Japan Policy Challenges for the New Administration

December 1, 2000

Transcript prepared from a tape recording

9:30 a.m.	Opening Remarks:	Christopher DeMuth, President, AEI
9:45	Panel One:	The Japanese Economy: Can Further Instability be Averted?
		Robert Dugger, Tudor Investment Corporation
		John Makin, AEI
		Tadashi Nakamae, Nakamae International Research (Tokyo, Japan)
11:00	Panel Two:	US-Japan Trade Relations: Is a Free Trade Renaissance a Possibility?
		David Asher, AEI
		Claude Barfield, AEI
		Richard Katz, Oriental Economist
		Nobuo Tanaka, MITI Research Institute (Tokyo, Japan)
12:15 p.m.	Lunch	Lawrence Lindsey, AEI
1:30	Panel Three:	A US-Japan Security Alliance for the 21st Century
		Patrick Cronin, U.S. Institute of Peace
		Paul Giarra, SAIC, Strategic Assessment Center
		Michael Green, Council on Foreign Relations
		Torkel Patterson, former of the National Security Council
2:45	Closing Remarks:	John Bolton, AEI
3:00	Adjournment

Proceedings:

MR. DeMUTH: . . . on Japan's policy challenges for the new Administration which will be running throughout today until mid-afternoon with a luncheon between our panels where Larry Lindsey will be giving the luncheon talk.

Many believe that relationships between the United States and Japan in economics and finance, trade and security policy have been woefully neglected in recent years by the American Government and by the American Enterprise Institute. At AEI, we are changing that.

We were very fortunate earlier this year to be able to lure down from MIT David Asher, one of America's most insightful and energetic young--I heard some titters at the use of the word energetic--young Japan scholars, who has done very important work in the past year on the serious financial problems facing the Japanese people and government.

David is now the Associate Director of Asian Studies at AEI. He has been conducting a series of research projects and conferences, both in the United States and in Japan, and this conference this morning is just one of the several new initiatives that AEI is undertaking in an effort to give heightened attention to this critical relationship and to produce new research and, we hope, practical progress at the level of policy.

We are holding lots of under-the-new-administration programs at AEI this month, and I wish I could say confidently that we have some sense of what the policies of the new Administration will be, but the arrival of the new Administration is still pending, and so we will have to be a little bit more speculative than we had hoped to be.

Nevertheless, it seems clear, both because of objective relationships in finance and security in the Pacific and because of the interest that both of the presidential candidates have evinced in Japan in the past, that we are going to be entering into a new era in U.S.-Japan relations, and that could be a very good thing for those of us on both sides of the Pacific.

I would like to thank in addition to David Asher, Robert Dugger of Tudor Investment Corporation, and also my colleague John Makin for all of their hard work in putting this conference together.

We have three extremely important and interesting panels with a fine group of people from AEI and elsewhere.

The first panel is "The Japanese Economy: Can Further Instability Be Averted?" Long-time AEI resident scholar and author of our monthly U.S. Economic Outlook, John Makin, will be chairing this panel, and I will now turn the proceedings over to John.

Thank you.

MR. MAKIN: Thank you.

Well, I find myself in the uncharacteristic role of moderator, but I'll do my best. Let's see. I'm going to start with Mr. Nakamae, who is going to give us some background on Japan, and then we'll continue with David Asher and Robert Dugger, get three viewpoints.

Is Richard Medley coming?

MR. MEDLEY: Richard's right here.

MR. MAKIN: Oh, there he is.

MR. MEDLEY: Yes. Hello. I think I'll come.

[Laughter.]

MR. DeMUTH: You slipped in. And fortunately, Richard is here, too, so we will get his views, and that should be quite stimulating, and then we can have a good discussion.

MR. MAKIN: Mr. Nakamae, would you start off please?

MR. DeMUTH: You know, around five minutes. And you can use the podium if you wish, or the microphone before you.

MR. NAKAMAE: Well, I would like to start and summarize my view on the Japanese economy.

On the question, the title, "The Japanese Economy: Can Further Instability Be Averted," my answer is no.

[Laughter.]

MR. NAKAMAE: But I think it's better to clarify my position first.

I am very positive for Japanese economy in ten years. Japanese economy has been totally isolated from growth in 1990s. Japan has not grown at all. There has been huge pent-up demand. If the system could be improved, Japan could grow very fast. So in ten years' view, I expect Japan will be the best economy among industrialized nations in terms of growth.

But in the short term, short-term point of view, Japan has not been able to complete structure adjustment. So I think Japanese structure adjustments started in the beginning of 1990s, and probably, I think, 70 to 80 percent of the structural adjustment of private sector is over, but the remaining 20 percent or so is very, very serious.

Thus it is my position to see current Japanese likelihood of crisis. I would like to elaborate this view in three points. One is the current economic developments, and two is what would be the solution, and three, the political process for that.

Now, I would like to use my handouts titled Japan's Economic Outlook. Talking of economic development, I think there are two dimensions. One is the real economy; the other is financial economy. In the last 15 years, the best indicator for Japanese economy has always been the golf course index.

[Laughter.]

MR. NAKAMAE: And I don't think there is any other good indicators on this.

Now, looking at the chart the golf membership index peaked in 1990 and the overall Japanese index peaked at 937 and latest number is 86.9. That's some ten percent. That is the reality of Japanese deflation rate, especially the asset deflation, and we can see lots of asset prices, which came down more than 90 percent in Tokyo.

The problem is that the index has not bottomed out yet. It is still declining week by week. This is the weekly index. And looking at the middle chart, this is more the short-term development. This is a very good guide of how Japanese economy is behaving.

Since the end of '98, this index rebounded, and in the real economy, people started to talk of the sound economic rebound after the banking crisis in the autumn of '98. But since the beginning of last year--sorry--middle of last year, this index started to decline constantly and it is declining quite steadily. The argument of economic rebound was over already more than twelve months ago.

Another I think important indicator is opinion polls of the Asahi newspaper. Looking in the last four months, 54 percent of the people think Japanese economy is in deep recession, and an additional 39 percent of people think it is in recession to some extent. Only 5 percent of people think economy is not in recession, and despite public perception, the Bank of Japan or lots of the business bank economists are talking of economic rebound. I think those arguments don't have any basis, in fact I think they are totally baseless.

Now, look at page 3. Looking at the Japanese economy and money supply on the top chart, money supply growth rate has been slowing down or decelerating, and nominal GDP growth rate has been in negative territory in the last two years.

The argument that the Japanese economy was rebounding is mostly looking at volume economy or real economy, but I think in an economy such as Japan where deflation is prevailing, there is no point to talk of real growth. I would like to give you a typical example.

For clothing, say shirts or underwear, the unit price has been declining by nearly 30 percent at supermarket chains, but their sales are declining by 50 percent. That means in real terms clothing sales are growing by 15 percent. Is this data indicative of a very good economy or a bad economy?

I think we should look at the numbers, and if you turn to page 4, this is the household survey of the Japanese--the consumption survey. Looking at the third-quarter numbers, consumption expenditure was minus 2.8 percent, but if we look at that excluding car purchase and, because of technical reasons, and imputed rents, what I call core consumption was declining by 3.6 percent. The nominal consumption was declining quite steadily.

If you look at the next page, the difference of the core consumption in the GDP consumption numbers, there has been very big gap since the beginning of 1990s. That could be explained by mostly the imputed rent. Imputed rent is very much virtual consumption. Just looking at the real consumption it has been growing, However looking at the nominal data, nominal consumption has been declining, reflecting the decline in employment and wage decrease.

Now, this is a consumption viewpoint, and if you turn to the next page, looking at the latest--the industrial activity on the left-hand side top, the gap of Japanese industrial production between so-called IT sectors and non-ITs is in the dark lines. The dark lines--they are 84 percent of the weight--have not grown at all in the last couple of years. Only IT sectors are growing. That is more clear on the right-hand side. Just picking up the capital goods productions, the IT--the capital goods production has been simply declining.

Now, thanks to the crash of NASDAQ, globally, IT sector is suffering very fast, and towards next year IT sector production and capital investment is very likely to decline quite substantially. Overall, I think there is no positive development in Japanese economy in the near future, but--would you turn to the last page, 13.

The foreign national aspect of the problems--thanks to the very much deflation biased economy, the financial system has been eroded very much, especially the banking industry and insurance companies as deflation deteriorated their capital base, and those financial institutions are very difficult to take risks.

This is a table of flow of funds of those institutions. If you look at the bottom, the insurance industry's money flow, just the investment side, the lending has been negative in the last two financial years, and investment in equities was negative last year, and overseas investment was also negative last year.

They were expected to be the major overseas investors in Japan, but what happened is that they concentrated their investment in JGB, securities other than equities, because by very definition, the JGB is risk-free.

That is also the case on top of the table. The lending came down, and it's a very big negative, or, say, minus 29 trillion, and the investment in equity was negative and overseas investment was negligible, and banks made a huge investment in JGB.

That means the national savings have been shifted or transferred to garment sector, and garment sector is the most inefficient sector, and because of that, the return on Japanese capital is declining and the efficiency of Japanese economy is deteriorating.

What is important, I think, is to create new conditions for Japanese economy to have the sustainable growth rate of, say, 3 percent.

The core of the reform issues is to eliminate weaker and inefficient companies. We need to create bankruptcies and much bigger unemployment first.

In order for that, the zero interest rate is very big mistake. Before the 3 percent growth economy a fall to -5 percent is needed. Only the companies who can earn more than 4 or 5 percent can only survive. That is the way.

Secondly, the fiscal expenditures should be cut substantially.

I think these are conditions for sustainable growth, and these conditions have not been created enough, and the economy has been simply deteriorating.

