Focusing on Japan and the Global Financial Crisis (2009)

• CPDS Comments
• Summary

Introduction

This document comments on an article by Professor Daniel Okimoto (Shorenstein Asia / Pacific Research Centre, Stanford University), namely "The Financial Crisis and America's Capital Dependence on Japan and China" (Asia-Pacific Review, Volume 16, Issue 1, May 2009 - of which a brief summary appears below).

The article concludes that major changes in the global economic order will be required because the global financial crisis (GFC) has made it impossible to maintain past patterns of growth that relied on international financial imbalances. Other major themes were that:

• the financial imbalances (involving huge investment in the US by Japan, China and Middle Eastern nations) allowed extravagant US spending and supported economic growth and development in Asia. This was based on 'financial mercantilism' by US, and created asset bubbles whose bursting led to the GFC;
• the US has accumulated large debts, while Japan and China have large holdings of US Treasuries - and are concerned about the increasing risk of losses;
• the GFC has radically changed the international financial order. The US will need to increase savings and be less able to exert international influence, while Asia will need to develop domestic sources of demand. The future world will be less stable and prosperous, but more dangerous;
• the US should not "bypass Japan", in its haste to engage with a rising China, as the US has many areas of shared interest with Japan.

• Past
• Future

CPDS Comments

There is no doubt about the need for the US (for example) to focus on Japan in considering the impact and aftermath of the GFC.

However this is necessary primarily because because the economic model, that Japan used as the basis for its rapid growth and development and then disseminated throughout East Asia, has been as opaque to outside observers (who typically don't understand its intellectual foundations) as financial derivatives have recently become to investors.

The Past

In the past, that model was the reason that Japan was viewed as the greatest challenge to the US's economic dominance in the 1980s (see East Asia in Competing Civilizations).

However it was also a major factor in the international financial imbalances that have contributed to the GFC. Reasons for the latter suggestion are outlined in:

• Structural Incompatibility Puts Global Growth at Risk (2003) - which suggested that global economic growth was likely to prove unsustainable, because a structural imbalance between aggregate supply and demand and potentially insolvent financial institutions have been built into the economic and financial characteristics of major East Asian economies - because of cultural traditions in societies with an ancient Chinese heritage that are radically different to those in Western societies;
• Financial Imbalances in Financial Market Instability: A Many Sided Story (2007) - which highlighted the role of imbalances in the then emerging financial crisis;
• Understanding East Asia's Economic Models in Are East Asian Economic Models Sustainable? (2009).

Professor Okimoto's article suggested that savings-rich countries such as Japan and China gained access to markets (and similar real-economy benefits) from a 'Faustian bargain' under which they invested heavily in US assets and thus allowed the US to maintain extravagant spending. 

However it seems that even more important was that they gained protection from the crises that are likely where financial systems direct resources through elite social networks with limited regard to the capitalist goal of profit - a phenomenon which led to crises in several of Asia's economies in 1997 that (until then) had not sought protection by maintaining current account surpluses as Japan and China had done. It also seems likely that:

• the suggestion in professor Okimoto's article that Japan emerged as a 'capitalist democracy' as a result of US influence in the post-war era is not quite correct. For example Eisuke Sakakibara, a very prominent Ministry of Finance official, argued (in Beyond Capitalism: The Japanese model of market economics, 1993) that Japan was a non-capitalist market economy;
• while most Western observers have little knowledge of the neo-Confucian cultural foundations of East Asian economic models, the latter's incompatibility with the global financial order and resulting potential for unstable international financial imbalances should have been clear to Japanese analysts (who had closely studied the cultural differences for decades) at least by the start of Japan's 'lost decade' - and one must wonder why this was not drawn to the world's attention at that time;
• the incompatibility between the global financial regime and the economic model that Japan originated arguably constitutes a more significant 'clash of civilizations' than that between the West and radical Islamists (see Competing Civilizations). Moreover, as professor Okimoto's article noted, the ultimate impact of the GFC on the international political and economic order was vastly greater than the attack on the World trade Centre in 2001 which diverted the attention of US leaders from Asia and economic issues. Symptoms of a 'clash of financial systems' had been emerging at least since the 1980s. For example, efforts to correct the trade imbalance between Japan and the US under the 1985 Plaza Accord had failed apparently because Japan's financial system was organised to limit the flow of capital to domestic spending (see Why Japan cannot deregulate its financial system);
• in setting (what proved to be) excessively low US interest rates over many years, and thus generating asset bubbles that gave rise to the GFC, Alan Greenspan as Federal Reserve chairman frequently referred publicly to the need to guard against the risk of deflation - though deflation was a risk that Japan faced (but the US itself did not). This implies that the Federal Reserve was setting domestic US monetary policy, in consultation with Japanese officials, partly to protect Asia from the macroeconomic consequences of the structural demand deficits built into export-dependent economies such as Japan's.

The Future

In future the economic model that Japan disseminated is likely to be a fatal obstacle to the ability of domestic demand in East Asia to drive regional / global growth in the post-GFC environment.

Professor Okimoto's article suggested that there is no reason why demand can not now be spread more broadly. Unfortunately it seems likely that such a shift would be impossible without fundamental reforms of the economic models that have prevailed in countries such as Japan and China. There appear to be significant risks that financial crises would disable strong domestically-driven growth in East Asia (and in emerging economies generally) in a future environment in which the US doesn't provide the excess demand needed to sustain global growth (see Are East Asian Economic Models Sustainable? and A New World Order: Leadership by Emerging Economies?). A key problem is the difficulty of balancing supply and demand where an economy is not controlled by profit-oriented (ie capitalist) enterprises responding to consumer demand but rather constitutes a modern version of 18th century European mercantilism whose goal was to increase the power of national elites (eg kings / Emperors in 18th century Europe, Communist Party connections in China now and bureaucratically-guided financial institutions and companies in Japan) by accumulating a stock of 'treasure'.

The potential for such a financial crisis may be becoming all too real in China [1]

If fundamental reforms are needed to East Asian economic models to enable demand to be spread more broadly, such adjustments need to be priority questions for international consideration. This is the main reason that the US (and others) should not now "bypass Japan" (the originator of those models) in responding to China's rise.

Summary of Okimoto D., "The Financial Crisis and America's Capital Dependence on Japan and China", Asia-Pacific Review, Volume 16, Issue 1 May 2009

Synopsis: In post Bretton Woods era, US has borrowed heavily from savings rich countries such as Japan and China. This has allowed it extravagant spending and great power. Lenders gained markets which facilitated growth and technological development. Despite these benefits, the imbalances placed financial system under stress - which led to a crash in 2008. To prevent a possible world depression, leading economies (especially US) have taken bold monetary / fiscal measures - which will increase deficits and inflationary risks, and put pressure on exchange rates. US access to capital will be weaker in future - and with a weaker financial superpower the world will be less prosperous / stable and more dangerous.

US-Japan Relations and the international system: In post war era US imposed its blueprint for reform on Japan - which emerged as a capitalist democracy. With expanded trade, Japan became the world's second largest economy in the 1980s and was seen as the US's main economic rival. However with Japan's lost-decade from 1991-2003 (featuring asset deflation and economic stagnation), China became the main economic threat to US. Over past 30 years, US has had ever larger current account deficits with China, Japan and Persian Gulf states. Its deficits reflect that fact that US is in the habit of spending more than it saved - and borrows heavily from China and Japan. The US has shifted from world's largest creditor to largest debtor - and diminished its power. Mercantilist finance: In 18th and 20th centuries UK practised 'mercantilist trade' whereby raw materials were extracted from colonies, converted to manufactures and then sold back at a profit. Since end of Bretton Woods in 1973 US has had a less overt and more effective approach to global exchange - 'mercantilist finance'. US leveraged $US (dominant instrument of international transactions) to borrow massive sums to under-write soaring debts. Ability to borrow from world has given US great fiscal flexibility and autonomy in monetary policies. This has been the source of its power as world's mightiest state/ Because Japan and China were willing to hold US Treasuries, US has been able to spend without concern about the cost of borrowing (thus enabling it to finance both costly wars and domestic services). Others were willing to lend because they depend on export access to US markets, and US Treasuries were considered safe. If others stopped underwriting US debts, US would have to cut consumption or pay high interest rates. Mercantilist finance sustained US power despite US's lopsided imbalances. .

