We are now experiencing the third episode of major economic conflict between the United States and Japan in the last 12 years.

The first of these episodes led to the U.S. import surcharge of August 1971, viewed in Japan as the second of the "Nixon shocks" aimed at that country, and a U.S. threat to invoke the "Trading with the Enemy Act" against its chief Pacific ally. The second episode produced major U.S. pressure on Japan during 1977-78 to boost its domestic growth rate, with lasting damage to Japanese confidence in its American connection and immediate impact on the political career of the then Prime Minister, Takeo Fukuda. The third, current, episode promises to be the nastiest yet-with the United States joined as demandeur by the European Community, with racist overtones already creeping into the rhetoric and frustration on both sides of the Pacific, and with obvious spillover onto the reemerging issue of security relations between the two countries.

To be sure, there has been fairly steady tension between the United States and Japan over economic issues ever since Japan emerged as a major industrial power. Japan's amazing success in penetrating an increasing number of key global markets, ranging from the original textiles through shipbuilding and steel to automobiles and high-technology electronics, has won it grudging admiration but also growing hostility as a disruptive force in American economic life and brought repeated charges of "unfair" competition. Its apparent reluctance, or even inability, to expand substantially its imports of manufactured products has produced steady charges that Japan is itself highly protectionist, a "free rider" on the open trading system from which it benefits so greatly but within which it seems unwilling to provide others with truly reciprocal opportunities.1

These ongoing problems have been the subject of virtually continuous negotiations between the two countries for over two decades. Such discussions have centered sometimes on U.S. demands for Japanese export restraint, sometimes on U.S. demands for Japanese import liberalization, sometimes on U.S. demands for freer access for U.S. investment in Japan. In most cases, they have produced positive, albeit frequently modest, results in terms of both Japan's policies and subsequent economic relations between the countries-results, moreover, which have sufficed to maintain a basically cooperative framework for U.S.-Japanese relations and the respective roles of the two countries in the world economic system.

Nevertheless, the level of U.S.-Japanese tension has escalated severely on three occasions in just over a decade. The first question, therefore, is why it has done so. One answer can be found by tracing the course of the bilateral balance on merchandise trade between the two countries:

- From 1966-67 to 1971-72, the U.S. deficit rose from an annual average of $0.5 billion to an annual average of over $3.5 billion.

- After falling back to an average of about $1.5 billion in 1973-75, the U.S. deficit in 1976-78 rose to an average of over $8 billion.

- After dipping modestly in 1979-80, the U.S. deficit reached a record high of about $16 billion in 1981 and will probably soar to $20-25 billion in 1982 and 1983.

As is well known, bilateral balances in themselves are neither a meaningful indicator of international competitive positions nor a sensible guide for policy. In the U.S.-Japan context, they are in fact more relevant as sources of political leverage for those looking to reduce the imbalance than as substantive problems in their own right. The changes in the U.S.-Japan bilateral trade account do, however, accurately mirror changes in the global current-account position of each country (including trade in services as well as merchandise). It is these overall balances that present real problems and require remedial action:

- From 1967 through 1972, the global U.S. current account swung from a surplus of over $2 billion to a deficit of about $6 billion, while the Japanese current account moved from modest deficit to a surplus of about $7 billion.

- From 1975 through 1978, the U.S. current account went from a surplus of over $18 billion to a deficit of $14 billion, while Japan shifted from modest deficit to a surplus of more than $16 billion.

- In the current situation, the U.S. current account has been deteriorating for a year (despite the domestic recession and sharp fall in oil imports) and Japan has moved from its huge deficits in 1979-80 back into sizable surplus; the United States is headed into deficit and Japan into surplus at record levels, probably by 1983.

There is thus a clear correlation between the escalation of U.S.-Japanese economic tensions, on the one hand, and sharp swings in the U.S. and Japanese external balances-bilateral and multilateral-on the other. This in turn translates directly into jobs, profits and economic activity within the two countries. It has been estimated that the U.S.-Japanese trade imbalance in 1980 (which was much below current levels) affected over 500,000 U.S. jobs.2 It should come as no surprise that huge improvements in the Japanese position, and similar deteriorations in that of the United States, rapidly become major causes both of global economic imbalance and deep concern within the United States.

