Late in December, 1989, the index of prices in the Tokyo stock exchange closed just below 39,000. This April, it fell below 16,000, a decline of nearly 60% in a little more than two years. Although the index rebounded from its recent lows, there is little chance that investors in Japanese stocks will see an early return to the once lofty values.
The fall in the Tokyo market has wiped out all of the gains since 1986. But the Tokyo decline did not spread to the rest of the world. Market indexes in most countries were higher at the end of April than in the previous December and far above 1986 levels. Tokyo was clearly out of step.
At first glance, this seems surprising. From frequent repetition, investors know that world markets for goods, bonds and shares are related: We live in a global economy, and events abroad have impacts at home. Financial assets are mobile. Investors can now move their wealth from country to country with a telephone call.
Most investors recall that the October, 1987, stock market crash was not confined to New York. Prices in all countries declined, some more and some less than New York. The Tokyo market was one of the latter; prices fell less than in New York, and they recovered more quickly. Despite the differences of timing and magnitude, however, linkage seemed to be present.
Why then and not now? Is there less to interdependence and internationalization than we have been taught to believe?
Discussions of the global financial marketplace usually neglect the role of exchange rates. In 1987, fixed exchange rates at first spread stock market collapse around the world. In 1991-92, fluctuating exchange rates worked to insulate markets in the United States, Europe and Asia from the deflationary effects of Japanese monetary policy.
The essential difference between fixed and fluctuating rates is the decision about what central banks, such as the Federal Reserve Board or the Bank of Japan, are permitted to do. An exchange rate is the price of one money in terms of another. With fixed exchange rates, the price is fixed. Central bankers keep it fixed by issuing more money if the value of domestic money starts to rise relative to foreign money (the exchange rate appreciates) and reduce money in circulation if the exchange rate depreciates.
A fluctuating exchange rate lets the central bank decide on the amount of money issued or withdrawn. If the bank issues too much, the value of each unit goes down; domestic prices rise and the exchange rate falls. If they issue too little, or withdraw too much, domestic prices fall and the exchange rate rises.
In January, 1987, Treasury Secretary James Baker and the finance ministers of Japan, Germany and other industrial countries, meeting at the Louvre, agreed to manage exchange rates within a narrow band. Exchange rate targets were not announced, but a rate of about 145 yen per dollar prevailed until late October.
To maintain this exchange rate, the U.S. had to follow a disinflationary policy, Japan an inflationary policy. U.S. money growth fell, particularly in the July to September quarter that preceded the October crash. Japan's central bank expanded bank reserves and money at the fastest pace in the decade.
Although there is no single cause of the 1987 stock market crash, exchange rate policy made a major contribution. This view was apparently shared by the Fed and the U.S. government. Within a day of the stock market plunge, they abandoned the Louvre agreement, expanded money and allowed the dollar to fall.
Although stock prices continued to fall modestly for a few weeks, stock price indexes, first in Japan and later in the United States, resumed their rise.
Inflationary policy continued in Japan after the stock market crash. In a major departure from its cautious policy before the Louvre agreement, the Bank of Japan pumped out reserves at 10% to 12% a year, far in excess of the growth of Japan's economy.
As anticipation of inflation rose, asset prices soared, particularly prices of land and buildings. Most of the major Japanese banks own shares in the principal Japanese corporations, and many of the corporations have large real estate holdings in Tokyo, Osaka and other cities.
Share prices rose, reflecting the rise in real estate values and the temporary boom in the Japanese economy brought on by unexpectedly rapid money growth.
By late 1988, the Japanese could boast that the value of all shares on the Tokyo stock exchange was 40% higher than total share value on the New York Stock Exchange or that the value of the land in downtown Tokyo was worth more than all the land in California. At the end of the 1980s, land prices in Osaka rose even faster than in Tokyo.
These oddities fed Japanese egos and American paranoia. It was time to sell.
Since January, 1990, the process has worked in reverse. Growth of bank reserves has slowed sharply. By March, stock prices were 25% below their peak.
Land prices that had risen in anticipation of inflation reversed direction. As stock prices and land prices fell, many small banks and other mortgage lenders found their equity wiped out.
Japan now has its own version of the property market bust that is familiar to residents of Boston, New York, Los Angeles, London, Sydney and many other cities around the world. Excess space means low income, falling values, often followed by default or slow payment of mortgage loans.
The initial effect of slower money growth is usually a temporary decline in economic growth and recession. On average, Japan's industrial production fell at an annual rate of 12% for the quarter ended March 31 and 5% for the previous 12 months. (By comparison, U.S. industrial production rose 2% for the 12 months.)
Fluctuating exchange rates insulated U.S. markets from developments in Japan. In the run-up to the Gulf War, prices on both markets fell, reflecting worldwide uncertainties. Once the war was over, stock prices rose in New York but fell in Tokyo. The dollar fell against the yen until last December. Then it reversed.
Given Japan's monetary policy, a fixed exchange rate in 1991 would have imposed slower money growth on the United States. In this case, the Fed would have more closely matched Japan's deflationary policy.
Instead of rising, stock prices in New York would have headed south, responding to fears of further decline in real estate prices and deeper recession. Those who urge international policy coordination may wish to remember this period.
This is not the only possible outcome. If we take U.S. monetary policy as the given, a fixed exchange rate would have required Japan to abandon its deflationary policy. That option remains available to Japan in the fluctuating rate system.
Global markets need a safety valve to partly disconnect wealth and income from destabilizing policies produced abroad. Exchange rates, if allowed to move freely, buffer these disturbances. Although the buffer is far from perfect, experience in 1987 and 1991-92 suggests how valuable the buffer can be.