Why Is Japan Shooting Itself In The Foot?Rudi Dornbusch
A decade ago, Japan seemed all-powerful--and all set to play a dominant role in world trade and finance. Today, the yen is as almighty as the dollar was at the peak of its overvaluation in 1985, but its strength is illusory. The truth is that overly hard currencies cut first into profits and then into jobs, financial stability, and social cohesion.
The U.S. went down this road in the '80s. It has taken a decade to repair the damage from high real interest rates, bad balance sheets, overvaluation, and premature and excessive deindustrialization. Japan, for its part, has had deep pockets: Losses were covered in home markets by shareholders and bankers who did not ask questions. Now, after many years of financial distress and no growth, the pockets are empty, and a serious battle is under way. Japanese companies know what to do--flee offshore and away from the strong yen, leaving behind broken lifetime contracts, broken banks, and broken public finance.
While the yen is going through the roof, Japan's economy is going through the floor. Companies are on the treadmill of currency appreciation and cost-cutting, banks are in trouble, and the government stands by wringing its hands. Japan is in a deadly spiral of overvaluation that is entirely self-inflicted: It madly pushes out goods and sucks in money. The Japanese save famously, but with profitability depressed, they invest little, and hence flood the world with goods. But as asset-holders, the Japanese insist on hard yen in their balance sheets and earnings flows, dumping surplus dollars around the world. The result, perversely, is a yen so hard that they can't afford to live on it.
TIRED MODEL. In the past, there was Japan Inc.--a tight partnership of government and business that assured stability and growth. The goods and asset markets were kept repressed so companies could enjoy cheap finance from forced savings and high domestic prices to support battles for foreign market share. A rising yen was the rule--but never so fast that productivity growth couldn't pay for the strengthening of the currency. Today, the model is wearing thin: Companies want to survive, and that means going offshore. Financial markets cannot cover up de facto bankruptcy forever, and that means credit is getting rationed. Government is straddling the fence between international commitments and the domestic conspiracy to keep markets sheltered. In policy and politics, the country is faring no better: Old-timers are running the Ministry of International Trade & Industry, the Bank of Japan, and the Ministry of Finance as if nothing had happened. But with one-party rule shattered, politics is turning into a free-for-all.
For once, U.S. policies are not the reason for the strong yen. In comparison with Japan and Germany, the U.S. looks far sounder than it did in 1985, at the dollar's peaks. The budget deficit is smaller than Germany's or Japan's, and the inflation rate has been moderate for a decade. True, budget-cutting would be desirable, and it would be a good idea to have a more concrete commitment from the Federal Reserve to moderate inflation, but even that would not make much difference to the yen.
TREADMILL. Hot money funds might magnify the problem, but don't blame them--this is a problem of Japan Inc. malfunctioning. Over the past few years, Japanese monetary policy has been `onsistently supertight. True, interest rates were low, but prices were falling, and that meant real interest rates were high, especially considering the strained balance sheets and the absence of growth. Fiscal policy was also misaligned: There was stimulus, but it was always too little, too late. The righteousness of wrongheaded policymakers is reminiscent of the U.S. in 1928-32, when insistence on balanced budgets and tight monetary control precipitated the Great Depression. Japan needs prosperity policies, not more deflation.
Japan must also deal with its perennial trade problem. Until Japan offers an honest program of market opening instead of the empty promises of the past decade, financial markets will view Japan's trade surplus and yen shortage as reasons to push up the yen even more.
So far, the problem has mostly been one for Japan and for yen debtors. The trouble may not stay there, though: Increasing fragility in Japan could cause worldwide instability. Until Tokyo grasps its own interests, the rest of us can do little to help Japan along.
To get off the treadmill, Japan must abandon the insularity of its trade and finance and come to grips with the incompetence of its policymakers. On the present course, the economy will hollow out at a rapid pace, and a society reared on consensus will become divided.