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Chapter One

The Economic and Policy Context

The United States and Japan are the two largest national economies in the world. In the century and a half since the forcible opening of Japan by Commodore Perry's Black Ships in 1854 and the conclusion of the "unequal" Treaty of Amity and Commerce in 1858, the two countries have experienced both a dramatic increase in economic integration and intermittent conflict on a range of issues from trade to finance and macroeconomic policy. In the 1940s, these tensions were a contributing factor to the outbreak of military hostilities between the two giants.

    Since the conclusion of the Second World War, policymakers in both countries have built robust economic, political, and security ties, forging what has been called "the world's most important bilateral relationship bar none." They have also experienced severe economic conflicts, however. The United States has in fact maintained, during at least the quarter-century from the early 1970s to the middle 1990s, a unique Japan-specific economic policy that was quite different from its approach toward any of its other major trading partners or the world's other large economies.

    This book is about the future of economic relations between Japan and the United States. That relationship turns on three key sets of variables. One, which we will argue is decisively important, is the state of each country's economy and their relative positions in the world economy. The second is the overall status of each country in the world as a whole, including its security and broader politicaldimensions. Third come the specifically bilateral features, both economic and political, of the relationship between the two, which are also of great salience but must be seen within the broader economic and security contexts. All three sets of determinants have changed dramatically during the past decade.

    There are four potential paths for US economic policy toward Japan in the coming period. One is to maintain the unique Japan-specific approach of the past three decades, which we believe has become more and more anomalous, and should now be explicitly jettisoned. A second, at the other extreme, is to essentially ignore Japan in the years ahead—a "bypass-Japan" strategy, which some US companies have in fact adopted in devising their own policies toward Asia. A third is to pursue "deep integration" with Japan, via a free trade agreement (FTA) or even more far-reaching effort to link the two economies, in an ambitious bid to sweep aside the problems and frustrations of the past with an expansive political initiative. The fourth is a middle course, in which Japan is still important but is treated like any other major economic power or trading partner of the United States (Canada, the European Union, or Mexico), mainly through multilateral channels and institutions.

    We will outline the four alternatives later in this chapter and conclude that the last of them, the treatment of Japan as a "normal country," is the best policy for the United States and for the relationship in the foreseeable future. We will suggest that actual policy is already moving in this direction, but recommend that the new approach be explicitly announced as soon as possible, to clarify its adoption and to inform the myriad actors in both countries (and around the world) of the change. We will outline the four alternatives after first spelling out the context for the new policy.

A Reversal of Fortunes

As recently as the early 1990s, Japan was widely viewed as the strongest economy in the world, and there were extensive doubts about the fundamental health of the US economy. Despite the highly adverse effects of two oil shocks in the 1970s and the endaka (strong yen) episode of the middle 1980s, Japan had averaged almost twice as rapid growth as the United States for three decades (table 1.1). Japan's per capita income passed that of the United States in the early 1990s and was more than 40 percent higher (at market exchange rates) in 1995. Measured unemployment in Japan generally remained less than one-third the recorded US level. Japan, with less than half the population of the United States, achieved a total GDP (at market exchange rates) that was only 30 percent less than the total GDP of the United States as late as 1995.

    International indicators painted an even starker picture. By the middle 1980s, Japan had become the world's largest net capital exporter and the world's largest creditor country by a large and growing margin over runner-up Germany (figure 1.1). The United States, which had been the world's largest creditor country as recently as the early 1980s, had become the world's largest net capital importer and debtor country by a huge margin over runner-up Canada. The US share of world exports declined steadily, while Japan's share rose sharply into the middle 1980s, almost equaling that of the United States at one point (figure 1.2). Japanese firms bought sizable shares of US industry and property throughout the 1980s, while US investors remained minor players in Japan. In 1990, Japan replaced the United States as the world's largest donor of foreign assistance, and it steadily increased its margin throughout the decade.