II

Six hypotheses have been put forward to explain U.S.-Japanese trade frictions, including those we are now experiencing:

- Japan's "propensity not to import" keeps out most foreign (including U.S.) products.

- Japan's periodic export surges, particularly in specific high-technology products, benefit "unfairly" from government support and exclusion of foreign competition in those industries.

- Whenever Japan's investment level lags, Japan's high rate of savings produces net capital exports from Japan, which in turn require it to run current-account surpluses to achieve overall payments balance.

- Lagging Japanese economic growth in particular periods has retarded Japan's imports and pushed its firms to mount major export offensives.

- Lagging American productivity and high U.S. inflation rates have rendered the United States uncompetitive in Japan (and elsewhere), especially as U.S. firms have not made effective efforts to sell in that market.

- The exchange rates of the yen and/or dollar have periodically become misaligned, promoting Japanese and undermining American price competitiveness in international trade (including with each other).

There is undoubtedly some merit in each of these views, and policy in both countries needs to take each of them into account. Despite the seeming elimination of most of Japan's overt import barriers, it does remain uncommonly difficult to penetrate the Japanese market in a wide range of product lines. Continued efforts are essential to eliminate the remaining overt barriers and to facilitate real access for foreign (including, but certainly not limited to, U.S.) goods in Japan.

Likewise, periodic surges in Japanese exports-be they in textiles, steel, autos or electronic products-have raised the level of tension during several periods of the past decade. Japanese sensitivity to the need to moderate the pace of its competitive surges and diversify its markets, and scrupulous avoidance of both the substance and appearance of excessive official help for its (already very aggressive) exporters, are essential to defuse this component of the overall problem.

During some periods, Japanese investment levels are insufficient to employ within Japan the full level of savings generated within that country. A net export of capital results, which requires an even larger merchandise trade surplus (in light of Japan's structural deficit in services trade) to achieve overall balance. The interests of international equilibrium would thus be served by increased levels of consumption within Japan, and/or higher levels of domestic investment-particularly in housing and other social infrastructure, which have lagged behind the norms in other countries.

American productivity growth has certainly slipped and contributed to the periodic declines in U.S. international competitiveness. Further, most U.S. firms have devoted inadequate attention to selling effectively in Japan. Every effort must be made to expand the level and efficiency of productive investment in this country, and to give the Japanese market the sustained attention it deserves.

The business cycle has also been a factor. Japan's "growth recession" of 1971, with its slower expansion of domestic demand, contributed to its surpluses at that time. America's lead in the global recovery from the world recession of 1975, and the lagging performance of Japan, were major elements in producing the record U.S. trade and current-account deficits of 1977-78. Better international coordination of at least the mixes of national macroeconomic policies, and perhaps the timing of macroeconomic policy shifts by the major countries, would help avoid the kinds of problems with which we are faced today.

None of these phenomena, however, explain the periodic outbursts of U.S.-Japanese economic conflict which, as noted, have occurred on three fairly discrete occasions over the past 12 years.

No one argues that the level of Japan's import barriers or export surges is rising. Nor do they apparently fluctuate in any systematic way over time. To be sure, the degree of U.S. (and European, Korean and others') tolerance for Japanese import barriers and export competition probably fluctuates in response to oscillations in the trade and current-account imbalances of those countries-as well as to their unemployment levels and other domestic variables. Japan's continued import barriers and periodic penetration of new product markets thereby intensify the periodic bursts of tension, and must be addressed steadily and urgently, but are not the primary cause of those tensions.

Nor does the high level of Japanese savings provide an explanation for these periodic bursts. Like other structural factors, this one does not change much over time-except in response to cyclical phenomena, which will be addressed below. Moreover, the thesis does not stand up empirically because Japan has frequently experienced net capital inflows and run sizable current-account deficits in the postwar period-on a massive scale as recently as 1979-80.

