The people here at AEI are well known for their timeliness in scheduling conferences of relevance to the policy community. And, when the invitations went out earlier this fall, December 1 seemed like a perfect day to talk about the likely foreign policy of the next Administration. The transition process would be well underway and the excitement of a new start in policy and the idealism of fresh blood in the policy making process would make for a fascinating discussion.
Too bad the American electoral process did not cooperate, in spite of all of AEI’s connections. No doubt the fault lies with some of my colleagues like Ben Wattenberg, Karlyn Bowman, and Norm Ornstein. They’ve been telling us all year that this was going to be a close election, but they didn’t warn us that it would take three recounts. Indeed, as we meet the United States Supreme Court is hearing oral arguments related to the election process.
This does allow me some enhanced degrees of freedom. Although it is virtually certain that George W. Bush will be the next President, the election has drastically shortened the normal transition cycle. Fewer decision makers have been named, and fewer decisions made than would normally be the case. As such, there are fewer toes out there for me to step on. So let me state from the outset that the views I am going to express are entirely my own and do not necessarily reflect those of anyone else, including any potential incoming Administration.
The topic at hand is the challenges to be faced by the next Administration in U.S.-Japan relations. While the relationship between the two largest economies on our planet is far from a trivial issue, it is not one that was discussed in the recent campaign. That absence of discussion is not due to a lack of difference between the parties. Indeed, the differences between the two parties on American policy toward Asia in general and Japan in particular is at least as pronounced as it is on any other issue.
It is no surprise that the Nikkei, like the NASDAQ, has moved in cycle with the probabilities of who the next President would be. Just this Monday, the Nikkei rose 450 points on the news of Florida's certification of Bush.
The view is widespread that a hypothetical Gore Administration can be expected to be an extension of the famous Clinton trip to China. Nine days spent at every photo opportunity there, concessions such as the "three noes" policy that had not been accepted by any previous Administration of any political party, and then a return to the United States involving a mere flyover of Japan airspace. The relationship between the United States and Japan, which has formed the cornerstone of peace and prosperity in Asia and the Pacific for half a century, has been subjected to a period of neglect verging on abuse for the past eight years.
Needless to say, I think that such an attitude toward Japan was wrong for the 1990s, and is a luxury we cannot afford in the 21st century. This is precisely the wrong time for both the Asia-Pacific region and the world economy for America and Japan to go their separate ways. While the U.S. and Japan will continue to have disagreements about the details of trade and security policy, there is in my mind no substitute for a close working partnership between the two countries. I personally believe that we should set our sights on enhancing that partnership in the years ahead.
This enhanced working relationship between the United States and Japan should not be viewed as an effort to exclude any other nation, particularly China. Indeed, it would be nice if the Chinese chose to join the club of nations that forms a zone of peace and prosperity that spans the Pacific. To do so effectively, they will have to bring their domestic policies in line with widely accepted norms of property, liberty, and judicial independence.
But the ideals and the principles of that club of nations, founded on a close relationship between the United States and Japan, should not be sacrificed to either appease or attract China. Those principles are the underpinning of the peace and prosperity of Asia. It is that very peace which should attract the leaders of any nation, including China. We fool only ourselves if we believe that we can maintain either peace or prosperity while compromising on the universality of the ideals of economic and political liberty as the fundamental underpinnings of human relations.
But, our focus today is on the future of American relations with Japan, not our relations with China. Let me turn to those directly. I mentioned at the outset that during the last eight years American policy toward Japan has been one of neglect. Let me be more specific. U.S.-Japan relations have been reduced to a single concept: gaiatsu, or foreign pressure on Japan.
Now, I’ll admit that gaiatsu is an important part of U.S.-Japan relations and has been since Admiral Perry. But, isn’t it a bit strange that a near totality of relations between our two countries, the largest two economies in the history of the world, comes down to subtleties and degrees of pressure of one of those states on the other to engage in various kinds of reform?
This reliance on gaiatsu has reduced the creative thinking necessary for our relationship. In America, "Japan-bashing" by the Administration has become a convenient way of appeasing some political constituency. In Japan, American tirades have become so expected that political discourse has moved away from creative solutions to domestic problems toward designing face saving, and necessarily short term, responses to American attacks.
In short, gaiatsu has become a substitute for creative thinking on both sides of the Pacific. Posturing has replaced policy, and attitudes have become more deeply entrenched in both Tokyo and Washington. Worse, this approach has reduced the capacity for cooperation between the U.S. and Japan on other vital issues.
The most prominent example of gaiatsu is, almost certainly, American government comments on Japanese fiscal and monetary policy. Lectures by U.S. government officials are both loud and very public. Yet, they are so common that we have forgotten how strange such behavior is between two advanced nations.
After all, monetary and fiscal policies are fundamentally a matter of domestic political concern, not for international negotiations. In the economic realm, the irreducible minimum of sovereignty for a nation state is control of its own currency, taxation, and spending. It may be that nation states choose to yield some of that sovereignty in order to be part of a larger order, as in Europe today. By contrast, the U.S. pressure on Japanese economic policy is not caused by any desire to unify American and Japanese fiscal or monetary regimes. We are not negotiating some "stability pact" that brings our business cycles into conformity based on mutual action. Stability has little to do with the issue, neither nation has stated a desire to unify our business cycles, and the actions under discussion are unilateral suggestions by America for Japan, and not mutual in nature.
Not only has the American rhetoric been harsh, but the signals being sent are confusing. For example, the U.S. Treasury has been fond of telling Japan that the path to economic growth is in ever expanding fiscal deficits. At the same time, the U.S. Treasury has been claiming here at home that our economic growth has been caused by ever contracting fiscal deficits. Which is it? At the very least, one might suspect that Treasury officials are not expounding some universal economic truth, but rather are applying, ad hoc, a relationship between two variables based on political necessity, not economic logic.
