The Great Upheaval:
US-Japan Economic Relations in a Weakened World Economy

Daniel I. Okimoto
Professor Emeritus, Stanford University
Chairman, Sterling Stamos Global Institute
June 28, 2009

From 1982 – 2008, under the Post-Bretton Woods system, the world enjoyed a quarter-century of dynamic growth. Capital flows, trade, productivity, and aggregate output soared while levels of poverty, unemployment, volatility, and inflation subsided. It was truly a “Golden Era”.

In 2008, however, the “Golden Era” imploded when Lehman Brothers went bankrupt. The world fell into a period of uncertainty and market panic not seen since the Great Depression. Asset values plunged; credit froze; trade contracted; and for the first time since 1945, global GDP shrunk. The world economy teetered on the brink of collapse.

Global Imbalances: The Great Upheaval shook the world economy because an enormous, un-sustainable capital imbalance had developed. A ballooning macro-imbalance—featuring massive US current accounts deficits and Chinese/Japanese (plus other countries) surpluses—had reached a point of possible collapse. America’s cumulative debt (public and private) hit a high of 350% of GDP in 2007. The root cause of America’s massive debt was uncontrolled spending (public and private).

Abundant liquidity contributed to the elevation of US debt. From 2000-03, the US Federal Reserve Bank made more money available than the financial circumstances warranted. A flood of money led to a huge real estate bubble.

With the dollar serving as the anchor of the Post-Bretton Woods system, the US has enjoyed the unique advantages of having both fiscal flexibility and monetary autonomy. The dollar-based global financial system has allowed the US to spend lavishly—far beyond its means—while borrowing freely from savings-rich countries like Japan and China.

If Japan and especially China had saved less, consuming more, it would have reduced the supply of capital available to the US; but global demand would have been better balanced. At 36% of GDP in 2008, Chinese consumption was abnormally low (compared to an abnormally high 71% in the US). One reason it was so low is due to the inadequacy of China’s safety net (health care, welfare, etc.), which encouraged Chinese households to save far more than they consumed.

Vast sums of capital poured into the US from Asia through the mechanism of US Treasuries. The nearly carte-blanche access to foreign capital gave the US the extraordinary indulgence of cutting tax cuts while at the same time waging a long and costly war in Iraq.

The Post-Bretton Woods system of capital recycling locked the US into a symbiotic relationship of interdependence with the China and Japan. The US needed Chinese and Japanese capital to finance its runaway spending. China and Japan needed the US to buy their exports in order to generate economic growth. China needed sustained, robust growth in order to ensure political stability.

Chinese & Japanese Purchases of US Treasuries: In financing US deficits, China and Japan became the two largest foreign holders of US Treasuries. In 2007, Japan held 28% while China owned 24% (more if third party purchases for China are included).

As the US government continues to sell hefty sums of Treasuries, an important question is whether China and Japan have the appetite to keep buying. So far, they have. US Treasuries are considered “safe havens” in times of unusual market volatility.

China and Japan cannot afford to stop buying Treasuries, or to dump their dollar holdings. Doing so would damage their self-interests. It would weaken the dollar, thereby depleting the value of their foreign reserves. It appears, therefore, that the global macro- imbalance will not be fundamentally corrected anytime soon. Not without wrenching costs.

US Innovation: Since 1992, the US has served as the world’s mightiest engine of economic innovation and growth. The list of new products, new start-ups, and whole new industrial sectors, born in the US, is impressive—semiconductors, computers, telecommunications, the internet, and biotechnology. Japan, China, and the rest of the world, have benefitted enormously from the multiplier effects of American value-creation.

Unfortunately, the list of US innovations also includes an assortment of financial instruments that have contributed directly to the Global Upheaval. Some of these “Made in American” products are esoteric, complex, and non-transparent credit derivatives. Many were designed to mitigate risks while maximizing the returns from leverage; unfortunately, instead of mitigating risks, the credit derivatives amplified the risks and elevated global debt to alarming heights.

The most toxic instruments—called “financial weapons of mass destruction”--were securitized derivatives, such as collateralized debt obligations (CDO) and credit default swaps (CDS). From 2000 – 08, the notional value of credit derivatives multiplied from $95 trillion to $684 trillion--roughly ten times the size of world GDP. US financial regulators failed to monitor and control the systemic risks caused by the rapid proliferation of these “financial weapons of mass destruction”.

In sum, the global economy has endured a devastating upheaval, owing to a combination of factors: an unstable global imbalance in current accounts, runaway US spending, inadequate consumption in Asia, proliferation of credit derivatives, imprudent leveraging, and lax regulatory control.

Current Conditions and Future Outlook: Many believe that the financial free-fall has either slowed down or has hit rock bottom. The world has narrowly escaped a catastrophic collapse. Recovery is thought to be underway.

Is such optimism warranted? Maybe. Maybe not. It’s possible that the “green shoots” of recovery will turn out to be a transitory “bear market” surge. Have enough of the “toxic assets” on bank balance sheets been cleared away? Many financial institutions—some very large—are, de facto, insolvent. More shocks like AIG may lie ahead. It’s premature therefore to declare that the world economy has turned the corner.

Even if the global economy is now recovering, there are daunting challenges ahead. For example, will deflationary forces—caused by a global “output gap”--be overtaken anytime soon by a sudden upsurge in inflationary pressures?

