In June 1997, the defense of the Thai baht--a measure crafted to contain the Asian crisis--failed. By fall 1997, the emergency had engulfed Indonesia and South Korea. Efforts to limit the exigency to Thailand and those two countries, including nearly $100 billion of special assistance from the International Monetary Fund, created a wave of hope during winter 1998. But the underlying symptoms of growing excess capacity have returned as the stock markets in Asia have dropped another 30-50 percent since their March 1998 highs and far more than that since the highs of 1997.

China has been swamped by the deflationary crisis, with its retail price index now falling at a year-over-year rate of close to 3 percent: the annualized rate of deflation in China over the past several months is approaching double digits. Simultaneously, deflation is upending Russia, with its heavy dependence on commodity exports. The Russians’ need to borrow $6 billion a month in the short-term ruble-denominated bill market can no longer be satisfied by global investors, who are trying desperately to reduce their exposure to emerging markets.

After a lengthy exercise in denial--which only postponed necessary measures to repair the badly damaged banking system--in June 1998 Japan succumbed to the crisis environment in Asia. As rumors of another bank failure spread, the government announced that the economy had contracted at more than a 5 percent annual rate during the first quarter because of a virtual collapse of domestic investment. The yen too collapsed, falling 6 percent in five days. Japan had inflicted on itself—through an ill-advised fiscal tightening in April 1997, followed by an unaddressed crisis in the banking system and the failure of a major bank and brokerage house—the same deflationary medicine that the International Monetary Fund had administered to smaller Asian countries.

As a result of the plunge in domestic demand, Japan's currency, like that of other Asian nations, must fall sharply in a desperate scramble to grasp demand for its exports. This struggle is all the more difficult in light of more signs that nominal global spending is shrinking, though it continues to expand, at least moderately, in the United States.

The accelerating shrinkage of global demand is forcing producers to meet competition with additional aggressive price cuts. And, with inflationary expectations replaced by expectations of either stable prices or, in most commodity markets, falling prices, buyers are in no hurry to respond to price cuts by producers perceived as increasingly desperate.

Full Circle from 1971

The Asian deflation crisis of 1997ÿ1998 brings global markets full circle from the American inflation crisis of summer 1971. In spring 1971, American dollars were flooding global markets as reflationary policies resulted in an unusual spillage of dollars into Europe. Europe had been uncomfortable with the American tactic of reflating and forcing European central banks to buy its dollars in the fixed-exchange-rate Bretton Woods system. By May 1971, the Germans and the Dutch had had enough and allowed their currencies to float upward.

After that minicrisis, markets settled down with reassurances of financial stability from the Nixon administration. Of course, the underlying need was dollar devaluation, which was considered unthinkable in a world of living by the Bretton Woods system for more than twenty-five years. By August 1971, however, the American government unilaterally decided to devalue the dollar by letting it float, while placing a 10 percent surcharge on imports and ending the convertibility between the dollar and gold at $35 per ounce.

In 1971, the currency crisis focused on Europe and the United States, with Japan a passive player. While European governments were intensively consulted on the U.S. move to devalue and cut the dollar link to gold, Japan’s government learned of the policy change from news broadcasts. The Nixon “shocku” of August 1971 has never been forgotten in Japan.

The 1971 currency plight was inflationary, emanating from the United States. The emergency required ending the Bretton Woods system of fixed exchange rates so that the dollar could float down to a more reasonable level against the currencies of Europe, where less inflation had been created during the heyday of the hard money Bundesbank. Simultaneously, the United States had to cut the dollar link with gold and thereby abandon the fiction that the dollar was as good as gold.

While it was painful in 1971 to abandon the dollar peg to gold and the familiar world of fixed exchange rates, governments hustled to reestablish parities, with the dollar devalued by about 10 percent by December of that year. But, in August, just letting the dollar float defused the danger. After fourteen months of struggling to maintain the December 1971 parities, governments gave up and allowed currencies to float in March 1973, just in time to prevent pegged exchange rates from exacerbating the oil shock that hit in fall 1973. The 1971ÿ1973 transition to floating exchange rates permitted continued divergences in national monetary policies in the 1970s and thereafter.

And Now Deflation

By contrast, the financial peril of 1997ÿ1998 erupting from Asia, especially Japan, is deflationary. Postwar governments are less equipped to deal with deflationary crises since the solutions run contrary to the instincts of most policy makers and are intrinsically more difficult to engineer.

In 1997, the world discovered far too much productive capacity in Asia and tried, incorrectly, to apply traditional remedies and currency policies derived from the experience of the 1970s. Faced with currency crises, the International Monetary Fund prescribed the usual medicine of crushing domestic demand. As a result, Asian countries were faced with the difficult choice of allowing either their stock market to collapse or their currency to collapse. Urged on by the IMF and G-7 governments, most chose first to defend their currencies until their stock markets fell by more than 50 percent and then to abandon themselves to debacles in both the currency and the stock markets.

