MIM 513 Pacific Rim Economics, Trade and Financial
MIM 513 Pacific Rim Economics, Trade and Financial
Popular in Course
Popular in Department
This 128 page Reader was uploaded by Clean Copy Inc. on Tuesday September 24, 2013. The Reader belongs to a course at Portland State University taught by a professor in Fall. Since its upload, it has received 418 views.
Reviews for MIM 513 Pacific Rim Economics, Trade and Financial
Report this Material
What is Karma?
Karma is the currency of StudySoup.
Date Created: 09/24/13
K a c i f i c Rim co Y o a k Financial R m m ITO PBFL1300DOO815O N 1R P N X Y L E Pam rm cm Ra mm Pwm We assure compi ance with US Government mpy r gh39 iaw iE 2 iquot t 5S iquoti to dupiicate any matariais cmvered by caapyright Eaw has been secured Included Readings for MIM513 Paci c Rim Economies Trade and Financial Markets Fall 2013 Instructor Hiro Ito Professor of Economics Mosk Carl 2008 Japanese Economic Development Ch l0 l2 Routledge Transformation Blackwell Chow GC 2001 China s Economic Publishing p 24 67 Krugman Paul 2008 T he Return of Depression Economics and the Crisis of 2008 Chapter 3 Japan s Trap Krugman 2008 Chapter 4 Asia s Crash Baumol William and Alan Blinder 2003 Economics ninth edition Ch 33 34 and 35 10 The slowdown The inevitable reversal in the trend rate of growth During the early 1970s the golden age of convergence ended While the empirical symptoms of this watershed are manifold the story is most strikingly expressed in terms of growth rates for the Western European countries and Japan Between 1950 and 1973 the average growth rate in income per capita for twelve Western European countries those listed in Panel A of Table 71 W was 38 percent for Japan the corresponding growth rate was 80 percent Over the next two decades l97392 the average growth rate in income per capita was 18 percent for Japan 30 percent Japan continued to grow faster than the Western European countries during 197392 Still its growth was truly within the Western European range According to convergence theory countries with the lowest initial levels of per capita income should grow faster than those enjoying higher per person incomes The three Western European countries with per capita incomes in 1973 close to Japarfs level are Finland Italy and Norway Both Italy and Norway experienced per capita income growth as close to orcloser to Japan s than to the average for the twelve countries Indeed Norway s growth rate 29 percentw was nearly as high as Japan s growth rate Convergence theory suggests one important reason why the slowdown occurred as the converging countries approached the levels of the leading country the United States in terms of capitallabor ratios levels of technology and organization economic structure and scale economies their growth slowed Let us consider each element of this account in a bit more detail focusing upon Japarfs case From Table Al we can see that the Japanese capitaloutput ratio grew rapidly during miracle growth reaching American levels by the late 1970s Indeed after the early 1980s the Japanese ratio soared to dizzying heights far above that of the United States As more and more capital is accumulated and the marginal productivity of capital falls the incremental contribution to output flowing from more private and public capital from more factories more robots more trucks and high speed trains more roads and airports more hydroelectric lines declines The rate of return that investors in companies banks owners of stocks and bonds can reasonably anticipate garnering from the savings they plough into savings account and into equities drops This is an inexorable 306 Deceleratzon consequence of accumulation The Swar1n Solow model neatly captures this argiiinent In Figure 15 A of Chapter 1 the point is illustrated graphically with the attening off of the labor productivity curve with rising levels of per worker capital Indeed it 1S plausible that Japanese capital accumulation had become excessive by the rnidl980s While the ratio of investment to national income did drop after the early 19703 after all the relatively high rate of return on new capital acquisition was a rnaj or rationale for high rates of investment durnig miracle growth so that a fallo 39 in the rate of return should temper investment it remained high by the standards of the Western European countries and the United States Japan was steadfastly falling victim to its spectacularly high savings rate The second source of slowdown was the exhausting of technological catchup potential According to Panel B 2 of Table 81 advances in knowledge constituted a major source of growth in miracle growth Japan As Japanese f irrns within pan ocular industries closed the gap between themselves and the international leaders in that industry whether the leader is located the United States Germany the United Kingdom or Sweden W the gains to total factor productivity from ferreting out best practice technique and imitating it dry up Again this point can be illustrated with the SwannSolow model The pace of the upward drift in the labor productivitycapitalmlabor curve slows down for a nation as its firms switch from being followers to being leaders developing the technologies of the future within their research laboratories Two other sources of the slowdown can be gleaned from the Denison and Chung estimates appearing in Table 8 1 Gains from improved resource allocation were drained away during miracle growth as most of the farming population abandoned agricultural pursuits to take up jobs in the burgeoning industrial and service sectors By the early 1970s the proportion of the population making a living primarily from agricultural pursuits had fallen to such low levels that further gains from structural change were all but completely exhausted As the proportion of the sel eiriployed labor force dwindled less and less gain could be expected from shifts into salaried occupations As the economy grew to garganw tuan size less and less could be expected from scale economies Generating growth from improvements in output per unit of input was being steadily eroded as Japan converged toward American levels By the same token improvements in the quality of factor inputs illustrated in Panel Bl of Table 81 were also vanishing As more and more individuals went on to tertiary schooling M to two year junior college or founyear university the returns to schooling dropped discouraging the marginal applicants to higher education those lacking the drive to excel in the examination competition from attcmpnng to gain advanced educations The rate of growth of the advancement rate to high school and tertiary schooling declined As for the capital stock it is true that high rates of accumulation kept the average vintage of the stock young 1 hence more likely to be compatible with the latest technologies Working against this advantage was the fact that the pace of technological progress was slowing down In short less and loss was to be expected in terms of growth potential from improvements in the quality of capital and labor The slowdown 307 While the slowdown in Western Europe and Japan can be readily analyzed in terms of the SWaI1I1SOl0W model and the UBYIISOII and Chung growth accounting decompositions it would be misleading to limit our account of the slowdown to the within nation factors pinpointed by those frameworks After the early 1970s the international economic order began to change in fundarrrental ways the Brctton Woods system collapsed oil prices began to skyrocket finally the United States reeling from deficits in its international trade account imports exceeding imports began to draw away from the leadership role in promoting tariff reduc tion and a relatively free and open trade regime through multilateral institutions like the General Agreement on Tariffs and Trade later becoming the World Trade Organization it had embraced during the golden age of convergence inoving gradually toward a regime of strategically linking limited protectionism and market opening demands through bilateral as opposed to multilateral negotiation All of these changes impacted Japan The United States like England before it was unable to remain the linchpin of the international monetary system as more and more countries caught up with it By the late l960s European countries became increasingly restive with a United States dollar based gold standard re isirig to absorb dollars at fixed exchange rates re ising to buy into the upward drift in Aniericaii in ation rates attributable in part to the way the Vietnam War was being financed In 1971 President Richard Nixon bowed to the inevitable severing the connection between the United States and gold precipitating devaluation of the dollar Shortly thereafter Japan abandoned the Dodge Line allowing the yen to adjust up somewhat relative to the United States dollar see Panel B of Table A4 ln theory appreciation of the yen relative to the dollar made Japanese exports to its mayor markets especially to the United States more expensive hence less attractive to foreign purchasers The second shock to the international economic order came from the expansion of demand for petroleum worldwide from countries converging towards Arnerican levels of income per capita in Western Europe from the nations of Latin America and Eastern Europe that grew rapidly in terms of total income but did not neces sarily converge toward American per capita income levels and of course from Japan itself Taking advantage of this upward thrust in demand petroleum exporters w having formed a cartel the Organization of Petroleum Exporting Countries well aware of the fact that their reserves would be gradually but inexorably depleted in the future engaged in strategic management of sales of crude in order to extract higher prices for their precious resource Since the price of oil affects the price of most goods and services oil being used as grease for machines as fuel for trucks used to transport commodities the oil shocks of the early 197 3 74 period set off inflationary tendencies throughout the industrial world worsening the trade bal ances in those countries irnporting more oil than they exported From Panel A of Table A4 it is apparent that Japan was no exception The consumer price index gurnped by an annual rate of 1 l5 percent during 1939l75 The reluctance of the administration in the United States to allow the American economy to absorb more goods from abroad than it exported indefinitely took five main forms during the postl9 390 period encouraging devaluation of the 308 Decelerntioo dollar relative to other key currencies Gcrmanyb and Japan s in particular imposing sanctions on countries accused of dumping goods in the American market negotiating industry specific voluntary export restraints with countries exporting to the United States putting pressure on countries like Japan that enjoyed massive bilateral trade surpluses with the United States to open up their markets to American goods and to American investment and promoting an enrichment of the menu of goods tradable on international markets through the twin avenues of multilateral and bilateral negotiations promoting globalization of services like banking computer software and most recently oconnnerce A dramatic reworking of the aggregate economic balance Beginning with the early l970s J apan s aggregate economic balance underwent a decisive structure shift Private investment rates fell short of private savings rates the governnient began to run deficits on its fiscal account expending in excess of the revenue it took in through taxation tariffs and user fees and the economy began to run surpluses on its trade account exporting more than it imported Table A6 in the Appendix illustrates a number of these points That investment fell short of savings was due to two factors a decline in the expected return on capital that depressed somewhat business enthusiasm for acquiring new plant and equipment and a steady falloff in the proportion of aggregate demand stemming from consumption see the figures in Table A6 Much but not all of the gap between savings and investment was new accounted for by governrnent negative saving the governnienfs fiscal balance shifting into the red as the Dodge Line of balanced budgets was effectively jettisoned Why did government begin running unbalanced budgets financing its deficits with bonds As Lincoln 1988 convincingly demonstrates the reason does not lie in an expansion of government spending for instance on a cradle tograve style welfare state erected along Scandinavian lines Rather it lies in the fact that tax intake growth began to lag behind relatively modest expenditure increase by European standards welfare related spending 111 Japan remain muted throughout the 1970s During miracle growth government had consistently underestimated income growth rates After the early 1970s it began to consis tently overestimate income growth rates the Ministry of Finance bureaucracy being used to piling up revenue increases year after year As Table A6 shows government spending jumped significantly from the low and declining levels experienced during the miracle growth decade 197685 Then it began to decline somewhat Why Alarmed by the growth of government deficits by a rise in the proportion of government expenditure in total national income and especially by concerns that welfare state programs were growing rapidly and were projected to explode as the population aged the business community represented by Keidanren lobbied through the Liberal Democratic Party to establish a Commission for Administrative Reform rirzrrhii in Japanese Working with an agenda that administrative reform should be achieved without further increasing taxes the commission issued a series of reports over l98l 33 T he slowdown 309 Its recommendations included cutting the number of government employees reining in social security benefits cutting public works investments and privatizing three governinent corporations including Japan National Railways and Nippon Telegraph and Telephone By the 1nid 198Os most of these recommendations had actually been implemented What was the ideological and analytical basis for the rinchr administrative reform movement for the energy and resources Keidanren put into pushing the reform agenda The self interest of the business community was obvious Japanese corporate taxes were and are relatively high in comparison to personal income taxesThis is because personal income taxes enjoy generous deductions from income earned depressing the marginal income tax rates that households are obligated to use in paying their household taxes The business community was naturally concerned that future tax increases might come at its expense raising the costs of producing output making Japanese products more expensive on international markets Setting this concern aside there was strong opposition to governmental expansion of the welfare state on ideological grounds This was long standing Throughout the period since Japan s industrialization commenced most of its business community opposing government meddling with the paternalistic arrangements arrived at by employers and employers in the welfare field Vocal corporate obgection to passage of the Factory Law of 191 1 was rooted in this logic According to the logic of this theory Japanese style welfare is best left to firms to implement not placed in the hands of government that is too bureaucratic too rule driven too willing to overlook realities on the ground A second line of concern motivating Keidanren to act was new not old It arose from problems encountered in Western Europe and North America with welfare state policies We can understand these problems in terms of the efficiency wage and aggregate demandsupply frameworks introduced in Chapter 1 we can follow the logic of the argument using Figures 13 and 14 E in the Appendix to Chapter 1 Suppose a combination of goverrnnent unemployment insurance and welfare program supports generates a standard of living oor higher than that than an indi vidual can expect to generate from employment in a small or medium sized company but not 111 a well paying large enterprise In the diagram illustrating the efficiency wage principle Figure 13 the government s support level wage a call it wg is less than the efficiency wage W but greater than the market wage Wm If this is the case the incentives are clear Individuals not successful in the queue for a well paying efficiency wage are likely to opt for the goverurnent s support level wage over the small and medium sized firm wage w Unemployment grows at the expense of employment in small and medium sized firms shifting in the natural rate level of national income in Figure 14 E Y shifts in full employment actually now means most but not all members of the labor force are actually working The work ethic IS eroded Taxes have to be raised to pay for the programs Big firms those dominating Ketdanren may lose sub contractors as small firms encounter increasing difficulty recruiting workers In short ideological concerns rooted in attitudes of business leaders going back to Meiji if not before were wedded to a general sense of unease with Keynesian 310 Deceleratzon deficit spending earn the welfare state to the Kerdanrcn inspired rincho campaign How sweeping was the victory of the rincho movement In terms of its stated goals dimensions the answer is clear It was a resounding success But the goals were formulated with political constraints In mind The electoral base of the Liberal Democratic Party being eroded by structural change the shift out of agriculture rapid urbanization was a hard cold reality that the administrative reform movement had to take into account 0 not cut into the pork barrel projects the infrastructure construction outlays dear to the hearts of rural voters Do not so tie the hands of the Ministry of Welfare that it cannot implement some welfare initiatives like a national pension program especially when news papers and televrsron are focusing with growing enthusiasm on the rapid aging of the population handing over to the opposition to the Liberal Democratic Party a set of issues that they can exploit in electrons Returning to the aggregate economic balance government deficits absorbed most of the savings not channeled into dornestrc investment but not all of the excess Some of the margin of savings over domestic uses of savings became capital export owing out of Japan into foreign lands Japan gradually emerged as the world s major creditor country Tokyo joining London and New York as one of the key financial centers Unlike American investment abroad that tended to take the form of foreign direct investment the Japanese outflow of capital rnainly involved purchasing foreign securities government bonds and the like especially in the United States the United Kingdom and on the European continent To be sure Japanese companies began to set up subsidiaries In countries like the United States companies set up plants in order to get around voluntary export restraints or domestic content regulations or to take advantage of free trade agreements like the