Japan’s Policy Trap Redux

As a follow-up to the review of Japan’s Policy Trap, I have excerpted a number of paragraphs in an essay titled Bubblenomics, published in the May-June 2009 issue of New Left Review where R. Taggart Murphy reviews the book The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crises by Graham Turner.  Murphy takes issue with a number of the conclusion Graham makes and he includes his alternative explanation of the economic situation in Japan which is a well-written summary of many of the central arguments in Japan’s Policy Trap.

The following four paragraphs are quoted directly from the essay and should bring some clarity to Japan’s Policy Trap:  “Understanding policy-making in Japan starts by grasping the central theme of the country’s modern history: the right to rule.  The absence of any institutionalized means of resolving the matter opened the way to the seizure of power in the 1930s by those with the means of physical coercion at their disposal.  The ruin to which they drove themselves and their country led to an American Occupation that in some fundamental ways has never really ended.  Japan’s policy elite was emasculated by a United States that assumed for Japan those elements by which a state can be most easily identified: security arrangements and the conduct of foreign relations.  A truncated remainder of the pre-war elite—the great economic bureaucracies and the cluster of nominally private-sector institutions around them—was left essentially free of any check on its power to undertake the restructuring and reordering of the economy.  But it always acted as if its survival and independence hinged upon the preservation of the political and economic arrangements that had been set in place by the Occupation.  Because those arrangements were locked into and contingent upon a U.S.-centred global financial and political architecture, the actions taken to preserve them ended up supporting that architecture.

…

Japan took advantage of the economic ecology of the era to construct an economy run on mercantilist lines, complete with trade protectionism and draconian capital controls.  The demands of the time for reconstruction were so obvious that implementation of whatever seemed to work required no political discussion or theoretical justification.  Japan’s truncated policy elite reoriented the institutional mechanisms they had used to direct scarce financing to munitions makers during the war years to ensure that promising export industries had priority access to funds.  The objective was to accumulate sufficient dollars to pay for essential imports of commodities and capital equipment.  Washington had no objection and indeed encouraged what Japan was doing; no one on either side of the Pacific at the time believed that the country posed any long-term threat to American manufacturing or technological supremacy.  The U.S. market was open to Japan without any reciprocal obligation—apart from unrestricted access for the U.S. military to bases strung throughout the length of the Japanese archipelago, lip-service in support of American foreign policy, and keeping leftists away from the levers of power (a ‘threat’ that Japan’s power holders exaggerated to Washington when their economic methods began to cause political problems in the U.S.).

Japan succeeded beyond anyone’s expectations, racking up growth rates between 1955 and 1969 that were higher than any previously achieved in human history.  But because Japan’s economic methods involved the systemic suppression of domestic demand and the deliberate channeling of financing into internationally competitive export industries, the inevitable result was a string of trade surpluses that began to alter the global economic ecology in which Japan had thrived.  Specifically, it exposed the flaw at the heart of Bretton Woods—that there was no way to force surplus countries to make adjustments.  By the late 1960s, the U.S. had become the world’s leading deficit country.  Unwilling to take the necessary measures to reduce the U.S. deficit—slowing down the economy and accepting lower living standards—and unable to persuade Japan to permit the yen to rise and thereby ease the strains on the Bretton Woods system, Nixon allowed it to collapse.

In the wake of its demise, however, which shocked Tokyo’s policy elite, the Japanese authorities began to implement policies designed to recreate its certainties: a dollar-centred global order and an undervalued yen that would permit Japan to continue to run an export-led economy.  There was little overt debate; indeed the Ministry of Finance actually went so far as to suppress discussion in the financial press of the possible virtues of allowing the yen to rise.  To any student of the country’s political history in the 20th century, the reason was obvious: a fear of the disorder that would come from the economic and political shifts necessarily accompanying a restructuring of the economy to put domestic demand instead of exports into the driver’s seat.  Instead, Japan accumulated dollars.  Among other things, it was those dollars that permitted the Reagan administration to finance an explosion in U.S. government deficits without paying any political or financial price.  When those dollars reached the point where they began to have serious effects on Japan’s ability to conduct monetary policy, the authorities began deliberately to foster the growth of asset bubbles to counteract the dollar build-up.”

