It is evident that the United States and Japan, and the world as a whole, would have been spared much economic pain and political cost had the two countries been working together to coordinate their economic and financial policies in a way that would have prevented the onset of huge currency misalignments, resulting trade imbalances and inevitable economic (and thus political) crises. This need for such cooperation has never been clearer; it represents the positive case for a G-2.
Another argument for a U.S.-Japan G-2 derives from the fact that the Europeans have comparatively less interest in global economic and monetary arrangements, for two reasons: (1) most of the trade of the individual European countries is with other European countries, and (2) they have therefore created the European Monetary System as a "zone of currency stability" to underpin that trade. The percentage of their production that is exported to the United States is relatively small—traditionally under 10 percent for Germany, compared with between 35 and 40 percent for Japan—and thus their direct interest in the dollar and global management is less intense. Germany’s deep abhorrence of inflation and its related insistence on total independence for the Bundesbank, and hence its fear of engaging in international arrangements that could undermine its pursuit of that independence, seems to deter Bonn’s seeking a leading global role.
Thus there is a strong rationale for constructing a G-2, and using it as a primary if informal tool for seeking to exercise leadership of the world economy. Secretary Baker and Finance Minister Miyazawa have taken first steps in that direction, and the broader groups have yet to offer a more promising alternative. The issue is how best to use the nascent G-2 arrangement to deal with the problems I have described.
One possibility is to defend a true target zone between the dollar and yen, as previously described, beyond the weak version established in late 1986. The United States and Japan could also consult seriously on economic policies before final decisions were made, and could coordinate their monetary policies to avoid untoward fluctuations in exchange rates or world price levels.
The United States and Japan must ultimately adjust to large external imbalances. The issue is not whether, but when (earlier or later) and how (via constructive or destructive means) they will do so. The core goal of any new cooperative arrangement would be to launch such efforts early enough to avoid the onset of irreversible economic dislocations and severe threats of systemic breakdown (as in 1971-73 and particularly today) due to protectionist actions and currency instability.
The second component of an expanded G-2 would relate to leadership of the world economy, with activities ranging from mild and hortatory to coercive.
At a minimum, the United States and Japan—as in the Baker-Miyazawa communiqué of last October—could invite others to join the agreement I have described. Major European countries, and perhaps Canada and others, might accept the invitation simply out of an unwillingness to run the risk of remaining outside the key decision-making forum. The finance minister of France, less than three weeks after the first Baker-Miyazawa agreement, indeed announced that his country would like to accept their invitation to "join" the arrangement and would be urging its European Monetary System partners to do so. Europe (and Germany in particular) would have to reflect seriously on whether security arrangements with the United States would survive intact if international economic management fragmented—with Europe left outside the core grouping. The G-2 would thus be most successful if it proved to be a way station en route to new global arrangements.
A much more aggressive alternative would be for the United States and Japan, having achieved the proper relationship for their own currencies, to intervene in the markets of the currencies of other countries as well. The United States and Japan have a major interest in ensuring the accuracy and stability of other key exchange rates, both to achieve systemic steadiness and to avoid excessive pressures on their own currencies. For example, pressure on the yen will be relieved to the extent that other currencies important to American trade, including those of the Europeans and the Asian NICs, rise against the dollar as well. Often, mere hints that market intervention was contemplated would obviate the need to implement such steps and/or induce the nonparticipants to cooperate.
Finally, a genuine G-2 could undertake a number of other initiatives. Eventually, it could work out methods to channel an increased share of Japan’s surplus funds to the developing countries instead of to the United States—implementing the "new Marshall Plan" proposed both inside and outside Japan. I would not suggest stressing such measures at the outset, because the adjustment steps are much more critical and an emphasis on reordering financial flows could deter progress on the adjustment front. But such schemes could become an integral part of G-2 management over the longer run once the adjustment process was in place and working.
The economic legacy of the first half of the 1980s threatens to create enormous disruption in the short run and will produce a fundamentally different global structure for the 1990s. These developments may have significant effects on international political and security arrangements, and could erode today’s alliance systems much as they are eroding the trade regime and international finance.
The adjustments made to date, mainly in the currency markets, have progressed with amazing orderliness. However, they have at best achieved only half the corrections needed in trade balances. There may yet be time for the major countries, especially the United States and Japan, but Germany (leading Europe) as well, to take constructive actions to complete the task in a constructive manner. But a failure to do so could seriously cloud the economic outlook and threaten international political arrangements as well.
Even if there is continued smooth management of the transition, the world economic environment of the 1990s and beyond—with America as massive debtor and Japan as massive creditor—will pose major challenges to global management in both the economic and political spheres. In both areas a newly pluralistic world power structure must be arranged, with a revised leadership role for America—perhaps using its security position to pursue economic goals—and an increasing leadership role for Japan. The only precedent dates from the 1920s, when Anglo-American cooperation attempted but ultimately failed to reconcile the decline of Britain and the rise of the United States, due to the unwillingness of both countries to understand and adapt to their new positions. The new Administration in 1989 will have to address these matters with the highest urgency.