North America Free Trade Agreement In Southeast Asia and later on in China Japanese companies in labor intensive industries like textiles began setting up production facilities with the arm of cutting labor costs As the yen appreciated on international markets Japanese wages rose relative to wages in the less industrial regions of Asra Why was the ow of capital coming out of Japan heavily focused on purchase of securities rather than on foreign direct investment The roost obvious candidate IS the rate of return on securities earned at horne and abroad If American secusi fi ties earn nominal returns of 10 percent because savings rates are low in the United States and Japanese securities 3 percent because savings rates are higlr the incentives seem clear But are they As we know from Panel B of Table N the yen appreciated against the dollar through most of the 19705 When the dollhi5quot falls relative to the yen say by 5 percent in a given year the return on F American dollar dominated asset earned by a Japanese investor falls by that rates If American securities earn 7 percent 111 nominal terms and Japanese S CtIlquotiiZi3 i 3 percent and the rate of you appreciation over the relevant period for the lllv slill flhi is 5 percent a Japanese investor 18 better off sticking to Japanese securrties To be sure investors operate on expectations not known outcomes Perhaps Japanese investors allowed access to fore1gn markets insurance contpantesg The slowdown 311 exporting corporations banks and finance specialists were simply trying to hedge against movements in the you up or down note that the yen did fall agarnst the dollar over the period l981 85 By keeping their assets in two denominations calibrated in terms of the crucial dollar the dollar remaining the key international currency despite the abandonment of the Bretton Woods system and the yen Invcstors could protect themselves to some extent against appreciations or depre ciations of the yen Diversifying into European currency denominated assets was a further step along the road to reducing risk by diversifying financial portfolios An additional possibility is that Japanese companies did not believe that their system of production was easily exported to foreign lands True managers could go to the United States to England to Thailand to the Philippines to China to supervise workers who were mostly nonJapanese But could these workers be motivated to work the way Japanese in Japan were motivated to Work Could the production system function smoothly in the absence of the domestic bureaucratic hand of adntinrstratrvc guidance providing arenas for cooperation between competing companies within the manufacturing sector An alternative theory is that Japanese investors distrusted their own financial system feeling that the banks were rnefftcrent or alternatively that administrative guidance in the financial field was woefully misguided promoting moral hazard through a coordinatingfacilitating model in which regulated and regulators mutually interacted banks encouraging the Ministry of Finance to regulate in a way that appeared to shore up then activities From an aggregate economic balance point of view capital export IS the inverse the negative of the trade balance As can be seen from Table A6 Japan began to consistently run a trade surplus after the late 1960s In principle the surplus of savings over the combined sum of government deficit and domestic investment equals the trade balance The national income not absorbed in the sum of consumption 1I1VBSlIT1 1 lZ and net government savings negative when the govern ntent runs a deficit on its fiscal account takes the form of net exports In this sense Japan emerged as the mirror opposite of the United States during the period l97090 True both countries were running negattve balances on their govern ment fiscal accounts But Japan exported capital its investment falling short of its savings the United States imported capital its tnvcstment exceeding its savings Substantial shares of Japan s trade surplus flowed into the American capital market snapping up a hefty share of the bonds being issued by the American government to mcl its budget deficit in effect making up for the low level of American savings stavtng off the tendency for American government deficits to choke off domestic American investment demand through the crowding out effect see Figure 14 C 11 Chapter 1 Growing capital market integration increasingly caused the desttmes of the two great economic giants to intertwrne forcing their political leaders to find common ground in atternpting to manage their econonnes keeping the two locomotives of economic expansion running on a common timetable as it were Japan s emergence as a net exporter in no way means that export demand was driving its economic growth after the miracle growth Appearing in Panel B of 3 l2 Deceleration Table A6 are percentage contributions to aggregate demand expansion oven successive five year periods Over the period 197 l95 not export demand tended to depress growth in gross domestic expenditure not increase it 198l85 is the sole exception to this ruleThere are negative signs for most terms under the ANX column from around l97l75 until 199195 That net exports did not play an important role either during or after miracle growth is actually not surprising In order to export goods Japanese firms must import raw materials and energy quot quot 5quot natural gas petroleum and coal from abroad Net exports are not a large share of the post 1955 Japanese economy whether they are positive or negative They cannot be a major shaper of Japan s aggregate demand growthThat said export demand was very important to J apan s big ten internationally known name brand companies companies like Sony Toyota Nissan Honda Mitsubishi Toshiba all monopolistic competitors Sales of these particular companies depended heavily upon courting foreign consumers It is crucial to differentiate between the aggregate situation and individual firm circumstances in regard to exports Had the big ten companies been unable to export as they did Japarfs aggregate trade balance would have been modestly negative not modestly positive Aging in a changing labor market When a country s population passes through the demographic transition it becomes older and older This is an inevitable consequence in a population closed to immigration of shifting from low life expectancy to high life expectancy from a high gross reproduction rate to a low gross reproduction rate of Panel B of Table A2 It IS a theorem of formal demography that the fall in fertility overshadows the rise in life expectancy in accounting for this tendency That Japan s gross reproduction rate fell below a value of one during the 19703 meant that aging would be relatively rapid That Japan s population was almost completely closed to net immigration is apparent from a comparison of J apan s population growth rate with its natural rate of increase the two rates shown in Panel A of Table A2 That the population was relatively young during the iniracle growth years and has been aging rapidly since is clear from the figures given in Panel B of Table A5 A population aging as Japan has been after the 1970s con onts two major economic challenges at the social public level how to support its elderly in retirement at the corporate level how to cope with a labor force 111 which the ratio of older veteran workers to younger fresh entrant workers 1S increasing Not surprisingly given the opposition of the administrative reform movement to the growth of Japau s welfare state and given the preference of the government for facilitatingcoordinating approaches responses by government the public authority and the private sector were actually deeply intertwined Perhaps the most pressing issue posed by rapid aging of the population was how to handle mandatory retirement in the corporate sector During the l950s and early 1960s mandatory retirement was typically set at age 55 a policy introduced T he Slowdown 313 for whitecollar workers during the interwar period During the 1920s life expectancy at birth for males was around 55 so the policy made sense for both companies and employees As life expectancies soared during the 19503 and 1960s it made less sense for workers Most of them moved to another company typically to a small or less prestigious enterprise upon retirement From the corporate viewpoint relatively early mandatory retirement made sense Under ncrzlco rules wages tended to rise with age and seniority Promotions tended to be automatic Younger workers tended to contribute more to a firm s bottom line than they took out in wages older workers tended to cost more than they contributed By the late 1960s as miracle growth was winding down and many large firms were experiencing slower and slower growth in their internal labor markets alarm bells started going o Declining sectors like iron and steel and shipbuilding were becom ing so concerned about the problem that they diversified into wildly different fields like amusement park management hiving off redundant older workers into these new ventures Something needed to be done to dampen the headlong increase in wage bills Hiking mandatory retirernent ages would only make matters worse From the government s viewpoint not raising mandatory retirement ages posed equally intractable problems Was the treasury going to be raided and depleted by government funded pension programs that a Liberal Democratic Party concerned about its slipping voter base ought be constrained to legislate Not surprisingly govemment 1 l39llI1SlCI391t3S were pressuring corporations to increase mandatory retire ment ages threatening to promote legislation designed to do precisely that if the companies did not respond voluntarily Begging off the immediate introduction of mandatory legislation the Nikkeiren and Keidanren business federations agreed to implement hikes to mandatory retirement ages as part of a set of reforms designed to restructure internal labor rnarketsThrough a set of protracted negotiations between the Nikkeiren business federation and the union centers mainly taking place under the shunro umbrella tradeoffs were worked out Firms agreed to increase mandatory retirement ages to age 60 In exchange unions agreed to be exible They agreed to moderate baseup wage increases so that exporting companies could continue to export successfully even as the yen appre ciated They agreed to make the export oriented automobile sector the topbatter in wage negotiations Most important they agreed to let management modify the nenkfi rules and they agreed to let management experiment with forced transfers of Workers to other companies especially to subcontractors Under the negotiated agreements companies began vigorously promoting a functional status system shokuno shikoku sezdo in Japanese as a replacement Under this system workers are paid according to family and individual needs age education and seniority performance rating determined by the conipanyb personnel office status shikaku the rank like corporal or sergeant in a military organi zation attaching to a worker regardless of his or her work assignment and 5 occupation I gt 3i J9 39quot 3 I4 Decclemtzou Items 1 3 were found at the classtcal aeako system The crux of the innovation iovolved bringing in items 4 and 5 maloug specific occupational asstgtuueats and status key to worker evaluation Under the revised system a freshly inducted standard worker enters an internal labor market from the educational sector experiencing automatic promooons for a number of years However after a speci ed number of years the employee reaches a break point To move up further in status the employee enters into competition for promotion contending With l11S or her colleagues for irther advancement The personnel department of the company limits the number of slots available at the higher grade to order to slow wage growth attached to promoting yuntor workers to order to select the most hard working and productive for fast tracking sending a stgial to the unsuccessful that they are likely to advance fauly slowly in the tture A battery of tests 139EH1I11lSCt I1lC of those used in the educational system a host of interviews with personnel office representatives and a comprehensive review of performance to date served to vvtnnovv out the more productlve from the less productive to separate out the wheat from the chaff so to speak To further weed out deadwood older employers the busmess federations pushed the idea of forced transfers of selected workers in their negotiations with the union centers Under a typical transfer program shukko 111 J apauese there are two main opttons In the more favorable from the worker s point of view of the two options a standard workers personnel file IS kept in the firm that he or she entered upon graduation from an educational tustttutzon hrs or her home enterprise If he or she is transferred to a f ism paying lower wages than he or she would naturally receive in the home enterprise the rm seodmg out the worker agrees to pay the tI E1l 1S ferred Worker the difference between the two wages However the home company makes it clear all future promotions are out of the question so that dtffereuce between the two wages does not grow appreciably lo the future In the less adverts tageous form of transfer again looking at the matter from the vvorkerb point of view the personnel file of the employee moves together wath him or her to the new company The likely outcome of this transfer is a fall in earnings That these innovations stayed off wage growth with age attening the agewwage proftle is apparent from Panels Bl and B2 111 Table 84 The movement to bring retirement ages more in line with lif expectancies than they had been In the past rendered the typtcal mtemal labor market a harsher more coropcttttve more dogs eat dog envitotunent Is it surprising that young Japanese became increasingly cyuw teal about the virtues of the socalled three jewels of the labor market contract Wlule the governmental sector solved some of its problems by workmg with the tools of administrative gutdance 111 a factlttatmgcoordmattog manner brandishing the cudgel of mandatory legtslatiou as a last resort to encourage companies to razse mandatory ages ll Still had to deal Wllll the growing number of workers and their dependents reaching age 60 As the media beat the drums of the aging problem the Liberal Democratic Party felt compelled to act the progressive parues to the left emboldened by the growing attention being gweu to the aging problem Adding to the dove to Introduce and manage a national government sponsored pt3l1SIO11 program was the logic of bureaucratic catch up The slowdown 315 rationally shopping among fO339 1g11 models developed elsewhere Japanese omzistries especially in the Welfare and labor fields look abroad for models In welfare thts meant looking to Western Europe to particular The Western European countries were gradually experimenting with the Third Way a compre lquotlE 11S1V set of welfare programs provtdiug their pubhcs with a cradletograve safety net jacking up utcotne taxes In order to pay for the redistrtbution programs By comparison the United States was far less umovattve far more commltted to equality of opportunity but not equahty of outcome Dravvtng upon a wide ranging menu of foreign models Working under the umbrella of the National Pension Law of 1959 passed by the Diet at a tune when the Japanese populatzon was relatively youthful the Mtnistry of Welfare began overseeing two major programs the Employee Penszoo System for employees workmg in enterpuses ranging from the smallest to the largest companies under the opportunities mandated by the system benefits for employees in larger firms generally exceeded those for employees in smaller firms and the National Pension System for farmers shopkeepers and some selfen1ployed Under the rules set out under the two systems some of the selfemployed were covered under the Employee Pension System that tended to be more generous than the National Pension System As Campbell 1992 shows the resources handled under the two programs grew appreciably throughout the 19703 and early 1980s Their growth was trained to to an extent in the nud19803 when concerns over future drains on the fiscal resources of the government concerns highlighted by the administrattve reform movement increasingly shaped debate over policy making An example of how these concerns impacted policy is the pension reform of 1985 that was designed to rein in the growth of government outlays directed toward pensions for the retired and elderly Still despite as image as a country lacking vigorous government spon sored welfare programs Japan had actually become a welfare state albeit not one embracing the cradle tograve model of Western Europe by the 19703 The myth about welfare to Japan 13 that family and company matter more 111 Japan than government It is a mythThrough the last half of the twentieth century Japan has managed the trausuion from a relatively young to a relatively old population Adjustments have been required Welfare programs have drained away fzscal resources that once were used for mfrastructure or for subsidizing export onented comparues Corporations have revamped their internal labor markets Savings rates have fallen But what does the future portend Lzke most of Western Europe predlctions suggest that by 2030 the proportion of J apan s populatzon over age 65 will exceed 25 percent Aging is an mexorable consequence of low gross reproduction rates and htgh life expectancies All CO1ll1tl 16S that have passed through the demo graphic transition will grow older In lih1S respect Japao s likely demographic future 1s similar to that of Italy where the pt p0I39t10I1 over age 65 is projected to exceed 27 percent by 2030 How w1ll the problems of providing pensions and setting retirement ages be handled in such an environment One way to stave off or rather to mitigate a bit some of the effects of aging on government managed pension programs is to promote immigration particularly 316 Deceler of young working age adults Japan has a long history of being relatively closed immigration True during the period when its Empire was growing by leaps bounds some immigration did occur Koreans came into Japan proper after 0 for instance But stung by discrimination in the aitertnath of the great Kanma earthquake Japanese attacked Koreans in Tokyo their numbers were limited Beginning in the late 19803 small and medium sized enterprises facing shortagest of recruits for jobs viewed as dirty and onerous by young Japanese brought up in as relatively affluent homes bristling with a growing number of consumer durables lobbied the government for a relaxation of its stringent constraints on irnmigratiotij The policy response smacked of nihonjinroa It was largely limited to encouraging the irnmigratiou of descendants of Japanese emigrants the nikkei n living in soeia eties with per capita inconies below that of Japan to take up these positions TheJ biggest target for this program was the nikkeijin population living in Brazil Perhaps it was