Similarly, the decline in U.S. productivity growth cannot explain the situation. First, that decline has occurred steadily over the past 20 years-both predating the onset of U.S.-Japanese trade problems, and proceeding without any apparent relationship to the ups and downs in U.S.-Japanese (or overall U.S.) trade. Second, all of the major industrialized countries, including Japan, have suffered from substantial declines in productivity growth over the last decade-and the reduction in Japan has been greater than the reduction in the United States.3 The level of productivity growth remains substantially higher in Japan (and some other countries) than in the United States, but the relative performance of the two economies on this indicator has certainly not changed in Japan's favor throughout the period in question.

Third, and perhaps most telling, U.S. trade competitiveness has recorded some extremely impressive results in the recent past despite the lag in productivity. From 1978 through 1980, U.S. exports rose twice as fast as world trade. The global U.S. current-account position improved, from its trough in early 1978 to its peak in late 1980, by an annual rate of almost $45 billion-despite an increased oil import bill of more than $30 billion. In early 1981, the U.S. share of world exports of manufactured goods was higher than it had been in 1971-completely reversing the losses of the 1970s. It thus seems clear that the United States faces no structural problems in competing in the world economy despite the productivity problem-which, to repeat, must be addressed continuously and effectively because of its pervasive impact on the U.S. economy and quality of life but not because it "explains" any lags in U.S. trade performance.

The fourth possible explanation for U.S.-Japanese economic trouble, differing growth cycles, also cannot "explain" the episodic acceleration of the problem. Of the three instances previously cited, only the 1977-78 episode, which was the least severe of the three, was heightened by the conjuncture of U.S. growth and a Japanese lag. In 1970-71, the United States was experiencing a modest recession-which should have helped its trade balance, despite the reduction in Japanese growth. Currently, the United States is facing its third consecutive year of stagnation while Japan has, at least until very recently, continued to grow at about the same rate relative to the United States (about two percentage points faster) as over the last decade. Hence these cyclical factors have probably reduced the level of U.S.-Japanese imbalances during two of the three periods of particular tension in the relationship, although they did add to the severity of the problem in 1977-78.

III

Of the six possible causal factors, only exchange rate misalignments were present in each of the three periods and go far to explain the difficulties which have arisen on each occasion. In each instance, the yen became substantially undervalued-dramatically improving Japan's price competitiveness in the world economy. In each instance, the dollar became substantially overvalued-undermining U.S. competitiveness, both in Japan and elsewhere. The huge swings in trade and current-account balances which marked each episode, and which triggered the outbreaks of U.S.-Japan hostility, can be traced primarily to these exchange-rate movements.

By the beginning of the 1970s, the parities of the dollar and yen-which had been set in 1933 and 1949, respectively-were clearly out of line with the underlying economic relationships between those countries and the rest of the world. With the onset of U.S. inflation from the mid-1960s, stemming from the Vietnam War and simultaneous expansion of Great Society programs, the dollar became substantially overvalued. With the dramatic expansion of economic capacity and productivity in Japan, the yen became substantially undervalued.

The results began to accumulate in 1968-69 and accelerated rapidly to the first postwar crisis in U.S.-Japanese economic relations in 1970-71. Japan began to run steady and growing external surpluses. The U.S. current-account balance slipped into deficit for the first time in the postwar period. As noted, Japan's bilateral trade surplus with the United States expanded sevenfold from 1966-67 to 1971-72.

One result was the most intense pressure for trade protection in the United States of the entire postwar period, probably including the present. The Mills bill, which passed the House of Representatives in 1970, would have placed numerical limits on import penetration in virtually every industry. The proposed Burke-Hartke bill, which would have drastically curtailed both U.S. imports and foreign investments, was the source of widespread congressional interest and support during 1971-72. For the first time, the bulk of the pressure was aimed at Japan. Exchange-rate misalignment had entered the picture as a major source of difficulty between the United States and Japan.

There is no need to speculate about whether the exchange rates had become severely misaligned. Despite the historical antipathy of both countries to parity changes, the realignments of 1971 and 1973 devalued the dollar and revalued the yen by over 20 percent. It was finally understood by both countries that such changes were essential to preserve an open trading system as well as to avoid the repeated bursts of international monetary instability which were eroding the entire global economic system.

