Monday, 26 February 2007

"Larry Summers on China": Lessons from Japan

Larry Summers in today's LA.Times online has written an interesting opinion piece on the similarities between China now and Japan in the 1980's and early 90's.

He makes some good points and Econ101 students should read this in light of some basic questions: "What does it mean to run a trade surplus or deficit?" Can the US run a deficit for ever? Can China run a surplus forever? What does China do with its surplus money? What role do exchange rates play? Can equilibrium be restored painlessly? What may happen if China does not act now to let its currency appreciate?

Importantly, in light of this article, is to consider the very large differences between the Japan of the 1980's and China now. The same mistakes are not inevitable.

Some of the answers are contained within this article. Also interesting are some of the comments on Greg Mankiw's blog post (see below).
"Summers of China

A Japanese lesson for China
A RISING Asian power is an export juggernaut and enjoys prodigious growth fueled by high savings and investment rates. Its rapidly modernizing industries threaten an ever greater swath of industry in Europe and the United States. Its formidable central bank reserves and burgeoning account surplus lead to claims that its exchange rate is being unfairly manipulated. Its financial system is bank-centric, heavily regulated in favor of domestic institutions and closely tied to government and industry. Rapid productivity growth holds down prices, but its asset values rise sharply.

Key congressional leaders in Washington demand radical action to contain the economic threat. Diplomats warn that public bashing is unproductive but make clear that economic issues are a crucial part of the bilateral relationship. Delegations of senior U.S. officials engage in "dialogue" with their counterparts about the many aspects of their economic policies that promote imbalances, warning of the congressional demons who stand ready to act if "results" are not achieved quickly.

All of this describes what is happening in China, and with our relationship with Beijing, today. It also describes the Japanese economy in the late 1980s and early 1990s, before its lost decade of deflation and considerable deterioration in global prestige. Although there are obvious differences, notably China's much lower level of development, the similarities are striking enough to invite an effort to draw some lessons from the Japanese experience.

The definitive history of Japan's dismal decade has yet to be written. But most observers would agree that key elements included the bursting of stock market and land bubbles, the resulting problems in the financial system, the collapse of aggregate demand as banks stopped extending credit and the difficulty of moving from export-led growth to domestic-led growth once consumer and business confidence was lost.

In retrospect, Japanese officials made several important policy errors. In order to avoid further yen appreciation in the late 1980s, they followed easy monetary and financial policies that gave rise to huge asset price bubbles and expansions in credit, which set the stage for the downturn. At the same time, they failed to encourage a shift to domestic demand-led growth at a moment when consumers were enjoying record increases in wealth. And they allowed problems in the banking system to fester. The result was that Japan was not well positioned to prevent or address the serious problems of the 1990s.

This suggests that if China is to sustain rapid growth and not repeat Japan's mistakes, it must fix the policy roof now, when the sun is shining. Allowing inevitable currency appreciation and spurring domestic demand by encouraging consumption is much easier now when the economy is at the edge of overheating than it is likely to be in the future when it cools off. It has been estimated that seeking to maintain the current exchange rate could require as much as $400 billion in reserve accumulation in 2007, which would almost certainly lead to rapid asset price inflation as renminbi are printed to buy dollars. And there will not be a better moment to fix problems in the banking system.

These lessons for Chinese economic policy contrast sharply with those drawn by observers in and out of China who attribute Japan's deflation and consequent poor performance to its willingness to accede to American pressure for currency appreciation. This alternative view offers no explanation for Japan's asset bubble and collapse, and no theory about what measures would have spurred domestic-led growth.

Another lesson of the Japanese experience is the need for modesty regarding economic diplomacy. Events and national and political decisions, not international communiques, shape economic outcomes. The effect of events beyond the control of governments — the collapse of Japan's asset markets, information technology's spur to U.S. productivity, the Asian financial crisis — dwarfed the diplomatic debate.

Even in areas in which government policies might have had significant effects, such as housing, finance, social security or retail regulation, there is no evidence that Japan in the 1980s and 1990s made any changes in response to U.S. pressure. If heavy-handed pressure makes it easier for special interests to invoke nationalism as they resist change, high-profile negotiations can be counterproductive. And in a world in which goodwill capital is scarce, heavy-handed pressure engenders resentments that spill into other spheres.

It was a cliche in the late 1980s and early '90s that the U.S.-Japan relationship was the world's most important bilateral relationship. Given China's scale, rapid growth and the greater level of imbalances in today's global economy, Chinese economic policy and its international economic relations are even more important. By learning from a rather unfortunate history, policymakers on both sides of the Pacific can avoid repeating its mistakes.


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