Post-Bretton Woods; international capital recycling: International Capital flows from Asia to US US dependence on Japanese and Chinese capital is historically unique - involving recycling of savings from non-western countries to advanced industrialized west with poor savings and high spending. Creditors face the risk that dollars will devalue while US faces possible inflation and $ devaluation..Creditor states have been still willing to lend because they have not yet generated sufficient domestic demand - which thus required an emphasis on exports. Faustian bargain: Benefits have come from lending (eg growth, technological advance). This, for example, allowed China to create enough jobs for migrating rural workers - and preserve social and political order. American innovation: new products, industries and sectors The world has benefited from US spending, while its entrepreneurs have used borrowed capital productively with new products, technologies and industries. US financial engineering: asset backed securities and derivatives However US financiers have produced large array of new non-transparent, unregulated instruments (eg derivatives, CDOs, credit default swaps) which expanded global lending and risk taking. This expanded exponentially global levels of leverage. An obscure catalyst (sub-prime mortgage defaults) brought the whole over-leveraged structure down. Lehman Brothers failure crashed stock markets and froze credit. The US failed to act as prudent guardian of world's leveraged assets and wealth. World is now struggling to deal with severe economic meltdown - a largely 'made in America' toxic product. Complex interdependence: symbiosis US and its biggest trade partners are locked in symbiotic relationship - as US runs large deficits in exchange for capital inflows while China and Japan hold US Treasuries in exchange for job-creation, technological development, growth and socio-political stability. This brings benefits to all, and all face costs in breaking arrangement (which became ever harder to maintain). However the financial crisis has disrupted this system.

A sea of US debt: Under mercantilist finance system, US has run up huge debts, and become ever more dependent on foreign capital. Unsustainability US borrowing can't be sustained at current rates. If deficits continue at 5% of GDP pa, in 10 years US net international investment position would make further borrowing impossible. To contain deficits to 3% of GDP would require politically impossible cuts - so in 2009 US has been sliding into a dangerous debt trap.

US Treasuries: Chinese and Japanese lending to US: China and Japan have bought over 50% of US Treasuries. China amassed $1tr in a decade - while expanding its foreign reserves from $400bn in 2001 to $2tr. Carry costs: net losses Governments don't simply hold foreign reserves passively - but sterilize them by issuing central bank debt (or expanding commercial bank reserve requirements). Such governments have to pay interest on the debt issues - and can lose money of the US Treasury yield is lower (resulting in a 'carry cost'). There can also be reserve asset losses associated with exchange rate risks, or the cost of hedging against possible losses. Also if funds are placed in sovereign wealth funds (as China did, but not Japan), they run risks of losses. Japan: positive returns As of 2009 Japan held $1tr in foreign reserves (88% in US Treasuries). It had been doing this for longer than China, had a sound private banking system in place - and so gained more than China from its foreign reserves (making net gains of around $280bn) . With US economy in crisis and currency values fluctuating, Japanese authorities are concerned about risk of yen appreciation. As US Federal Reserve cut its interest rates to near zero the interest rate differential favouring Japan has disappeared - and $US depreciation could cause Japan large losses. Thus Japan has had a 'weak yen' policy. China: losses As of 2008 China held $over $1tr in US government debt - and managed this through both institutions which commercially seek to backstop China's banks and others whose approach is less open. Since 1999 China has lost about $300bn - resulting in criticism of the agencies responsible. Governor of China's central bank has proposed the expanded use of IMF special drawing rights as an alternative to $US. Unloading $US holdings would be costly for Japan and China - and failing to purchase new securities would be self=defeating at present.

