For the foreseeable future, the United States will run a sizable current-account deficit, while Japan will continue to post an equally large current-account surplus. Forecasts for the respective balances are in the range of $120 billion to $130 billion.
Due to the imbalance in domestic savings rates, there is a need for a significant flow of Japanese savings into U.S. coffers. However, as a consequence of the phenomenal strengthening of the yen against the dollar in recent years, Japanese investors in dollar-denominated assets already feel badly burned. The value of these assets has eroded in a spectacular fashion. Some observers estimate their losses to be in the range of $300 billion.
Under these circumstances, it is quite unlikely that Japanese investors will be keen on re-entering the market to buy U.S. assets with dollars in a significant volume.
This leads us to a conclusion discomfiting for all major economies: The dollar would become even weaker and, in order to defend its eroding currency, the United States would have to raise interest rates significantly above the levels indicated by conditions in the domestic economy. Its current upswing would be an obvious victim along the road.
Japan's domestic economic problems would also worsen. Over the past year and a half, the country has--for the first time in its postwar history--seen domestic production capacity lie fallow. In the process, an outright culture shock has hit Japan. It has had to cope with the unwelcome fact that the bureaucrats have proved themselves incapable of managing the economy according to plan. In addition, the resulting shift toward investment outside of Japan will do little to stimulate the opening up of the country's domestic economy.
What can be done in the light of these circumstances? One constructive step would be if the U.S. Treasury, or at least some government agency, began to issue yen-denominated paper (bonds whose value is in yen rather than dollars). This approach would have several advantages.
First, the markets have been telling the U.S. government--despite its reasonable assurances--that they are not certain whether the Clinton Administration can be relied upon not to use the exchange rate as a tool to promote U.S. competitiveness. Right or wrong, as long as that perception is out there, the politicians in Washington are forced to deal with it.
Issuing yen-denominated U.S. Treasury bonds would provide crucial comfort to Japanese institutional investors. With new bond assets denominated in the yen, they would no longer have to assume the exchange-rate risk. It would therefore go a long way toward enticing the Japanese to once again recycle their trade surplus.
But more important, it represents a very potent tool to convince the markets of the credibility of the Clinton Administration's intentions. By taking this step, it would show itself prepared to put its money where its mouth is. By using a foreign currency to fund part of its debt, the U.S. government effectively assumes the exchange-rate risk on such debt. In other words, it would stand to lose if the dollar went down even further. Under this scenario, it would get fewer yen for the dollars it budgeted to service that debt and would thus be forced to spend more dollars than planned.
While this may sound dangerous at first sight, the downside risk is very much worth taking. Aside from eliminating the nagging doubts about the real intentions of the Administration, these yen-denominated Treasury instruments could be issued at interest rates below current U.S. levels. Given the lower level of interest rates prevailing in Japan, they would still be very attractive to investors in the yen zone. Obviously, this would also help reduce the potential costs of the exchange rate risk mentioned above.
What should be the size of such yen-denominated U.S. public debt? While obviously limited in scope initially, this kind of funding could eventually be as high as the Japanese share of the U.S. current account deficit. That amounts to roughly $70 billion, which coincidentally is equal to one-third of the federal budget deficit.
Why should I, a European, be concerned about all this? First, none of the world's major industrialized economies benefits from wild swings in exchange rates. Second, we Europeans have worked hard at home to bring about exchange-rate stability. Against much skepticism in the markets, and due to an ever-increasing degree of coordination in economic and fiscal policy as well as a result of greater trade integration, we are reaping the benefits of such stability within the European Monetary System.
However, there always is a danger that this delicate balance may be upset, primarily due to extraneous circumstances (for instance, great volatility in the dollar-yen exchange rate.). Such cross-rate pressures may well have significant spillover effects on European currencies, thus upsetting the balance established within the system.
Yet there is an even more important issue. Europe currently finds itself the bystander in what it considers to be an unproductive fight on trade issues between the United States, the world's sole remaining superpower, and Japan, a country without much of a functioning government and therefore in some disarray. This dispute leaves the world financial system vulnerable. If we were to see domino effects, for example as a result of overleveraged Japanese firms collapsing due to an excessive use of the exchange-rate weapon and a potentially unaware lender of last resort (the Japanese government), the world financial markets might be at risk.