    These macroeconomic developments were replicated, and in many observers' eyes magnified, at the industry-specific level. Japanese-based firms seized large chunks of world market share from their US (and other foreign) competitors in a host of key industries. Japanese companies produced more than 50 percent of world semiconductors as late as 1989, while US companies' share hovered below 40 percent. Similar developments had already occurred in automobiles, numerous consumer electronics products, and (in an earlier period) steel. Japanese banks appeared to dominate world finance, in 1990 accounting for the top 5 banks and 6 of the top 10.

    Moreover, Japan's region was clearly the most dynamic in the world. "Asian tigers" and "the Asian miracle" became household terms, partly due to the impact of Japan's own development on its neighbors, partly due to the active engagement of Japanese companies, and partly through emulation of Japan's "economic model." Latin America, the backyard of the United States, was by contrast suffering through the debt crisis and "lost decade" of the 1980s.

    This pattern originated in the 1960s and broadly persisted throughout the 1970s and 1980s. Hence it seemed sufficiently grounded to constitute an established trend and to justify extrapolation into the future. Ezra Vogel, a leading US expert on Asia, already proclaimed Japan as Number One in 1979. Clyde Prestowitz, an experienced trade negotiator with Japan, posited the Trading Places of the two countries. The so-called revisionists—Fallows, Johnson, van Wolferen, and Prestowitz—argued that the United States could recoup only by simultaneously adopting much of the Japanese system and declaring economic war on Japan itself, without regard to the likely negative impact on the security relationship between them (see especially Johnson 1982, Fallows 1989, Prestowitz 1988, and van Wolferen 1989). By the late 1980s, surveys regularly showed that far more Americans were afraid of Japan than of the Soviet Union (James 2000).

    US policy responded to these perceptions and pressures. As will be detailed below, a succession of presidential administrations from that of Richard Nixon to that of Bill Clinton, under strong pressure from the Congress and large parts of the business community, adopted Japan-specific approaches that were unique to the foreign economic policy of the United States. Despite the continued centrality of the security relationship, Japan was the target of a series of sharp economic attacks from the United States, ranging from the "Nixon shocks" of 1971 (which were both economic and political) to the "managed-trade" initiatives of the middle 1980s to middle 1990s. The United States coerced Japan into a series of bilateral "dialogues," "initiatives," and "frameworks" to pursue US concerns that stood alone in the annals of global economic relationships.

    The seeming verities of less than a decade ago appear surreal at the outset of the 21st century. Economic growth in the United States has been more than double that of stagnant Japan for a decade, reversing the ratio of the previous 30 years (table 1.1). After more than a decade of steady expansion, interrupted only by the brief recession of 1990-91, US domestic demand growth accelerated to 5 percent annually in the late 1990s—relative to 1 percent for Japan throughout the decade, including two recessions and perhaps a third in 2001. Consensus estimates in the two countries suggest that the sustainable trend growth is now at least 50 percent higher in the United States—3 percent a year, versus 2 percent in Japan—because US productivity growth substantially exceeds Japanese productivity growth and is widely expected to continue to do so, absent significant reform in Japan; and because the US labor force will continue to expand, whereas Japan's is already declining owing to the aging of its population and its resistance to immigration. This resurgent US economic performance was led by many of the high-technology sectors that were widely viewed, less than a decade earlier, as under intense threat from Japan. Even measured unemployment in the United States fell below that in Japan by the end of the decade.

    Government finances exhibit similarly dramatic reversals. The government of "thrifty" Japan has now run annual budget deficits of more than $300 billion, larger in absolute terms than have ever been incurred by the United States, and the largest as a share of GDP of any country belonging to the Organization for Economic Cooperation and Development (OECD). Japan's national debt has reached $6 trillion and is still climbing, whereas US debt peaked at about $5 trillion and is now declining rapidly. In 1999, the Government of Japan replaced the United States as the largest issuer of government debt, and the OECD projects that it will undertake more than 90 percent of net OECD debt issues in the coming years.