Japanese and American financial crises: Current financial meltdown has wiped out $40tr - about 2/3 world's 2008 GDP, and there is no end in sight. This has led to comparisons with Japan's 'lost decade' (1991-2002). Is US headed for lengthy stagnation, asset deflation and potential inflation? Similarities Both crises emerged from real estate bubbles, inflated by a sea of liquidity, easy credit, low interest rates and unwise investments. Central banks cut interest rates and held them down too long. Real estate bubble always involved excess lending and entangle banks in non-performing loans . There is a need for governments to restore health to financial system before economy can recover. Differences US crisis is larger and more global than Japan's and harder to unwind. Japan's bad loans *$1.6tr) were about 40% of GDP. By 2007 securitized debt ($63tr) exceeded global GDP with write-offs by the end of 2009 likely to be $3tr. Also crisis is global. During Japan's crisis it alone was weak - now all major economic regions are weak together. Government responses: US government response has been faster, bigger and hopefully more effective. Unprecedented monetary / fiscal policy has been brought to bear. US officials had more freedom of action than those in Japan. Implications Fed will need to continue selling US Treasuries and hope there are customers. Interest rates will rise and recovery strengthens. $US and Euro both seem headed for devaluation. Inflation is a way of dealing with unsustainable national debts (the Latin American solution). If US and Europe try to devalue, China and Japan may use $ reserves to intervene in foreign exchange markets - resulting is a race to devalue. As financial crisis grew out of US financial engineering, many leaders worldwide has criticised US. Anglo-American paradigm of market capitalism has been seriously damaged. Confidence in US financial institutions / opaque derivatives has been shaken. With this 'Made in America' mess, US financial hegemony is waning.

Conclusions: Global rebalancing Current crisis has (a) pushed many big financial institutions towards insolvency (b) contaminated securitized debt financing (c) debated mark-to-market values of derivatives (d) collapsed over-extended leveraging (e) contracted credit {f) crashed equity values (g) forced states into deficits to stimulate demand and (h) put flexible exchange rate system at risk. An altered global financial system is evolving - with less capital recycled from Asia to post-industrial states. US will curb spending, and increase savings while Asia will increase domestic consumption. The adjustment has been traumatic because it was quick. US savings went from zero to 4% of GDP in year. China's private consumption will likely rise from a low 36% of GDP to 45-50%. There is no reason China can't make transition to domestic demand driven economy. Overall effect on US's power and leadership remains to be seen. Outcome could be more stable as world needs to have China, Japan, India, Brazil, Russia, Germany and others generating more demand. America's multilateral orientation While US will attract more capital, this will be at a reduced rate. US faces daunting task of paying from years of profligate spending. Domestic needs will take precedence over foreign wars. Soft power diplomacy will be emphasised - and support will be needed from allies such as Japan and Europe. A reorientation of US-Japan relationships Japanese leaders fear that US will pay attention only to China. However China's rise makes Japan (and other allies in the region) even more important to US. US and Japan have shared interests eg in renewable / clean energy; environmental protection; health care - and in these areas Japan has useful contributions to make. Japan can also play lead role in stabilizing regional finance (eg via Asian currency swaps, bond markets, common Asian currency). Financial crisis has been more damaging that 9/11 attach on WTC. Crisis has shaken financial foundations of global economy. After-shocks will bring down unstable political regimes, increase the number of failed states, increase poverty, exacerbate conflicts, foster extremism and set back globalization. Even with vigorous leadership it will take years to restore normalcy - and the world may become less stable / prosperous and more dangerous.