Japan has followed the same strategy; because it is wealthier, Japan could until May of this year hold its currency nearly steady while propping up its stock market with heavy purchases using government funds. The continuing deflationary collapse of the Japanese economy and its banking system, however, made it impossible to hold the currency, which dropped sharply, by nearly 14 percent between April and mid-June.

While the response to the 1971 inflationary crisis emerging from the United States was to allow the dollar to float, the instinctive response to the deflationary collapse emanating from Asia in 1998 was to try to peg the yen. Although allowing the dollar to float and cutting the dollar link to gold essentially let markets register the inflationary reality in the United States and thereby reduce pressure on the global system, the effort to peg the yen while demand collapses in Japan and the rest of Asia increases the tension.

U.S. Intervention

The dramatic American intervention in the currency markets on the morning of June 18 was undertaken because of a perceived need to stabilize the yen to avoid a further round of devaluations in Asia, especially in China. No doubt the Chinese made it known to the Clinton administration that, in the absence of any U.S. effort to stabilize the yen, they could not guarantee that the Chinese currency would not be devalued during President Bill Clinton’s June 25-July 3 visit to China.

The Chinese pressure on the American government put Treasury Secretary Robert Rubin in an awkward position. Just five days before, Rubin reiterated that a strong dollar was in the best interest of the United States and suggested that Japan could best strengthen its currency by strengthening its economy through addressing its serious banking problem and increasing domestic demand. This sensible viewpoint was shared by many Japanese policy makers who are initiating efforts to deal with the banking system crisis, having abandoned the idea of successfully staunching the wound with the overblown 16 trillion yen stimulus package announced in April 1998.

The Clinton initiative that tied U.S. support for the Japanese yen to immediate and serious efforts to “fix” Japan’s banking problem and stimulate domestic demand put the Japanese in an awkward position. Having begged the U.S. Treasury for joint intervention for more than a year, Japan did get its wish. But the decision to send Deputy Treasury Secretary Larry Summers to lecture the Japanese yet again about the need to repair their banking system and energize their economy was probably a tactical mistake--the Japanese realized that some of the urgency of the yen-pegging exercise derived from the president’s wish to please the Chinese. The Chinese can now pose as heroes for the rest of Asia, after forcing the Americans to take action to stem the currency plummet.

Many in the Japanese government would like a visit from President Clinton on his return from Beijing to reassure them that the United States still has Japan's interests at heart. They are not optimistic, however, and suspect, with good reason, that a precondition of the presidential visit to China is keeping Japan off the itinerary.

Consultations between Summers and Japan's ruling Liberal Democratic Party, which will be responsible for drafting new bank legislation, focused on the repair of the financial system. The urgency of the problem intensified, with another Japanese bank about to fail. In addition, the markets had long ago dismissed the April 1998 government package for domestic stimulus (too little, too late) as merely a stopgap measure, with no more than five or six trillion yen of real stimulus. The collapse of domestic demand in Japan's investment sector and household sector would more than offset the fiscal stimulus and leave the growth rate in the current fiscal year at negative 1.5 percent and falling.

Unfortunately, the U.S. Treasury decision to support the yen in currency markets leaves the Japanese in a ridiculous position. The American government is apparently requiring, in exchange for helping to strengthen the yen and thereby reducing the demand for Japanese goods even further, a reflationary effort to recapitalize Japan's banking system. And so they should be since the urgent need in Japan is for reflation and stimulus of demand, even if through the traded goods sector. This inconsistency is crowned with the Japanese suspicion that America's real concern is its relationship with China, especially during the president's visit there.

The Same Old Trap

By attempting to stabilize the yen, policy makers are falling into the same trap that snared them in every other Asian currency crisis. Stabilizing the currency deprives a nation experiencing deflationary pressure of the only means available to stimulate demand for its products. In Japan the situation is even more acute because the banking system is on the verge of a breakdown that will exacerbate existing deflationary pressure.

The proximate symptom of growing trouble for the Japanese economy will probably be the same as for other economies. Japan's stock market will fall, and the government will be forced to devote even more government pension funds to shoring it up. Given the considerable resources directed at the stock-buying effort since the start of Japan's fiscal year early in April, the effort to support the stock market is unlikely to succeed in the presence of the triple deflationary thrust of a stronger currency, a collapsing banking system, and faltering domestic investment.