felt that Brazilian Japanese could be more easily assimilated into Japan than other peoples Perhaps the logic of the program was rooted in the View that young adults growing up in households where Japanese values and Japanese cultural traditions were practiced could more easily fit into Japan than Taiwanese F ilipinos and Indonesians If this was the View it proved to be a myth As Tsuda 2003 were truly strangers in their ethnic homeland They spoke Portuguese they danced the samba and they rooted for Brazilian soccer teams Over its long history since 1690 Japan has been relatively closed Opening up wt economically demographically and politically has been a process fraught with difficulties for a country that existed in a virtual state of autarky between the 16503 and the 1850s Miracle growth largely took place in closed capital markets Import and export ratios were relatively low Entire sectors banking and insur ance agriculture Wholesaling and retailing were almost completely insulated from the outside world through the golden age of convergence But as Japan entered the 19703 its exports eating up a growing share of the American consumer market this state of affairs was about to change Key terms and concepts in Chapter 10 Capital output ratio Devalnation of the US dollar and the collapse of the Bretton Woods system Aggregate economic balance and the gap between savings and investment Rirzcho Keidanren Shokuno shifcaku seido Shulcko Third Way National Pension Law Brazilian nikkezjin 11 The bubble economy A Japanese system During the l970s and early 1980s the nature of J apan s economic success loomed larger and larger on the international stage In one sense this simply reflected the fact that Japarfs national income had reached gigantic size Japanese goods showed up everywhere Even with a low ratio of imports and exports to GDP the sheer volume of Japanese goods sold abroad and the sheer volume of Japanese purchases of raw materials of cool iron ore nickel zinc peuoleum potash timber and rubber grew by leaps and bounds during miracle growth reaching massive levels by the early 1970s Consider automobiles New Japanese cars made huge inroads in North American and European markets in part because they were fuel efficient and small in part because they embodied quality in their components their excellent repair records garnering praise in consumer magazines Used Japanese cars sold by Japanese drivers wishing to avoid the shaken appeared all over Southeast Asia even in New Zealand Taxi cab drivers in Bangkok were churning the streets with Toyotas and Hondas There was a second reason why the subject of Japan s economy became a matter of burgeoning interest to Americans and Europeans trade deficits In the United States in particular the bilateral trade imbalance between itself and Japan became an increasingly potent political topic Since the 19605 the American governrnent establishment responsible for trade negotiations the office of the United States Trade Representative office Congressional committees appointed to look into trade related matters tends to focus on that country enjoying the largest bilateral trade surplus with the United States Spurred on by political demands on the part of indust1ies that felt besieged by imports from Japan the American iron and steel industry pressed for a triggenprice mechanism designed to drive up prices of imports of Japanese steel on the American market the American automobile industry lobbied for the negotiation of Voluntary export restrictions that would restrict the volume of cars brought in from Japan Congress appointed a committee of American economists with expertise on Japan to better learn about Japanese exporting companies to better understand how Arnciican companies could make inroads into the Japanese consumer market In the case of the United States some of the concern was about global leadership both technological and economic In the late l9th century the 318 Decelercztion United States supplanted England as the global technological leader After World War II it emerged as the political leader committed to lproinotnig international trade through its support for multilateral organizations like the General Agreement on Tariffs and Trade the World Bank the United Nations ln addition it underwrote international currency markets with the Bretton I Woods system Some of the concern in the United States about Japan s rapid growth and its gargantuan economic size reflected anxiety that Japan was now 39 taking over global leadership from the United States Linear pr39ojections suggesting that Japan s economy would soon become the biggest in the world bolstered the View that Japan was rapidly becoming an economic supeI state quot a cornucopia for connnercial and industrial innovations the world s quotlargest capital market to boot Interest in Japan s successful development also blossorned in the developing world in many ways South Korea and Taiwan two of Japarfs former colonial possessions seemed to imitate Japanese economic policy making and Japanese economic performance industrialquot policy and zoibatswstyle combines called chaebol in Korean were especially important in South Korea s remarkable economiic growth between the inid l960s and the late 1980s To policy makers in the nations of Southeast Asia to Latin American regimes struggling with the problem of f rnoving front import substitution to export prornotion along the lines of the ying geese model of trade it seemed that Japan offered a better model of development than did the more market driven model associated with United States 39 economic advance Of course drawing this conclusion required that one buy into a particular theory of Japanese economic development one in which politioal constraints andor norms and values played an important role along with invisible hand market forces 39 39 In short Japan quots remarkable success forced intellectuals and policy makers in 39 both the advanced industrial world and in the developing world to ask aquot set of probing questions What can be learned from the Japanese experience Are there aspects of the Japanese economy that are transferable to other economies lilow do foreign leaders cope with negotiate with Japan Can they should they shape and change Japanese practices How did Japan get to Where it was in the early 19803 How is it likely to change in the not so distant future up To many foreign students of the Japanese the problem of Japan s global 39lead ership posed disturbing thoughts itself One concern was political corruption as exemplified in the political rise ofTar1aka Kakuei prime minister of Japan and author of a prominent treatise a Vision statement about how Japan should revamp itself in the future Tanakas Volunie published in English 1972 entitled Remodeling of the Japanese Arcizipeiugo seerned to be a direct extension oftlie pork barrel logic he had used in rising to national power A second concern was Japarfs closed nature The growing popularity of m39honjinron books in Iapaii exemplified an attitude of Japan as different unique impossible to imitate or really learn from quot A third concern was that Japaifs economy was part of a system in which politics and policies economic behavior and social norms and values interacted The bubble economy 319 320 Deceleration There was a System the Japanese System The chief advocate for this View was V011 Wolfereri quotl989 He argued that holding andachieving power was paramount in Japan For this Very reason it was widely diffused bureaucrats political elites corporate managers and union federation leaders all having some power With The bubble economy 32 power came responsibility To blunt the efforts of those enjoying iess power to make claims on the powerful to keep at bay attacks on one s power from other power seekirig quarters those with power attempted to hide disguise their prowess The result was a System quotWithout a core No one was in charge No one quotholder of power could easily impact the behavior of other power centers The Japanese state was doughnutlike lacking a true center power diffused around the ring This View suggested three disturbing conclusions It would be difficult to negotiate with Japan because it would be impossible to find someone who was in charge It would be difiicult to learn from Japan since quotbehavior iii any one sector of the society was corinectcd to behavior in every other sector the System being in some kind of equilibrium How could you pluck out one practice one lesson when everything was intertwined It would be difficult to change the economics and political behavior of the System since it was in some kind of longwstanding equilibrium Indeed Von Woifercn 1989 went as far as to argue that Japan had been this way since the 8th or 9th century He did not rule out change But he thought it would be difficult Arr equally provocative account of Japen s disturbing place in the world was Scimiiegelow and Schmiegclow 1989The focus of their volume was on how Japarfs performance challenged the very conceptual bases of Western social science Nof39Western1 models were up to the task of understanding how and Why Japan performed as well as it did Japan fit into every theoretical competing category in at least some ways hence in none It could not be pigeonholed The keyquot to their interpretation was that Japan Was Schunipeterian in a novel way polic39y39 making was innovative emphasizing strategic pragmatism Key Japanese innovations quotwere administrative guidance the promotion of implicit contracts linkingquot public actors and corporations negotiating potential conflicts between policy outco1nes by establishing clear hierarchical ranking of policies and the rnan agiug of markets in danger of being disrupted for instance by gluts of quotproduction orexcessive growth 39 Most social scientists were not willing to go this far For instance Vogel 1979 argued that there were very specific aspects of Japarfs society polity and economy that could and should be emulated or at least learned from From the 324 Deceleration economis s viewpoint however the most concerted attempt to argue that Japanese economic behavior was explicable in terms of Western social science concepts and transferable abroad was due to Aoki 1988 Aoki s key points con com the different ways hierarchies and information flows are managed in typical Japanese and in typical American companies he calls the former the Ifirm the latter the Afirm Armed with these arguments Aoki concludes that a hybrid form is emerging one that combines features of the two extreme opposite mod cls of market oriented enterprises Aoki 1988 rests his analysis on theoretical arguments made about why firms exist anywhere and on empirical studies of job rotation in Japanese work groups notably the observation field work of Koike 1984 The basic argument is that when transactions costs are sufficiently expensive f iriins by definition organizations in which hierarchical command and control modes of behavior are normal dominate over invisible hand market solutions For instance we have seen how puttingont gave way to factory production with the introduction of steam power and the orientation of manufacturers toward wide ranging mass markets Specifically organizing production in firms provides the following benefits by centralizing information about material requirements to meet production objectives a hierarchy can economize on inventories stockpiled on how materials are most efficiently utilized on the shop oor by encouraging specialization and division of labor and repetition of tasks firms drive down labor input costs per unit of output by centralizing information hierarchies can respond to changing demand for the output that they generate As Aoki 1988 notes these arguments are typically used to justify the existence of the Afirth In the typical A firrn a small group of managers and engineers establish plans for production laying out tasks to be performed on the shop oor giving orders about how many components of a product are to manufactured in a given period how many are stockpiled Production decisions are highly centralized By contrast in a typical Awfirm evaluation of workers and assignment of wages is done in a decentralized manner Shop stewards and union representatives work with detailed scales set through collective bargaining or at least posted by management for all to see The Ifirm is the mirror opposite Personnel decisions Wage determination are highly centralized They are made in the company personnel division that enjoys a wealth of information about each and every worker But the production plan is implemented in a decentralized nonhierarchical manner Job rotation is common workers changing work assignments on an ongoing basis flexibly adjusting to changing market demand conditions filling in for one another when someone is ill or disabled doc to accident or injury In short a duality principle applies lo the A firn1 personnel decisions are decentralized production decisions centralized and hierarchically applied In the Jfirm personnel decisions are centralized and hierarchically applied production decisions decentralized There are two distinct models of how information flows and hierarchies are established in capitalist firms The bubble economy 325 Aoki 1988 argues that the Jfirrn type model is transferable Indeed steps taken in some American firms during the 19803 to reduce the number of distinct occupational codes W from hundreds to five or six seemed to bear out his pre diction In advancing this line of analysis he criticizes the View of social theorists like Nakane who believe Japanese are prone to form small groups frames into which they fit He notes that keeping the small work group from spiraling off on its own losing its connection to the rest of the factory would be a real problem in the Jfirrn if Japanese Workers were simply committed to Working in small work teams What about negotiating with Japan There is ample evidence that the political leaderships of the two nations could and did Work together in an effort to correct the trade imbalance between the two countries that was generating waves of con cern in Washington Getting agreement between the central banks of the two nations was key to negotiating the Plaza accord that led to dramatic appreciation of the yen relative to the United States dollar When this policy of manipulating 326 Decelerafio The 5245516 ec0rr0my 327 relative prices failed to correct the trade im oalance the two governrricnts worked together to hammer out agreements on structural issues that they believed would help address not only the trade imbalance but also other sources ofpolitical fric tion in the two countries associated with the trade imbalance lo the Strategic Impediment Initiative negotiations and talks that took place in the late 1980s both couritries demanded more open access to one another s rnarkets The United States was keen to break up the hold that the vertical keiretsu in the distribution system seemed to have relaxing of the restrictions on department store sqaare footage specified in the Large ScaZe Retail Store Law and speeding up ofiroport clearance pI 0C 3d ti1 S Japan was equally keen to see the United States clarify its anti dumpiag measures maling them more transparent end language based dis crimination in the way the United States adhered to ir1ternational patent agree U391 IlS involving a requirement that the patent be expressed in the English language and encourage reform of product liability laws In short recognizing that their combined national incoraes were almost 40 percent of world GDP rec ognizing the growing capital market integration of the two economies encour aged the governments of both Japan and the United States to reach cooperative agreements in the economic field 328 Deceleration Interestingly enough as Alexander 2002 shows negotiations designed to Init igate trade friction between the two economies went on a completely separate track from negotiations over other bilateral issues military security for instance Both countries avoided linking their economic negotiations to geopolitical issues As important as correcting the bilateral trade imbalance was to the United States it was not important enough to endanger strategic military arrangements that mutually benefited both nations perhaps East Asia more generally The yendollar exchange rate The upward drift in the yen turned into a gallop after the Plaza Accord This is apparent from Table A4 and from Figure lll More important the Plaza Accord marked a fundamental change in the terms of trade the price of exports relative to import prices As Figure lll shows there is a tendency for movements in the yenfdollar exchange rate to be associated With to be mirrored by parallel movements in the terms of trade When the yen goes up the relative price of exports improves However prior to the midl980s export prices tended to fall faster than import prices regardless of whether the yen was appreciating or depreciating relative to the dollar Prior to the mid l 9803 import prices tended to go up even though each yen was buying more raw materials more natural gas more petroleum more iron ore most of these commodities denominated in 5 I 1 r I ease rreaeedeooxe 3 lt5 xar sh 95 39 3 gt53 cg395g 5 39gt 3 xcgk 9q 3xQ9Gc gt9lt b399gs bx 3b 3 p f is 2 10 Growth Rate of Yen US Dollar Exchange Rate Negative of Growth Rate of Yen per Doliar Five Year Moving Average 1965 998 Growth Rate of Terms of Trade index of Export PTJCES Divided by Index of Import Prices Five Year Moving Average 19654 998 Figure 11 Growth rate of yenU S dollar exchange rate negative of growth in number at yen per US dollar and growth rate of terms of trade index of export prices divided by index of import prices five year moving averages Japan i 9651 998 The bubble economy 329 United States dollars To some extent this was the result of the price hikes for petroleum that roiled the global economy during the 19703 From the rnidl98390s Plaza Accord until the rnid l990s appreciation in the yen went hand in hand with positive rnovemcnts in the terms of trade Import prices fell more than export prices Japanese firms were paying less and less for the raw materials that they were bringing in The tendency of import prices to fall because the international purchasing power of the yen was going up kept export prices from rising as much as they would have risen in the absence of yen appre ciation This Was one reason why the dramatic appreciation in the yen known as andaka in Japanese after 1985 did not correct the bilateral United StatesJapan trade imbalance at least as it was calibrated in United States dollars A number of other factors operating in the rnediurn run kept the bilateral balance computed in dollars from closing First under the agreements reached in the shunts that mainly dealt with extending the retirement age the union federations agreed to modify their Wage demands so that exporting firms could continue to export even quottinder endaka This kept a lid on inflationary pressures in the Japanese economy As can be seen from Panel A of Table A4 the consumer price index hardly increased