You pat my back, I'll pat yours: while many Americans resent Japan's hunger for foreign investments in the eighties, we may yet feel nostalgia for the rising yen.

While many Americans resented Japan's hunger for foreign investment in the Eighties, we may yet feel nostalgia for the rising yen.

DURING THE 1980s, the U.S. often quarreled with Japan over her import barriers and aggressive export strategies, but the two countries had highly complementary macroeconomic policies. The U.S. needed foreign capital to compensate for her low domestic savings rate and large budget deficits. Japan-because of her austere fiscal policies and high private savings rate-had excess cash and was willing to funnel it to the United States.

In addition, Japan was extraordinarily protective of the United States in the conduct of her fiscal and monetary policies. Since the mid 1980s, the overwhelming priority of Japanese public policy has been to promote international economic harmony by helping America to cope with her financial difficulties. First, the Japanese pursued highly stimulative macroeconomic policies after 1986 and more than doubled the level of their manufactured imports. Second, during the dollar crises of the late 1980s, Japan intervened on a large scale to help stabilize the U.S. financial markets. The Ministry of Finance (MOF) purchased nearly $60 billion of U.S. dollar securities. The Japanese central bank attempted to restrict credit growth not by raising interest rates but through controls on bank lending. The MOF even requested the big Tokyo insurance companies to stop selling U.S. Treasury bonds. Finally, unlike some other allies (such as Britain) Japan has strongly backed the Brady plan to provide debt relief for Latin America. Boosting the economies of Latin America, according to the MOF, is a good way to stimulate U.S. exports.

To be sure, because Japan is so dependent upon America for trade and military security, her support for the U.S. financial markets reflected self-interest as well as altruism. If there had been an election-year recession in the U.S., it might have provoked an even sharper swing toward protectionism than we in fact saw. Many Japanese industries also endorsed the MOF'S dollar-support operations because of concern about excessive yen appreciation damaging their own competitiveness. But irrespective of her short-term motives, Japan deserves considerable credit for recognizing as early as she did the global implications of her new creditor-power status. This was in striking contrast to America's behavior during the 1920s, when she displaced Britain as the world's leading creditor power. At that time, the U.S. helped set the stage for the Great Depression by failing to recognize the public-policy implications of her new role. Despite America's large capital exports, the U.S. Congress enacted two major tariff hikes which made it difficult for other countries to service their debts by increasing exports to the United States.

Sayonara?

ALTHOUGH the United States and Japan continue to have a strong interest in working together, the relationship now faces a series of threats.

First, Japan will soon have to comply with several new American trade demands or face sanctions. This spring it has to satisfy both the Administration and Congress that it has taken effective action to comply with the 1988 omnibus trade bill by opening its markets for supercomputers, wood products, and satellites.

Meanwhile, American and Japanese bureaucrats are locked in a complex round of negotiations over the removal of several so-called "structural impediments" to trade. The SII talks were originally conceived by the U.S. Treasury as a complement to Super 301, but several Democratic congressmen now want to add SII to the 1988 trade bill itself [See also "Tricky Dick ... Gephardt," p. 26.1 If they do, Congress would effectively be demanding that Japan undertake the most far-reaching changes in her laws governing land use, retail distribution, and taxation since the American occupation. Some Tokyo officials actually favor such reforms because they would enhance the efficiency of the Japanese economy, but there are powerful domestic interest groups opposed. America's demands are also coming at a time when Japan has a relatively weak government. In 1989, the ruling Liberal Democratic Party lost control of the upper house of the Diet. Despite his election victory in the lower house, Prime Minister Toshiki Kaifu has such a narrow political base in his own party that he may be replaced later this year.

A second major threat derives from the passing of the cold war and Japan's rapid advance as a formidable competitor in high technology. Japan is increasingly viewed as a challenge to traditional American beliefs about the effectiveness of laissez-faire trade and industrial policies. As a result, many American intellectuals and journalists believe that the fading struggle between capitalism and Communism is to be replaced by a new competition between Asian corporatism and American capitalism. There is also the temptation to make Japan a scapegoat, blaming our trade deficit on Japanese microeconomic rigidities rather than American macro imbalances.

