Economists' Forum

By Lawrence Summers A rising Asian power has emerged as an export powerhouse and enjoys rapid, export-led growth fuelled by extraordinarily high savings and investment rates. Its technological capacity is upgraded at prodigious rates and its businesses threaten an ever greater swathe of industry in Europe and the US. Its high level of central bank reserves and burgeoning current account surplus lead to claims that its exchange rate is being unfairly manipulated or, at a minimum, should be guided upwards. Its financial system is bank-centric, heavily regulated in ways that favour domestic institutions and has close ties to government and industry. Rapid productivity growth holds down product prices but asset price inflation is rampant. US congressional leaders demand radical action to contain the economic threat. Delegations of senior US economic officials engage in “dialogue” with their counterparts about the many aspects of the country’s 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 and with China today. It also describes the Japanese economy in the late 1980s and early 1990s before its lost decade of deflation and considerable deterioration in its international relations. While 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 for China and its partners from the earlier Japanese experience. The definitive history of Japan’s dismal decade has yet to be written. But almost all knowledgable observers would agree that significant elements included the bursting of the 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 demand-led growth once consumer and business confidence had been lost. In retrospect, Japanese officials made several important policy errors. In order to avoid further yen appreciation after the 1987 Louvre agreement, they followed easy monetary and financial policies that gave rise to huge asset price bubbles and expansions in credit that set the stage for the subsequent downturn. They failed, at a moment when consumers were enjoying record increases in wealth, to encourage a shift to domestic demand-led growth. They also allowed problems in the banking system to fester rather than confront them directly. The result of these mistakes was that Japan did less than it could have done to prevent the serious problems of the 1990s and was not well positioned to address them when they arose. This suggests that if China is to sustain rapid growth and not run into the kinds of problems that Japan encountered, now, when the sun is shining, is the time to fix the policy roof. Allowing the 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 exchange rate at or near its current level could require as much as $400bn in reserve accumulation in 2007, which would almost certainly lead to rapid asset price inflation as renminbi were created to buy dollars. Also, there will not be a better moment to address issues in the banking system. These lessons contrast sharply with those drawn by some observers in and out of China, who attribute Japan’s deflation and consequent poor performance to its willingness to accede to US pressure for exchange rate appreciation. This alternative view offers no explanation for Japan’s asset bubble and collapse and no theory of what measures could have been taken that would have spurred domestic demand-led growth. An additional lesson is the need for modesty regarding economic policy dialogues that seek to create pressure for change. Events and national and political decisions, not international communiqués, shape economic outcomes. The impact of events beyond the control of governments – the collapse of Japan’s asset markets, information technology’s spur to US productivity growth, the Asian financial crisis – dwarfed the issues debated in economic dialogues. Even where government policies might have significant impact, there is no evidence that Japan in the 1980s and 1990s made any changes in domestically sensitive structural policy areas such as housing finance, social security or retail regulation in response to the US Structural Impediments Initiative or its successors. Policy in areas of this kind is shaped by domestic politics; if heavy-handed pressure makes it easier for special interests to invoke nationalism as they resist change, high-profile dialogues can be counter-productive. In a world where goodwill is scarce, heavy-handed dialogues engender resentments that spill over into other spheres. It was a cliché in US-Japan relations during the late 1980s and early 1990s that the US-Japan link was the world’s most important bilateral relationship. Given China’s greater scale, more 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. The writer is Charles W. Eliot university professor at Harvard