during the late 1980s or 1990s Cost push due to upward movement in nominal wages was muted under the collective bargaining umbrella Because inflationary pressures were less in Japan than in the United States the real exchange between the yen and the dollar did not increase as much as the nominal exchange rate This worked to keep Japanese goods competitive in the American marketplace 39 Alexander 2002 shows the yendollar nominal exchange rate did tend to diverge from the real exchange rate a er 1985 the yen growing stronger than would be expected taking into account inflati on rates in the two economies Why The answer lies in the discrepancy between movements in prices for goods and services only produced and consumed in Japan wholesale and retail rent on land infrastructure the so called nomtradable sector and rnoverncnts in prices of tradable exports and imports As you can see from Table A4 tradable goods and services fell in price export prices continued to decline throughout the period 19804000 while overall goods and services tradable and nontradable rose sornewhat in price over the same period The export oriented sector was far more efficient enjoyed more rapid productivity growth than did the non export oriented sector The result is that the nominal yendollar exchange that mainly reflects the flow of traded goods and capital movements moved up more vigorously than the real exchange rate Second the total cost of consnrner durahles includes the discounted costs of maintenance and repair Once a Japanese automobile is purchased in the United States and used there maintenance costs are expressed in United States dollars and are unaffected by any further changes in the yendollar exchangerate The reputation for building quality into cars that Japanese manufacturers enjoyed allowed them to hold onto market share in the United States despite erzdaka In the short term there are two factors that always help explain why the bilateral trade balance at least measured from the American side in United States dollars 330 Deczelerct on did not vanish The Jcurve is one factor Qnce orders are placed by wholesalers arid retailers in the United States for Japanese goods the dealer must absorb any depreciation in the dollar relative to the yen occurring between the date the order is placed and the date shipment takes place paying out more dollars than the dealer originally expected to spend This Lcurve effect wealrens the bilateral trade imbalance calibrated in United States dollars Adding to these concerns is currency speculation Actiiig on expectations about future movements in the yendollar exchange rate speculators can drive the exchange rate at least in the very short run In the medruiri term iridarirentals shape exchange rates But is the short run speculation can drive it it one sense in terms of actual volumes of goods traded the bilateral trade imbalance between the two countries did shrink as the yen appreciated relative to the dollar indeed calibrated in yea the bilateral imbalance actually Sl1I 11il Negotiators for lapan could and did point this out to their American counterparts Urifortuiiately for the American side what counted was the bilateral trade imbalance computed in American dollars it was cold comfort that the Japanese side was observing slirinkage when it carried out its computations in yen The bubble From the mid19805 until it began bursting in December 1989 Japan was caught up in tall oftwin bubbles in land prices and in stock prices is this deseriprioti as accurate reflection ofthe facts on the ground The figures in Table A4 and the graphical VCl I1C presented in Figure l l 3 suggest that talk of a bubble was exaggerated The in ation in land and stock 40 30 26 growth rate oi nekkes stocic exchange average ciosmg pace five year moving average 19554 998 1 l growth rate of urban land price index five year moving average 19654998 Figure 3 22 Growth rate of Nikkei stock exchange average closing price and growth rate of urban land price index five year moving averages ffapan l965 l S8 The bubble economy 33 market prices was greater during the 1970s than it was during the late 1980s Indeed in the first two decades of the twentieth century when the intercity railroad lines were being built and bedroom suburbs were proliferating the upward thrust in land prices was probably equal to that of the 19705 Is this surprising When rapid urbanization is occurring dabbling in land speculation is a natural thing to do Buy cultivated fields and unused land when it is still cheap sell it when it becomes dear Moreover investing in housing that appreciates in Value is a good way to make more money on asset holding than by putting your mds into a bank account particularly with a shaky financial iristitution that might go under The orily way to make sense of the talk of a bubble economy is to relate the upward thrust in land and stock prices to emiaka Once one does this talk of a bubble makes sense Calibrated in American dollars land and stock in Japan became incredibly expensive It is the linkage between the yendollar exchange rate and domestic land prices that makes the idea of a bubble occurring during the late 1980s reasonable 332 Deceleratforg Why did land and stock prices escalate during the late 1980s in the literature on the subject we can distinguish three major lines of argument those that mainly focus on domestic circumstances those that take into account globalization Japanese companies increasingly financing their activities abroad foreign finan cial institutions moving into the Japanese market the range of tradable services being extended to finance and banking and those that directly link movements in the yendollar exchange rate and the terms of trade to the in ation in land and stock prices We begin with arguments centering upon domestic circumstances Consider expectations What counts in 3 stock or bond market is What other people do One forms expectations based on what you think other people expect In this Way expectations can drive expectations This may explain some of the most famous bubbles in history Underlining these arguments is deregulation of the stock and The bubble economy 333 334 Dacelerarion bond market Had the volume of securities traded on the Nikkei exchange not exploded as fast as it did the bubble would not have gathered the force it did As Lincoln 1988 points out the Japanese government had no choice but to deregulate the equity market during the early l970s since it was increasingly engaging in deficit financing bond issue M in order to raise funds to cover its outlays An alternative view also domestic in its orientation has to do with the rate of return on capital in the industrial sector As we have seen the capitaloutput ratio in Japan surpassed the American level during the late l980s Other things equal this should drive down the marginal product of capital Investing in corporations became increasingly unattractive Seeking higher returns on alternatives to indus trial loans banks turned to funding real estate developers who put up land as col lateral As the value of the coilateral held by real estate developers escalated so did the attractiveness of continuing to lend to them Compounding the bubble like potential of this type of market activity was the linkage of stock market prices to land prices cf Figure ll2 Banks lent to individuals wishing to speculate in stocks on the basis of collateral in particular on the assessed value of the land assets that they held As land prices jumped so did stock and bond prices The headlong upward drive of the market became self fulfilling expectations feeding on expectations Moral hazard is usually invoked in stories that emphasize bad banking prac tices As long as banks think that they will be bailed out under the convoy sys tem by other banks the scenario played out under Ministry of Finance administrative guidance or by the Bank of Japan or by the taxpayer they have little incentive to be cautious in their decisions As long as a market is on an upward spiral as long as the downside risk of failure is negligible why not jump in riding upward with the rest of the market This is a basic theorem of financial economics Allen 2001 provides a good treatment of the logic underlying this theorem Financial globalizaation may help account for the bubble In 1980 the Japanese government revised the Foreign Exchange Control Law allowing Japanese firms to freely issue unsecured foreign bonds Attracted by the less regulated atmos photo in overseas markets major Japanese firms entered the Euromarket floating bonds and stocks raising funds that they could use to liquidate their obligations to Japanese banks In effect globalization encouraged Japanese companies to The bubble cconomv 335 switch from indirect financing of their debt using banks to direct equity issue issuing stocks bonds and debentures on both domestic and foreign markets Banks had no choice but to switch away from loaning to export oriented presti gious companies to loaning to real estate developers construction companies and more risky domestic manufacturing ventures in this version of the story the emphasis is on deregulation rather than on the declining marginal productivity of capital But the two arguments are not inconsistent with one another Foreign pressure to open up the Japanese capital market to nondapanese banks and investment houses increased competition in the financial market applying further pressure on Japanese banks Many bankers felt that J apancse banks had to consolidate through wholesale mergers before Western banks were allowed relatively free entry into the Japanese market Foreign banks were far more knowledgeable about financial opportunities than Japanese banks that had relied almost exclusively on industrial loans to make returns on their capital Not coincidentally Western banks tended to crowd into the heart of the Tokyo financial district adding fuel to the ames of land in ation in the center oflapanfs capital A third line of analysis links movements in terms of trade to the movements in the stock market hence to the land market Consider Figure l l3 As you can see the terms of trade and the Nikkei stock exchange index tend to move together from the midl970s until the bubble had fully burst in the early l990s the terms of trade did not start moving as long as Japan was adhering to the Dodge Line with a fixed exchange rate of 360 yen to a dollar The key to a possible linkage between the two variables lies in expectations about the fortunes of the major 407 30 1 JITFEIIT If I lte eeo39mo lt7 I i d amp o see 10 V growth rate of terms of trade export once index divided by import price index fave year moving average 19651998 growth rate of nekkes stock exchange average closing price five year moving average 196519 8 Figure 113 Growth rate of terms of trade Index of export prices divided by index of import prices and growth rate of Nikkei stock exchange average closing price five year moving averages Japan l965 l99S 336 Deceleroriorz exporters of the top ten name brand companies in particular As the terms of trade improved so did the expectations about future profits in the exporting sec i tor This drove up stock prices in the tradable goods sector Stock like land could be used as collateral In this version of the story trade becomes crucial to the bubble Regardless of which story one finds the most convincing one thing is certain Any convincing story about the bubble economy must include a discussion of erzdaka in that sense the bubble economy was an outgrowth of the process by which a once tightly shut system was being integrated into the international eco nomic order an international economic order in which the menu of tradable goods was being steadfastly enriched Globalization and the bubble economy went hand in hand Key terms and concepts in Chapter 11 Choebol LargeScale Retail Law Remodeling of the Japanese Plaza Accord Archipelago Endakcz Japanese System Icurve Strategic pragmatism Foreign Exchange Control Law Duality principle Terms of trade Strategic lmpediment Initiative Nikkei stock exchange index 12 Stagnation and reform Deceleration with a vengeance In the wake of the initial bursting of the bubble in late 1989 Japan 3 growth rate slowed to a crawl This is apparent from Figure 11 in Chapter l and from the figures in Table Al in the Appendix During the bubble phase and even during the first five years after the bubble began to burst Japatfs per capita income continued to converge towards American levels However during the next fiveyear period between 1996 and 2000 it diverged Whether this divergence Will persist is unclear Projections for lapan s growth of income have a high level of variance There are a number of reasons why the variability of the estimates is considerable as you know from the discussion in Chapter l national income is estimated imperfectly at best and as you know from the discussion in the Appendix to this volume nailing down statistical models of an economy that can be usefully employed in forecasting is treacherous highly controversial at best Compounding difficulties are ongoing technical disputes about whether the national income accounting schemes employed by the govern mental agencies in charge of national income estimation are used to confuse and mislead rather than inform the citizen about the underlying reality After all politicians do not like figures showing anemic growth in national income Why not cook the books This said most estimates suggest that the Japanese per capita income has grown over the post l990 period and will continue to grow in a range between 1 percent and 2 percent per year extreme optimists put the figure higher at 3 percent but this is less likely While the difference between the two rates appears to be small the difference does matter significantly in the long run if the economy grows at 2 percent per annum in per capita terms real income per capita doubles in 35 years if it grows at 1 percent per annnrn income per capita doubles in 70 years Growing from l2 percent per annum is respectable Indeed in a Swann Solow model in which the capitallabor ratio is high the marginal product of capital low and there is relatively slow growth in technological progress achieving growth in this range is completely expected Growing at rates in the 12 percent range puts Japarfs growth squarely within the economic territory occupied by other advanced industrial countries However in terms of Japan39s historical 338 Decelemriozi record growing faster than the other advanced industrial economies over the last half century the possibility that Japan has once and for all entered a new era of dramatic deceleration is a very sobering thought indeed To bureaucrats and politicians accustomed to growing far faster than other advanced industrial economies the slowdown to so called normal growth seemed to be a chastening experience Does the bursting of the bubble represent a fundamental watershed in Japan39s economic development a sharp structural break with the past In a provocative book Teranishi 2005 argues that it has Reasoning that a capitalist economy has three major subsystems the division of labor between private sector and government the institutions of the private sector and the interface of government and private sector Teranishi argues that fundamental system change takes place when three conditions characterizing a political economic system occur The economic costs of maintaining it are too costly the political costs of keeping it going are too high and the rules governing the operation of the system become incompatible with social norms and values When these conditions are met the prevailing system becomes dysfunctional Evolution takes place A new system emerges out of the ashes of the old structure being discarded Using this framework Teranishi argues that pOSt l870 Japan has passed through two systems the lleiji Taisho system and the high miracle growth era system In the MeijiTaisho system the private sector dominated the economy government playing a relatively minor role The main interface between government and the private sector was local the meiboka elite lobbying for infrastructure in their districts in return for drumming up Votes for the two major political parties Local pork barrel politics dictated what the bureaucrats in the national ministries could and did accomplish Eventually during the 19205 and 1930s this system became dysfunctional Extension of the franchise empowered tenant farmers agricultureh share in national product fell weakening a fiscal system mainly dependent upon the land tax small rural banks became increas ingly fragile and many companies that had carved out niches during the World War l boom when imports were largely cut off became shaky bringing down banks with them in some cases Out of this system emerged W during the late l930s World War ll and the American Occupation the institutions of the higlvspeed growth era These included internalization of labor extensive intervention of national government ministries in the private economy industrial policy emerging as the key interface between the private and public sectors This was the system that generated miracle growth Eventually it too became dysfunctional Rising political costs of carrying out industrial policy were one problem Increasingly ministries were at cross purposes in implementing industrial policy declining sectors competing for attention each demanding intervention cutting into the interests of other sectors when they managed to get protection from imports or subsidies that propped them up at least temporarily The economic costs of maintaining the system soared as the yen appreciated Consumers clamored for the benefits of a strong yen Stagnation and reform 339 becoming increasingly restive over high prices that they attributed to excessive regulation In addition consumerism affected social values The younger generation became oriented towards consumption of material goods less inclined to derive satisfaction from being a member of a prestigious name brandquot corporation The bubble economy marked the last gasp of the highspeed growth system A new system began emerging during the W903 Is there evidence bearing out the notion of a system change There are at least four quantitative indicators that suggest that a new era has dawned a substantial drop in the investment and savings rates a rise in unemployment rates especially for young individuals from the extremely low unernployntent levels of the miracle growth period a worsening of the income distribution and consolidation and restructuring of the financial sector Consider investment and savings As Table A6 demonstrates investment demand has been falling olif particularly striking is the sharp drop in the contribution that investment demand growth makes to aggregate demand growth during l99l 2000 see Panel B of the table Even more striking is the decline in measured household savings rates Estimates suggest that the rates have steadily declined over the 19903 from around 108 percent in l99O to 64 percent in 2000 tumbling further to around 24 percent in 2064 Moreover credit card usage has