However, these conditions are almost impossible to be created politically. No politician can argue that we should create more unemployment or more bankruptcies.

From that point of view, what Japan is awaiting is financial panic, and financial panic is the only way to solve the problems, and only after the financial panic, [unintelligible] can start to work.

That is what I am expecting. Thank you.

MR. MAKIN: Thank you for those stimulating comments, Nakamae-san. When someone says it takes a financial panic to get politicians moving, I can buy that.

[Laughter.]

MR. MAKIN: Now, to each of my fast-talking American colleagues, I want to say try to do it in ten minutes because we have a very lively audience that I think will want to participate, and, being able to add and subtract, I can see that if we take ten minutes each, we will have time to do that.

David, I know you can talk fast. And are you next?

MR. ASHER: Yes, I am.

MR. MAKIN: Good. So we will now hear from David Asher, who be shall I say a tempering offset to Mr. Nakamae's comments.

[Laughter.]

MR. ASHER: Well, the optimistic title of my presentation is Japan's Financial Mount Fuji Threatening Economic Stability. So I just wanted to brighten things up after Nakamae-san's very articulate presentation.

I'm going to move very quickly as so ordered. The first point is that Japan's public finances have entered into unsustainable territory by any standard I can reckon, and I have been studying public financial crises for about 15 years of my life, since I was in college. I have never seen anything like Japan today.

A major crisis in the Japanese bond market cannot be ruled out in the next 12 to 24 months. A minor crisis, which I define as a 100 to 150 basis point quick shift, seems almost certain without a sharp policy change. I expect increasing volatility under any circumstances.

The next point is that Japan's private sector finances also remain very fragile. High borrowing costs which would be produced by a spike in long-term inter est rates would cripple much of the corporate sector, and potentially bring down the banking system as well.

Japan's debt, indeed, has become a global problem, and Japan is caught in a debt trap rather than a conventional liquidity trap. An IMF-style reform plan, in my mind, is the only affordable way out, however unaffordable that may seem. However, implementing such a plan seems almost impossible without a motivating crisis, so in some ways, I agree with Mr. Nakamae, although I personally do not welcome the idea of having a crisis in Japan, but I do see, given the political situation, it may be the only way they can act.

This next chart shows the Japanese Government main-line finances, the central government's finances, not measured on a debt-to-GDP basis, but actually measured on a cash-flow basis, which is much more how we would approach the balance sheet of a corporation. That's why I say if the Japanese Government were a company, they would be facing insolvency. However, the government is not a company, and so there is always hope.

What is important to understand is that the ratio of long-term debt for the central government today, which is about 527 trillion yen, is more than 15 times in excess of retained tax revenue; that is, the central government's tax revenue after mandatory transfers to the prefectures, which cannot be avoided unless you want to send the Japanese prefectures or the states of Japan into financial crisis.

That compares to the United States at its worst point in 1992 when I was doing some work on U.S. finances where we had--and we were quite worried by this--a long-term debt ratio as percentage of revenue of about 400 percent. Italy at its worst point was similar.

But more disturbing from the standpoint of economic history is the amount of revenue going to debt service. Debt service today occupies 65 percent of Japan's central government tax revenue. That compares with Italy at its worst point of 37.5 percent.

Now let's move to the next slide, please.

Japan's situation isn't just bad in a comparative contemporary perspective; it's the worst I could find in economic history. Rob Dugger and I looked at over 25 countries which have gone into major fiscal crises in the 20th Century, including Great Britain in 1947, which had a debt-to-GDP ratio in excess of 274 percent. However, Britain was blessed--maybe not from the standpoint of the British taxpayer--with a much larger amount of revenue. The ratio of government debt to tax revenue was seven to one. They thought that was astronomical at the time. It was astronomical, but that is less than half of Japan today.

Financing, overall financing as percentage of tax revenue, bond issuance and borrowing was only 15 percent, and the rate of debt service, I should say, to tax revenue was 13.85 percent. So Britain was in much better shape, as bad as it was.

The Japanese Government and the Ministry of Finance has acknowledged that. I think the Ministry of Finance quite rightly tried to implement fiscal reform in 1997, and actually well before that, and they were rebuffed. It was partly bad timing with the consumption tax; however, I think the consumption tax impact--they increased the consumption tax from 3 to 5 percent. That was in the market for years before. I think it has been radically over-evaluated by economists.

Tadashi and I and others have stripped out the data from Hyogo prefecture where the Kobe earthquake was held, and it shows very little impact to the consumption tax increase on the economy if you just adjust--if you normalize the Kobe, if you take the Kobe earthquake rebuilding process out of the '96 data.

It doesn't mean it was a good idea necessarily, and it doesn't mean it was great timing, but I don't think the effect was as bad.

However, what's important to understand is the Ministry of Finance is still trying to push forward financial reform, and I think that they have maybe become a little more careful in terms of how they are proposing to do so. But essentially, there is no alternative. Japan does not have state sector assets in surplus that it can sell off to help remedy this debt servicing problem that it has.

Essentially, the Japanese Government has a negative net worth of well in excess of 132.56 trillion yen, which was recently revealed by the Ministry of Finance. So essentially the Japanese Government, by some standards, is insolvent. Of course, governments aren't insolvent. The Japanese economy is still the second largest in the world. But it means the scale of adjustment is going to be tremendous.

This chart illustrates the scale of adjustment. Essentially, if the current situation in terms of the primary fiscal imbalance is maintained, even with extraordinary low interest rates and an assumption of--actually, that's not .05, it's .5 percent nominal GDP growth, which is much higher than they've had in the last four years.

Even if one assumes that, Japan's debt by 2005 is on a track to exceed 200 percent debt to GDP, and by the end of the decade, it will probably be well in excess of 300 percent, because this is quite optimistic.

The reason it's optimistic is that social security, which is a partially funded system in Japan and absorbs a large amount of government revenue, is going to have to absorb much more revenue or more revenue is going to have to be devoted to social security in Japan in the future. Government revenue transferred to social security and welfare will increase from 9 trillion yen to 23 trillion yen in 2010.

Merely to stabilize the Japan Government debt, you need to go from running a primary deficit of around 8 percent of GDP--that's including social security, be cause social security being a partially funded system in Japan, which means it relies on government revenue transfers to stay in the black, justifies that you can't take that number out in calculating a prime rate balance. You have to go from an 8 percent primary deficit, which is by far the largest in the G7 today, and I think in the OECD, to a 3 percent surplus--just the basic mathematical model shows that--to stabilize the debt. Now, if you don't do that, then the debt will keep growing.

That is 11% of GDP--a 55 trillion yen fiscal transition. That would be one of the biggest--probably the biggest in the history of the world, and 55 trillion yen, to just simplify it, is more than the government today has in revenue, and it's also two-thirds of expenditure.

So moving quickly again, why doesn't the bond market respond to it? My argument, and I think it's an argument shared by Rob Dugger and others, is that the bond market in Japan is not very "market-like"--it's not that they haven't liberalized it on paper, but functionally, it's not very liquid, and the government still plays a very large role in it, at least in terms of holding over--the public sector in Japan holds about 55 percent of outstanding bonds. Until recently, they absorbed over 70 percent of net new issuance.

The problem today for the bond market, looking ahead, is that the government has backed out because of recognizing its own financial problems in the public sector with the fiscal investment loan program, which is in the Trust Fund Bureau of the Ministry of Finance, which have been forced to adopt asset liability management standards, which is a very important improvement. However, that means they are starting to be a net seller of government paper, and they are only participating on a sort of symbolic basis in government bond auctions.

When they decided outright that they couldn't participate in bond auctions in the fall of 1998, bond prices spiked by over 100 basis points and it promptly brought the government back in.

But the government is increasingly having to rely on Japanese banks, as Nakamae-san pointed out, and life insurance companies to absorb this tremendous flood of bond issuance, which this year will exceed 32 trillion yen.

However, given the balance sheet problems in the banks and the life insurance companies which make up the bond market syndicate that absorbs the issuance and channels Japanese savings into the market--individuals are not a big part of the Japanese bond market at all; they own I think less than 6 percent--problems in their balance sheets I believe are likely to impair their ability to participate in the future.

This is how you could see, without some sort of intervening debt restructuring, a serious problem in Japan's interest rate structure. That would be a big problem because the Japanese private sector has not even partially deleveraged since the end of the bubble.

The total stock of outstanding debt of the non-financial corporate sector has nearly doubled in the last twelve years. Japan's level of debt as a percentage of GDP for the private sector remains by far still the highest in the G7.

One can do a simple interest rate coverage ratio calculation for even the largest companies in Japan listed on the Tokyo Stock Exchange and reveal that even a 100 basis point increase in borrowing costs for companies would bring down the average ratio of interest rate coverage--i.e., their ability to service their debt--by nearly 45 percent. A 200 basis point erosion in coverage would bring the average ratio for companies listed on the top section into junk bond territory, essentially. Their coverage would fall below 2.5.

If it falls below 2.5, then bankers are going to increasingly call on companies to repay their outstanding principal. What happens in Japan is the majority of finance is still carried out through banks. The corporate bond market has developed, but not developed necessarily sufficiently. The ratio of debt to equity in the corporate sector is extremely high, and what would happen is the banks, which have routinely rolled over loans, usually one- to two-year loans for, you know, ages, for 40 years to many companies, would start to call those loans in. The companies would never be able to pay their principal in many cases. In many cases, companies would not be able to repay their principal out of even 15 years' cash flow.

So we are facing a private sector financial problem. And how big is the financial problem that we have already? Well, Japan's ratio of bankruptcy liabilities as a percentage of GDP, annualizing the first half of this year and not including Kyoto Life Insurance and Chaoi (ph) Life Insurance, the two biggest failures in post-war history for Japan, is on track to exceed 4.3 percent of GDP. This line down below compares that to the U.S. at the height of the Great Depression.