It is less widely recognized that these exchange-rate realignments achieved their objectives, on this as on later occasions, with almost textbook precision. In 1973, even before the onset of the first oil crisis, Japan had returned to global balance and the United States to modest surplus. The bilateral merchandise account, on which the oil shock had little direct impact, returned during 1973-75 to the much lower levels of 1969-70. True adjustment had occurred, and the first major episode of U.S.-Japan economic conflict receded into history.

In 1975-76, however, a renewed exchange-rate misalignment began to develop. The dollar appreciated substantially during that period, though the U.S. current-account surpluses, which triggered the appreciation, were due primarily to the depth of the U.S. recession (especially in 1975), which was far sharper than in Japan or other major industrialized countries. Hence the seeds were sown for a renewed deterioration of the U.S. competitive position, and the record deficits which ensued in 1977-78.

Meanwhile, Japan had committed one of its most serious policy errors of the entire postwar period. Arguing that its renewed current-account surpluses were transitory phenomena, attributable solely to the cyclical situation, Japan intervened massively in the foreign exchange markets throughout 1976 to block significant strengthening of the yen. The result, as I predicted at the time,4 was a renewed undervaluation of the yen and massive Japanese surpluses in 1977-78-including a fivefold rise in its bilateral trade surplus with the United States.

This juxtaposition of developments produced the second outbreak of major U.S.-Japanese economic tensions, in 1977-78. Again, the main culprit was a severe misalignment in the exchange rates between the two currencies. Again, a correction of that misalignment-which began to occur from early 1977, when the Carter Administration successfully insisted that Japan let the yen rate respond to market forces-was the crucial factor which corrected the situation. By 1979 and 1980, the United States returned once more to global surplus and Japan (hit also by the second oil shock) moved into sizable deficit.

For a third time, however, the pendulum swung too far. Beginning in early 1981, the peculiar policy mix of the new U.S. Administration produced record levels of real interest rates, huge movements of capital into the dollar and a dollar probably as overvalued as in the final stages of the Bretton Woods system of fixed exchange rates in the early 1970s.5

From its lows of late 1978 to its highs of August 1981 and April 1982, the dollar rose by 35-40 percent against the yen. Meanwhile, Japanese inflation ran about 20 percentage points less than U.S. inflation. The price competitiveness of the United States in world trade, vis-à-vis Japan, thus deteriorated by 50 percent or more within about three years.

A new crisis would inevitably follow-and it did, currently reaching levels of tension not seen since a decade earlier. The global U.S. current account has deteriorated substantially over the past year, despite the deep domestic recession and sharp reduction in oil imports. Indeed, this decline in the external accounts has been as important as the housing and auto slumps in pushing the U.S. economy into its current recession.

On the other side of the Pacific, Japan has moved back into global current-account surplus. The bilateral imbalance in favor of Japan has soared to record levels. All these developments seem likely to become much worse throughout the rest of 1982 and especially into 1983, as dollar overvaluation and yen undervaluation persist; their full effects take up to two years to emerge fully, so the die is already cast for continued major trouble. Hence any serious effort to remedy the U.S.-Japan problem must address the underlying causes of the repeated, and severe, misalignments which periodically emerge between dollar and yen.

Some, perhaps most, of these causes lie with the domestic economic policies of the two countries. Some, as with Japan's intervention to avoid a strong yen in 1976 or the U.S. unwillingness to intervene to brake the excessive appreciation of the dollar in 1981-82, relate directly to the countries' international monetary policies. Some, to an unknown extent, may relate to the functioning of the international monetary system itself. Any serious program for dealing with the current U.S.-Japan impasse must therefore address all of these issues.

IV

Beyond the prescriptions mentioned above for dealing directly with trade flows and underlying economic conditions in both countries, each needs to take several steps to remedy the immediate exchange-rate problem. Together they should help launch a new international initiative to seek improvements in the functioning of the global monetary system that would reduce the prospects for future misalignment, repeating the three such episodes of the past dozen years.

The current misalignment between dollar and yen stems from five basic factors, ranked in what I would judge as their order of importance:

- The U.S. policy mix, whose prospect for continuing huge budget deficits places all the pressure of fighting inflation on monetary policy. The result is stratospheric real interest rates, which attract massive flows of capital toward the dollar and sharply increase its value.