Japan’ Policy Trap: Dollars, Deflation, and the Crisis of Japanese Finance

Japan’ Policy Trap: Dollars, Deflation, and the Crisis of Japanese Finance by Akio Mikuni and R. Taggart Murphy, argues that Japan’s economic problems are caused by perpetual current account surpluses and the accumulation of U.S. dollars.  To start, the author’s lay out the goals of Japanese policy makers, which are threefold: remain independent from foreign control, survive as a ruling elite and retain control of key economic and political levers within Japan.  The author’s argue that most politicians are figureheads and are not involved in the real policy debate.  Instead, the ruling elite maintain their grip on Japan through the bureaucracy or more specifically that economic policy resides or lives within the ministries, such as the Ministry of Finance (MoF) or the Ministry of Economy, Trade and Industry (METI) and not with elected officials.  Powerful politicians and business leaders are by and large in their positions due to their relationships with the bureaucracy and their willingness to execute on the policies implemented by the bureaucracy.  The importance of pointing out the power of the bureaucracy is to show that policy is shielded from the impact of political whim or popular desires.

Success in achieving the three policy goals is measured in large part by the size of the trade and current account surpluses.  Having a surplus means Japan is not beholden to outsiders, which achieves the first goal of independence.  In order to create surpluses, policies have been designed to maximize production capacity and exports and suppress consumer spending in order to drive domestic saving to fund the acquisition of a positive foreign net investment position.  These policies have led to overinvestment in plant and equipment not only for export but also for domestic supply.  As a result domestic demand suffers.  Japanese leaders engage in policies to enhance economic growth as long they do not contradict their main policy goals.  Two examples are the policies surrounding the creation of a property bubble in the 1980s, which the author’s argue was deliberately created by the MoF, and the fiscal stimulus in the 1990s and 2000s.  Policy makers could open up markets and allow free-market based allocation of capital, but as argued in the book this would remove the elite from its position of control over the economic levers of the country and even threaten their survival.

That current account surpluses and the accumulation of dollar claims are creating deflation and an economic slump in the country is plausible although the author’s may have explained in greater detail the relationship behind the linkage to more forcefully make the argument.  The more difficult link to establish is why the Japanese government pursues a policy of targeting the current account to the exclusion of other economic variables.  Much of book’s thesis rests on its theory that Japan’s policy elite is motivated to achieve the primary goals of independence, survival and control above all others even if it means slower growth and lower living standards in the country.  The author’s support the notion that policy makers did not see the current state of affairs as the end-game of their policies which makes their thesis easier to accept.  Rather, through a series of decisions that made the most sense at the time, the economy has evolved to where it is today.  The result is that while policy makers never envisioned a $2.8 trillion dollar net external asset position (as of 3Q09), it is explainable in light of trying to achieve their key goals over time.

For an analyst evaluating Japan as an investment opportunity or their financial role in maintaining the global economic equilibrium, several factors look promising to monitor if the author’s are correct in their thesis.  The first is the ability of Japan’s leadership to pursue its policy goals to the exclusion of increasing living standards and economic growth.  Real political change driven by displeasure with economic results seems to be the biggest threat to the continuance of the status quo.  The second factor to analyze closely is Japan’s balance of payments.  A significant change in the current account could show a deeper underlying change in policy or the inability of policy to continue to be directed as necessary due to underlying economics.  The third factor to observe is the level of the yen and the intentions or actions to intervene to depreciate the yen.  Yen depreciation or at least stabilization is a key feature in keeping the current account positive and the current Japanese economic order alive.

Japan’s Policy Trap: Dollars, Deflation, and the Crises of Japanese Finance

In an article published in August 2006, R. Taggart Murphy gave a partial update and expansion of his view outlined in the Japan’s Policy Trap.

New Left Review – R. Taggart Murphy: Eat Asia’s Dollars

Golden Fetters: The Gold Standard and the Great Depression, 1919-1939

Golden Fetters: The Gold Standard and the Great Depression, 1919-1939 by Barry Eichengreen is a history of international finance in the period leading up to and including the Great Depression.  The book’s primary focus is on central bank policies and the gold standard.  The author advances the view that the initial recessionary impulse leading to Great Depression was a restrictive monetary policy in the U.S. coupled with significant imbalances in the pattern of international settlements.  The continuance of restrictive monetary policy not only in the U.S., but globally throughout the Great Depression, pursued to adhere to the gold standard, turned a recession into a long depression.