What is remarkable about Japan and what makes me somewhat optimistic is that the economy hasn't collapsed in the face of this. Frankly, there is still demand--consumption has remained intact; even though it hasn't increased very much, but it hasn't collapsed in the face of this.

So the problem is, if companies start going under at this rate-actually, continue to go under at this rate, bank capital will start to be wiped out. Essentially Japanese bank capital in truth is only about 8 trillion yen.

Let me explain. You have 24 or 26 trillion yen, depending on how you count it, in Tier 1 core capital under the BIS rules for Japanese banks, but one-third of that is in the form of tax loss carry-forwards. I don't know any bank that can take a tax loss carry-forward and get cash for it. It's a sort of accounting blasphemy, as far as I'm concerned. The U.S. did it briefly, and we backed out of it at the height of the S&L restructuring in the early '90s. Another third of tier 1 capital is government-preferred stock.

So essentially the real water capital, core capital for Japanese banks is only around 8 trillion, versus over 40 trillion in acknowledged problem loans, and that's probably quite a large underestimate.

This is a problem which the government authorities I think recognized, and they realized that at some stage, there is going to have to be another bank recapitalization and restructuring.

That brings me to my conclusion. That is simply that Japan's over-leveraged system, both in the public sector and the private sector, has created what I call a debt trap.

Essentially, when you ask individuals, you ask consumers why they haven't expanded their consumption as they have gotten older--and most of the savings in Japan is occupied by the 65-and-older cohort--their number one reason is that they are scared about the stability of their pensions; the number two reason is they are scared over the fiscal stability of the country. Those are both very good reasons to not spend so much money. They have been precautionarily and quite prudently saving money.

Therefore, my conclusion is in order to get out of this debt trap and in order to increase consumption to offset a rational decline in investment, in order to improve capital productivity of Japan and bolster economic growth, there has to be debt restructuring, both in the public and in the private sector.

This is a problem for us in the United States, where we borrow so much from Japan. Japan's current account surplus is around 2.6 percent of GDP. The needed fiscal adjustment, by my calculations, in order to stabilize the government debt again is around 55 trillion yen or 11 percent of GDP. It might be a little bit smaller, but I don't think it will be that much smaller than that. That dwarfs Japan's current account surplus.

I believe if they went through a fiscal adjustment, it seems quite rational that it would radically affect the investment-to-savings balance in the Japanese economy. Myself as well as a number of prominent economists in Japan believe that could lead to an outright movement away from a large current account surplus to a current account deficit.

Rather than the United States be worried about Japan's current account surplus, in which we have been investing quite successfully over the last two decades, we should be worried in the future about what will happen when that current account surplus disappears.

Thank you very much.

[Applause.]

MR. MAKIN: Thank you, David.

Rob Dugger.

MR. DUGGER: Yes. I will just make my remarks from the dias.

Let me ask first to just open up, since you all will eventually, just go ahead and bring out this short, very few tables, very few numbers, just sort of a listing of observations.

Let me now ask you to go to the last page of that. As occasionally happens, the copy that you've got has a small error in it, but the error is actually critically important and may be instructive.

In the first table on that last page, it says, "Japan's problem is government and business; America's is household and business," and there's a table underneath.

The U.S. numbers, 124 percent, 151 percent, the column title for those numbers should read Business and Households, not Government, Business and Households.

The only number that applies to government plus business plus households is a negative 6 percent for Japan, so there is actually needed another column there which is just called Business and Households, and under that column would be the two U.S. numbers.

We will come back to that observation because it's relatively critical to what I want to try to add today to Tadashi Nakamae's and David Asher's enormously insightful comments, and perhaps serve as a segue to Richard Medley's observations on how the market looks at this situation.

On the front page, I have my entire remarks summarized in five points.

Clearly, Japan's financial Mt. Fiji is beginning to tremble. The warning signs are in the stock market, but the source of the problem is Japan's public sector debt. It has reached 11 percent of global GDP.

The long decades of import protectionism, export-led growth and massive business and public sector debt accumulation have reached their absolute limits. I think after Tadashi's comments and David's comments, there's really no debate about that.

My focus in this analysis of this problem is that Japan does not have a problem in isolation. Japan is a huge economy operating in a global economy, and if it has problems, then they're probably mirrored somewhere else in the world.

I in a somewhat rhetorical with some metaphorical flourish would just refer to the U.S. Mt. St. Helen's. We have a Mt. St. Helen's emerging within the U.S. It's an unsustainable build-up of household and business debt. U.S. growth requires ever-rising foreign capital in-flows. The U.S. stock market household consumption and business investment are beginning to signal a critical weakness.

While all of these indicators at this point are relatively strong, we can see evidence appearing in a variety of places in the U.S. economy where important shifts in outlooks and important shifts in expectation, important shifts in intentions, are being registered.

My sense about why the U.S. has such a remarkable household and business sector debt scale relative to GDP in comparison to what Japan has is that the Cold War decades were characterized by an import-export codependency in which our Cold War allies produced and saved and we consumed and imported. As a consequence, their business and government sector debt structure grew and our business and household sector debt structure grew.

The downturn that looks almost inevitable in Japan appears to me to have an inevitable consequence for the United States, and in some respects, the reason you haven't had a downturn in Japan is because we have been able, over the past five to six years, to steadily increase the scale of the U.S. household debt structure financing ever larger imports, and we have, by this process, financed Japan's sort of holding onto the cliff, if you will.

But this can't be sustained simply because the flow of capital into the United States to finance this trade deficit depends on the rest of the world never getting the message, and that simply is an impossible thing to believe.

So from my limited perspective, it's clear some sort of global adjustment process is going to occur. It's probably going to occur next year and if the Japanese numbers, which are relatively easy to get to, are any indication, the adjustment could be rather large.

This conference is about the issues relating to Japan that affect the incoming administration, and what I want to emphasize in this conference is that Japan's restructuring crisis has global security implications which we need to think about.

In the Point Number 4, the history of economic downturns and global security and political stability are enormously important. We have to pay attention to them, and we have to prepare for them.

In this regard, we have to find a way to stabilize Japan's debt architecture. We may not be able to prevent Tadashi's cleansing crisis. In fact, I don't think we can and I don't think we should. But just as there was an RTC and a financing framework for resolving the S&L crisis, we need to have a process, a policy deliberation focusing on a mechanism for financing and resolving Japan's debt architecture.

I am going to suggest two--the second element that has to be addressed is we have to find the substitute for U.S. global demand, the component of global demand that is accounted for by our excessive capital dependency and build-up of debt within the household sector mainly.

I am going to suggest two solution approaches in Item 5A. The political system of Japan has to be reformed. From my own perspective, politics proceeds economics. We have to do something about the relative representation of citizens in Japan. The rural areas are overrepresented, the urban areas are underrepresented. That has to be corrected.

As that is done, a lot of other things can happen, but without being repetitive, let me just point to points 2, 3 and 4, all of which the people in this audience are very familiar with.

We need a resolution process. We need a way to ultimately--since in my judgment Japan's problem is the consequence of multiple decades of policies, consumption-incentivizing policies in the United States, production export policies in Japan and elsewhere in the world, South Asia and in Europe, if we think about resolving Japan's problems, we need to think about it in a global context, and hence that Item 3. Because Japan's debt is increasingly short-term, Japan literally takes on the characteristic of a Third World country.

But B is where I want to close and emphasize today, 5B. We have to find an alternative source of global demand, and at the same time, we have to take steps which are going to minimize any global security or political instability associated with the restructuring process which is inevitably in our future.

We have to find ways to provide capital to those companies and countries that are dependent on very, very high levels of U.S. consumption. We have to find a mechanism that is not dependent on the trade channel. We have to deepen the capital markets of those countries, those regions.

We have to find a way for private capital markets to allocate credit to 50, 100, 150, 200 million new middle-class families in China, South Asia, India, Africa, and Latin America, and we probably have about five years to do it.

If Tadashi is right, and Japan is the fastest growing economy in the world in ten years, that means that the U.S. could be in a recession for many years.

We have to find this alternative to demand. We need to deepen democratic institutions in these large population regions of the rest of the world. We cannot have a circumstance where instability emerges in China because of its rapid collapse of exports to the United States.

One approach to this was provided by Walter Meade (ph) and Sheryl Swinninger (ph) at the Council on Foreign Relations. I have included their website citation. I encourage you to take a look at that and get a sense of what can be one approach to creating capital markets of sufficient depth and maturity so that mortgages, car loans, durable goods financing could be provided.

Thank you.

[Applause.]

MR. MAKIN: Thank you, Rob.

Richard.

MR. MEDLEY: Thanks.

Every time I listen to Tadashi and David and Rob, I find, as the conversation goes on, I have an increasing urge to be under the table with my head wrapped in my arms.

Luckily, as investors, we have a response pattern to that: We just run away.

[Laughter.]

MR. MEDLEY: Which is what we have been doing for most of this year, since March or April, and it's most likely what we will be doing for at least the next few years with regard to Japan.

The case that has been laid out here today, I would love to be able to say, you know, they've overlooked one fundamental thing and everything will be all right, and, in fact, I have said that repeatedly, and been . . .

[END OF TAPE 1, SIDE A]

[TAPE 1, SIDE B]

MR. MEDLEY: Luckily, I have been right in cycles enough to make some money being wrong, and then got out before being wrong cost me money.

One of the secrets and one of the things that will determine whether we really are in the end phase of this devolutionary process for Japan is what happens to the Nikkei starting sometime in mid-December and ending sometime in mid-March.