Whither the Dollar? The US government deficit in 2009 will reach 13% of GDP. 5% will be covered by increases in household savings. Another 4% can be raised from the ongoing influx of foreign capital. That leaves 4% of GDP to be financed. The only viable option appears to be for the Fed to monetize the 4% debt—that is, to print enough dollars literally to “paper over” the 4% hole.

If that happens, the dollar is bound to devalue steeply against the renminbi and the yen. Dollar devaluation will unleash inflationary pressures. The US may follow the old Latin American formula of inflating its way out of debt. But the costs of doing so could be devastatingly high, including the creation of one more bubble--or worse yet, the delivery of a final, crippling blow to the Post-Bretton Woods structure.

If confidence in the dollar erodes, countries like China will seek to diversify their foreign currency holdings away from the dollar—perhaps towards a SDR-type of currency basket. Even a specie-backed international currency is not inconceivable. Shifting from a dollar-based system is apt to be gradual, taking years, if not decades. Yet, an abrupt, disruptive shift is not out of the question, particularly if there is a wrenching dollar crisis.

Implications for Japan. Even if the dollar-based system remains in tact, the financial symbiosis between the US, Japan, and China will loosen. Less consumption in the US will shrink its current accounts deficits. China and Japan will be under somewhat less pressure to buy Treasuries. Japan already is exporting more to China than to the US. This trend will continue. The emerging markets in Asia will become the main destination for Japanese exports. Asia, as a whole, is bound to become a bigger engine of global growth.

Changing Comparative Advantage: The value of international trade is based on the concept of comparative advantage. Countries with differing factor endowments—at varying stages of industrial development—reap the greatest gains from trade. Because the US and Japan have reached a similarly advanced stage of post-industrial development, bilateral trade is no longer as beneficial as it used to be—say, 25 years ago. Japan stands to reap higher rates of return from trade with emerging markets in Asia.

Beyond shifts in export markets, Japan may also find it beneficial to shift away from its aggressive export-led strategy of growth. Sooner or later, Japan will lose its competitive advantage in old-line manufacturing. The time has come for Japan to lighten its heavy dependence on exports as a prime driver of growth. .

With an aging population, and a falling savings rate, domestic demand can be expanded. The health care sector, including an upgraded health care infrastructure (world class hospitals, retirement facilities, pharmaceuticals, etc.), can become a positive driver of growth.

Clean Technology: Another major potential driver of domestic growth is clean technology. A broad definition of “clean technology” includes alternative and renewable energy, advanced energy infrastructure, improved energy efficiency (energy conservation; smart power grids), construction retrofits (solar heating, insulation); waste management (recycling and re-utilization); and efficient modes of transportation.

Clean technology covers a sprawling expanse of commercial activity. It holds forth the promise of accelerating economic growth for Japan and the US— and the world.

Fortunately, the US and Japan lead the world in many segments of clean technology. Clean technology ranks as one of President Obama’s top priorities. To make an impact on containing global warming, the US will need Japan’s full support and active cooperation. This means that there will be many promising avenues of bilateral cooperation—both in the public and private sectors.

Conclusions: The Great Upheaval may represent a critical turning point. Whether it does or not depends on what happens over the next 18 – 24 months. It’s possible that the US might lose the financial domination that it has long enjoyed.

History reveals that periods of systemic change tend to be unstable, conflict-ridden, and unpredictable. Stability will hinge largely on how the US deals with the rising power of the emerging markets, particularly the RICs—Russia, India, and China, the old historic empires with vast land masses and teaming populations and are industrializing rapidly.

Japan’s interests lies in helping to slow down the pace of America’s decline. This will require that the two allies make a concerted effort to work together in such areas as the promotion of health care and clean technology. The US and Japan ought to launch joint projects in both fields. The US and Japan--and possibly Europe—should cooperate in leading-edge R&D projects to conquer cancer as well as to overcome the world’s addiction to oil.

In this age of global transition, smaller coalitions tend to be more effective than larger ones. A “collective goods” problem exists: nation-states have an incentive to stand back and let others spend the energy and capital to provide the collective goods while they derive the benefits.

More than a decade has passed since the last broad-based multilateral effort was successfully mounted (the establishment of the World Trade Organization). A bilateral or trilateral coalition may be more easily organized than an all-inclusive coalition in the areas of clean technology and health care.

For Japan, a historic power transition also expands its “elbow room”. Japan can disengage, to some extent, from its tight, sometimes suffocating embrace, with the US. It can diversify its economic networks throughout Asia and deepen its ties especially with India, Indonesia, Australia, and Vietnam.

Democratic Indulgence: One reason that the Post-Bretton Woods system careened out of control and lurched to the brink of collapse was because America’s political system has made it exceedingly difficult to raise taxes and to curb spending. Advanced democracies tend to have trouble balancing revenues with expenditures. Citizens want to consume but they’re not willing to pay higher taxes. Entrenched interest groups refuse to give up government entitlements.

The US possesses the resources to overcome the devastation wrought by the Great Upheaval. But whether America’s political system provides elected leaders with the incentives and the will to enforce the pain of short-term sacrifices in order to reap the long-term benefits of sustainable prosperity remains to be seen. The same question can be asked of Japan and Europe.