Slowly, countries came to abandon the gold standard in order to gain the freedom to pursue independent financial action.  As countries abandoned the gold standard and allowed for domestic credit to expand, increases in economic activity followed.  Eichengreen makes the point that depreciation alone was not the cause of recovery; rather it was the ability of depreciation to allow for an expansion in domestic credit.  In countries that depreciated but did not allow domestic credit to expand, recovery was muted.  In countries that adhered most rigidly to the gold standard initially, France and the U.S. specifically, economic growth was most constrained even though two countries had by far the biggest gold hordes in the world.

Worth noting is that as opposed to the commonly held view, Eichengreen asserts that the gold standard was never an automatic mechanism for balancing international settlements.  Instead, the gold standard as constructed both prior to and after World War I (there were substantial differences which the author addresses at length), required proactive cooperation among countries.  Eichengreen explores this notion in order to defend against those who would espouse that had the gold standard merely been allowed to work as it naturally should have, then the economic problems would not have been as serious.  At the same time, the author does admit that the gold standard in the interwar period had credibility problems for example due to domestic opposition to central bank cooperation, which may have been as much at the root of the gold standards failure than substantive economic issues.

Golden Fetters is filled with economic history, in many cases well beyond what is necessary for the author to pursue an explanation of his thesis.  While paring down dome of the material in the book may have made it more succinct, the extra material is quite useful to students of the period.  Four key points, some partially tangential to the author’s main thrust caught your writer’s attention.  These points were the most helpful in understanding the period from the point of view of an investor and will form the basis for the balance of this review.

The first point is that there are numerous examples of capital flight during the period, brought about by the prospect of confiscatory tax measures taking place and similarly, there are examples of capital friendly policies causing capital repatriation.  Capital flight during the period caused either gold loss from a country’s central bank or a decline in the currency while repatriation had the reverse impact.  The author details at least four separate periods of capital flight from Belgium, France, Germany and Switzerland caused typically by the threat of increased taxes, especially capital levies.  A separate impact of proposed capital levies was a measured decrease in savings rates.

The second illuminating point in the book was that currency weakness or gold losses were often associated with central bank finance in response to budget deficits.  Budget deficits alone were not enough to weaken the currency.  Rather, deficits had to be financed by monetary emissions from the central bank.  Eichengreen points out a viscous self-perpetuating cycle that can take hold once the central bank begins financing the government.  Taking monetary emissions as the starting point, inflation would likely follow discouraging public purchases of government debt and forcing the central bank to monetize larger and larger portions of the budget over time.  Longer-term debt would become difficult to issue due to investor concerns over inflation and increasing market interest rates.  The solution to the problem therefore was to first balance the budget before reducing the scope of central bank finance.  If instead the central bank tried to take action first, budget deficits would only get worse due to increased interest costs.  In the book, Eichengreen explains this cycle in relation to interest rate pegging at the Fed after World War I.

The effects of imbalances in international settlements constitute the third important point from the book.  The main insight, at the core of the author’s thesis, is that long-term imbalances can readily create financial and economic crises.  In the 1920s even while the economy was strong, there were tensions in flows of funds between countries.  Germany had its own well publicized problems after World War I servicing reparations, but so too did commodity producers which were reliant on the developed world for capital imports due to weak commodity prices.  In fact, the world as a whole ran balance payments deficits with the U.S., which were balanced by long-term lending from the U.S. to the rest of the world.

When monetary policy began to tighten in 1928 in the U.S., long-term lending was cut dramatically leading to balance of payments crises in the rest of the world.  In the case of Australia, balance of payments deficits after 1929 forced Australia to ration access to foreign exchange, institute austerity measures and eventually allow its currency to depreciate.  Argentina and Brazil followed similar courses, while Canada , due to continued access to borrowed funds from the U.S., was able to avoid a balance of payments crisis, though suspended convertibility nonetheless.

Lastly, a smaller point but significant nonetheless is that political change can lead to substantial economic and financial change.  The author shows in two ways how the enfranchisement of greater parts of the population in the wake of World War I changed the economic landscape.  First, the electorate was more likely likely to single out the rich to pay taxes and second, central bankers were more likely to regard unemployment problems as a bigger challenge than balance of payment dislocations.

In focusing on the above points in this review the hope is to avoid the errors investors made in the Great Depression and the period leading up to it.  While the policy debate central to the book is of keen interest, from a practical point of view, the period covered is filled with information to help an investor in times that may be similar, including today’s environment.  Golden Fetters includes many more lessons for investors than presented here and as well for those primarily interested in policy, significantly more explanation of the issues.

Golden Fetters: The Gold Standard and the Great Depression, 1919-1939