Historically, even during this lost decade, as it's being called in Japan, the Nikkei rallies from mid-December through mid-March. There are many conspiracy theories to explain this, but wise investors have simply jumped on board and ignored the--and followed the conspiracy theories.

I'll be very interested to see whether that happens again this year. If it doesn't, then I think it truly is a signal that we are entering the end phase of this, the resolution phase.

Japanese corporations, Japanese banks, Japanese individual investors, have always been able to count on the run up to their fiscal year end on April 1st to bail them out of a lot of sins of the other nine months and to make books look good in that snapshot approach to accounting.

I'm not certain that we're going to see that. In fact, I certainly would not intend to be a participant in that previously winning bat during this year for a couple of major reasons.

One is that that opportunity costs of being involved in Japanese stocks right now is much higher than it has been before. One thing that has been true at least from 1995, '96 until now is you could always look at the Nikkei and say, you know, it's a pretty pathetic country in terms of growth, but it's also the most under-valued stock market in the world. It's the one stock market that isn't the subject of a bubble, it's the one stock market where there's still real value.

After what we've done to the NASDAQ and the DAQs and the CAQs and other grown-up stock markets in the world, that's no longer true. Nikkei is no longer the only potentially under-valued stock market in the world.

In fact, you can say that not only is it no longer the only potentially under-valued stock market, but it may have the most downside vulnerability from here, because now, with the NASDAQ and other stock markets at relatively lower values compared to the Nikkei, people have to now go back to more basics and say, are the growth prospects of Japan higher than the growth prospects in the United States, France, Germany, the U.K. and other places where you can invest?

Almost certainly that answer is no. Whatever the growth prospects are in the United States, they're almost certainly better than the growth prospects in Japan because Japan's pseudo-recovery was based on exports and was based on capital deepening.

Even the Bank of Japan, in our conversations with them two weeks ago, the previous hotbed of optimism outside of my office in Tribeca was saying, well, you know, we didn't exactly screw the pooch, but almost, and we're probably in a position where we're not exactly going to be aggressive on the rate front from here on out.

The fact is capital spending has topped or is topping, exports--if the U.S. is in trouble, exports can only begin dropping and, as Tadashi has shown us, the consumer for very good reasons is not participating, is nowhere to be found, and is likely to stay well ensconced in the bunker in the new year.

So take whatever growth forecast you have for the United States, cut it by somewhere between a half and 75 percent, and you've got Japan's growth forecast. That relative growth comparison is going to hurt the Nikkei going forward.

Then we come to the JGBs. JGBs have cost Americans more money than anything except our campaign that we just went through, which has cost certainly John and I hundreds of thousands of dollars.

The problem with shorting the JGBs, of course, is also shown in Tadashi's chart. If you're buying 57 trillion yen worth of JGBs by the banks, it's hard to get a good short going on that.

Also, of course, the way they do benchmarking, a lot of funds simply have to keep up with a fixed-income benchmark, and benchmarking unfortunately is done in terms of volume of issue outstanding, and no one can compete with JGBs for volume of issue outstanding except Nigeria. So as the JGB outstanding is increased, their weighting in the bond portfolio--the idea bond portfolio has increased.

So those two--and that's drawn in foreign money, even at 1.5, 1.6 percent return yield. Those two things have overwhelmed any ability to short on the kind of Asher-Dugger thesis, and it has cost a lot of people, a lot of Western investors, money.

Two things signal--or three things signal that may be coming to an end. Number one is there is active push back by many benchmark investors to change the way the bond benchmarks are weighted. You've seen some of that already in stocks, in the stock re-weighting Morgan Stanley has been doing. We think you may see that more aggressively in terms of re-weighting the JGB index. Any kind of move to weight the bond index by risk as well as by supply would obviously just take the JGB market out, stomp it into a small ball, and leave it for dead.

Also, there is the problem, a very technical problem, but that the real-time growth settlement system and a custodian withholding problem now hanging over the JGBs, both of which are supposed to hit on January 1st, is causing foreign investors to have to think they may have to put--John, do you know, was it 30 percent withholding?

MR. MAKIN: I don't think about JGBs anymore.

MR. MEDLEY: Okay.

[Laughter.]

MR. MEDLEY: That it will require people to actually put up cash for tax withholding purposes. That's causing people to rethink whether, even with the benchmarking pressures as foreign investors, they want to be in. And obviously, you have those two things--if those two things occur, then you do have also, with low to negative growth next year, the very strong chance that the Dugger-Asher thesis will finally crest and begin to press unbearably down on the JGBs.

What's the conclusion? The conclusion is there's one thing you can do, and that is bet the dollar-yen is going to rise. Dollar-yen has broken its range. As I came in this morning, it was at 112, and it looks like it's on its way at least to 120.

Why anyone would resist that on either side of the Pacific is beyond me, except for personality defects. And so I think dollar-yen is something you'd want to say is very safe, and otherwise, I agree with John--ignore JGBs for the time being until we see how those three elements sort out. And watch the Nikkei. If the Nikkei does not rise in its historic pattern, that is truly, truly an end-game moment for Japan.

Thank you very much.

MR. MAKIN: Thank you, Richard. And thanks to all our speakers.

I'll just add a couple of comments, and then we'll throw the discussion to the audience.

There's I think a great unifying theme running through all of the presentations, and that is one that suggests that Japan's biggest problem is deflation and the symptoms that go with it.

It hasn't perhaps been said, but one of the difficulties that Japan is having is a persistent inability to get out of a kind of liquidity trap.

Japan investors are essentially, as we've seen from the data presented by Nakamae-san and others, are trapped in buying JGBs. That's why the JGB prices hold up. And they're trapped because the deflationary tendency in Japan makes it relatively attractive to hold JGBs.

JGBs' nominal yield today on ten-year bonds is 1.6 percent. The official deflation rate in Japan is about 1 percent; the actual deflation rate in Japan is probably more like 2 percent based on studies by the Bank of Japan, which suggests there are upward biases in Japan's measures of core inflation due to an inability or an insufficient adjustment for quality, and an incredible oversight with the Bank of Japan excludes energy from the core inflation rate for reasons that are not clear to me, but there they are.

So if you have 2 percent deflation and 1.6 percent nominal yield on bonds, it's the equivalent of 4.6--3.6 percent earnings on a bond where there's zero inflation, which is comparable to the real earnings on U.S. bonds. So Japanese money stays at home and reinforces the deflationary tendency because there's nothing else to do with the money.

Japan in the 1980s showed that you could invest too much in the private sector; the stock market collapsed. In the 1990s, Japan has shown you could invest too much in the public sector and the real return on capital has been driven very low.

Japan's debt picture looks like the debt picture that you see in David's chart in a country that has just been through a serious war. The only difference is you've got deflation instead of the inflation that usually accompanies the end of a serious war.

The problem with the deflation, of course, is that it's a tremendous additional burden on people who owe money--i.e., the government--and puts a very heavy burden on the government to sustain the large transfer it's making to the holders of JGBs.

The traditional remedy here is not more stimulus on the fiscal side--that is, another supplemental budget--and those are probably largely over for the reasons that have been articulated here.

I am not sure the rating agencies or the markets would stand for another large stimulus package from the Japanese Government that was aimed at more public works.

Indeed, the Japanese public probably wouldn't stand for it because they have indicated that in some prefectures where people have demonstrated against some of the public works projects proposed by the government.

The classic solution here lies with reflation, big debt burden. The Central Bank, of course, in order to induce a reflation, has to print more money and has to do so in a very convincing way. And my guess is that one of--part of the crisis that Nakamae-san talks about will be a revolution at the Central Bank where the current leadership in the Central Bank is removed either by the government or some other means and a new governing body in the Central Bank will recognize that they should at least target price stability. That would be a step toward sustaining Japan through a very difficult period which is part and parcel of all these very large burdens that are lying atop the Japanese economy.

Again, the big need is still to deregulate the domestic sector of the economy. Yes, there's been some progress, but nothing terribly dramatic. The current government in Japan is not what I would call a group of young turks looking forward to rapid reform, and I think that's recognized by most serious Japanese analysts, and efforts are being made to change things, but it's very difficult to do so.

So my guess is that things will be very difficult. It's hard for me to see the Japanese stock market recover, it's hard for me to see the JGB market do much of anything until we get a break toward reflationary policies, and that will require some decisive action by the Central Bank.

I think one of the disconcerting things that I see now is that normally deflation is a currency strengthener, but that's on a flow basis. Deflation and the attendant problems have destroyed so much wealth in Japan that the outlook for the economy is bad, and I think that's why the Nikkei won't recover, and that's why we'll probably see the yen start to weaken.

In that sense, that would be a start down the road towards some reflationary pressure for Japan that would actually be very constructive.

So like Richard, I would expect there to be very little protest coming from Japan or the United States on a move of the yen weaker, maybe by 10 percent from current levels, which would perhaps be a modest reflationary impulse that might be helpful, but certainly no overall solution to the problems.

So again, we have, I think, a very important strategic and economic player in a very important part of the world--that is Japan and Asia. Japan's plight is perhaps not as well recognized by the American Government as it might be. It probably will be better recognized by whichever administration comes in because as Japan reaches a crisis or a critical period, and it does play the role as one of the major suppliers of capital flows into the United States, as Rob Dugger has pointed out, Japan will probably get more attention.

But let me stop there. I think our panelists have put a lot of stimulating ideas on the table and we would love to get some questions or comments from the audience.

I'll start over here and I'll just sweep across the room.

Yes. Please identify yourself and then ask your question.

VOICE: [Inaudible]. I have two questions. [Inaudible.] Even the financial companies are now showing pretty good growth in profits. Over the course of the '90s, that was always the big bugaboo for Japan, is non-profitability of firms. Now that seems to be turning the corner. It seems like a very important turning point that maybe you can talk to.

