Bush-League Economics

The Bush administration is getting an A for its prosecution of the war against al-Qaeda and the Taliban, but it is flunking international economics. While energetically lobbying Congress for "fast track" authority (which is not a trade agreement, but merely a means of winning approval of one), it has botched every actual economic-policy challenge that it has faced. That was woefully apparent in its policies toward Argentina, but it has also been true of its policy toward Japan, the world's second-largest economy.

The Bush team, led by White House adviser Lawrence Lindsey and Secretary of the Treasury Paul O'Neill, have followed the same script each time a new crisis has beckoned. First, they deny that it is all that serious; then they deny that the United States--or international lending institutions--can do anything about it; then they put forth solutions that make things worse. Last summer, O'Neill insisted that Argentina's dire predicament was entirely its own doing and could be rectified without international help. "Nobody forced them to be what they are," he announced. In late October, he told The Wall Street Journal that if Argentina's economy did implode, it would not affect other nations. And then when leaders in Buenos Aires began to threaten default on foreign loans, O'Neill proposed a solution that ignored the roots of Argentina's problem. Instead of advising those leaders to abandon the bizarre nineteenth-century currency arrangement that American-trained free-market economists had imposed, O'Neill and the Bush administration insisted that Argentina slash social spending as a condition of international aid. When the government complied, eliminating 28,000 jobs, the people rioted and the government fell.

The administration has followed a similarly inept course toward Japan. During the 2000 campaign and in the months after the election, Bush's advisers sharply criticized Clinton's secretaries of the Treasury, Robert Rubin and Lawrence Summers, for using public pressure and criticism (gaiatsu) to force the Japanese to change their policies. "Gaiatsu has become a substitute for creative thinking," Lindsey explained. O'Neill declared that there was no "O'Neill plan" for Japan. "I'm not going to tell them how to pursue a monetary policy," he said.

As Japan slid this fall into its fourth recession in a decade, and as deflation took hold, threatening a 1930s-style Depression that could infect Asia and the United States, the administration reversed itself and began using its own brand of gaiatsu. In a speech in October to the Council on Foreign Relations in New York, U.S. Trade Representative Robert Zoellick declared that "there's a paralysis in Japan, and it's a serious problem. I mean, it's a serious problem in terms of the domestic economy, it's a serious problem in terms of East Asia and the world economy, and we're seeing it now." Zoellick's speech, which was widely covered in Japan, was followed by a speech by Deputy Treasury Secretary Kenneth Dam urging the Japanese to do something "swiftly" and "efficiently" about their massive overhang of bad bank loans. Meanwhile, Lindsey chimed in with advice of his own.

But while the Bush policy makers spoke with one voice to the Argentineans, they gave conflicting advice to the Japanese, betraying their own confusion and uncertainty about what Japan should do. Especially vexing was the critical relationship between the yen and the dollar. Since World War II, Japan's economy has been driven by industrial export earnings. Japan's modern version of mercantilism depended not only on the sacrifice and productivity of Japanese workers but also on the low value of the yen relative to the dollar, a factor that ensured that the prices of Japanese goods would be competitive with goods priced in dollars.

In a normally functioning world economy, this strategy might not have worked. Ordinarily, when countries run trade surpluses, their currencies appreciate, making their exports more expensive and, in turn, reducing their surplus. But, as R. Taggart Murphy and Akio Mikuni argue in a forthcoming book, Japan's Policy Trap, Japan deliberately failed to repatriate many of the dollars earned from the export surplus. Instead, they used them to invest in American businesses and Treasury notes. That had the effect of depressing consumption and living standards at home, but it reduced upward pressure on the yen. (If they had cashed in their dollars for yen, they would have driven up the price of the yen relative to the dollar.)

Japan's approach allowed its top-tier firms like Toyota and Matsushita (Panasonic) to flourish. It also bestowed benefits on the United States. In the 1980s, Japanese purchases of T-bills paid for much of the U.S. deficit and reduced the upward pressure on interest rates. In March 1995, Rubin and Summers, worried about a Japanese recession, agreed to a Japanese plan to allow the value of the yen to fall further against the dollar. Japanese dollars, from the rising export surplus, fueled the American stock-market boom. But this time, the low-yen, high-export strategy began to do more harm than good. In Japan it allowed politicians and government officials to ignore the growing inefficiency, corruption, and insolvency that increasingly affected all except the very top Japanese firms.