Ironically, one of the most strident critics of Japan has been Arthur Laffer, the original high priest of Reaganomics and thus one of the men most responsible for the dramatic expansion of Japan's trade surplus in the 1980s. In his January newsletter, Mr. Laffer expressed a bewildering mixture of anger and resentment at Japan's new global financial role:

On a public-policy level, Japan is far and away the world's most dangerous nation. By analogy, they are the equivalent of an immature teenager with a fully gassed Corvette or a 13-year-old with a loaded shotgun. . . . The irrational behavior of well-to-do adolescents is legendary. They start wars. Qaddafi without oil money would be nothing.

Hostility toward rich foreigners is not a new phenomenon. During the late nineteenth century, Britain emerged as the great bogeyman of American political debates about the cause of low farm prices and high real interest rates. Britain was then America's primary creditor, and the dollar was linked to the pound via the gold standard. The 1896 Democratic platform even referred to the gold standard as a "form of financial servitude to London." But while there is ample historical precedent for America's new economic nationalism, it is the Japanese, not the Americans, who should be worried about the consequences of so much of Japanese savings being diverted here. Japan's large capital outflows are depressing the yen and increasing Japanese interest rates while reducing America's own capital costs. In March, America's real bond yields were slightly lower than Japan's despite the wide gap in the two countries' savings rates. As low capital costs have been one of the major underpinnings of Japan's high rate of investment, the outflow of money may do more to alter Japanese business practices and investment patterns than all the demands being made by U.S. negotiators.

The third great threat is growing concern within Japan about the asset inflation which resulted from the subordination of Japanese monetary policy to dollar-support operations. Between 1986 and 1989, price-earnings ratios tripled and property values soared. Now this asset inflation has become a source of great social and political divisiveness. In January, the new governor of the Bank of Japan, Yasushi Mieno, rocked Tokyo's financial markets by suggesting that interest rates should be hiked in order to depress rising land prices. During 1987-88 Mr. Mieno was a fierce critic of Japan's pro-dollar policy, and he now wants to overshoot the other way. The MOF has resisted his advice on the grounds that the asset inflation reflects supply distortions in the real-estate market, not just monetary policy, and that severe monetary tightening would conflict with Japan's new role as an anchor for global monetary stability.

But while the surge in Japan's asset prices has not yet triggered a broad rise in retail prices, it does pose inflation risks. Because of the high price of domestic land and equities, Japanese investors have been expanding their foreign direct investment and equity purchases to levels which now exceed the current-account surplus. As a result, The yen is weak and import prices are rising. When Japanese capital outflows were targeted primarily on foreign bond markets, the yen did not fall sharply because purchases were often hedged. But since the Japanese do not usually hedge foreign real-estate and equity purchases, it will be difficult to stabilize the yen without some mixture of higher interest rates and lower asset prices within Japan.

Enter Germany

THE FINAL great threat to the yen-dollar axis is the probable effects of German reunification on global capital flows. It is quite possible that the costs of reintegration will push Germany's public-sector deficit from 1 per cent of GNP in 1989 to 5 or 6 per cent next year. Private investment in East Germany could be as high as 500 billion marks during the next few years. After a decade of global macroeconomic harmony resulting from highly divergent savings behavior on the two sides of the Pacific, the international system must now contend with a lurch toward fiscal overconvergence on the two sides of the Atlantic. Instead of being Nippon's automatic borrower and spender of last resort, America is now heading into a financial monage d trois which will include a capital-hungry Europe and a less thrifty Japan. If Americans resented Japanese financial power when the MOF was protecting the dollar, what will they think when Japan decides to divert more of its shrinking pool of surplus savings to Europe?

The good news for Japan is that a reunified Germany could ultimately emerge as a target for some of the economic xenophobia which Americans now reserve for Asia. The new Germany will have eighty million people and a GNP equal to 35 per cent of America's. Like Japan, Germany was a late industrializer and has a corporatist economic tradition. In contrast to the Japanese, German officials also have a long history of publicly scolding American policymakers. As this Teutonic tendency toward outspokenness is unlikely to shrink as Germany's economy expands, Washington could easily find itself turning back to Tokyo for consolation when quarrels with Berlin develop. In fact, we may see a dramatic realignment of American international economic policy. Since the mid 1980s the U.S. has criticized other industrial countries for oversaving and underconsuming. But if Germany's new capital needs continue to push up world interest rates, the Administration is likely to rethink the advice it dispenses to Europe and Japan. Indeed, might we see, at this June's G-7 conference in Houston, Mr. Bush rising to express alarm about the high level of world interest rates, to criticize countries that hog surplus savings through profligate budget deficits, and to announce that it is time for a large tax increase-in the Federal Republic of Germany?