Before the U.S. intervention, Japan was on the way to a “pain before gain” approach to recapitalizing its banking system. While the Japanese government is, for obvious reasons, reluctant to admit it, upward of 100 trillion yen will be required to recapitalize the banking system, and much of that can and should be provided by the Bank of Japan. The BoJ will eventually print money to buy a huge bond issue created by the government or a large bridge bank, which will then use the proceeds to purchase bad loans from weak banks at markdown prices. Because the determination of those prices is expected to be a political rather than an economic exercise, the danger of failure is large. Banks will want top dollar for their bad loans; to the extent that they get it, the cost to the public of bailing out the banks will be even larger.

Far more desirable would be an auction market in which the bad loans are sold to the highest bidder, including bidders from abroad who would be especially interested with exchange rates of 160 or higher between the yen and the dollar. Many of Japan’s bad loans, however, are collateralized by property that has not changed hands for decades—or, in some cases, for centuries. Japan’s belief and the operational reality—is that such collateral cannot be sold in an open market without years of legal procedures to unwind the complicated claims on such property.

Japan's perception of its markets for bad loans as constipated may or may not be true in principle, but, as far as the ruling Liberal Democratic Party is concerned, it is true in practice. Therefore, disposal of Japan's bad loans will be considerably arbitrary. That quality could save banks that are insolvent. Japan has too many banks: any defensible evaluation of assets of Japanese banks would imply the closure of many. The ruling Liberal Democratic Party, however, is still claiming that it can rescue the banking system without closing any insolvent and redundant banks. This claim will continue to delay the process and thereby exacerbate deflationary pressure in Japan.

No doubt the American government, in deciding to intervene, was attempting to buy time for the Japanese and to stop the spread of Asian deflation to China and beyond. It is not clear how pegging the dollar and the yen at a level that markets clearly disbelieve will achieve these laudable goals. Japan's resolution of its banking crisis by its nature implies both a weaker yen and lower interest rates. Unfortunately, buying time for the Japanese reduces pressure on them to address the politically unpopular banking emergency while simultaneously intensifying the deflationary pressure in Japan and the rest of Asia by preventing weaker currencies from doing their needed job of shifting demand to the exports of Asian countries.

One could argue that, since the falling Asian currencies are a symptom of spreading deflationary pressure, some government intervention is necessary to prevent deflation outside Asia. Clearly, the need to suppress the growing deflationary pressure in the global economy is most urgent, but the remedy is reflation both in Japan and in the United States and Europe, awkward as it may seem given the tension on the Federal Reserve Board.

This admission takes us right back to fundamentals. If we want the dollar to be weaker against the yen, either the Japanese must tighten monetary policy--totally out of the question given Japan’s failing economy and crisis-burdened banking system--or the United States must ease monetary policy. The latter measure is considered difficult because of perceived incipient inflationary pressure and overheating in the U.S. economy, which have created anxiety on the Federal Reserve Board.

U.S. Monetary Policy

Those hoping for a reduction of tension on the Federal Reserve Board over the proper direction of American monetary policy may be sorry to get their wish. After 5 percent growth during the first quarter, the American economy seems to be slowing rapidly in the second quarter. The drag from net exports, which subtracted 3 percentage points from growth in the first quarter, will probably subtract another 2 percentage points from growth during the second quarter. Meanwhile, rising deflationary pressure has caused a reevaluation of the optimistic notion that the Asian crisis ended during the first quarter. Therefore, the strong investment growth of the first quarter, except in the U.S. housing sector, will probably be reversed. Simultaneously, the large inventory buildup during the first quarter--large given deflationary developments and additional weakness in Asia with some weakness in Europe creeping in during the second quarter--will contribute to a significant drag of probably 2 percentage points on growth from inventory decumulation during the second quarter.

Given all demand-side factors affecting the U.S. economy, consumption growth may be as high as 4 percent during the second quarter and thereby contribute about 2.8 percentage points to growth of the gross domestic product, while the drag from net exports and inventory decumulation still forces down general growth to about 0.5 percent, with final sales growth of about 2.5 percent. The difference of 2 percentage points between GDP output growth of 0.5 percent and final sales growth of 2.5 percent will reflect a sharp drawdown in inventories.

Falling inventories and output will hamper the optimistic double-digit profit growth expectations for the second half of the year. The American stock market may be sensing this: the market has ceased to rise since April and has dropped by about 6 percent from its highs. Meanwhile, the market is narrowing: any strength in the stock market is coming from a shrinking group of companies.

In this environment--where, if anything, the Fed will need to ease to aid Asian governments with their deflation while output is slowing in the United States--bonds will probably outperform stocks. Even if the Fed eases as an acknowledgement of an increasingly pressing need to reduce the deflationary momentum out of Asia, that easing may be accompanied by a falling stock market. But, then, with the Fed easing and the stock market falling, the American government may get its wish for a stronger yen. Under those circumstances, the Japanese government may well wish to reconsider its acquiescence to that American initiative.

John H. Makin is a resident scholar at AEI.