- The Japanese policy mix, which is the opposite of that of the United States. Its emphasis on reducing the level of Japanese budget deficits has left the task of sustaining economic growth to monetary policy, producing interest rates which are low by international standards and thus inducing huge capital outflows from Japan, which reduce the value of the yen.

- Global political uncertainties, ranging from Poland through the Mitterrand election in France to growing fears of another global conflict, which reinforce the "safe haven" appeal of the dollar and thus induce capital flows to the United States. (There is nothing that economic policy can do about this phenomenon.)

- The shift over the past two years in Japan's manipulation of its capital account. When running large current-account deficits in 1979-80, Japan placed tight (administrative) limits on capital outflows and borrowed heavily abroad. Since late 1980 it has largely stopped such manipulation. Indeed, from the end of that year it has significantly liberalized foreign access to the Japanese capital market-a desirable structural step from the long-run point of view, but one which adds to capital outflow from Japan and thus weakens the yen in the short run.

- The unwillingness of the U.S. authorities to intervene directly in the exchange markets, to slow the rise in the value of the dollar, which (in conjunction with Japanese intervention to strengthen the yen) could have kept the misalignment from becoming so severe.6

A multifaceted effort, with new initiatives from both countries, is thus needed to deal with the immediate problem. The objective should be a yen-dollar rate of between 180 and 200 to 1 by the end of 1982.7 The rate did reach 180 to 1 briefly in late 1978, though that level probably represented a somewhat overvalued yen at the time, and most (including Japanese) analyses suggest that Japan would still be able to compete effectively in international trade with exchange rates in this zone. There should, of course, be complete agreement to resist any renewed weakening of the yen from current levels.

As its major contribution to such an effort, as well as for overwhelming domestic reasons, the United States simply must tighten its fiscal stance over the next several years by reducing the huge budget deficits which are inevitable under current policy, even under very favorable assumptions concerning economic developments in this country. It would be a mistake, in terms of maintaining the battle against inflation, for the Federal Reserve to loosen substantially its restraint on the growth of the money supply. Hence the route to lower interest rates clearly lies through bringing fiscal policy into accord with monetary policy. The path to greater fiscal stability is clear: a stretch-out in the buildup in military expenditures, further judicious cuts in nonmilitary expenditures (including entitlement programs) and primarily a substantial rollback (or offset) of the massive tax cuts voted in 1981.

Japan should also alter its policy mix. Even if U.S. interest rates do begin to come down, higher Japanese rates will almost certainly be needed to achieve the degree of exchange-rate adjustment which is needed. It would not be desirable, however, either for Japan or the world economy, if tighter money in Japan were to promote continued economic stagnation in that country.

One can readily understand, and sympathize with, Japan's desire to reduce its own budget deficit. However, an easier fiscal policy during this (one hopes, temporary) adjustment period appears to be essential to permit the needed tightening on the monetary side. Japan should thus postpone for one year or so the sharp tightening of its fiscal policy which is now planned. It should, at a minimum, maintain in the second half of its 1982 fiscal year, via a supplemental budget, the level of government expenditures now planned for the first half of the year, to avoid the substantial reduction in aggregate demand which would occur otherwise. As will be noted below, foreign investors could (and should) be sought for at least a large part of the new government debt that would be created-thus obviating the problem of forcing more such debt on Japanese commercial banks.

In reconsidering the impact of its domestic policies on its international situation, Japan should also adopt a new stimulus program. The Japanese economy has now been quite stagnant for about three quarters, and Japan will need an expansion of domestic demand to offset the weakening of its external balance which would stem from the strengthening of the yen. Moreover, an upsurge of Japanese growth would be the quickest way to reduce Japan's trade and current-account surpluses, would deflect sales of Japanese companies to the domestic market and away from exports, and would by itself push interest rates in the proposed (upward) direction.

On the other hand, these improvements would be no substitute for the needed realignment of competitive positions via the exchange rate-and any resultant weakening of Japan's external balances could actually retard that development. So accelerated growth should be part of the Japanese contribution to any new "restoration of equilibrium" package, but should not substitute for changes in the policy mix and other steps to right the currency relationship.