My other question leads on from what you were saying, Dr. Makin, about deflation, and it seems like the scenario that you've used or that Dr. Asher has used of like a .5 percent nominal GDP growth rate seems--I mean, that's one possibility, but it seems like an exceptionally low nominal growth rate projecting out forward.

I guess I would wonder, what would your scenario look like if you had like three or four or five percent nominal GDP growth, which is what I think a more consensus kind of forecast would indicate?

MR. MAKIN: Who wants to do the profits?

MR. NAKAMAE: I think as far as employment is concerned, I think there are basically three reasons. One is that raise cost was cut substantially. That mean s employee income came down. So that is very negative for consumption.

But in the longer-term, it's very positive because for the first time, Japanese corporations started to lay off. But in the short-term, it is negative.

Secondly, looking at the corporate profit by the size of corporations, big corporations are making very big money, but small corporations are not making money. That is because the big corporations are demanding small corporate suppliers to cut prices very hard. So that is creating a very serious problem for small businesses and bankruptcies are increasing. That will be [unintelligible] banking crisis of small--the regional and small finance institutions' crises are inevitable.

The third reason is manipulation, and lots of corporate executives have had very huge pressure to make money under the globalized market situation, and I don't think that all of the profit increase is not genuine, but I think basically there are three [unintelligible] profit, and that is not so positive in the short-term.

MR. MAKIN: Thank you.

VOICE: Another point with profits is they're engendered mostly by a significant increase in sales, a lot of it export-driven, so a lot is hanging on the U.S. economy as well as the Internet sector in Japan. We saw IT investment, how much it had gone up, but they are facing the same problems with continued investment there that we will be.

As for nominal growth, we haven't seen .5 percent nominal growth in Japan since 1996. Moreover, in my projection, I'm assuming nominal growth of .5 percent in the midst of an 11 percent of GDP fiscal shift. That is a remarkably optimistic assumption. I'm also assuming interest rates remain low. If they don't do that, then the fiscal shift will not succeed, and that's my point.

However, I do believe if you look at the consensus estimates for nominal GDP--I would, for example, look at Robbie Feldman at Morgan Stanley's work. He is projecting negative nominal GDP out for the next three years right now still.

Real GDP essentially has been engendered by rapid acceleration in the GDP deflator, a point that John Makin has been pointing out. So you have what I call surreal GDP. So, I mean, you know, that's an important point to consider.

But not all is bad. I mean, Japan is a highly dualized system right now. Maybe ten to 15 percent of the corporate sector is really accelerating its profitability and can continue to do so in the midst of a major downturn. It's the rest of them that we really have to worry about.

MR. MAKIN: Thank you.

Any other comments? Let's go on. Burt Ely (ph) has--

MR. Ely: In my opinion, the ultimate measure of the debt trap in Japan is the household sector's net financial claims on the non-household sector Japan, and that percentage has risen from 140 percent in 1991 to 210 percent as of June 30 this year. In effect, based on the nominal value or face value of those claims, the value of real assets in the non-household sector of Japan is twice GDP, and I doubt that very, very much.

This means what Japan is basically facing is a huge domestic debt restructuring with a hit ultimately being taken by the household sector where most of the claims they hold are debt claims, not equity claims, which means in effect a society-wide bankruptcy. Now, how that's going to be achieved in an economy where bankruptcy laws are so ill-developed, I don't know.

But this comes back to my question for Mr. Asher. If I understood you correctly in your conclusions, you were suggesting that as part of this restructuring, debt restructuring that Japan has to go through, if I heard you correctly, you said that Japan would have to go from a trade surplus to a trade deficit, and I don't understand why that would be.

It would seem to me if Japan goes through a domestic debt restructuring and domestic consumption, at least in the short-term, goes down even further, that would be--that the only way manufacturing companies could hope to survive would be to export even more.

So I'm wondering if you could walk us through the logic of how you go from surplus to deficit.

MR. ASHER: Well, you know, it's hard to make this projection exactly with the possible currency adjustment, because if the currency would weaken enough, you would see that.

But I'm not talking about a trade surplus disappearing-- --I'm talking about a current account surplus; basically, I'm talking about a shift in the excess of savings and investment over consumption.

I just think a huge amount of income will be cut away from households as part of fiscal restructuring--what would happen potentially is that the government would have to cut entitlement transfers radically to the elderly, the people who have been saving the most in the economy. They would then have to drain down their stock of savings and their flow of income derived their stock of savings as well as from transfers would radically fall. They would effectively dis-save.

The question is where investment goes. My feeling is it would fall precipitously--I don't think a fiscal adjustment, if it was carried out properly, would not be totally destabilizing to investment; it might actually create some confidence that there's light at the end of the tunnel and things aren't going to move to a total meltdown. Further, I think consumption might actually increase after perhaps an initial sharp drop.

I mean, consumption in countries which have gone through fiscal adjustment, including our own country, has actually increased. I can't find a country, frankly--even New Zealand included, I think-which has gone through a pretty radical fiscal adjustment which hasn't actually led to an increase in total stock of consumption as a percentage of GDP. Therefore, you know, myself and a lot of economists who are much more technically-minded than myself see this as a possibility.

Thus, I'm just saying that, fiscal adjustment or fiscal crisis, we Americans have to be worried about Japanese national finances as a country which is borrowing a large amount in yen. Japan's equity markets may have crashed in the 1990s with relatively little negative effect to the United States, but a bond market crash or a fiscal adjustment in Japan I think would have much more negative implications for the global flow of funds.

But I think your point is extremely important about the private debt situation and the need for debt-equity swap.

MR. MAKIN: We have a question.

VOICE: It's a question to Tadashi.

You are highly optimistic that ten years from now, Japan will be one of the best, you know, growing industrialized countries. Ten years ago, the Russian economy was like one of the second or third largest in the world. Ten years later, I mean, we barely mention it.

I'm just curious, what are the sources of your optimism? What are the sources of that explosive growth? And maybe we'll just, ten years from now, face a situation of Japanese economy, you know, cut down in size, maybe ten times, maybe more, and barely a factor.

Thank you.

MR. NAKAMAE: Two years ago, we published the Japanese future scenario called Three Futures of Japan. We have two economic scenarios. One is the crash and rebirth. By the crash, [unintelligible] will start to emerge and all necessary reform will be completed and the economy will return to the normal growth rate, and that is what--I still believe that.

The other scenario is a continuous decline of Japan. That is what you are supporting. I think that is--I can't say that my expectation is sure, but I think the--basically, I don't think the--I think the 1990s was not the lost decade, but that was the decade to prepare for another growth period.

Although it seems that the Japanese adjustment has been very slow, in private sector, it is steadily improving. And compared to, say, UK or U.S. reforms in 1970s, it took probably 15 years before Margaret Thatcher or Ronald Reagan emerged. I think from that point of view, Japan has spent only ten years. Another two years is not a very long time.

I think Japan has still very big potential, human resources, and a lot of the technology and education and so on. So I think only if Japan could distract present regime, I think future is very bright, but that is a big if.

MR. MAKIN: Thank you.

The questions are building and time is going by. Let me see. I had one over here, and then I'll go over to this side.

Yes.

MR. BALLINGAL: Andrew Ballingal (ph).

While I don't in any way disagree with the panel's arguments and the force of logic in favor of a weaker yen, I think there is opposition to a weaker yen, and as recently as six weeks ago in the Ministry of Finance, the prime opposition is concerns that if the yen starts to weaken again as it did in '98, the cost and feasibility of funding the public debt in Japan becomes a major issue.

It's very much a concern that the trickle to which Nakamae-san refers to in his piece on the JGB time bomb, that trickle of private sector savings leaving Japan turns into a flood, and that is a very real concern expressed to me by the Ministry of Finance.

The other and a secondary concern, and it's a question rather than an observation, particularly picking up on what Robert Dugger said, is what are the implications of your forecast for Japan for the rest of Asia, particularly if the yen weakens and particularly in relation to China?

MR. MAKIN: Would you like to take the first part?

VOICE: Yes. We have to understand Asia in terms of the United States. The United States' massive consumption expansion of the past five years, this past decade, has supported Asia enormously. Asia has become more export-dependent, not less. Everything in public policy in the industrialized world was focused on increasing domestic-demand-led growth. The opposite has happened in South Korea, Japan, Taiwan, Hong Kong, South China, Eastern China, Southeast Asia, India, Latin America.

So the consequences of a U.S. slowdown are breathtaking. That's why when we look at Japan, we have to look at developing aggregate demand in the two-and-a-half billion people in China, South Asia, Africa and Latin America. We've got to focus on that. That is our salvation.

The reason--I share Tadashi's optimism about Japan because I basically believe that we will succeed in developing very deep mortgage markets, auto loan markets, consumer durable credit markets in China, South Asia, India, Africa and Latin America. I'm confident of that. And as a consequence--maybe not in Russia where the--one of the reasons you can be reasonably optimistic about Japan--I'm seeing our friend in the back shaking his head--is the lifespan of the average Japanese is twice that of the average Russian. Certain lessons get learned and they get retained.

But I'm confident that we will build these capital markets and I'm confident we will bring these 100 million, 200 million new middle-class families which will basically add to global aggregate demand an amount which is not so different than the entire middle-class population of Europe.

MR. MAKIN: Actually, that suggests a solution to Japan's pension problem and something that could help Russia: the export of large quantities of vodka from Russia to Japan.

[Laughter.]

MR. MAKIN: But anyway, let's see. The other question was the question of the Ministry of Finance attitude toward dollar-yen. Richard, do you want to--

MR. MEDLEY: Sure. I agree that they do not want it to get out of hand, and I think both John and I were talking about, you know, a depreciation down to about 120, not moving out to 140 or 160, which obviously would be a crisis, and they have exhibited a lot of sensitivity right around the 120 low, and I think they would again. But again, it's a modest depreciation, maybe moving toward the reflationary policies that John was talking about.