    Sectoral data naturally mirror these aggregate shifts. In contrast to a decade earlier, when Japan accounted for the world's 5 largest banks, by 2000 Japan provided only 2 of the top 10. The profitability of Japanese banks lagged behind their European and US counterparts throughout the entire 1990s. After a series of capital injections beginning in 1998, Japanese banks are still far from being strong in their balance sheets and earning power. They are still withdrawing from foreign operations. Even in the traditional manufacturing sectors, such as automobiles, US companies have improved their positions vis-à-vis most Japanese firms. Respected authors now ask Can Japan Compete? (Porter, M. Sakakibara, and Takeuchi 2000) and note that Japan's performance has been slipping, even in its most successful industries.

    Regional developments appear to replicate these swings in national fortunes. The Asian financial crisis of 1997-98 derailed the "miracle economies," at least for a while, and exposed weaknesses in financial systems and corporate governance that undermined confidence in Japan itself and its entire "economic model." Latin America continues to have its troubles, but the creation of the North American Free Trade Agreement (NAFTA) and Mercosur have imparted new bursts of dynamism to the largest countries in the region.

    To be sure, a few elements remain unchanged. Some Japanese auto and electronics firms remain at the top of their world leagues. US external deficits have continued to grow sharply, and its net foreign obligations stand far above all others', now exceeding $2 trillion (about 20 percent of its GDP). Japan's external surpluses remain the largest in the world, as does its net creditor position of about $1 trillion (about 25 percent of GDP).

    Moreover, the United States confronts a series of vulnerabilities that are somewhat reminiscent of those faced by Japan in 1990. The most obvious in the short run are macroeconomic uncertainties due to possible further declines in the still richly valued stock market, a possible decline of real estate prices in some regions, and consequent reverberations in the banking sector; there are many who still believe that the United States is a "bubble economy" à la Japan a decade ago. The United States also faces a possible sharp change in the external value of its currency, most likely in the downward direction, whereas Japan's problems in the early 1990s were subsequently compounded by a record appreciation of the yen; a major fall in the dollar while the US economy was still near full employment could lead to a substantial rise in prices and interest rates, and hence a plunge in the financial markets, that could sharply deepen the turndown of 2000-01.

    The United States also continues to face a number of more deep-seated economic problems. It is unclear whether the sharp rise in productivity growth, which fueled the dramatic rise in output in the second half of the 1990s, will turn out to be sustainable. The private savings rate is abysmally low and partly explains the country's large external deficits and dependence on foreign capital. The US primary and secondary education system, although gradually improving and clearly a high priority of national policy, remains inadequate to equip many Americans to compete effectively in a globalized, high-technology world economy. Partly as a result of these educational deficiencies, the United States has experienced a domestic backlash against globalization for almost a decade that could limit the country's ability to reap the benefits from further internationalization of its economy.

    But the economic underpinnings of the Japan-United States relationship have virtually reversed during the past decade. Indeed, it is abundantly clear that Japan's economic problems of the 1990s, which continue as this book is completed, are far greater than those of the United States in the 1970s and 1980s. We leaned against the wind of "Japanaphoria" and "Ameropessimism" a decade ago (Bergsten and Noland 1993), but no one even came close to predicting either component—let alone both ends—of the turnabout of the past decade. Those who extrapolated from the past have been proven decisively wrong.

    Indeed, Japan's weakness rather than its strength has become the greatest concern of the United States (and the rest of the world). Since 1998, there has been recurrent fear of a true implosion of the Japanese financial system—runs on banks, widespread failures and defaults, withdrawals of funding around the world by the world's largest creditor country, free falls of the stock market and the currency, and a renewal of financial crisis in East Asia and perhaps the entire world. This shift in the nature of "the Japan problem," and perceptions of it, dramatize the reversal of the past decade.

    Japan will of course eventually overcome this crisis, as it has so many others in the past, and restore at least a modicum of economic growth. But Japan also faces important long-term problems. The most notable is an aging population that, on current trends, would lead to a halving of its total population by 2050. Hence there is reason to believe, from both the US and Japanese perspectives, that an important part of the "reversal of fortunes" of the last decade will persist.

    This book is about future economic policy between the United States and Japan. Hence it is essential that we attempt to assess the future course of the two economies as one important starting point for the analysis and subsequent prescriptions. This, in turn, requires us to try to explain both the performance reversal of the past decade and its implications for future developments.