The best way to strengthen the yen substantially is thus for the two countries to make substantial changes in their macroeconomic configurations, which would amount to something of a "swap" between the U.S. and Japanese policy mixes. Unfortunately, however, such changes are unlikely to be adopted soon enough or in sufficient magnitude to achieve the major change in the yen-dollar rate which is needed so urgently.

Therefore, Japan should take a number of temporary measures to strengthen directly the capital account of its balance of payments, as it has done frequently in the past-most recently in 1979-80. These measures should include: sharp administrative limitation on capital outflows by Japanese residents, via a declaration of a moratorium on most categories of such outflows; thorough liberalization of capital inflows; and aggressive efforts to attract foreign investment in yen instruments, including government securities.

Foreign investments by Japanese residents have been running at levels in excess of one billion dollars monthly for about two years, and have been increasingly in the two- to three-billion dollar range in recent months. About one-half of the outflow stems from Japanese purchases of foreign securities, and another one-quarter from foreign direct investment by Japanese firms. Despite continued large purchases of Japanese securities by foreigners, the Japanese capital account is in sizable deficit and generates substantial downward pressure on the yen-even with the resumption of a healthy current-account surplus.

There are several ways in which Japan could alter its capital movements in the suggested direction. One, emulating a U.S. initiative of the 1960s, would be to institute an Interest Equalization Tax. Such a tax would raise to (or above) the international level the cost to foreigners of borrowing in Japan. It would thus discourage capital outflows (and provide some additional revenue for the government budget).

In the Japanese context, however, direct administrative action would probably be much more effective than a tax.8 Most of the Japanese capital outflow is motivated by the desire of Japanese investors to acquire higher yielding assets abroad, rather than by the desire of foreigners to tap the lower borrowing costs available in Japan. Moreover, such a tax would be of no help in attracting capital inflows to Japan. Thus Japan should now declare a moratorium for whatever, presumably temporary, period is needed to strengthen the yen to the needed extent.

The moratorium on capital outflows by Japanese residents should particularly focus on the three largest components thereof: Japanese purchases of foreign securities, loans to foreigners, and capital outflows associated with foreign direct investment. (Direct investment could continue but would have to be financed externally, just as much foreign direct investment by U.S. firms had to be financed abroad during the latter 1960s under the "voluntary capital restraint" program designed to defend the dollar at that time.) Exceptions could be granted for genuine trade credits and flows to developing countries.

On the capital inflow side, as with imports of goods, complete liberalization is the first requirement. In addition, the government of Japan should again borrow abroad aggressively in different currencies, converting the proceeds immediately into yen. In addition to strengthening the yen, such investments-whether by official or private foreigners-would provide at least some of the needed financing for the temporarily higher Japanese budget deficits, just as Germany simultaneously financed much of its budget and current-account deficits by borrowing from foreigners in 1979-80.

One further step which could support such a Japanese effort would be an explicit endorsement from its authorities of an international key currency role for the yen. De facto, such a role has been growing rapidly for the yen over the past five years. The Japanese official attitude has remained ambivalent, however, even during the episode in 1979-80 when capital inflows were actively courted. A clear statement of Japanese intent to play a key currency role, which would include total freedom for nonresident capital movements both into and out of Japan, would encourage additional foreign investment in yen assets.

Any such statement would have to be carefully drawn, to avoid both the pitfalls of key currency status itself and being interpreted in the United States as "a slap at the dollar." If one takes the view that key-currency status for the yen is inevitable, however, and particularly if one adds the view that such a role is desirable, then explicit recognition of the situation could be of help both in dealing with the immediate problem and in reducing the structural symmetry cited above regarding the Japanese capital market.

Contrary to my call for temporary but sharp limitations on Japanese capital outflow, the Reagan Administration and others have advocated freer foreign access to the Japanese capital market as a means of dealing with the current problem. To be sure, liberalizing foreign access to the Japanese capital market has structural and long-term merits. The immediate impact, however, has been-and will continue to be-increased capital outflows from Japan and a weakening of the yen.