I just want to add one thing. What you said on the BOJ, there was a move--I think it was last night--in the DIAT discussion to make BOJ Governor Hyami personally take responsibility if the economy begins to turn down again.

VOICE: What does that mean? What are they going to do to him?

[Laughter.]

MR. MEDLEY: It means that he has to be put in a box with Prime Minister Mori for 24 hours.

[Laughter.]

MR. MAKIN: All right. We have time for one more question, and I said I would go over here, this gentleman back--yes.

MR. VADERE: I'm Steve Vadere (ph).

A question. There was just a brief mention of the reflation option for Japan, and I was looking in the Asher-Dugger paper in the Wymar (ph) scenario. It seemed to be not favored.

MR. ASHER: Well, basically I think that John and I do have, you know, a philosophical difference on some of these monetary issues, although I think we both agree on the problems at hand. I would say that the only time you could aggressively and competently adopt a reflationary policy would be in the midst of very aggressive fiscal reform. In this case it could help neutralize the deflationary fiscal reform process.

I think without it, the danger is you have what's happened in so many Third World countries and which happened in Vimar, Germany. You have this vicious interaction between a growth in high-powered money and debt, and the cost of servicing debt rises faster than nominal GDP, and you then set things up for a hyper-inflationary spiral. That is a possibility.

I'm just less confident that the government, once it commits to this path of monetization, will be able to stop it, because what happens essentially in hyper-inflationary situations is that the Central Bank starts to monetize aggressively, and then people say, oh my God. Monetization becomes a private sector phenomenon, too. Institutional investors even in Japan, despite their relatively sheepish attitude up until now, may say, this money could be worth a lot less tomorrow than it is today, and then start monetizing assets. They essentially take their debt and put it to cash. Individuals do the same thing. Potentially that leads to capital flight or, you know, they just hoard capital, and that creates the potential hyper-inflationary high powered money build-up.

I'm not saying this will happen--we rank it as only a 25 percent likelihood. I really think it depends on the aggressiveness of the policy and whether it coincides with an aggressive fiscal restructuring. If it doesn't, I think aggressive monetary inflation could be a very poisonous cocktail for Japan in the world economy. That's one man's opinion.

MR. MAKIN: Thank you, David.

I am pleased to give the last question to Senator Charles Percy.

MR. PERCY: Former Senator Charles Percy who would like to introduce myself as Chuck Percy, and I was Chairman of the Foreign Relations Committee in the United States Senate for many years. But before that, I was at Bell & Howell Company, and before that, I--while I was there, I went into the Navy.

And I have no question for you; I just wanted to comment on the fact that I am so proud of the American Enterprise Institute for having this meeting and proud of all of you for coming to it and participating in it, because Japan, to me, was very important.

When I came back from World War II after having been a gunnery officer out in the Pacific for three years fighting against them--I lost my hearing out there because they didn't cover our ears. Now they cover their ears. I finally got the Navy to do that after World War II.

But when I came back to Bell & Howell Company, they asked me to help globalize the company. So what I did was we had a--before we war, we had had an agent in Japan, Yosho Osawa (ph), and he was the exclusive distributor of Bell & Howell motion picture cameras and projectors and so forth for all of Japan.

As I returned, he wrote a letter to me saying, I understand now that you're globalizing the company, but we were your agents for three years. Of course, we've had no equipment for three years, no sales, and we are absolutely bankrupt ourselves. We can't buy anything. So would you recommend us to the agent you appoint to be a consultant to them? And I would like my young son, who will succeed me some day, as I did my father, as head of this company, I would like to have him work with it, too.

So I wrote back and said, no, I'm terribly sorry, Yosho, we cannot have you be a consultant to another company because when we--when the war broke out, we were required to seize the money that you had deposited with us, and it was about $60,000, and we invested it in United States war bonds. Now we have about $100,000 in there, and instead of turning it back to anyone else, we're going to loan it to you now to buy equipment, so you will be our agent providing you use a part of it to have your son come to this country, get his education as you did at a university here, and he can then work as an apprentice at our company in the summer, and we'll make room for him at our house.

So I believe very deeply, as President Eisenhower knew when I told him about this--he said, you've always believed that political friendships follow the trade lanes through the years, and that if we start to trade together, we will become friends. And so we have become dear friends of Japan. You couldn't imagine a war between Japan and the United States ever now. We do trade back and forth. And if there's anything I can do with the new administration to--as I pressed very hard to have the Middle East the number one priority for Bill Clinton and Gore, I would be happy to do anything I can, just as a volunteer, to recommend to the new administration to put greater attention on Japan in assisting and helping in any way it possibly can, because our friendship must be very good.

I'll add one other thing about trade. I urge--also when I went back over to France and Berlin, and Germany, that both of those countries ought to--we wanted to trade with both of them after the war. But both of them should start trading together. They don't trade at all and they've had centuries of fighting between Germany and Japan, and they started to become trading partners.

I was never so thrilled as last year when the big headline said that France--in the Wall Street Journal--said France and Germany have become their biggest single trading partners, and you can't imagine a war between Germany and France now.

So trade between countries would be very great and we should do everything we can to stimulate good trade between the United States and Japan.

With that, that's the shortest speech any ex-Senator has ever given. It may seem awfully long to you, but--

[Laughter and applause.]

MR. PERCY: Thank you very much, and again, congratulations to every one of you for your interest in this very great problem that we have in the American Enterprise Institute and the wonderful things that it does.

MR. MAKIN: Thank you very much, Senator Percy.

That's an excellent segue, because Panel Two is coming up, and we are going to focus on U.S.-Japan trade relations. So we will vacate the podium here and switch to the next panel. Remember, lunch with Larry Lindsey, and this afternoon, U.S.-Japan security issues.

Thanks very much.

[END OF TAPE 1, SIDE B]

[TAPE 2, SIDE A]

MR. BARFIELD: . . . through the so-called financial crisis or the financial crisis of 1997, '98.

If you look back, whether you're talking about Korea or Japan, Taiwan, these countries have done very well in terms of economic growth, much better over the last three or four decades than the countries which have organized in regional arrangements. But it is not necessarily true that they have been left out.

I think another force that is unstated, though, a more recent force, is a worry around the rest of Asia about the implications of the emergence of China as a major economic power. China is sucking up now almost two-thirds of foreign direct investment in the region.

When China comes into the WTO, there's going to be a tremendous divergence of trade, I think, from many of the smaller countries in East Asia and in South Asia to China as barriers fall as a part of its entrance, membership in the WTO.

For the Japanese, I think, there are probably two impelling forces, one economic, one political. The economic is, with the doldrums, recession, low growth or no growth over the last decade, the Japanese companies, I think, see the lowering of barriers, symbolized by signing free trade or some sort of new commercial agreements, as one way of getting out of the economic doldrums.

A second, I think, again, and this is an unstated force, and that is the gradual movement of Japan out from under the tutelage--I'm not saying they're moving away from the alliance, but out from under the tutelage or alliance with the United States. I think that is a force that the gradual, I think, move within the Japanese population in terms of the [unintelligible] and as reflected in the government over time, Japan ought to take a more independent role, certainly in economic affairs if not in political or security affairs.

Now, Japan is faced in its changing policy already with criticism, as you know, and I think some of this is unfounded, but you had as late as this week in the WTO a number of members expressing concern about the Japanese movement towards a bilateral set of arrangements, like Moore saying, warning, I think, again I think much too hurriedly, Mike Moore, the Director General of the WTO, that there was a possibility of substantial trade diversion.

The other, I think, area that the Japanese themselves have not really thought through is what finally do you do with China? If you're negotiating all these bilateral or regional trade arrangements, where does China fit in this?

Then a final thing I think that the Japanese and the United States have to take into account is that the United States has not even begun to think of the implications of a set of new treaty arrangements in Asia that does not include necessarily United States.

Let me make three or four final points about bilateral or regional arrangements in general. They are certainly a decided second best from the point of view of economic overall welfare. That is not to say you shouldn't have them, but they are certainly--the payoff economically is much less than you would have with any kind of world trading, a new trade arrangement. The possibility of trade diversion, though, as I say, I think it was unfounded yet for Mr. Moore to be so gloomy about it, is definitely there.

Thirdly, you step back and you see all this activity, you're likely to get what [unintelligible] has called the so-called spaghetti roll effect where you've got all different kinds of arrangements among nations that are different. The whole question of rules of origin, that is the rules of origin as to how you decide who gets the lowering of trade barriers and who does not. So you end up with a very mixed and confused, I think, situation. I'm not talking about just the Japanese movement; I'm just talking about the move in this way around the world.

Then finally, to bring us back to the United States, I think that the United States' trade policy is likely to be paralyzed no matter how the presidency turns out because you have a deeply divided Congress. I don't see any way, at the moment, at any rate, that you can get around the big divisions over whether or not the United States will push labor and environmental rules in any new trade agreements.

I actually think in the case of whoever would win, whether Mr. Gore or Mr. Bush, I think the pressure would be not to do a lot.

Mr. Gore particularly will face a deeply divided party. If he comes into office, he will be heavily dependent upon labor and environmental support.

I think Mr. Bush has less pressure, but I don't think that a Bush administration would cash a lot of chits on trade. I think they will look in other directions.

So I would not foresee--this is not to say that Mr. Bush will not support a trade round, let's say, or want to move forward, but I can't see a Bush administration or a Gore administration actually doing a lot in the first year or two.

So this means that, I think, the drift that we're seeing toward bilateral or regional arrangements will continue, and I think we're going to go in that direction.

