Originally published in THE BOSTON GLOBE
Tuesday, October 12, 1999
Economy in Fed's hands
By Martin and Kathleen Feldstein
Japanese woes have relatively little impact on US
When the finance ministers of the seven leading industrial countries met in Washington recently, they focused on the problems of the Japanese economy. Japan has had virtually no growth and rising unemployment for nearly a decade and the recent sharp increase in the value of the yen now threatens Japan's nascent recovery by depressing exports and increasing imports.
The foreign finance ministers, led by the United States, advised Japan to increase the rate of growth of its money supply to stimulate the domestic economy and to weaken the yen. The Japanese government, which strongly favors a weaker yen to help Japan's exports, provided ambiguous signs that it would accept this advice and called upon the US Treasury to help by selling yen and buying dollars. Such coordinated intervention, the Japanese argue, is needed to convince financial markets that the yen is actually going to decline.
The US advice is, not surprisingly, based on Washington's perception of what is good for the United States. Our officials believe that a weaker yen, by reducing the cost of our imports from Japan, will help to hold down inflation in the United States. Stimulating the Japanese economy by faster money growth in Japan would also help the United States by increasing Japan's appetite for imports, thereby shrinking the massive US trade deficit. While the United States has not committed itself to intervention in the yen-dollar market, it has made it clear that such intervention will definitely not happen unless the Japanese expand their money supply.
The situation is complicated, however, by the outright refusal of the Bank of Japan, which controls the Japanese money supply, to go along with the policy of faster money growth. Since the Bank of Japan, like the US Federal Reserve, is independent of the government, the Tokyo politicians cannot deliver faster money growth even if they want to.
The result is a stalemate. The yen remains relatively strong and the Japanese economic outlook is doubtful at best.
Should we in the United States be worried? No. Although Tokyo's monetary policy is important for the Japanese, it has relatively little impact on the US economy. It is wrong to think that Japanese actions hold the key to US inflation or to our trade deficit. The actions of the Federal Reserve and the US Congress are far more important than anything that happens in Tokyo. A policy stalemate in Japan should not be an excuse for permitting inflation to rise in the United States or for our growing trade deficit.
Consider the effect of the yen on the US rate of inflation. Since we import about $150 billion a year from Japan, i.e, less than 2 percent of total spending in the United States, the direct effect of a 10 percent fall in the yen would lower the US price level by only about 0.2 percent. This relation is not exact for two reasons.
First, many Japanese exporters base their pricing on US market conditions and would not pass through the full decline in the exchange rate. Second, lower import prices would induce some US firms to keep down their own prices. Nevertheless, it is clear that a 10 percent decline in the yen would have very little effect on the US price level. Moreover, any such reduction would be only a one-time effect. If the yen stabilizes at a 10 percent lower value, there would be no continuing impact on inflation.
US inflation depends primarily on what happens to US wages and productivity. That's why the Federal Reserve is correct to focus attention on the tightness of the labor markets and on what is happening to wages and other forms of compensation. The impact of import prices in general, and the prices of imports from Japan, in particular, are of very much secondary importance.
What about our overall trade deficit? The excess of our worldwide imports over our total exports is likely to be almost $300 billion in 1999. Even if easier money in Japan could cause the growth rate of the Japanese economy to rise from 1 percent to 4 percent (a far bigger increase than anyone expects would happen with easier money), the resulting increase in Japanese imports would have a very small effect on the US trade balance. If an extra 3 percent rise in Japan's GDP raises its imports by 3 percent, US exports to Japan would rise by about $4 billion, less than 2 percent of our current trade deficit.
Moreover, a weaker yen, by reducing the price of Japanese goods, would raise our imports and reduce our ability to export to Japan and to other countries where we compete with Japanese products. The US tends to ignore this when we focus on the possible effect of faster Japanese money growth on Japan's GDP and therefore on its imports from the United States. The fact is that the dollar is overvalued relative to our trading partners. At some point foreign investors who make it possible for the United States to run a large trade deficit will reduce their demand for dollars, causing the value of the dollar to fall. When that happens, our exports will be more attractive around the world and Americans will want to substitute US products for foreign imports. Since all of that will tend to be inflationary, the Federal Reserve will have to be certain that there is enough unused capacity in labor and product markets to absorb these increases in demand for American output.
The great danger in the international discussions is that they suggest good performance at home depends on what other countries do. That is wrong. Our nation's ability to sustain low inflation while the trade deficit returns to a more sustainable level depends on what happens at the Federal Reserve and not at the Bank of Japan.
Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.