spiraled upward during the same period Estimates for 1980 showed Japan with a ratio of consumer credit to disposable income of around ll percent about half of the level in the United States During the l990s lapan s rate was actually greater than the American rate dropping back to around 20 percent during the early years of the twenty first century During miracle growth most households in Japan had to save in order to purchase consumer durables No more Showing that a structural break has occurred in savings behavior can be justified by considering the impact of factors that probably shaped savings in the past income per capita growth the level of assets relative to income and aging True the Japanese population continues to age thereby depressing savings But the drop in savings in the 1990s and early 2800 is far too dramatic to be explained away in terms of aging True assets have fallen relative to income in the aftermath of the bursting of the bubble But savings rates were dropping even as asset prices were being driven up during the l98s Finally income per capita growth embarrassingly low by miracle growth standards perhaps has tended to be positive albeit low beginning in the early 1990s The labor market has also been transformed From Table A3 it is apparent that the rate began to creep up after the era of miracle growth had largely come to a close accelerating in the late 1990s Particularly striking is the growth of unemployment amongst the young aged l5 l9 The growth of young adult unem ployment has gone hand in hand with the proliferation of freeters The term freeter is an amalgamation of the German word fret or the English word free with the German word Arbeiter worker It describes a person who is either unemployed or underernployed moving in and out of employment or working as a freelance worker perhaps for a company that dispatches temporary workers to employers seeking an employee who works on a short term basis 340 Deceleration Examples of freeter employment are convenience store workers supermarket checkout employees fast food employees and waiters in restaurants Estimates of the number freeters in Japan varies depends on which ministry is doing the counting The lapanese Ministry of Labor began publishing estimates of the number of NEET not in education employment or training a definition that approximates the freeter definition in 2000 A White Paper on National Life in 2003 estimated the number of freeters at over 41 million an alternative official estimate was about half that number What motivates an individual to choose a freeter work style The Japan Institute of Labor classifies freeters into two categories One describes those who rej eet the values that the adult generation of the miracle growth era held regarding working for a large prestigious company To some degree these individuals may be reacting to the way the implicit contracts of internalized market were revamped in the aftermath of miracle growth the struggle for promotions was intensified the possibility of forced transfer becoming a disquieting reality A second type is the individual who has no alternative who has no chance of securing employment in a good salaried position The social consequences of the freeter life style are important Earnings being low most freeters cannot afford to marry and start a family Female freeters tend to marry late or not marry at all Often they end up living with their parents joining the ranks of the socalled parasite singles As more Japanese embrace the freeter lifestyle it is likely the gross reproduction rate will continue to fall Does low fertility encourage even further drops of fertility in post1990 Japan One can argue that parents are willing to tolerate housing freeters precisely because the number of children that they raised is small Another sign of changing labor market institutions is the growth of demand for midcareer hires Rather than relying on fresh school graduates more and more companies are recruiting workers who have experience working elsewhere Is this due to the increasing presence of foreign managed companies and subsidiaries in the Japanese market Or is it the result of an increasing disintegration of the internal labor market model Is Japan s labor market converging toward an American style market in which tenyear job retention rates are relatively low especially for adults in their twenties and thirties Has the natural rate property of the Japanese economy changed Has the Japanese economy shifted from one where the noninflationary rate of unenrployment the so called natural rate of unemployment is over 4 percent as opposed to the rates ranging between 1 and lS percent characteristic of miracle growth One of the miracles in miracle growth was the fact that highspeed growth was achieved with equity This surprised many economists One of the assumptions made by most mainstream economists is that there is a tradeoff between growth and equity At a low level of income per capita when agriculture predominates income is assumed to be distributed fairly equally With industrialization and rapid accumulation of capital this changes For instance when dualism emerged in Japan during the early twentieth century income inequality did worsen But Stagnation and reform 341 during miracle growth income inequality seems to have been muted partly because agriculture was subsidized with the government s rice procurement program partly because of the way the shzmto operated Using estimates of the Gini coefficient the lower the level of the Gini coefficient the more equal is income distribution for Japan in 1968 0350 and in 1979 0336 we see that income distribution in miracle growth Japan and its immediate aftermath was relatively equal However during the 19905 this changed the Gini coefficient seems appears to have shot upward from around 04 to around 0433 estimates of the Gini coefficient vary a bit depending on the nature of the households surveyed There is little doubt that this trend mirrors the increasing presence of freeters and unemployed in the labor force Another quantitative indicator of structural change is the shakeup in the banking sector Some banks were allowed to fail As van Rixtel 2002 250 shows between 1990 and 1998 three city banks disappeared eight second tier regional banks vanished 109 credit cooperatives closed their doors and most dramatically over 2000 agricultural and forestry cooperatives folded Has Japan entered an era when unconditional moral hazard every bank is bailed out no matter how badly managed it is no matter how bad its loan program is has given way to conditional moral hazard Under conditional moral hazard government stands prepared to salvage responsible banks not those managed irresponsibly True fear of foreign takeovers of Japanese banks limits the willingness of the Ministry of Finance and the political leadership to carry out a consistent conditional moral hazard approach But the existence of bank failures suggests that the days of unconditional moral hazard are over 34 393 L Deceleratioii Stagaariorz and reform 343 D agzr t5 iai r iJs39a39skgr itvrtd tile wiZ t3ageeivs h the 0 0O In addition to quantitative indicators of system change there are a number of qualitative indicators suggesting that Japan was undergoing substantial and wrenching change in the aftermath of the bursting of the bubble International surveys of happiness carried out in the early twenty first century ranks Japan Very low suicide rates for middle aged men terminated from their jobs appear to have been increasing during the l990s and early 2800s a Japanese television series about Project X highlights quality defects in Japanese manufacturing Egregious examples cited in the television series include Sony s recall of over 300000 batteries and a upward surge in the number of recalls carried out by Toyota that latter committing itself to hiring thousands of engineers in an effort to reverse criticism of its deteriorating quality To a growing riornber of Japanese consumers it appeared that South Korea Taiwan and China were producing liigherquality goods than Japanese manufacturers were Teranishis theory of sweeping structural transformation aside economists and political scientists have weighed in with an abundance of theories about why growth in Japan has slowed down as much as it has One argument that you should be familiar with from Chapter l is the liquidity trap theory see Figure 14 D The idea here is that interest rates had been driven to such a low ievel during the E9905 by Bank of Japan policy that further use of expansionary monetary policy was impossible In one variant of this hypothesis emphasis is put on expectations about the yertdoilar exchange rate To ericourage investors to purchase American securities in the face of a possibie depreciation of the doiiar relative to the yen Japanese interest rates dropped to a low level True nominal interest rates in Japan declined to extrerriely low levels during the 1990s But as we can see from Table A4 in ation rates were aiso very low during the late l990s and the doilar actually appreciated against the yen during this period Stilt if Japan was in a liquidity trap during the l990s monetary policy became useless sharply limiting the number of stabiiization policy options A second hire of argument focuses on factiitatingcoordinating policy espe cialiy industrial poiicy in manufacturing and Ministry of Finance administrative guidance in the case of banking Aiichordoguy 2000 argues that Japanfs system of catchup capitalism in which the Ministry of International Trade and Industry promoted rnodeis for acquiring foreign technoiogy from international industry ieaders began to soar during the post miracle growth era Using the software industry as an example Anchord ogoy argues that the Japanese computer companies became obsessed with using BM style methods under administrative guidance from the Ministry of lnternationai Trade and Industry employing reverse engineering wherever possible in l982 Mitsubishi and Hitachi were 344 Decelerariort caught stealing IBM technology ultimately being forced to fork over massive annual fees to IBM for the use of the technology Reacting to the IBM industrial spy incident the Japanese government sponsored a series of research and development projects designed to lead the industry away from the IBM standard the most ambitious being the TRON project aimed at creating a Japan specific operating system While this project had some limited success within Japan itself outside of the country it had little appeal Internationally IBM mainframe and personal computer software had a dominant position that TRON could not assail lapan had locked itself out of international markets in the mainstream software sector Japan s computer game sector offers an interesting contrast according to Anchordoguy 2000 Largely left alone by the Ministry of International Trade and Industry it has ourished enjoying strong demand in both domestic and international markets The lesson is clear industrial policy may be a good way to speed the process of catch up growth But it is a bad strategy for creating industries that ourish on their own innovative drive in a post catcl1 up environment The critique by Van Rjxtel 2002 of Ministry of Finance administrative guidance in the financial sector emphasizes other problems in the facilitating coordinating model of policymaking policy arising partly out of the regulated industry itself Van Rixtel argues that Ministry of Finance accommodation of the wishes of the banks helped fuel the bubble itself whose bursting undercut the viability of many of the banks In effect he argues that administrative guidance in the financial field spawned moral hazard problems that would not have occurred had a different type of regulatory regime been in place The problem was not regulation per Se The problem was the type of regulation The plight of the banks is often cited in explaining Japat1 s slow growth during the 19903 and early 2000s It is said that they did not lend enough or rather that they were not willing to lend to potentially innovative entrepreneurs that they became overly cautious that they refused to terminate nomperforrning loans The fact that land prices continued to fall throughout the 1990s see Table A4 certainly made their fiscal lives difficult As long as the value of their collateral kept following they were reluctant to terminate non performing loans continuing to extend credit to bad borrowers As is pointed out in the introduction to Blornstrorn Gangnes and La Croix 2001 the fact that Japanese banks were viewed as increasingly shaky and ill advised in their lending policies created growing distrust of Tokyo as a world class financial center Stung by this evaluation maintaining the prestige Japan had garnered during the late 1970s and 1980s cannot be discounted as a motiva tion the government further deregulated the industry with the Big Bang reforms of 2083 Despite these reforms many foreigi financial institutions remain skepti cal of the Japanese governrnentb commitment to a responsible regulatory regime in large part because of Ministry of Finance use of administrative guidance as opposed to clear and transparent rules Stagnation and reform 345 For many students of the Japanese economy however it is not the banks not aggregate stabilization policy not administrative guidance and industrial policy which is at the roots of Japan s current economic woes Rather according to Katz 2003 the problem is total factor productivity As long as sectors are protected from imports and thus shielded from the sting of global price reduction stemming from technological change in leading countries whether the leader in a particular sector be the United States as in information technology and general purpose software or Germany in the case of automobiles productivity growth in Japan is likely to lag behind that of other countries Exacerbating this problem is the fact that the most successful exporting companies Toyota and Honda for instance are increasingly carrying on their manufacturing outside of Japan Another factor cited in discussing lapan s productivity problem a decline in the skills acquired by youthful engineers perhaps fueled by a failure of the Japanese educational system to keep up with trends in schooling initiated elsewhere Is the longstanding emphasis on rote rnernorization in examinations catching up with the Japanese educational system Or is the shop floor once stimulating indeed exciting to work in becoming boring as workers are replaced with robots and digitally controlled machines True productivity can grow from sources other than total factor productivity Accumulation M an increase in the capitallabor ratio can fuel it But as we know from Table A 1 lapan s capitaloutput ratio is already extremely high So this is not 3 likely source for growth at least for quite a while Again productivity growth can come from shifting resources like labor out of low productivity areas of a sector into higher productivity areas of the same sector Moving workers from room and pop retail outlets to convenience stores is one example of a possible productivity spur How much productivity gain can be squeezed out of this type of change is questionable however Unlike the sweeping gains during miracle growth in which agricultural employment gave way to manufacturing employment one sector giving way to another the type of structural change envisioned here involves change within a sector less likely to boost the productivity figures at the aggregate level The political response The fact that the bubble economy and the retardation afterward coincided with a growing number of scandals involving high level bureaucrats and politicians did not go unnoticed by the lapanese voter Not surprisingly the Liberal Democratic Party s political support continued to erode Still a fragmented opposition was having difficulty capitalizing on the disenchantment with the party that had ruled the country for so long Growing dissatisfaction with this state of a airs was the political backdrop for the jettisoning of the system of voting for lower house representatives that had been put into place during the American Occupation the multimember medium sized district system being abandoned in favor of a system that mixed proportional representation with a single member district scheme 346 Dcceleratiorz As Reed 2003 points out there has been ongoing debate among students of democracy over the merits of single member winner takes all versus proportional representation systems Those who think that it is important to have a mztjority in government one that can actually pass legislation one that can be held accountable in a future election for its deeds M favor winner take all systems in which one candidate from an electoral district emerges triumphant This approach is known as niajoritarian The alternative View is that obtaining discussion dialogue and consensus is the proper goal of democracy Each voice should be heard Parties should he represented in the legislature in proportion to their relative vote getting power in elections Between i993 and l996 lapao changed its system moving away from the rnultiwmemher district system in which a voter cast one OI1 1 a lSfB1 2Ibl vote to a mixed system in which a voter cast one vote for 3 single candidate in 1 single member district and a second vote for the party of his or her choice the propor tional representation component of the election system That Japan took this raclical step H relatively few democracies have tinkered with their electoral systems in the post World War ll period New Zcaland has taken similar steps suggests that the Diet was concerned about growing discontent with the political status quo Less convincing as a theory of the why the political system was willing to gamble on a radical change in the electoral system is the much vaunted theory that the Japanese people seek consensus If this were true why was proportional representation riot adopted earlier Indeed in the 1993 election the Liberal Democratic Party did not actually garner 3 majority of seats in the Diet l hirty nine members of the party precipiw rated the 1993 election by voting to support a nowconfidence motion aimed at bringing down the psrty s cabinet ln bolting from the ranks of the Liberal Democratic Party they formed several new parties including the Renewal Party and the Japan New Party A combination of Liberal Democratic Party defections and the possibility of voting for fresh new parties ended almost four decades of Liberal Democratic Party rule ironically introducing the new voting system actually helped the Liberal Democratic Party No longer were its candidates pitted against one another in districts Now iridividual Liberal Democratic Party candidates could draw upon party funds rather than upon individually managed local furidrsising bases in standing for electiori Rather than ininorityfcoslition governments emerging froin the new voting system the Liberal Democratic Fsrtys fortunes were revitalized While Liberal Democratic Party hegemony over the national political scene soon resumed it occurred in so environment in