I think the first speaker is going to be Mr. Katz.

MR. KATZ: It's customary to start a speech about Japan or in Japan with an apology, so let me apologize for my froggy voice. My throat decided to betray me last night.

I am accustomed to being the pessimist on the panel. But this crowd is--I feel like I have to be the house optimist here.

Let me make two very quick minor points, and then go into the main theme. First of all, if people will take their handouts out of their folder, there are a number of articles from the Oriental Economist Magazine. There's also a sheet with some charts on them.

Number one, there's an awful lot of talk that if the U.S. should have a recession next year, which I think a soft landing is more likely than a recession, but even in the case of a recession, there's a lot of talk that this means a new trade war between the United States and Japan. I vehemently disagree.

If you look at the chart, Japan is not the source of the rising trade deficit of the United States; there are other countries. Number two, to the extent that the United States trade deficit with Japan is growing, it's primarily not because they flooded imports from Japan to the U.S., but rather declining U.S. exports to Japan. Steel is the exception, it is not the rule, and therefore even in light of a downturn in the United States, I do not foresee a sort of U.S.-Japan trade war. We're not going to have a repeat of the '80s and '90s.

Number two, just on the fiscal situation in Japan, the crisis, I believe the danger to Japan is not cataclysm; the danger is drift, of lurching from mini-crisis to mini-crisis through which they muddle through for long-term corrosion, but a galvanizing crisis that forces action I do not foresee, and therefore I would describe myself as a short-term pessimist and skeptic that restructuring is occurring, but in the long-term, I agree with Nakamae-san, perhaps maybe more like ten to 15 years rather than ten, but in that time, Japan will be a rapidly growing country, perhaps three to four percent GDP per year with reform. Reform will occur, and globalization will be a key part of that reform.

It is impossible for Japan to reform--it is impossible for Japan to grow without reform. It is impossible for Japan to reform without more globalization, and therefore Japan will do it. It will take fits and starts and a bumpy ride and ten to 15 years, but it will happen.

I'm going to give three points along that line.

Number one, Japan will increase globalization by which there will be more trade and more foreign direct investment for two reasons: One, there's almost no country in the world you can point to that has succeeded in a reform program without more trade and globalization. It's the vast majority of cases. China is a stunning example; India now joining other countries. Certainly Asia is true. Poland.

Two. The lack of sufficient globalization is the heart of Japan's problems, and therefore will have to be the heart of the solution. The secret to Japan is that there are two Japans. There is the Japan that most people know about, the Japan of Sony and the Japan of Toyota. They are very competitive precisely because they face world competition on the export stage.

But the majority of Japan, the 80 percent of Japan, is a domestic Japan which is shielded from global competition because of low imports, because of low foreign direct investment. And the low exposure to international competition is really a bodyguard for a low efficiency at home and cozy practices that are anti-competitive in many cases, which the Dongo arrangement, the bid-rigging construction, is the most prominent example.

We see the industries that are most exposed to international competition have the most efficiency. The industries that are least exposed have the least efficiency.

If we turn to the chart in the article called "The Dual Economy Worsens," on the back page, you will see that over the last decade--well, first of all, this dual economy has actually gotten worse, the restructuring has actually gone in the negative direction for the most part.

But we see history is not destiny. Those industries that have been willing to expose themselves to more international competition have overcome the legacy of backwardness.

A prime example is textiles, as you see on the top of the chart. Traditionally a very backward industry, production 40 percent of U.S. levels, very shielded, but in the last decade, much more open to international sourcing as retailers who are independent of the manufacturers go abroad, source cheap clothes. The manufacturers then have got to go abroad to compete.

As you see in the top chart, those sectors--and the bottom chart--those sectors which have most increased their trade and most increased their imports over the last ten years have most increased their efficiency, and textiles is kind of the poster child for how you can turn around a backward industry, because the retailers were independent of the manufacturers, another real good debate in Japan, because the manufacturers are now saying shut down the imports, and the retailers, who represent consumer power, are saying, no, keep them open, we need this. This is the kind of debate Japan needs and I think will have more of. So there is a possibility there.

So point number one: You cannot have reform without globalization. Where we have had globalization, we have had success, which leads to point number two: the political awareness of this in Japan.

Tanaka-san and I--it's like old home week for the three of us here--we were having a discussion whether he or I should be the most critical of Japanese trade patterns. I said he should go, he should be most critical today. But the fact is, there is this change in Japan.

For the first time, you get very important people in the Japanese bureaucracies, in Japanese multinationals, in Japanese media, in Japanese academia, who talk about greater opening of Japan, not for be sake of international harmony, but because it is necessary for Japan's own reform.

MITI--I don't want to steal your thunder, but MITI, in response to the Council on Foreign Relations study, in which I participated, talked about using globalization to help reform in Japan. MITI is launching a new initiative along this line. So there are some real tendencies for a genuine, open debate.

There are those who say we need globalization reform and those who still want to protect the vested interest, and in fact, contrary to popular impression in the United States, some of the most radical reformers in Japan are some bureaucrats, who I have to say are still the minority of the bureaucracy, and always bureaucracies are divided. So point two, finding forces in Japan that seek globalization is key to ally reform.

Bring us to point number three. The U.S. can help in this process. I'm skeptical of a formal free-trade agreement, but I believe that, as we saw in the Richard Fisher talks with Japan on telecommunications, that where the U.S. aligns its own interests with the interests of the reform process in Japan and seeks allies in Japan, so the reform the United States wants for the interest of American firms coincide with the interest that Japanese firms want for their own interests--for example, all the firms who are hurt by NTT's monopolistic practices, firms like Sony, et cetera, and other ministries who represent those firms--then they tend to use what they call gaiatsu (ph), foreign pressure of the U.S. to promote reforms. And so you get this alliance between-- it's always sort of vochi (ph), never admitted, but alliance between U.S. helping reform process in Japan and Japanese reformers.

If we pick and choose our battles carefully, and not a question of Japan bashing or the U.S. dumping on Japan, but where we can generally ally U.S. interest in market access and Japan interest in reform--the expression goes, "Sleeping in the same bed and dreaming different dreams"--there I think there is a real potential for progress on this front. We have seen it in finance, and we have some experts on that here. We have seen it in retail, we're seeing it in auto.

The major opening has so far been in foreign direct investment where that has occurred in finance, in auto, in retail, in telecom, now in insurance, spreading from sector to sector. I believe we'll begin to see it in imports as well. There is fierce resistance to it, including the LDP, particularly the LDP. So I believe, therefore, this trench war prefacing the forces of reform and the forces of resistance will take ten or 15 years to wash itself out, but at the end, I have very little doubt the outcome will be success, will be Japanese revival, and will be a more globalized Japan. And sorry not to share the pessimism of my panel base, but that's how I see it.

MR. BARFIELD: Thank you.

David Asher.

MR. ASHER: I have a lengthy set of slides here. I'm not about to go through all of them at all, but I wanted to not leave too many holes in the presentation. I figured I might as well give a little extra reading to you.

You will see that I'm an optimist on trade with Japan despite my pessimism on the macro economy. In fact, I think I may be more optimistic than Rick is on trade.

The reason is I feel that the scale of the domestic structural problems in Japan that need to be addressed is so great that the Japanese are being forced to adopt a much more liberal attitude toward trade. And trade is not just something between countries; trade is within countries.

I would like to just address some central questions in the next 12 to 15 minutes.

Will U.S. economic policy toward Japan next year change? The answer: if it's in the new administration that happens to be run by a governor from Texas, I believe it will change quite substantially. In fact, I'm quite confident of that.

Has the framework approach, the approach the United States has adopted toward Japan since 1993, been a success? You will get my view on that in a moment.

What should the new administration aim to accomplish in its economic relations in Japan?

And finally, is a free trade renaissance, both inside Japan and between the U.S. and Japan, a possibility? Again, I'm optimistic, and I would say that not only am I optimistic about free trade, I'm optimistic about expanding the terms of the U.S.-Japan security alliance, something I worked on in another stage in my career as well. Perhaps, however, I may have worn too many different hats for a young guy.

Let me first say briefly that the Clinton framework in its initial stages from 1993 to 1997 was probably one of the most disastrous trade approaches ever adopted in the history of the world. It was fatally flawed because it was based on an assumption that Japan’s economy was not changing.

As Roger Altman explained in Foreign Affairs, in his wonderfully titled article "Why Pressure Tokyo?", "the U.S. emphasis is precisely designed to shift the debate away from changing the nature of the Japanese economic system." Instead the Clinton policy was about carving out certain patches of ground Americans in the Japanese economy so that the USG could create an illusion of market access in Japan.

That was because people like Altman and many revisionists believed that Japan was not fundamentally changing and would never change, and the economic structure was sort of going to be like 1965 forever.

Their approach essentially, therefore, was to not trust the invisible hand and instead "target definite results," as Altman also said, "until hell freezes over if necessary." Let’s see what they got waiting for hell to freeze over.

What they got was a tremendous rise in bilateral tension, a massive rise in the yen, and in 1995, a crazy crisis over auto imports into the United States, which was a patently absurd issue as far as I'm concerned, that actually started to affect our security alliance quite visibly, something I was working on at the time.

The only bright spot of that approach was essentially the attempt to de-manage trade in cooperation with the Japanese Ministry of Finance and the U.S. private financial sector in Japan. Robin Radin (ph) here was one of the leading people in the private sector in Japan at the time with Morgan Stanley and C.S. First Boston pushing for a big bang. Guided by such voices the Ministry of Finance and the Treasury Department in 1995 began that process essentially.

But these financial talks were totally against the whole grain of the Clinton policy. The grain of the Clinton policy essentially, as I said before, downplayed the critical structural reasons for Japanese resistance to market penetration by outsiders, foreign or domestic, and what finally happened was that they found that approach failing.

