Originally published in THE BOSTON GLOBE

Tuesday, March 3, 1998

Asian crisis began with country's economic shortcomings

Japan's the cause, not cure

Martin and Kathleen Feldstein

"The policies followed by Japan have indeed been a primary cause of the economic crisis that has now spread throughout East Asia."

Japan has been pursuing an economic that has both failed to revive the stagnant Japanese economy and has been a major contributor to the regional financial crisis that has swept Asia since last summer. But while a turnaround in Japan would be welcome news for the region, it cannot be enough by itself to reverse the collapse that is now so widespread.

The United States has been the leading critic of Japanese policies, but is now joined by the other countries of the G7, whose finance ministers and central bank heads met recently in London. Japan's economic growth has averaged less than 1 percent a year for the past five years, and its unemployment rate has been creeping up steadily since the beginning of the decade. But the Japanese government, fearful of growing budget deficits, has responded to the slump with weak half-measures that have been ineffective.

The G7 leaders are calling for Japan to stimulate its economy in the good old-fashioned way: by cutting taxes to stimulate spending by households and businesses. The increased imports from neighboring countries that would result from stronger Japanese demand would help to stabilize the whole trading region.

While we agree with both the criticism of and the prescription for Japan's policies, we think the G7 ministers are wrong to suggest that the right policy for Japan will also solve the regional collapse.

The policies followed by Japan in the past decade have indeed been a primary cause of the economic crisis that began with Thailand last summer and that has now spread throughout East Asia. Because it was unwilling to use tax cuts to stimulate the economy, the Japanese government in the early 1990s instructed the central bank to cut interest rates. The official discount rate went from 6 percent in 1991 to 2 percent in 1993 and has recently approached zero. The interest rate on 10-year government bonds is less than 2 percent.

This decline in interest rates and the persistent weakness of the economy have caused the yen to fall in value from 90 yen per dollar in the first half of 1995 to about 125 yen per dollar now. The currency depreciation has led to an enormous trade surplus, but that has not been enough to drag the economy out of its doldrums.

The same decline of the yen was a major cause of the currency collapses in Thailand, Malaysia, South Korea, Indonesia, and the Philippines that began last summer. This has included a vicious circle of exchange-rate movements to maintain trade competitiveness. The currency depreciation quickly spun out of control and became a crisis on its own. To compound the problem, Japanese banks made irresponsible loans to these same countries. Faced with low interest rates and weak demand for credit at home, the Japanese banks were eager to lend and made most of these loans in dollars. Thailand and Malaysia, in particular, became dependent on large capital inflows from Japanese banks.

When the yen fell relative to the dollar, it became impossible for many of the Asian borrowers to service their dollar-denominated debts. The difficulties were exacerbated as Japanese banks suddenly reduced their foreign lending to stop the declining ratio of capital to loans.

Resolving the crisis requires different approaches for Japan and for the other Asian countries. Japan needs to work on two fronts to restore economic growth. It should reverse the misguided increase in the value added tax and jump-start consumer demand with a tax cut.

In addition, the financial sector in Japan badly needs better regulation and the discipline to close insolvent banks. The recently announced measures are little more than symbolic.

But even if Japan does follow an expansionary policy, whether in recognition of its inherent correctness or in deference to the pressure of its G7 trading partners, the G7 countries should not expect miracles to happen throughout Asia.

Japanese consumers would increase their demand for imports from other Asian countries, whose products would be more competitive as the yen increased. This increased demand, however, would not be enough to revive growth in those countries that accumulated large and unsustainable short-term borrowings from Japanese, American, and European banks.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.