Tokyo Stock Market Goes Crashing Through a Cliche

We live in an integrated world economy. Everyone knows this, but many people still proclaim the integration of the world economy as if it were a daring, radical discovery--what I think of as the “gee-whiz” school of international economics.

In fact, it is a crushingly conventional observation. We have been told about globalization, about the growing economic irrelevance of national boundaries, so many times that it has become a tired cliche. Like most cliches, it is mostly true, but not entirely. And it is always a good idea to challenge conventional wisdom, to try playing devil’s advocate.

Can we make the case that the modern world economy is not all that integrated, after all?

The answer is that we can, and events in Japan provide a nice illustration that we are still a long way from having a world economy that links the destinies of nations tightly. The global consequences of the Tokyo stock crash--or more precisely their absence--demonstrate a number of ways in which national economies remain sharply divided from one another.

Consider first the direct financial consequences of Japan’s crash. An enormous amount of money has been lost in the stock slump, which in terms of paper losses is one of the great financial disasters of the century.

But who has lost this money? The answer, overwhelmingly, is the Japanese themselves. Despite the rhetoric of world financial globalization, it remains true that there is remarkably little international diversification of portfolios. Americans hold mostly U.S. stocks, Japanese mostly Japanese stocks, Europeans mostly European stocks. Presumably, transaction costs and lack of information explain why; but in any case the important point is that the great bulk of the capital loss in the Nikkei’s slide is a Japanese, not a global, issue.

Next consider the indirect financial effects. The Japanese stock slump may depress some stock prices around the world. It is a good bet that Japanese firms, their net worth in dollars sharply reduced by the combination of the stock slump and the falling yen, will pause in their aggressive campaign of acquisition of foreign companies. The stock price of potential targets will therefore fall.

Also, some investors who fled the Tokyo market because of skepticism over its very high price-earnings ratios (skepticism that turned out to be amply justified) may return, shifting from stocks elsewhere. So some of the Nikkei’s fall may be spread around the world. But so far, at least, the damage has been remarkably contained. It appears that our global financial markets are still sufficiently Balkanized that one of the two major stock markets can experience a historic crash without dragging the rest down with it.

What about the real consequences of the crash? If the Bank of Japan does not aggressively offset the effects of the slump, lower stock and land values may depress both Japanese investment and Japanese consumer spending. Won’t this have an adverse effect on business around the world? Well, no--not so you would notice. The vast bulk of Japanese consumer spending, and most of its investment spending as well, goes for goods and services made in Japan; a slump will have only marginal effects on the demand for goods and services produced elsewhere.

But what about the fall in the yen, which has been (depending on whom you ask) either a cause or a consequence of the crash? Won’t that have important effects abroad?

Yes, it will, but they will be smaller and slower than many people seem to imagine, for two reasons.

First, despite growing world trade, prices and wages in major countries are set in domestic currency, and they are not much affected by currency fluctuations. Consider that the yen has fallen 25% against the dollar since early 1988. If we lived in a truly global economy, national currencies would be irrelevant, and the cost of living in Tokyo compared to that of New York would not change when the exchange rate did.

But have we seen U.S. prices fall by 25%, or Japanese prices rise by a third, during the past 14 months? By no means--the cost of living in New York in dollars, and that in Tokyo in yen, have hardly changed. So Tokyo has become 25% cheaper, simply because of a fluctuation in currencies. You won’t see the cost of living in Los Angeles fall 25% relative to that of Boston in the course of a year;that is the difference between a truly integrated economy, that of the United States, and the only partially integrated world economy we still live in.

Second, trade takes a long time to adjust. The fall in the yen has undermined years of efforts by U.S. firms to regain competitiveness with Japanese rivals, and will--if it continues long enough--lead Japanese firms that have begun to produce in the United States to think again. Eventually we will see a ballooning Japanese trade surplus, which will have ominous implications for international trade relations.

But these consequences will not materialize immediately. Indeed, the short-run effect of the lower yen will actually be to reduce the Japanese trade surplus, because it leads to lower dollar prices for Japanese exports (the so-called J-curve). It will be two years before the trade effects of the falling yen are really felt in earnest.

Isn’t there some way in which Japan’s spectacular financial bust will change the world economy? Aside from an eventual rise in Japan’s trade surplus because of the weaker yen, the answer is “probably not.” This is not just because the world economy is actually less of a village than the gee-whiz school imagines, but also because financial markets in general are less important than many people suppose. Just because financial markets are glamorous and trendy does not mean that they rule the world. Even in Japan itself, with intelligent management the stock crash need not lead to a recession. After all, the U.S. economy grew faster in the year after its 1987 stock crash than in the year before.

The 1987 stock crash turned out to be one of the great non-events of business history. Never has so much money been lost in such a short time with so few real consequences. The Japanese crash is already rivaling or surpassing the U.S. crash on the first two dimensions. Don’t be surprised if it is equally inconsequential.