    Was the shift simply a temporary phenomenon based on an inevitable US recovery from its policy errors and economic woes of the 1970s and early 1980s, and on a series of Japanese mistakes that should be avoidable in the future? Even worse, did it simply reflect a US bubble à la Japan's bubble a decade earlier that could burst at any moment and throw the United States back to slow growth or even renewed stagflation? Indeed, could Japan come back strong during the next 5 to 10 years, as the United States did after its earlier "decade(s) of decline"?

    Or does the reversal of the 1990s represent a lasting change, with the United States seizing a permanent lead in the technology revolution of the modern era and Japan continuing to decline due to its structural rigidities and aging population? Does the answer lie somewhere in between, with the United States likely to keep doing reasonably well, if not as well as in the late 1990s, and with Japan resuming at least some of its traditional dynamism and thus creating a world where the two largest national economies are moving ahead roughly in tandem? What would be the implications for the Japan-United States economic (and overall) relationship of these very different relative economic patterns?

    Chapter 2 will attempt to answer these questions for the United States, assessing both the structural changes that have transpired within the US economy and the macroeconomic record. Chapter 3 will provide a similar analysis of Japan. Our emphasis in both cases will be on the likely persistence of the radical changes of the past decade, the outlook for the future, the interaction between the two economies, and the implications of all these developments for policy. Our goal is to discern the economic foundations for the relationship that are likely to prevail for the next decade or so, recognizing the huge errors that any similar effort of 10 years ago would almost surely have made and hence the inherent uncertainty of the exercise.

    Before turning to the underlying economics, however, it is essential to consider the other two dimensions of the relationship. We will thus review briefly the two countries' overall global positions and the specifically bilateral interactions between them during the past three decades.

The Global Positions

These dramatic changes in the economic performance of the two countries have of course also affected their overall global positions. The strong economic resurgence of the United States has strengthened its status and prestige, and restored luster to both "the Anglo-Saxon model" and US "soft power." Conversely, Japan's decade of stagnation or worse, along with the broader Asian crisis, have dimmed the Japanese star that shone so brightly a decade ago.

    In addition, the demise of the Soviet Union and the end of the Cold War resulted in a decline in the relative importance of US security alliances, including its alliance with Japan. The revisionists and other "economic hawks," who favored a much tougher stance in US trade negotiations with Japan, argued that the United States had always deferred to Japan for security reasons but could now follow their advice. The Clinton administration indeed adopted a hard line on trade matters in its first couple of years in office and then, after a short hiatus, instituted an equally tough approach on macroeconomic and monetary issues during its second term. We will evaluate those efforts in chapter 5, but it is clear that the epochal change in the global security situation was a key enabling factor.

    However, this tendency has been tempered by the rise of China, which presents major challenges to both the United States and Japan in both security and economic terms. In the case of the United States, China's perceived challenge had already led to a reevaluation of security matters as early as 1995-96, leading to the Nye Report on strengthening the military alliance with Japan and contributing significantly to the reduction in US economic pressures. It was demonstrated again during the George W. Bush-Junichiro Koizumi summit in June 2001, where economic issues largely took a back seat.

    For Japan, China presents a challenge to its vision of its unfettered role as the regional leader of Asia and the go-between intermediating between the developing countries of the Asia-Pacific region and the rich industrial countries of the OECD. This vision has in fact been shattered by the concomitant rise of China and the stagnation of Japan itself. Japan is still far richer and more technologically advanced than China, and its trade flows and financial markets remain much larger than those of its neighbor. However, according to some estimates of national output converted at purchasing power parity equivalents, China has now exceeded Japan in terms of total GDP (and become the world's second largest economy, trailing only the United States). Moreover, China possesses considerable military assets (including nuclear weapons) and appears to have much greater confidence in asserting its influence, regionally and even globally.

(Continues...)

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Excerpted from NO MORE BASHING by C. Fred Bergsten, Takatoshi Ito, Marcus Noland. Copyright © 2001 by Institute for International Economics. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.

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