The reason is that comparable liberalization on the inflow side, regarding foreign investment in Japan, will not offset the effect of liberalization on the outflow side enough to have the desired effect on the value of the yen. This is because the range of yen assets available to foreigners is much more limited than the range of dollar (and other foreign) assets available to Japanese investors. Hence Japanese capital liberalization, even if fully symmetrical both in principle and in application, is likely to produce sizable net capital outflows from Japan for structural reasons. Such liberalization during a period of relatively low Japanese interest rates, as at present, is certain to have such an effect.9

Because of the views previously expressed by the U.S. Administration and elsewhere, however, the Japanese authorities have legitimate reason to fear that adopting the steps proposed here would be criticized abroad as "simply more short-run manipulation" or as "deviating from market principles." The U.S. and European governments should therefore make clear to Japan that they would publicly welcome such steps, as an important contribution to dealing with a crucial global problem. The United States has such a major national interest in reestablishing dollar-yen equilibrium that, if the Administration remains unwilling to attack the root of the problem by altering its own policy mix, it should at least blunt its ideological fervor for "free markets" long enough to accept (and even encourage) the only action which is available to deal with the problem with sufficient urgency and on an adequate scale.

The final step in dealing with the immediate problem would be a resumption of active exchange-market intervention by the United States, in coordination with the monetary authorities of Japan (and other major countries), to speed the return toward equilibrium once a basic trend in that direction has been established by changes in the national policy mixes and direct approaches to the capital account. Intervention neither could, nor should, be expected to turn exchange rates against their underlying trends. Recent history demonstrates amply, however, that it can effectively alter both the extent and pace of rate movements. It is to be regretted that intervention has not been used over the past year, to limit the extent of dollar overvaluation and yen undervaluation. For the future, at a minimum, it should be used to avoid any further deviations from equilibrium-as it was used by the United States, with strong support from Japan and the West Europeans, as part of the dollar support program of November 1978.

V

While the Tokyo Round provided the framework for resolving the U.S.-Japan trade problems of the late 1970s, the absence of either a viable monetary system or a major trade negotiation made it much more difficult to resolve the conflict of the early 1970s. Indeed, the systemic reforms of that period-primarily the move to flexible exchange rates-were triggered more by the U.S.-Japan conflict than any other geographic dimension of the overall international economic problem. Today's conflict between these countries provides the clearest evidence of the need to recommence serious discussions of the viability of current international monetary arrangements while, on the trade side, another major global negotiation will probably be needed as well. Beyond dealing with the immediate issue through bilateral talks and changes in each nation's individual policies, the United States and Japan should thus strongly promote new efforts aimed at systemic change-at least to reduce the prospect of still more outbreaks of major economic conflict between them in the future, as well as for the broader systemic benefits which would result.

The magnitude of the efforts needed to deal with the present problem, like the programs which were needed to deal with the primarily monetary causes of the two earlier episodes of major U.S.-Japanese economic confrontation, provide compelling reminders of the value which would accrue from an international monetary system that would prevent the onset of such extreme misalignments. The system of flexible rates was supposed to do so, of course, but it has obviously failed in that task both in 1976-78 and again at present.

Both the United States and Japan thus have a major interest in systemic reform which would, at a minimum, avoid the repeated development of massive misalignments. This need not-nor indeed could it, even if desirable-imply a return to fixed exchange rates. It could, however, involve systematic surveillance of the exchange-rate constellation with a view to keeping rates within fairly wide "target zones." When rates moved outside those zones, and thus became clearly inconsistent with underlying economic relationships, a series of steps would be triggered to push them back inside: pronouncements of official intent, coordinated intervention and, when necessary, changes in the underlying policies (like today's U.S. and Japanese policy mixes) which contributed to the contemporary misalignments.

In sum, major efforts, at several levels, are needed in both the United States and Japan if the present conflict between them-which will otherwise get much worse over the coming year or so-is to be resolved. At best, some patience will be required because it will take several quarters before the trade balances of the two countries begin to change significantly in response to the needed alteration in the yen-dollar rate (or in specific Japanese trade barriers). It is thus essential to move quickly, on all fronts cited here but especially in the financial sphere, to begin the process of constructive adjustment and to head off the restrictive, protectionist, even discriminatory reactions which may otherwise occur.