which the demand for economic and political reform continued As a result the party itself split into reformist and noryrellorrnist wings in effect one wing of the party engaging in all out political warfare with the other wing The result was the dramatic election of 2005 in which Prime Minister Koisiurii hinichiro triumphed over the opposition of his own Liberal Bernocratic Party colleagues At the heart of his campaign was a drive to weaken the faction within the party coininitted to the Tsnaka Kalruei pork barrel approach to policy nialting Stagmzticm arm rcfiir39m 347 P t i I s 8 I its at s U l P C H til quotl39ltt 5tt1 9tttl k l t3f15Wl i3 ii ltIl tliiltf 5 illitttlitltt lsrrstss sis 39 stir Is its 39 P quotg2oliii iil tlteetsiquott or on P 4 I tIst t l ill i t5 iiflllliszss 9f393l1 t cliff eZliiigquotiliii a said I 39 G d1 5 i7JzZ this i r1 ipi7rtisttic quot their prriitsstiitstitst t si sisrll Atsirttlisttslrlt pG i iI fL quot srersfisdoo rszepisfgs2sissier 7 p 6 szhsss tszss zrsis A 0s gquotlit39g rIt2r1 itt itsctt 1 r I quot ismistresses P i P t P f ssrss 2sfssrr ti 4 39 quot f p p9g f f f f t 348 Deceleration One can argue that Koiztnni was completing a process initiated by the administrative reform movernent of the late 1970s and early 1980s In that movement the bureaucracy was under attack but not the Tanaka style model of dispensing pork for votes lsioizurni carried the logic of the attack one step further After ail Koiaumi had progressed through his political career during the heyday of the administrative reforin movement His thinking was shaped by the debates going on about the spectrum of reforms that should be packaged into the rirzcInquotv39 program One of the main tenets of the administrative reform movement however was reinirig in government spending Koizurni adhered to the logic of this position thereby discouraging the use of expansionary f iscai policy as a tool for stimulating growth and reducing unernpl39oymeiit in this sense his corninitment to political reform may have hampered his willingness to counteract l39apan s economic doldranis through bold stabilization measures Concerns about ineffi cient uses of pebiic funds in pork barrel projects concerns about controlling the Stagnation and reform 349 bureaucracy concerns about the impact of aging on the viabiiity m in short structure concerns dominated the l39ltIoizumi agenda The question whether this approach to reform will continue to dorniuate Japazfspolitics remains to be answered What is clear is that Liberal Democratic Party rule in the early twentieth century if it continues is likely to look very different than it did in the miracle growth period and its immediate aftermath Paths walked paths taken Path dependence is a strong concept Whatever happens in the future depends at least partly on what has gone before Many social scientists think the idea is absurd Consider Japan s economic transformation over the period l886200 as captured in the snapshots that are Tables A l A7 in the Appendix By all accounts Japan is so different in the early twenty first century from how it was in the late nineteenth century in terms of per capita income in terms of life expectancy and fertility in terms of structure of output and labor force in terms of the structure of aggregate demand in terms ofthe anthropometric measures of height and weight M that talk of continuity over time is seemingly ridiculous Still continuity abounds Indeed one can argue that the greatest continuity is in the very drive to innovate what became apparent when entrepreneurs built the first steam driven integrated spinning and weaving inills in Osaka in the 1880s Even during the bubble and its problernatic aftermath Japanese companies continue to be innovative continue to take risks continue to push into new ventures In so innovating they embody a past that they project into the xture 350 Deceierazion Smgmzriorz and z forrrz 351 I quot oiI ESIzZifltt x eriv amp o1 iIquotquote139iao Vwigs tfw V 394 3 3iampofV 53 39 I ypoiayz1g39t39ampexom 39 w ka prgitodegimretup o V zzio ior 39quotandquot tl 2n quotzfefe391siims 39 0 393 1rgIE jI f r39 39iiiF 453 i quotioampb is hed 39 dxquot39cz max t1z quot39z3zzsrz 39zs2ae i ei 39 i 39 i 3Q I oquotifz ei i r o39p39rafzt ti 1 peoi i j392 hom 39 3 g of 12 Ff imzrah aazvam in393ii1i39i j5 fiSl39di12 1 v h 2fh 1 3 i o oA 7 agg29e s v 3 3 i39ff11 quot395 of rim 39quoti f539 W A A 39 P d w q lX X V K 0 6 o2 l39 2pai2 3 1223j totk 6Lg3mnag e239 12 Zfiq2amp1quot 39 o 7 x arovaazaz F4mzrapaod H 0 e io rngf wd P ii fampf o1a 2 FwigtRa 6i35I 395 7i39139 3Q5 3132 o 39 V I P e Ma q 4 j M4 39 P 539Siz Lo wquot P X 1z2zz 2A ioJ9903 quot mo do o 2of o I2ardmV woo am ur omrha s 39 d P rz39 1g az 1tquot i c2 z3 szof r immitigd afrm o l inozsmieza2s z2 ssmk 1f iquotl 3 04T 39lt iz 5 gzpgtmagriczztio z 1amp2 5 H eo s iizg 3g r 3f 39Sha2fposie3 gtmzl39zi ic 34 f i ziquot l2ra39 39 16233si j it pz d Virro its 39r f 1t 39 e a a4io of q 4 J True much of the innovation in Japan invoives hybri dizatiorfx the adapting of foreign technology to the Japarmso economic social and po1oitical environment But this is true everywhere Indeed the same charge was leveled againsz the American innovating entrepremsurs during ihe E9113 century Gm of the greatest examples of Japanese innovation is in faciii ati2gfcoo dinatiI3g policy making an area that may be proving to be as much a bamer as 9 fiiiip to future ecoznomic zzdvance in Japan But as we have seen adn1inistrative guiiiance is itse2i undergo ing change unconditional morai hoazard gmog way39 to conditiona morai hazard in ihe financiai field 39 it is easy E0 dismiss Japanfs iongqun grow h potentia in light ofthe struggk its economy has been enduring in the wake of the bursting of hebubb1e economy That wouid be a mistake When the Western powers broke Japan open in the 1850s they set in motion one of the greatest locomotives of economic growth the World has ever witnessed Gnce unbound from its shackles this Eocomoiive of growth oowered by innovation M has contz foueai on its dramatic joumoy for ova 21 century 352 Decelerarion It will continue on that journey perhaps gaining speed at times perhaps slowing down at times for centuries to come The strongest continuity in Japsuls modern history is change itself Whether we View Japan through the less of markets or norms and values or political constraints the continuity of change is the one overriding reality the one hedrock proposition that We should t3 Y2139 ignore Emerging out of Japan s long and tumultuous history wedding traditional norms and values to Western institutions and technology the Japanese company is a formidable innovator a formidable competitor adapting to changing market conditions to changing political realities to changing social norms That is the most important implication to draw from this account of Japan s remarkable longrun economic development Key terms and concepts in Chapter 12 Forecasting national income Freeter Giui coefficient Moral hazard and conditional moral hazard Changes in the voting system introduced during the earlymidl 9903 Appendix Japanese economic development l886 2000 a statistical portrait A rich statistical record One of the great attractions of becoming a student of Japan s economic development is access to statistical documentation covering Japazfs economy prior to during and after its extensive industrialization and transformation from low to high levels of per capita income Indeed it is difficult to deny the statement that the statistics documenting Japatfs economic development are more wide ranging and detailed than are the statistics of any other country undergoing development in the nineteenth twentieth and twentyfirst Cf 1liiJI1 S Ultimately Japanese government ministries deserve our gratitude for collecting processing and publishing tabulations from the censuses and surveys they have carried out since the 1870s While corporations and individuals have left useful statistical records of their activities it is the Japanese government agency that has done the lion s share of documenting Japan s economic transformation It should be kept in mind that while some of the numerical information available is generated from administrative functions carried out by officials for instance collecting taxes and duties on imports administrating employment exchanges managing Welfare offices counting persons who clear customs at airports much of the data was secured through special surveys Some surveys like the population census attempt to count everyone residing in Japan Other surveys attempt to sample from the population in order to make reasonably reliable inferences about the population or sub populatioos as a whole For those interested in working with the original publications of Japanese ministries a word of warning is in order The names of the publishing agencies change due to administrative revamping and reform in Japan s national prefec ture and local bureaucracies For instance consider the agency that publishes the statistical yearbook for Japan Between 288i and 1939 the Cabinet Bureau of Statistics Naikalcu tokeikyoltu was responsible for issuing the Statistical Anmial of the Japanese Empire in the early 2000s it is the Statistics Bureau of the Ministry of Internal Affairs and Communications that publishes the yearbook and maintains the website wwwstatgojpenglishfdatachouki containing longeerm historical statistics for Japan Or consider the census Between i920 and 1940 it was administered and processed by the Cabinet Bureau of Statistics Beginning 1quot 2 Experiments with Planning and Economic Disruptions The history and economic institutions from the estabiishrnent of the Peopiefs Republic of China in 1949 to the beginning of economic reform in 1978 are reviewed The theory and practice of economic planning during this period are studied to provide an under standing of the shortcomings of a pianned economy and the need to reform 21 The Communist Party Rises to Power The main purpose of this chapter is to describe how the Chinese economy func tioned in the period 1949 78 To do so we need to provide both a historical institu tional account and a theoretical analysis of economic planning as practiced in China during this period The iirst two sections of this chapter are historical and institu tional Sections 23 to 25 are concerned with the theory and practice of economic planning dealing respectively with a simpli ed model of a planned economy the behavior of individual economic units and the behavior of the planning authority Section 26 describes the government organizations concerned with economic plan ning Before describing the economic institutions and the major economic events from 1949 to 1978 it is useful to review brie y how the Chinese Communist Party came to power The party was founded in Shanghai in 1921 at a time when China was fractionalized and lacking strong political leadership There was a political vacuum to ll and China faced the urgent tasks of improving its political status as a nation and developing its economy The Soviet Union had just been established under Communism after a successful revolution and this new country promised to make the former Russia strong and avoid some of the pitfalls of capitalism Although Com Experiments with Planning and Economic Disruptions 25 munist ideology might sound unreasonable to most people today it had appeal at that time to some Chinese who Wanted to build a better country In fact in a prosm perous and politically stable country like the United States many intellectuals joined the Communist Party in the 1930s after the experience of the Great Depression China was poorer in 1921 did not have a stable government and had not had a successful experience with modern capitalism ome people in China associated capi talism with imperialism They disliked imperialism as it was practiced by the capitalw ist Countries It did not occur to them that all powerful countries could practice imperialism whatever form their economic system happens to be If capitalism and imperialism were evil a possibly better system could be Communism ideologically Communism is the antithesis of capitalism and imperialism As We pointed out in section 13 Sun Yat sen cooperated with the Communist Party in the early 1920s in order to unify China under his leadership Other political and military leaders also wanted to unify China under their leadership Sun was not in a stronger position than at least three others who occupied the northeast the north including Beijing and central China While Sun was barely able to lead the south after some military struggles To succeed Sun needed the support of the So viet Union as no Western nation was willing to support his Nationalist Party or Kuomintang After Sun s death in 1925 Chiang Kai shek split with the Communist Party in the course of his northern expedition to unify China The Communist Party tried to establish in uence and control in certain rural areas by working with and helping the farmers After the Long March of 1933 and being chased by Chiang the Communists finally settled in Yanan during the Second World War Their rule was popular among many farmers although not necessarily among some of the intellec tuals who moved to Yanan Their popularity was witnessed by the American writer Edgar Snow who was allowed to live there Snow Wrote the well lltnoWn book Red Star veer China which depicted the rule of that area as much superior to the Nation alist rule over other areas of China unoccupied by the Japanese Because of Snow s book the American media sometimes called the Communists agrarian reformers SnoW s book is probably accurate and Communist rule in Yanan was by and large popular This was a factor contributing to the popularity of the Communist Party during the civil war after 1949 The failure of Chiang to control his corrupt officials when they took over the coastal areas from Japanese occupation after the Second World War and the failure of the economic policies of his government contributed as much if not more to the success of the Communist Party The Communist Party excelled in organizational skill and ability to gain support from the masses even by deception if necessary Some of this skill was acquired from the Soviet Union It has been observed that a Communist would try to achieve his goals without regard to means for a Communist ends justify the means During periods of political struggle many Chinese political leaders including Chiang were willing to gain power by harsh means also For example to gain the support of the Chinese capitalists the Communist Party deceived them by promising that they could continue the operation of their capitalist enterprises under Communist rule 26 Historical Background and General Survey 22 Historical Review 194975 221 194952 During the initial three years of the People s Republic of China the government was quite popular Many welltodo people left China before 1949 anticipating the trou bles under Communist rule The majority of those who remained had hopes of bet ter things to come First a major land reform was introduced when the government forced the landlords to surrender land to the tenant farmers This made the farmers happy but the landlords unhappy To accomplish the desired land redistribution the landlords as a class were brutally extinguished Mass meetings in the countryside were called and landlords were singled out for criticism Before each meeting cer tain farmers were assigned to tell stories of how the designated landlords had misbe haved and collected unreasonable rents At the meeting the landlords were denounced and asked to confess their crimes resulting in their execution As a result of such meetings many landlords were killed In this period industrialists were allowed to continue the operation of their enter prises State enterprises belonging to the government of the Republic of China were taken over by the new government Life in the urban areas remained much as before Existing educational institutions were allowed to function as before People had much the same freedom of expression as long as they did not criticize the Communist Party or the government they also had freedom to choose their jobs and freedom to travel The border between Hong Kong and mainland China was open However many residents sensed that changes towards a totalitarian regime were soon to come 222 19537 Things began to change later in 1952 Educational institutions were reorganized All private universities ceased operation and were incorporated into state universities modeled after the Soviet educational system The border to Hong Kong was closed The capitalists were asked to surrender their enterprises step by step until they be came only managers of the enterprise and had to follow government instructions if they were to remain a part of it The farmers were organized into cooperatives under the pretense that this would improve production and marketing but they were soon forced to surrender their produce to government procurement agencies Trade in farm products by private traders soon ceased and the government became the sole distributor Many of these changes were made in order that the government could initiate its first Five Year Plan of 19537 In addition political campaigns were ini tiated during this period to control intellectuals who might be critical of the govern ment During the campaign Letting one hundred owers bloom of 1957 Mao encouraged intellectuals to criticize the government and speak their minds Some fell into this trap and were severely punished when they did speak out Experiments with Planning and Economic Disruptions 27 223 195561 In 1958 Mao launched the Great Leap Forward movement with the purpose of increasing China s output dramatically and developing its economy rapidly Mao did not understand economics and was extremely skillful in mobilizing the masses He thought economic obiectives could be achieved in the same way as political ob jectives and revolutions simply by rallying mass support In 1958 he organized the fartners into comrnunes in the previous few years they had been organized suc cessively from family farms to cooperatives and more advanced forms of coopera tives Within less than a year during 1958 almost all farms in China were converted to communes where people worked as a team and ate together in mess halls Mao also assigned unreasonable output targets for the communes Industrial output was also to be rapidly increased People were asked to build furnaces in their backyards to produce iron To satisfy output targets nished products were put into the fur nace to produce iron and steel The end result was an economic disaster Food production was greatly reduced and bad weather was to blame From 1958 to 1962 it was estimated that over 25 million people died of famine the most severe in Chi nese history 224 19625 This was a period of readjustment after the Great Leap The economy returned to normal Mao lost political power because of the failure of the Great Leap which he had initiated although he was still nominally the Chairman of the Communist Party A more moderate government led by President Liu Shaoqi allowed