10/9/97

CONTACT: Kathleen O'Toole, News Service (650) 725-1939;
e-mail kathleen.otoole@stanford.edu

Dollar/yen wars a lingering pox on both countries' houses, economists say

The danger of a country thinking its government can manipulate the real value of money is showing up not just in Thailand and Malaysia. It is also a chronic syndrome bedeviling America and Japan, say a Japanese and an American economist in a new book.

America's insistence for more than two decades that the value of the dollar be lowered repeatedly in comparison to the yen in order to alleviate the American trade deficit with Japan is responsible for much of Japan's recent economic woes, and the higher yen hasn't helped America either, according to a new book by Ronald McKinnon, the Eberle Professor of Economics at Stanford, and Kenichi Ohno, an economist at Japan's Saitama University.

From August 1971 through April 1995, the yen's value ratcheted up from 360 to the dollar to 80 to the dollar. This was primarily because some U.S. industries, anxious about their eroding share of world markets, put political pressure on American politicians. The American government in turn put pressure on Japan's politicians and central banking officials to keep raising the value of the yen against the dollar. With some support from academic economists, American producers argued that a higher-valued yen would help their products sell better in competition with Japanese products and therefore reduce the American trade deficit.

The great yen appreciations, to which the Bank of Japan acquiesced, temporarily ameliorated political tensions between the two countries. But they imposed relative deflation on Japan without correcting the trade imbalance between the two countries, McKinnon and Ohno say in their new book Dollar and Yen: Resolving Economic Conflict Between the United States and Japan (MIT Press). The money meddling eventually resulted in a severe economic downturn in Japan from 1992 to 1995 ­ what the Japanese call endaka-fukyo, or high-yen-induced recession.

In early 1995, the U.S. Treasury finally recognized that the Japanese financial system was on the verge of collapse, the authors say. The American and Japanese governments collaborated to drive down the value of the yen on world markets, and the Clinton administration quietly suspended some of its complaints about Japanese trading practices. (Kodak's complaints against Fuji, for example, were sent to the World Trade Organization for resolution rather than the government initiating unilateral sanctions against Japanese importers.) Today, the yen, at about 120 to the dollar, is near real purchasing parity with the dollar, the economists say, but that doesn't mean that what they call the "syndrome of the ever-higher yen" is permanently over. The countries have apparently developed a reputation with their own citizens for exchange rate meddling so that even when they aren't trying to change the dollar/yen rate, people expect a currency battle to break out again.

Evidence that the problems aren't going away easily comes from investors, McKinnon says, who are willing to buy Japanese bonds that earn substantially less interest than American bonds.

"Ten-year benchmark Japanese government bonds (JGBs) now yield less than 2 percent, while 10-year U.S. Treasuries yield more than 6 percent," he said. The large spread suggests that "on average, the markets expect the yen to drift upward against the dollar at the rate of about 4 percent per year over the next 10 years. Without this expectation, investors would be unwilling to hold JGBs instead of U.S. Treasuries."

The dramatic shift in American policy in the spring of 1995 "allowed modest recovery of the Japanese economy in 1996 and into early 1997," he said. "But Japan's economy seems to be weakening again in mid-1997. In the second quarter of this year, Japan's domestic expenditures and GNP fell sharply. Not surprisingly, imports declined and exports increased because domestic demand was so weak."

With Japan's trade balance growing again, Americans could start hectoring the Japanese to appreciate the yen. "This would cause another major slump in Japan's financially weakened economy, continuing the vicious circle," he said.

"Ohno and I claim that the main factor weakening aggregate demand in Japan at the present time is the threat that the yen will again start rising against the dollar. The present exchange rate of 120 yen to the dollar is more or less right. We would estimate the purchasing power parity exchange rate to be about 125 yen to the dollar. Nevertheless, if people expect the yen to begin rising again, this will deter current investment and consumption. Investments in plant and equipment in Japan now would seem unprofitable to operate in the future. Similarly, Japanese consumers might wait for a better deal before making big-ticket purchases."

The dilemma is how to revive Japan's domestic demand for goods and services without running large government deficits, he said. "Huge but low-yield government investment programs throughout most of the 1990s have already left Japan's government with an enormous gross debt relative to its GNP and relative to its aging population," he said. The only way out, he and Ohno argue, is to remove the threat that the yen is likely to rise into the indefinite future so private investment and consumption will surge.

While they don't claim it is simple, the two say the threat of the syndrome can be unraveled if Japan and the United States can "rationalize" their relationship in complementary dimensions.

"First, Japan agrees to complete the opening up and liberalization of its domestic markets, including agriculture and construction, while the Americans agree to cease all trade threats in automobiles, computers, semiconductors and so on as well as cease demands for yen appreciation," McKinnon said, summarizing the detailed analysis in the book.

Second, he said, "we recommend that the Bank of Japan and the U.S. Federal Reserve system agree on a joint program designed to keep the yen and dollar trading within 8 percent of their current purchasing power parity of 120 to 125 yen to the dollar. Although leaving rates flexible in the short run, the expectation of continual yen appreciation would be ended." SR