As depicted in Richard Katz's book Japan: The System That Soured, Japan is composed of two economies: an extraordinarily advanced one that can compete against any other, and a backward one, sustained by government subsidies and political interests, that resembles Indonesia at its worst. In the late 1980s, the sheer superiority of top Japanese firms, along with the bubble created by bank lending, sustained the whole. But in the 1990s, as Japan's bubble burst and its most powerful firms moved offshore and acquired strong competitors, the inefficient, insolvent economy increasingly overshadowed the high-tech advanced economy. The yen-export strategy acted like a narcotic, providing temporary and increasingly fleeting relief for the country's economic stagnation while allowing the real problems to fester and grow.

The yen-export strategy also wreaked havoc outside Japan. When the value of the yen began to fall in relation to the dollar in 1995, other Asian countries, whose currencies were pegged to the dollar, suddenly found themselves at a disadvantage in sales to the United States and competing against Japanese goods in their home market. The weak yen contributed to the currency crisis that shook Asia in 1997 and almost plunged the world into recession. The United States escaped that recession and enjoyed a boom partly because of foreign investment from Japan and other Asian countries and partly because Federal Reserve Chairman Alan Greenspan, determined to prevent a downturn, kept interest rates low until 1999. America's dot-com bubble was the price it paid for encouraging Japan's yen strategy and for avoiding contagion from Asia's currency crisis.

As the Bush administration took office last January, there was talk that Japan was on the mend and that any U.S. downturn would be brief and shallow. But each country's recession has contributed to and reinforced the other's. The U.S. recession has reduced the demand for Japan's exports, threatening even Japan's top-tier companies and diminishing the power of the trade narcotic to work. Japan's recession has reduced foreign investment in the United States and contributed to the fall in stock market prices. And things could get much worse over the coming years. According to Mikuni and Company, Japan's only independent bond-rating agency, between 10 percent and 20 percent of Japanese companies could face liquidation. If that occurred, Japanese firms and their banks would be forced to call in their overseas loans in order to remain solvent. These loans are huge. By the end of 1999, Japan had $2.7 trillion in overseas assets, including more than 11 percent of the outstanding private debt on U.S. Treasury securities. If Japan were to call in these debts, it would put upward pressure on America's interest rates and cause stock prices to plummet--in the midst of a recession. You could be talking depression, not recession.

The way out would seem to be some combination of financial reform, which would allow Japan's banks to divest themselves of bad loans and force marginal businesses to close, and massive macroeconomic relief (through tax cuts and social insurance rather than public-works boondoggles) that would stimulate consumer demand and provide a safety net for workers who lose their jobs. Richard Katz believes that through such a strategy, Japan could emerge stronger than ever within five years or so.

But that's not what the Bush administration has been pressuring Japan to do. On November 22, The Financial Times quoted a Bush administration official urging the Japanese to purchase foreign bonds in order to further weaken the yen. According to Katz and to trade expert Chris Nelson's daily newsletter, the official in question was Lindsey, who was acting with the approval of O'Neill. On December 11, after a meeting of the administration's economic policy makers, Lindsey told Richard Medley of Medley Global Advisors that the meeting had "strongly re-affirmed that the U.S. would welcome Japanese purchases of U.S. bonds." When The Financial Times queried O'Neill about Lindsey's statement, as reported in Medley's newsletter, O'Neill shot back: "This report does not represent Treasury's position. The president has said that only the secretary of the Treasury speaks for him on exchange rates."

In the absence of a clear message from the befuddled O'Neill, Japanese officials heeded Lindsey's gaiatsu and called again for policies aimed at weakening the yen. On December 27, the yen fell to a three-year low of 132 to the dollar. This policy--if used once more as a pretext for avoiding domestic reform--will at best postpone the agony of a deeper recession. It could also make things much worse. It could set off a round of competitive devaluations by other Asian countries to enable them to compete with the weaker Japanese yen--China and South Korea have already vigorously protested the falling yen. It could also spark protectionist measures by the United States and other countries affected by cheap Japanese exports during a time of rising unemployment. And by discouraging dollar purchases of yen, it could cause Japanese stocks to fall, threatening more bankruptcies and making it more difficult for banks to maintain their loan reserves. If you want a historical precedent, consider what happened when the Hoover administration tried to use the Hawley-Smoot tariff in 1930 to pull the United States out of the Great Depression.

The Bush administration denied responsibility for the falling yen, but in fact it was directly attributable to the confusion sown by Lindsey and O'Neill. The Financial Times reported that "the Bush administration's hints that it backs the idea have helped to undermine the yen." Just as they had with Argentina, O'Neill, Lindsey, and the Bush administration went from destructive indifference to malignant concern. Their blunders and confusion are currently shrouded in technicalities about currency boards and devaluations and are rarely reported except in the business pages of the daily newspapers. But before Bush's first term is over, they could loom very large, perhaps even overshadowing the administration's successes in the war against terror.

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