The results were poor. We saw a relatively negligible impact on the bilateral trade relationship in terms of the volume of trade. Exports did increase a little bit, but not nearly in pace with the massively strengthening yen, and recriminations increased much faster.

So in 1997, the White House finally threw in the towel, and they have gone back to something resembling the Structural Impediments Initiative, called the Enhanced Deregulatory Initiative, which I think is a very welcome development, and it is a good approach to bilateral trade relations.

The problem with this initiative is that it's very piecemeal, and it lacks the high level direction and energy that went into the Framework talks. Consequently, good intentions aside, I believe it really hasn't led to much in terms of definite results, in terms of increasing market access in Japan for foreign companies. It has done some positive things, but it's not really enough to change the structural features in the economy of Japan that account for the high cost of doing business and the lack of inward direct investment.

Moreover, the approach has been radically confounded and contradicted by an emphasis on fiscal largess as well as the continued insistence on monitoring an outdated agreement such as the auto procurement agreement. Essentially we should be aiming much more at taking over Japanese auto companies than worrying about auto imports from Japan to the United States at a time when the Japanese are producing more Japanese branded cars in the United States for the U.S. market than they're importing.

But more importantly, as a result of Larry Summers' strenuous vocalizations about fiscal stimulus, the United States has been branded as the key instigator for the growth of Japan's massive debt mountain that I showed in the earlier presentation. So despite the 38 trade agreements since 1993, some good, some bad, some ugly, I feel like trade relationship remains relatively uninspired.

Still, I still have hope that a new approach could be adopted. The reason why a new approach is needed is quite obvious to me. The next slide, please.

As the slide shows, Japan is a frontier market. It's largely unexploited by foreign companies. At the same time, the Japanese business system is fundamentally changing, the big bang is a serious development, as is in some ways is the "big bankruptcy,"through which the weed-out of inefficient companies in Japan continues apace and it's accelerating as I showed. This failure of the old system is very hard, it’s a very difficult situation for the Japanese and it has a negative impact on macro-economic performance in the short run, but in the long-term, it's absolutely necessary, as Mr. Nakamae pointed out earlier today.

Moreover, I believe the current framework approach, even its modified form, the Enhanced Initiative, places way too much emphasis on nickel-and-dime issues, even ones which are somewhat important. I mean, getting a 20 or 30 percent cut in NTT interconnect fees for the Internet is important, but the fact that we had to send countless delegations of U.S. negotiators over to achieve this objective, which was blatantly in Japan's own self-interest, to me is a sign that our policy is not necessarily properly focused.

I think it would be much better if we tried to assemble a comprehensive list of changes and tried to just put it forward all at once, instead, a sort of up or down decision on market opening. Essentially, that moves us toward a trade agreement that's starts to resemble a free trade agreement with Japan.

That's another reason why I'm so optimistic. Because a trade agreement like this is now becoming feasible. The Japan have just entered into full negotiations with the Government of Singapore in a free trade agreement that is not just about bilateral reduction of tariffs--there aren't so many tariff barriers between the two-instead the Singapore-Japan FTA is aimed at structural reform in Japan in order to facilitate increased imports and increased domestic demand.

The fact that Ministry of International Trade and Industry, which has now become the Ministry of Economics, Trade and Industry, has been willing to do that is a sign that Japan is moving in a direction that the United States should consider positively and make us much more emboldened in terms of considering putting forward something resembling a free trade agreement with Japan.

The FDI data also should give hope. This chart here just shows basically the performance of U.S. exports indexed from 1990 comparing Japan, EU, and Latin America. The other looks at inward direct investment. Inward direct investment has increased. It's an important increase, it's an important sign. But let’s face it: just to bring Japan up to global standards in terms of inward direct investment as a percentage of GDP, we need another $500 billion in inward direct investment in Japan. That's how isolated Japan continues to be. That's a problem for the Japanese, and it's a problem for world economy.

This next chart just shows the increased mergers and acquisitions, but despite the remarkable increase in mergers and acquisitions, M&A in Japan only accounts for about 6 percent of global M&A despite the fact that there is this tremendous amount of business failure going on in Japan. You would think that there would be many more opportunities for foreigners.

I have a modest policy proposal to improve the situation. My policy proposal is simple: that the United States and Japan try to update the 1953 Friendship, Commerce and Navigation Treaty (FCN), which is the underlying key treaty for our trade relations and use this to further the development of a bilateral common market. I believe it would have a very substantive positive impact as well as a symbolic impact. It's not merely a left-over from the occupation; it actually dates back to the 1854 Okinanawa, the treaty that Commodore Perry imposed upon Japan, as well as the 1858 Amity in Commerce treaty. The language is remarkably similar to these black ship agreements. We could aim at revising the FCN it in time for the 50th anniversary of the treaty on April 2nd of 2003, this would truly take our trade relations out of the 19th and into the 21st century.

What could this new treaty accomplish? In my mind it could function as a sort of Treaty of Rome. The Treaty of Rome served to cement foundations of the Euro pean Community and the common market in 1957, laying out clearly the principles for a common market and setting forward a trade integration agenda. Likewise, a new US-Japan FCN should lay out new principles to guide our trade relations in the coming decade, principles which we could then further by creating implementing legislation to harmonize our regulatory systems and to truly bring our economies together in a common market. Thus, my idea is not simply a free trade area as others propose. Free trade between us is not enough. We need to create the grounds for free trade inside the Japanese economy.

As you see in the slide, I have actually even suggested a possible preamble for this new FCN highlighting price convergence as a guiding principle. Although, I'm not going to read it out loud, the point is that a new FCN need not be a 1,000-page agreement like NAFTA. That's not the purpose of FCN treaties. It's basically to set a strategic direction for the relationship.

As I note, promoting price convergence should be a guiding principle for approaching negotiations and setting up a new FCN. Obviously, despite my disagreement with a conventional results oriented approach, the creation of a common market does need to be based on some measure of evaluating the success of agreements pursuant to it. My belief is the best measure of that is to aim overtly at the harmonization of the pricing mechanism for labor, land, capital, energy information services between the United States and Japan. Price convergence in Japan will produce the best results for both Japan and the US and aims at de-managing trade, rather than managing it.

Let's go to this chart here, moving ahead.

Why use prices as a measure? Essentially, prices in Japan, despite the tremendous deflation we have seen, are still radically out of line with averages in the G7. The only reason prices could be this high is essentially protracted over-regulation, and it's over-regulation in areas that we know very well. It's in telecommunications, it's the telecommunications monopoly held by NTT, it's the gas monopoly held by Tokyo Gas, and the electricity monopoly held by Tokyo Electric. It's the distribution monopoly or quasi-monopoly held by many of the transportation companies. These are non-tariff barriers which we have been talking about for years.

Thus the only binding element of this agreement that I am suggesting should be a commitment to moving toward purchasing power parity in goods and services with the United States, which is sort of right at the middle of the G7 average, over a five-year period after an agreement is put forward.

How do we get the process started, politically and diplomatically? To come up with a new FCN and lay the foundations for a common market the US needs to build consensus on both sides of the Pacific. My recommendation to the new administration is to form a task force with the Japanese, a bilateral task force between Japanese scholars, policymakers, politicians, and business people, and their American counterparts, as the Japanese recently did with Singapore. This economic integration commission would establish guidelines for the revision of the FCN, and also establish guidelines for the launch of a common market negotiation in Japan to begin subsequent to the promulgation of a new Friendship, Commerce and Navigation Treaty.

What would the benefits be to the U.S. of this? And I'm sorry, I'm sort of skipping around because it's a difficult area to get into technical policy details. I think that the first benefit would be, if the Japanese were to implement serious structural reform pursuant to a common market agreement as the Europeans have, would be the realization of the great investment potential in Japan. Fundamental access to the Japanese market, which is, as I said, extremely isolated still from inward trade investment compared to the OECD averages, would be seriously improved.

By the way, a new FCN would be conforming to Article 24 in the GATT. This would not be a preferential agreement that would raise barriers to anyone; it would be strictly lowering barriers between us on a MFN basis plus removing myriad domestic structural barriers outside of the GATT sphere of influence. This would only further market access for, including non-insider Japanese in their own country.

I'm confident that this approach can succeed because the things that the Japanese would have to do to fulfill a common market are exactly the things which their own government is proposing in terms of structural reform. However, their government hasn't, unfortunately, been able to implement these reforms.

Who specifically benefits in the US, you ask? I think that American industries, such as airlines, telecommunications, energy, financial services, information services, would be particularly empowered.

In the airline area, for example, as a quid pro quo of any sort of common market agreement, we're talking about an open-skies agreement at long last between our two countries.

That means that there are global mergers and acquisitions in airlines, something Peter Evans here and his colleagues at Cambridge Energy Research have been pointing out as long overdue. If that comes to pass, so be it. If Japan Airlines were to be taken over by American Airlines, well, that's the way things go in the world. If Japan Airlines wants to take over American Airlines, so be it. That's the way we need to be moving.

Mr. Barfield: Fritz Holland (ph) has just had a heart attack somewhere.

[Laughter.]

MR. ASHER: Basically my view is that there isn't as much standing in the way of this sort of bold agreement as people think, and the fact is, on a tariff level, our trade is relatively open.

What's not open is the domestic internal structure of the Japanese economy. It's something which the Japanese themselves know has to be opened up much more aggressively. And to the extent that politicians and the policymakers continue to ignore the necessity of implementing policies which further this objective, their economy will continue to collapse.

The irony is the markets have essentially collapsed into a state of quasi-liberalization in many areas in Japan in the 1990s rather than been liberalized, and tha