the farmers to farm on private plots of land while the commune system still existed nominally Letting farm families have their own land to farm was a policy later adopted when economic reform took place in 1978 Unreasonable output targets were abolished In December 1964 Premier Zhou Enlai announced the government s objective to achieve four modernizations of China The four areas were industry agriculture defense and science and technology The policy was not carried out until after eco nomic reform because of the interruptions of the Cultural Revolution 225 196676 Mainly to regain his political power Mao initiated the Cultural Revolution in 1966 Mao was a perpetual revolutionary It was not enough to overthrow the Republic of China on the mainland He now wanted to overthrow the bureaucracy of the party and governrnent that he had built himself To do so he appealed directly to Chinese youth who were organized into the Red Guard The Chinese government adminis tration and economic system were under attack by millions of Red Guards on the pretext of a cultural revolution Political power was transferred from the pragmatic econornic planners to the radical elements of the Communist Party in the name of destroying an old cultural tradition that was said to hinder social revolution To be a 25 Historical Background and General urvey revolutionary was and still is considered good and a CO c1I1lZ i f VOll1 1OI1fll39y consid ered evil in China An outside observer might not understand why in the year 2002 when the country is ruled by the Communist Party a revolutionary who is supposed to advocate overthrowing the existing regime is considered good and a counterrevo lutioiiary who objects to a revolution or supports the status quo is considered to be bad Many elderly people and intellectuals were physically harmed by Red Guards who invaded private homes and destroyed art treasures and books Fighting also took place among different factions of the Red Guard all claiming to be the true followers of Mao A Red Book of quotations from Mao was brandished and treated as a gospel for study and memorization The education system ceased to function and universities were closed The ensuing political turmoil including worker demands for higher wages led to a resolution to freeze all prices at the end of 1966 The movement lasted for a decade and prevented the proper functioning of the Chinese economy The economic losses of the Great Leap and the Cultural Revolution were estimated in two papers by Chow and Kwan in the jlozmzel of Comparative Eccmomics and Pacific Economic Review 1996 the first of which is discussed in chapter 8 226 19765 After Chairman Mao died in September 1976 political power was soon transferred from the radical and irrational elements of the Communist Party to more pragmatic planners who wanted to carry out Chitia s fourfold modernization The Gang of Four who helped engineer the Cultural Revolution were stripped of political power A political and economic system somewhat resembling the one existing in the early 1960s was restored Deng Xiaoping became the leader in 1978 because he had the support of the top leadership in the Central Committee of the Communist Party He took over power from Hua Guofeng the Chairman designated by Mao to succeed him As of 2001 Hua remained a member of the Central Committee of the Com munist Party This is one example which illustrates that political succession under Chinese Communist Party rule was peaceful and orderly Another is the succession after Deng died in 1996 Iiaiig Zemin succeeded him as the leader smoothly and peacefully The period of l976 8 witnessed the re establishment of political and economic order after the Cultural Revolution In 1979 the People s Republic of China established formal diplomatic relations with the United States By that time China had made a major resolution to initiate economic reform Before we discuss reform we need to understand how the Chinese planning system worked 23 A Model of the Chinese Planned Economy To understand Chinese economic planning 1et s consider a simpli ed model Many of the institutional details are omitted in this discussion as in any discussion using an economic model Note that economic planning did not cover the entire Chinese economy and that the planning model is relevant only for a part of it Furthermore planning was interrupted by the political turmoil of the Great Leap Forward move ment and the Cultural Revolution Given these qualifications note first that the Experiments with Flamiing and Economic Disruptions 29 main difference between a planned economy and a market economy is that in the former economic decisions are centralized and in the latter decentralized To make the centralized economic decisions there is a planning cziirhorziy in the model consist ing of a group of economic planners The Chinese counterpart is the Economic Planning Commission in the State Council The planning authority has control over all physical productive resources covering land buildings machinery and other capital goods Directly or indirectly it controls all enterprises farms and factories It can assign a production target to each farm and each factory to tell it how much of each good to produce It controls all sources of supply of inputs In assigning an output quota to a farm or a factory it also supplies the inputs required for produc tion such as fertilizer and tractors for farming and materials for industrial produc tion in addition it assigns workers to different factories it can direct a person from a city to work in a particular farm It can direct a farmer to work on a different farm or to work in the city although the latter seldom happened in China Thus the production of final outputs and the allocation of inputs for production are controlled by the planning authority As far as the consumption of nal products 1S concerned in our model the sup plies of all consumer goods are under the control of the planning authority There are two kinds of consumer goods rationed and nonrationed In China the former included food grains vegetable oil meat sugar and cotton cloth These goods are distributed to consumers through a rationing system Every month each consumer is given a fixed number of ration coupons which have to be used in addition to money to pay for the rationed goods The nonrationed goods are also sold through stores operated by the authority but the consumer can decide what and how much to buy and can pay for these goods by money only The income of a factory worker depends on the wage rate that the authority deter mines Workers have 10b security in the sense that they cannot be dismissed rarely is a worker reassigned to another job A farmer gets a fraction of the income of the farm on which he or she works Each farmer accumulates work points throughout the year at the end of the year the work points of all farm members are added together and the fraction attributed to each person is calculated The fraction determines what share of the farm income he or she gets The total income of the farm is the difference between its revenue and its costs The revenue is the money value of the products of the farm Designated amounts of farm products produced in a commune must be sold to a procurement agency authorized by the planning authority and the remaining prod ucts are left in the commune for distribution to its members The planning authority decides on the amount and price of each product it will purchase from each farm By changing the purchase prices and purchase quotas of farm products the authority controls the incomes of the farmers One can compare the functioning of our hypothetical centrally planned economy with that of a market economy by noting that in each economy there are consumers and producers including farms and factories There is a flow of goods or services from one economic unit to another Consumer goods ow from producers to con sumers Labor services flow from consumers to producers Material inputs and capi tal goods ow from producers to producers The main difference is that in a market economy the ows are determined by the economic units themselves through the 30 Historical Background and General Survey market and in a planned economy the flows are determined centrally by the plan ning authority There is a bureau of material supply in the State Council of China which controls the distribution of material from producers to producers The plan ning authority orders the producers to produce certain consumer goods and distrib ute them to the consumers It assigns laborers to work in various production units It orders producers to produce material inputs and distribute them to other producers It also directs the production of capital goods and the construction of investment projects When goods and services flow in one direction money payments for these goods flow in the opposite direction Consumers pay for the goods they buy Producers also pay for the inputs and capital goods that they use In a market economy the buyers and sellers can settle the exchanges directly in a market or through intermediaries who perform the services of commerce and trade The prices are determined by the forces of demand and supply In a centrally planned economy the users and the producers have to go through the planning authority or distributors who Work under its Cli1 tC tiou All prices including wages for labor services are determined by the planning authority in China through the State Price Commission of the State Council In any economy goods have to be produced for consumption and for capital accu mulation Consumer goods are produced mainly for present consumption and capi tal goods are produced in order to expand the future productive capacity of the economy In a centrally planned economy the planning authority has the responsi bility to decide the total amount of each consumer good and capital good to be produced the speci c quantities of each good to be produced by the enterprises under its control the supplies of each important input to be allotted to these enter prises and the amounts of capital investment to be allotted to the enterprises It then decides how the consumer goods are to be distributed to consumers Work gets done by central command as in an army The commander of an army directs all the activi ties of the soldiers and determines their food rations Great projects were completed by central command all through history including the Great Wall of China and the pyramids of Egypt However only in a planned economy in the twentieth century did a central government authority attempt to direct all the complicated tasks con nected with the production of thousands of goods by thousands of enterprises and their distribution to millions of people In the remainder of this section we examine three difficult tasks of a central planning authority in directing the economic activi ties of a country In a centrally pianned economy the production and distribution decisions are made by the planning authority In a market economy these decisions are made by millions of individual consumers who try to buy from the cheapest source and thou sands of producers who try to sell to maximize gains No central direction is re quired as pointed out by the Chinese historian Sirna Qian whom we quoted in section 124 Given his or her income and the prices of different products each consumer decides what to buy from the market Wfhen the price of a commodity goes up the consumer will consume less of it Given its production technology and the prices of outputs and inputs each enterprise decides how much output to pro duce and how much of each input to use in production Prices will adjust so that the quantities produced will equal the quantities demanded by the users Each enter prise only needs to know its own economic conditions including its technology the Experiments with Planning and Economic Disruptions 31 productivity of its workers the capacity of its capital equipment the kinds of inputs required and the demand schedules for its products It can then determine the kinds and quantities of its outputs to produce and of the inputs to use optimally To make such decisions for thousands of state enterprises under central planning a central authority has three difficult tasks to perform The first is to obtain a mass of information on the production conditions of all the enterprises under its control and the demand conditions of millions of consumers Wimout such a vast amount of information it cannot efficiently choose the thousands of products to produce as sign production quotas to thousands of enterprises and supply them with appropri ate quantities of inputs In a market economy no single authority needs to have ali this information Each enterprise makes its own output and input decisions knowing only the production and demand conditions facing the enterprise itself Economic infonnation is decentralized among thousands of enterprises In a planned economy the vast amount of economic information has to be centralized in the planning au thority aod it is impossible to obtain in practice The second difficult task facing the planning authority even if it could know the economic conditions of each enterprise is to provide sufficient incentives to each state enterprise manager to produce economically and to expand the productive capacity of the enterprise and introduce new products e ectively In a market economy pro t incentives help ensure efficient production optimal investment and introduc tion of new products In a planned economy the central authority may allow enter prise managers to share pro ts and it may appeal to their sense of patriotism and reward successful ones with honors The Chinese have accumulated valuable expe fiance concerning the use of nonmaterial incentives However it is difficult for the planning authority to iudge which enterprise managers should be rewarded when the production targets are set arbitrarily and the economic conditions of the enterprise cannot be ascertained accurately If each state enterprise is allowed to make produc tion and investment decisions on its own and if prices are determined by market forces and not controlled by the planning authority the economy is a socialist mar ket economy and no longer a centrally planned economy China s economic reform which will be described in the next chapter to a large extent succeeded in trans forming the economy from a planned economy to a socialist market economy The incentive problem is particularly difficult to solve in the undertaking of risky investment projects As compared with the situation in a market economy the enter prise manager in a planned economy does not receive sufficient reward for taking risks in investing because the reward for success is limited while the punishment for failure is severe At the other extreme the manager may be willing to engage in expensive and wasteful investment projects as long as the result is not recognized to be a failure For example without a market test it is difficult to judge Whether setting up new plants to produce certaimtypes of cars is economically efficient since the government monopolizes the production of cars This applies also to large projects for infrastructure building The third task of the planning authority is the setting of prices In a market economy prices affect the consumption production and distribution of goods In a centrally planned economy prices can affect consumption but cannot encourage or discour age production if the enterprises do not operate to make pro ts Prices perform an important function in the distribution of consumer goods to consumers and the 32 Historical Background and General Survey distribution of producer goods and materials to producers In the Chinese planned economy the procurement prices of agricultural products affect the income of farm ers wage rates affect the income of workers The prices of consumer goods affect the quantities of these goods that they will purchase Prices of producer goods and ma terials affect the revenues of those enterprises producing them and the costs of those enterprises employing them In setting these prices the central planning authority has to consider three sets of balances First the total value of all consumer goods produced should be equal to the total value of the quantities that consumers want to buy given the total value of their incomes Since the supplies of all consumer goods as well as their prices are set by the planning authority the total value of all consumer goods is determined In the meantime wage rates and purchase prices of farm products help determine the in comes of consumers Consumers decide how much of their incomes to spend on consumer goods and how much to save If the total value of the consumer goods that consumers decide to purchase given their incomes is larger than the total value of the goods available there will be hidden in ation or even open in ation if the prices of some goods are not controlled In fact at any price which the planning authority sets for a particular nonrationed good the supply of that good may not be sufficient to satisfy the demand In that case there will be shortages with consumers Waiting for more supplies to come In practice the prices of consumer goods in a planned economy tend to be set too low because of a sense of fairness Demand therefore tends to exceed supply and shortage results Second the planning authority has to set prices so as to balance the total revenue and expenditures of all enterprises under its control The total revenue of each enter prise is determined by the output quota and the price of the output Its total ex penditure is determined by the quantities and prices of the inputs that it employs and the capital goods that it needs for the targeted expansion If an enterprise s total revenue exceeds its total expenditure it has a surplus that belongs to the planning authority If total revenue is less than total expenditures the enterprise needs a sub sidy from the planning authority to balance its books If the total revenue from all enterprises is less than their total expenditure the planning authority has to find ways to subsidize the money losing enterprises In China during most of the period of planning state enterprises made pro ts to be used as government revenues After economic reform many state enterprises were losing money and required govern ment subsidies Third the planning authority has to balance the government budget or find ways to nance government de cits Deficits can be nanced in two ways by issuing new money and by issuing government bonds to be sold at home or abroad Issuing too much new money will cause inflation open or hidden Since prices will affect the balancing of the government s budget the central authority has to take this factor into account in setting prices 24 The Behavior of Economic Units in a Planned Economy We have described the basic organizational arrangement of a centrally planned economy and the three difficult tasks of the planning authority How the economy Experiments with Planning and Economic Disruptions 35 Works and how well it works depend on how and how well the planning