Should officials of one country discuss monetary and fiscal policies with officials of another country? Yes, certainly. But, those conversations should be held quietly and should be based on a consistent application of economic principle, not domestic political advantage. Let me get right to the heart of the matter discussed this morning: the subject of appropriate Japanese fiscal and monetary policies, and what American attitudes toward Japanese policies should be. Three principles are as applicable in America as they are in Japan, and thus form the starting point for considering our position.
First, what is the actual cause and effect between growth and budgets? Almost certainly the primary causal link is that growth rates determine revenue, with an elasticity of revenue with respect to real growth that exceeds unity. Therefore America’s fast economic growth has produced its surplus, while Japan’s slow economic growth has produced its troubling deficits. This is the fundamental fact behind the contradictory Treasury position on fiscal policy.
Second, the relationship between long term growth and government finance is not tied principally to deficits, but to how resources are used. If the public sector has a use for resources which yields a very high return, then either taxing or borrowing resources from the private sector will be moving resources from comparatively low return activities (consumption or lower return private investments) to high return activities. If, on the other hand, the public sector procures funds and invests them in low return projects, then it is systematically reducing the rate of return on capital in the society by moving resources from higher return private activities to lower return political or public activities.
In the extreme example, a government which borrows funds on its own authority and spends them to sustain the activities of a failing enterprise is literally moving funds from a higher return private sector activity to a private sector activity with a negative return. If government does this through borrowing, it creates the long-term prospect of a debt trap.
But, the right alternative to a debt trap is not greater reliance on tax finance; tax revenue, by definition, must come from profitable private sector activities. Done to excess, the state creates a "tax trap" as painfully debilitating as a debt trap, in which profitable activity is drained of resources in order to maintain unprofitable activity. From the point of view of long term prosperity, the central problem of public finance is how the money is used by the state, not how it is raised.
Third, there is no question that state finances can be used to cushion the short run vagaries of the business cycle. The "right" fiscal policy for a country in a protracted slump is almost certainly not a government surplus. But, the short-term process of moving toward a more prudent fiscal policy, to meet the objectives stated above, do involve some short-term economic sacrifice. Thus, reform of Japanese finances to achieve long-term goals is likely to be painful in the short run.
What then are the right policies for Japan? It is hard to maintain after a protracted period of slow growth that the central problem of fiscal policy is business cycle stabilization. It is much more plausible given the debt levels in Japan and the strong political forces which shape the allocation of resources in the state sector, that Japan’s primary problem is capital misallocation. The massive debt of Japan will become increasingly difficult to service unless the rate of return on Japanese saving is increased. I do not believe that this is a controversial conclusion based on the discussion of this morning.
Furthermore, I doubt that it is controversial to maintain that the best way to raise the return on Japanese saving is to commit less total resources to existing types of public sector projects. One good alternative use of the money, with a high social rate of return, is probably tax reform. But, failing that, it might well be argued that the total return on capital in Japan would rise simply if the state were not to borrow so much and instead cut back on some project spending.
Such a cutback would no doubt cause some short-term difficulties for the Japanese economy. Here is where coordinated action between the United States and Japan might help. The most likely result of Japanese fiscal reform is an increase flow of both goods and capital to the United States. The combined effect of this will be to produce no net change in the dollar-yen exchange rate. The former we will feel somewhat ambivalent about: grateful for the increased choice for domestic consumption and inflation-fighting competition, distressed because some of our import competing industry will bear the brunt of the adjustment.
The latter we will no doubt rejoice in. The current American expansion is being financed by a record setting inflow of foreign capital. Even given an improvement in the long-term soundness of our tax and retirement systems designed to promote national saving, we are likely to be reliant on foreign capital for the foreseeable future. A temporary increase in the outflow of Japanese capital seeking higher returns in America would be welcomed in these circumstances.
The challenge for the next Administration therefore seems three-fold in nature. First, cut the volume of the rhetoric. Japanese fiscal reform can only be done by Japanese politicians accountable to Japanese voters. American gaiatsu sets America up as the scapegoat for the pain, which is sure to be associated with such reform. Our current outspoken position therefore allows Japanese politicians hostile to good Japanese-American relations to run on anti-American platforms, and do so with some credibility. The price America may well pay for a continuation of the current noisy gaiatsu policies may be an increasingly nationalistic and isolationist Japan.
Second, we must change the nature of our advice. Rather than give advice which is plainly politically self-serving, our discussion should focus on the universally applicable principles stated above. The great bulk of Japanese voters and politicians understand the truth behind these principles. While America should not take sides on deciding the details of Japanese fiscal or monetary policy, aligning ones statements with a statement of the obvious, is most likely to promote necessary reform.
Third, we may want to consider the implications of Japanese reform for our own economy more carefully. If Japan does indeed choose to adopt fiscal reform, it will need to rely on U.S. markets--product markets for exports and capital markets for expatriation of savings. Such changes are an inevitable adjunct to Japanese fiscal reform. They will happen either through cooperative arrangements and an opening of markets, or through a forced adjustment in the exchange rate. We should recognize that our interests are in the former, not the latter.
The next decade will be a challenging one because it will involve great change. The neglect of the last decade was not only unfortunate, it is probably unsustainable as well. In place of gaiatsu, we must substitute a policy of mutual cooperation and respect. That is not only the right policy, it is also the one that objectively is the most appropriate for the world’s two greatest economies.
Larry Lindsey is a visiting fellow at AEI.
