Russia Thinks America Is Bluffing
To Deter a Ukraine Invasion, Washington’s Threats Need to Be Tougher
The fashionable view among economic pundits and the financial press is that American industry, led by the auto and semiconductor makers, has regained its international competitiveness in recent years. On the contrary, the root cause of virtually all of America's economic problems, from the current run on the dollar to the budget and trade deficits, is the continuing deterioration of the industrial competitiveness of the United States, most notably compared with Japan. The United States has grown dependent on the narcotic effect of dollar devaluation and the dreamy, euphoric (but false) sense of economic well-being derived from it. A massive deterioration of the dollar's value, particularly relative to the yen, has masked the problem of declining competitiveness and functioned as a habitual surrogate for both industrial policy and productivity improvement. It has become as corrosive and addictive as cocaine.
Once this dependency is established, it is likely to persist indefinitely. The trade deficit of the less competitive U.S. economy will grow while its currency dives. Nowhere is this more dramatically demonstrated than in the Japan-U.S. relationship. The dollar has been in a more or less steady decline against the Japanese yen for a quarter century while the trade deficit has continued to expand. In 1970, the exchange rate was $1 to ¥360, and the U.S. trade deficit with Japan was $1.2 billion; by March 1995, the exchange rate had reached $1 to ¥90, and the deficit was $66 billion. Furthermore, despite the perennial spate of rosy predictions, it is quite likely that the dollar will continue to fall and the trade deficit will continue to rise for the indefinite future.
THE PRODUCTIVITY GAP
Compelling evidence of that likelihood can be found, ironically enough, in the declining profitability of the major Japanese industries over the 25 years since 1970. Three industries comprise the preponderance of Japan's bilateral trade (and trade surplus) with the United States: machinery, autos, and electronics. In those industries, average operating profit levels declined from 10-12 percent in 1970 to 1-2 percent in 1994. At first glance, this would suggest that the protracted devaluation of the dollar has pushed Japanese industry to the wall, and that further yen appreciation would put them out of business.
Unfortunately, it is not so simple. The major Japanese industries have demonstrated the ability to drive their costs downward at an average compound rate of 5 percent per year for the past 25 years, while their U.S. counterparts, addicted to currency devaluation, have not. This means that the major Japanese export industries have been able to reduce their yen operating costs by virtually the same degree that the dollar declined against the yen. That their costs declined at a slightly lower rate than the dollar against the yen explains the decline in Japanese operating profits.
A similar analysis of U.S. counterpart industries shows no comparable cost reductions. American operating profits declined slightly in diversified machinery and electronic instruments, which means that costs in current dollars actually rose;  in machine tools, the trend line was essentially flat; and while costs declined somewhat in autos and semiconductors, the decline was far less dramatic than that of their Japanese competitors.
The implications are sobering. This means that, contrary to the popular view, American industry has not closed the productivity gap. It has steadily fallen further behind, with that trend masked by a deepening exchange rate addiction. Until this productivity gap is closed, the dollar must continue to decline against the yen if major U.S. industries are to survive, and the U.S. trade deficit will continue to grow. Even in the unlikely event that relative productivity should stabilize at current levels, a dollar appreciation to the level of ¥105 to ¥110 to the dollar would restore Japanese profit margins (and trade competitiveness) to 1970 levels, and a new cycle would begin. The trade deficit, absent political intervention, would skyrocket, and some major American industries would once again have their backs to the wall. The instinctive American reaction to this might well be to assume that there must be some limit to Japanese cost reduction and that, once the Japanese have depleted their bag of tricks for a given industry, their costs will inevitably level off. But "continuous improvement" is practiced more seriously in Japan than in America, and there is no reason to believe that it cannot go on indefinitely.
The exchange rate is driven by the relative productivity gains of American and Japanese producers in the major bilaterally traded industries. The good news is that the long pattern of trade imbalances coupled with a declining dollar can be dampened or reversed at any time by either a reduction in the rate of Japanese cost improvement or a significant increase in that of American industry. Realistically, however, neither of these things will happen in the foreseeable future.
PLAYING FOR KEEPS
The truly important competition in international trade is concentrated in a small number of sectors in which global markets are large, capital intensity is high, and wages are much higher than in other sectors. These sectors include autos (which dwarfs other sectors), industrial machinery, office machines (including computers), aircraft, photographic equipment, consumer electronics, telecommunications equipment, and steel. A national economy with a high proportion of these large, high-wage industries will generate greater prosperity and higher living standards than one that lacks them.
Many American economists and government officials do not believe in industrial policy, and even today are debating whether there is any such thing as competitiveness. The Japanese have taken a different view, channeling both human resources and capital into the critical sectors listed above. Japan has not accepted comparative advantage in these strategically critical industries as a permanent, God-given condition, but rather has seen it as man-made and dynamic, subject to challenge and capable of being shifted from one economy to another through intelligent allocation of resources and hard work. Contrary to their critics' glib assertions, Japanese planners have never engaged in "picking winners and losers." They have simply identified those sectors that will result in a more prosperous economy and gone all-out to win there. As a result, they now dominate the spectrum of high-wage industries that were once the domain of the United States.
Many American economists argue that a trade deficit, however large, is essentially harmless, because when it is incurred, the United States is only exchanging American currency for foreign goods and services, and because the currency has no intrinsic value unless and until it finds its way back and is re-exchanged for American goods and services. What goes around, they say, comes around.