Instead of adopting all of the proposed measures together, it would of course be possible to proceed one step at a time in the hope that the full panoply would not be needed-or that some exogenous forces would come along and rectify the situation. Unfortunately, however, Japan has in the past failed to get due credit for the steps it has been willing to take, in the trade area and elsewhere, because it has strung them out one at a time, and then only when pushed to the wall. By contrast, the successive U.S. balance-of-payments and dollar support packages of the 1960s and 1970s have probably had an impact well beyond their substantive content because they were packaged skillfully and sold as comprehensive programs. For once, therefore, Japan should move in an all-embracing manner-with full U.S. support and cooperation-to demonstrate once more that U.S.-Japan economic problems can be resolved effectively within a continuing framework of cooperation between the two countries.

1 Manufactured goods constituted less than 23 percent of Japan's total imports in 1980, while the comparable numbers for the six other largest industrial countries ranged from 50 to 75 percent. World Financial Markets, Morgan Guaranty Trust Company, January 1982, p. 9. It should be noted, however, fthat one careful analysis of the issue has suggested that "when the differing quantity and quality of Japanese labor, capital and natural resource endowments and distance from trading partners is properly given its full allowance, then . . . the Japanese share of manufactures in total imports is comparable to European and American experience." See Gary R. Saxonhouse, "Evolving Comparative Advantage of Japan's Imports of Manufactures," Mimeographed paper, University of Michigan, Ann Arbor, 1981, p. 36. It might also be noted that Japan's exports are quite small relative to its gross national product, when compared with West Germany and a number of other major countries.

2 Thomas O. Bayard, "Preliminary Estimates of the Labor Content of U.S. Merchandise Trade with Japan: 1970-1980," Mimeographed paper, U.S. Department of Labor, December 1981.

4 See testimony before the House Banking Committee, June 3, 1976, and the Joint Economic Committee, October 18, 1976. Reprinted in Managing International Economic Interdependance: Selected Papers of C. Fred Bergsten, 1975-1976, Lexington, Mass.: D. C. Heath & Co., 1977; as well as "Let's Avoid a Trade War," Foreign Policy, Summer 1976.

5 For details see my "The Costs of Reaganomics," Foreign Policy, Fall 1981 and "The Villain is an Overvalued Dollar," Challenge, March/April 1982.

6 It should also be noted that protectionist rhetoric in the United States (and elsewhere) exacerbates the exchange-rate problem, because it generates fear of reduced Japanese exports in the future and thus weakens the yen in the exchange markets. Ironically, some of those who most fear trade competition from Japan are intensifying their own problems by calling for new import barriers.

7 Assuming maintenance of Japan's wide array of "voluntary" export restraints. If these VERs were dismantled, the exchange rate of the yen would have to be correspondingly stronger to achieve and maintain equilibrium.

8 Partly for the same reason, I am skeptical of the proposal for a Japanese export tax to attack the trade problem directly. Moreover, any such direct disincentive for Japanese exports would tend to weaken the yen and thus work in directions opposite to what is needed. The usual arguments against trade protection apply as well, of course.

9 Some U.S. officials have even argued that the yen would strengthen if Japan were to further open its capital market to borrowing by foreigners-on the view that, eventually, this would drive up Japanese interest rates. This view is simply wrong: the interest-rate effect would, at best, offset the initial capital outflow; much more likely, it would weaken the yen via its primary effect of triggering heavier capital exports and the Japanese authorities would sterilize any upward pressure on their interest rates anyway.

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  • C. Fred Bergsten is Director of the new Institute for International Economics in Washington, D.C. He served as Assistant Secretary of the Treasury for International Affairs from January 1977 through January 1981, as a Senior Fellow at the Brookings Institution during 1972-76, and as Assistant for International Economic Affairs on the Senior Staff of the National Security Council from January 1969 through May 1971. He is the author of eleven books on a wide range of international economic issues.
  • More By C. Fred Bergsten