Well, yes and no. When dollars are ultimately redeemed, they need not be exchanged for American exports but can be used to buy other things, some of which may worsen the deficit. These might include American technology and technicians or mass media advertising, marketing, and distribution services to enhance the growth of the imports that initially caused the deficit. Dollars can also be used to play Monopoly with such emotionally charged tokens as U.S. baseball teams, Rockefeller Centers, golf courses, etc. What goes around does not necessarily come around in the same way.
In addition, a chronic trade deficit that is concentrated in the core sectors of our economy means fewer high-quality jobs and lower revenues and profits--in short, a poorer economy. And the true cost cannot be measured by simply calculating the deficit in terms of lost American jobs. The larger cost, by far, results from the loss of U.S. opportunities in Japan, Europe, and other markets. Perhaps most important, a deficit in competitive trade leads to a steady deterioration of the value of one's currency.
DISCOUNTING U.S. ASSETS
In today's global economy, to suggest (as some commentators do) that a weakening currency is a deficit remedy and weapon in the trade war is as Orwellian as asserting that white chips are more valuable than blue ones in a poker game. The value of the U.S. dollar is not some vague, disembodied statistic. It is the hard, ultimate measure of the economic worth of the United States. Everything that Americans own or produce is valued in dollars--homes, savings and investments, real estate, natural resources, skills, and labor. The dollar is, in a sense, the price of a share of America. When it is devalued, the dollar cheapens not just U.S. exports, but the entire economy. A recent New York Times article pointed out that, while the stock market is currently reaching new record highs (in rapidly deteriorating dollars), the S&P 500 has actually lost 23 percent of its value in yen terms since mid-1990.
Economists are fond of telling us that dollar devaluation will affect only those Americans who want to travel abroad, drink French wines, or wear Swiss watches, but that is as disingenuous as telling a worker that his pay cut will not matter unless he wants to drive a nice car, take his wife out to dinner, or send his kids to college. A weak dollar has put Japan essentially off-limits to most American tourists. On the other side of the coin, America has become a bargain basement for the Japanese. Tens of thousands of ordinary Japanese workers flock to the United States each year, marveling at the low prices and traveling in a style unaffordable to many middle-class Americans.
The costs of opening and maintaining business offices in Japan have become prohibitive for all but the largest, most profitable American firms; office space, services, and salaries are valued at four or more times comparable U.S. costs in dollar terms. Japanese junior executives and administrative personnel demand, in dollar terms, more than many senior executives earn in the United States. Television advertising is out of the question for most American companies. All of this is particularly hard on the young, high-tech American firms that should enjoy clear competitive advantages in Japan and become the foundation for future U.S. markets there. Unable to afford the high cost of market entry in Japan, they often sell or license their technology to potential Japanese competitors, and the downward spiral is perpetuated.
Debasing the dollar has nothing to do with competitiveness. It does nothing to enhance the productivity of American industries or the quality of their products. It simply discounts them while simultaneously discounting everything else Americans own. In that sense, the United States is subsidizing its noncompetitive industries by steadily discounting the entire national asset base. The Japanese, on the other hand, by concentrating single-mindedly on the competitiveness of their export industries, have used that small part of their GNP to enhance their national asset base and enrich their entire society. The contrast in positive and negative leverage between those two approaches is mind boggling.
This profligate form of industrial welfare probably could not be justified even if it had kept U.S. trade in balance, but it has not. At ¥90 to a dollar, the United States is now worth 25 percent of its 1970 value to bearers of Japanese yen and still declining, while our trade deficit with Japan is 54 times greater than in 1970 and still expanding.
As with any addiction, the compelling question is: How does one stop? Unless the quality of life in America has no meaning, the steady deterioration of our industrial competitiveness is the most serious problem we face. It underlies the trade deficit with Japan, the steep decline of the dollar, much of the federal budget deficit, and many of the social and economic ills that beset us. Neither spending cuts nor tax cuts will solve this fundamental problem; reallocating the slices will not expand a shrinking pie. The only way to break the cycle is to reestablish the competitiveness of American industry.
 All costs cited herein are expressed in current dollars and yen. Net of inflation, cost declines for both U.S. and Japanese producers would be steeper, but the relative rates of decline would be essentially as depicted.
UP TO THE CHALLENGE?
by C. Michael Armstrong
Over the next two decades, 12 countries with a combined population of 2.7 billion--more than ten times the population of the United States--are expected to account for 40 percent of all export opportunities. The question is whether American industry can match international competitors in satisfying this hunger for goods and services. The most recent study by the Council on Competitiveness of U.S. industries' strengths and weaknesses in 84 cutting-edge technologies showed some positive movement. American business improved its position in 22 categories, but in 11 of them the movement was from the last rank of "losing badly or lost" to "weak." In the other 11, the movement was from "weak" to "competitive," and in no case was it from "competitive" to "strong." Getting off the critical list is welcome news for anyone, but finding out the patient has a pulse is not the same as watching him hop out of bed and run a marathon. To be an export superpower, the U.S. market system must produce over time a competitive commercial base. And our governmental system must remedy a disabled dollar, a results-absent education strategy, and undisciplined deficits.
Adapted from a speech at the Council on Foreign Relations, May 9, 1995, by C. Michael Armstrong, Chairman and CEO of Hughes Electronics Corp. and Chairman of the President's Export Council.