authority performs its functions and how the economy s other units respond to its directions We will now describe the behavior of the component economic units including con sumers farmers workers farms and industrial enterprises leaving the behavior of the central planning authority to the following section The behavior of consumers in a centrally planned economy can be explained by the basic theory of consumer behavior presented in economics texts if the rationing of consumer goods is taken into account If there is no rationing the textbook theory is applicable to Chinese consumers In this theory a consumer is assumed to rank different bundles of consumer goods according to his or her preferences Graphi cally bundles of goods equally preferred are points on an indifference curve Given his income and the prices of all goods the consumer is assumed to choose that bundle on the highest ranllted indifference curve that he or she can afford The most important implication of this theory is that when the relative price of a commodity goes up the consumer will buy less of it given his real income A demand function for each commodity is derived from the consumer s search for the highestranked indifference curve subject to the constraint of his or her budget The demand for any commodity is thus a function of consumers incomes and the prices of all com modities When rationing is present the consumer not only has to pay the price of a rationed good but also has to surrender a ration coupon for one unit of that commodity The rationing of a particular commodity is said to be effectzbe if all rationed coupons for that commodity are used up If they are not used up the ration coupons do not restrict the consumption of that commodity and the demand for it is the same as the demand for a nonrationed commodity If there are several commodities for which rationing is effective the theory of consumer behavior can be modi ed by taking the quantities and prices of these commodities as given The quantities are equal to the numbers of coupons issued Subtract the value of these commodities from the con sumer s income the consumer now has a smaller income to spend on the remaining commodities Given this smaller income net of spending on the rationed commodi ties and given the prices of the remaining commodities the consumer now chooses a bundle of the remaining commodities that he or she prefers subject to budget constraint on purchases of the remaining commodities The demand for each com modity is a function of the net income and the prices of the remaining commodities When the relative price of a remaining commodity goes up its consumption will go down as usual In addition we have to allow for the effects of the quantities of effectively rationed commodities on the demand for the nonrationed commodities If the quantity of an effectively rationed commodity increases the demand for a nonrationed substitute will decrease and the demand for a nonrationed comple mom will increase See Neary and Roberts 1980 2542 for a theoretical treatment which is applicable to China as well Secondly let s consider the behavior of a Chinese farm worker From 1959 to 1979 the Chinese farms were organized as comrmmes which served as both political administrative and economic units of the government Each commune was divided into brigades and each brigade was divided into work teams According to the Almanac of China s Economy 1981 965 the total population of the communes in 1979 was 8074 million There were 1749 million families organized into 53348 34 Hiatoricai Background and General Survey communes 699000 brigades and 5154000 teams On the average these statistics imply 131 brigades per commune 7 4 teams per brigade and 157 persons per team The central planning authority directs each commune to grow particular kinds of crops assigns production quotas for the products and the amounts to be delivered to a government procurement agency at given prices and provides the necessary sup plies of farm inputs to each commune The communes also engage in large projects such as road construction and irrigation that require the work of an entire brigade and in sideline nonfarm activities such as the production of light industrial products Each farmer is paid a fraction of the income of the team to which he belongs The fraction is the ratio of the number of work points the farmer earns to the total number earned by all team members An incentive problem arises because the farmer is not paid according to the marginal product of his labor if he works harder to increase output he gets very little of the additional output which is shared by all members of the team Under the commune system there is indeed little incentive for farmers to work hard Third the behavior of a Chinese industrial Worker likewise depends on her work ing arrangement In the first place the worllter s job is assigned to her by a labor bureau which tries to match jobs with workers As compared with a market system in which Workers find jobs for themselves and enterprises decide for themselves which Workers to hire and discharge this system leads to the mismatching of jobs and workers Furthermore the government s labor bureau is less quali ed than an enterw prise s personnel manager to decide Whether a particular worker is suitable for a certain job The labor bureau staff will often assign the more desirable jobs as com pensation for favors In addition once assigned a job the worker cannot be dis charged and she gets the same pay whether she works harder or not From 1960 to l97 7 the Wages of most Workers were not changed at all although some received bonuses or awards of one kind or another Different wage rates apply to different jobs Under these conditions one can expect to find a lack of incentive and low productivity among the workers as is in fact the case Fourth consider the behavior of Chinese farms as economic units A commune is both a politicaladministrative unit and an economic unit of production formed in the spirit of a planned economy in such a unit peasants workers students and members of the army engage in farming shing forestry industrial sidelines and construction activities Labor is mobilized to perform the important economic tasks of supplying food and material and of building roads bridges irrigation systems and other construction projects Each commune is directed by the planning author ity to produce particular kinds of products and sometimes to use certain acreage allotments and farming techniques such as multiple cropping The lack of expertise on the part of the central planning authority and its staff can lead to and has led to the misuse of farmland and low productivity In reality Chairman Mao emphasized the production of grain at the expense of other crops even at locations not suitable for grain production This led to a great loss in agricultural productivity When the planning authority assigns production targets to each commune the latter in turn assigns production targets to the brigades and the production teams The produc tion teams have difficulty getting the farmers to work hard because as we have pointed out the farmers do not receive the value of the marginal product of their labor under the payment system In other words by commanding farmers to produce as teams Experlmenta with Planning and Economic Disruptions 35 and not paying them according to their individual productivity the commune can not effectively manage the production of farm products Fifth as in the case of a Chinese factory inefficiencies can come from three sources First with jobs guaranteed and wages independent of productivity the management has difficulty in motivating workers to work harder as we have pointed out Second Yainain goal of the management is not to maximize pro ts but to meet the produc tion targets set by the planning authority and there is a lack of incentive for the management to increase outputs beyond the targeted amounts or to introduce new products that satisfy the consumers Since the management can in uence the setting of production targets by providing the planning authority with estimates of the pro ductive capacity of the enterprise it has an incentive to lower the production targets in order to make them easier to meet Third because the management receives ma terials and other required inputs from the planning authority it has little incentive to economize on the use of the inputs Nor does it have much incentive to keep its input estimates low because the management does not bear the cost of additional inputs but it is penalized if inputs are insufficient to meet the production targets Waste of tnaterial and other inputs will result leading to the accumulation of large invent ones 25 Output Planning in Theory and Practice We will now discuss the behavior of the planning authority in theory and practice In theory it is responsible for solving all the economic problems related to the produc tion and distribution of goods and to the accumulation of capital It has to rely on the above mentioned individual economic units to carry out all the tasks of produc tion distribution and capital accumulation How and how well the tasks are accom plishcd depends on the rules set by the planning authority We have discussed the behavior of each type of economic unit under one set of rules that approximates the actual conditions in China from 1959 to 1978 It is not our task to explain why the planning authority might want to increase the production of one kind of product relative to another kind Given its objectives the planning authority has to face the production constraints of the economy the physical and human resources available the Way productive units are organized the technology available and the rules the production units have to follow When the planning authority attempts to increase the outputs of certain products relative to other products it will try to increase the production targets of the former products relative to the latter products How much of one product can be increased when another product is reduced depends on the economy s production transformation curve also called the production poss139b239lzryfron tier The production transformation curve summarizes the production possibilities in an economy Given the technology resources and organizational arrangements of an economy the output of one product can be increased only by sacri cing a certain amount of the output of another product We can conceptualize the planning authority as selecting a point on the production transformation curve that is most preferred If the preferences of the planning authority are summarized by a set of indifference curves the combination of target outputs will be a point at which the production transforrnation curve is tangential to an indifference curve 36 Historical Background and General Survey To understand the shift of output targets along the production transformation curve of a cennally planned economy we need to describe how resources are trans ferred from the production of one commodity to the production of another com modity When the planning authority desires an increase of one product it must ensure that sufficient resources will be made available from somewhere else In other words if a central planner Wishes to produce certain units of good 1 certain units of good 2 and so on it must make available the inputs required to produce them The balancing of inputs is an essential task for a central planning authority that sets prow duction targets for its production units The process of balancing the total requirement in production and total supply of each input is known as material baiancing as first practiced in the Soviet Union It consists of the following steps First on the basis of its knowledge of each productive unit industrial enterprise or farm including its inputs and outputs of the last pe riod the central planning authority through its sta and lower level administrators sets preliminary production targets for each enterprise and obtains requests from it concerning the amount of each important input required Second the planning au thority adds up the quantities of each input required by all production units and compares the total with the total produced by all enterprises If the two sums are the same the requirement and the supply of this input are in balance Otherwise as a third step the central planning authority advises some production units to reduce their input requirements instructs some units to raise their production of the re quired inputs and reduces the output targets of enterprises producing less essential products After some negotiations the planning authority goes back to the rst step by issuing a revised set of production targets for each enterprise and a revised set of inputs to be made available to each enterprise An annual plan is created based on the output targets so obtained Details on the misuse of resources in the process of material balancing for one particular stateowned enterprise will he discussed in sec tion 152 Often the balance between the production and the use of each product is achieved only on paper X7hen actual production takes place some materials may be in short supply creating bottlenecks in production while other materials may be in excess supply creating large inventories Excessive inventories held by one enterprise may not he made available to another enterprise that needs them there is no incentive and no mechanism to transfer the excess material from one enterprise to another The problem of balancing the demand for and supply of each input is solved in a market economy When demand exceeds supply the price of that item will rise to discourage its use and encourage its production When the consumers as a group decide to have more of product 2 relative to product 1 the relative price of product 2 goes up relative to the price of product 1 and production of product 2 increases while production of product 1 decreases Producers of product 2 demand more in puts and obtain them from the other producers through the market All balancing is achieved by the price mechanism without the interference of a central planning authority Li Kaixin describes the management of supplies in China 1982 6l320 Be tween 1949 and 1952 supply management was controlled by the Financial and Economic Commission of the Administrative Council In 1950 eight major materi als including rolled steel timber coal and cement were allocated directly by the Experiments with Planning and Economic iaruptione 57 central government or administrative regions each consisting of several provinces The number of maior materials under state control was increased to 55 in 1952 In the first Five Year Plan of l9537 the State Planning Commission increased the number further Producer goods allocated by government units were classi ed into tlitec categories those under unified state allocation those allocated by different industrial ministries and those allocated by local authorities By 1957 the number of products in the first and second categories had increased to 532 These were mainly products of enterprises run by the state at a level not lower than the provincial gov ernment or some large scale state private joint enterprises and products of private enterprises entirely purchased and marketed by the state They were not allowed to be marketed by the enterprises themselves but were to be supplied by a combination of direct planning through central allocation and indirect planning through the mats ket They accounted for 70 to 90 percent of all producer goods in the country The rest was allocated by provincial municipal and autonomous regional authorities they were distributed through market channels Li 1982 61344 writes Between 1958 and 1960 there was a serious shortage of materials chaotic management and frightening waste all of which caused great difficulties for major production units and construction projects directly under the control of the central authority This pre dicament came about because the production targets of industry m heavy industry in particular were set so high as to be beyond the capability of the country s economy To make matters worse control over allocation and distribution of many kinds of mate rials in the first and second categories was given over to the local authorities in 1961 the Party Central Committee and the State Council decided to adopt policies of re adjustment consolidation expansion and raising standards for the national economy While reducing the scope of capital construction and readjusting industrial production the State Strengthened its uni ed control of materials The number of materials in the first and second categories increased to about 500 Between 1962 and 1965 the question of controlling the supply of materials was dis cussed on many occasions by the Party Central Committee and the State Council decisions for work improvement were made On controlling the circulation of goods Comrade Lin Shaoqi s concept of setting up a system of second commerce was put into practice This included establishment of institutions in charge of materials management 1e specialized material supply corpo rations and stations organizing service teams to keep regular contacts with user enter prises at the grassroots level setting up many factories and shops for processing materials according to fixed models As a result there was a marked improvement in the supply of materials During the ten years of turmoil between 1966 and 1976 however the supply of producer goods was seriously disrupted The ministry in charge of that supply was smashed Such state institutions in 24 provinces and autonomous regions were sus pended and most of the special goods supply companies service companies and supply stations were either dissolved or merged Consequently state control of the alloca tion and distribution of producer goods was greatly weakened The institutions in charge of material supply gradually resumed work and some regu lations for the management of goods which had proved effective during the 19603 were reinstated There has been a strengthening of state control for the allocation and distri bution of producer goods Most of the goods in the first category have been placed once again under control of the state organizations in charge of material supplies Mean 58 Historical Background and General urvey while local authorities have been enjoying greater power in the control of goods The goods in the first category under the control of local authorities in 1978 accounted for the following percentages of the national total coal 46 rolled steel 42 copper aluminum lead and zinc 36 timber 18 and cement 71 This quotation suggests that the central direction of a planned economy including the supply and allocation of materials does not cover all goods and services but only the most important ones In China the coverage and the effectiveness of control varied from time to time according to political conditions This fact has to be borne in mind when discussing a model of the Chinese planned economy up to the late 19703 Side by side with the balancing of materials in a centrally planned economy there is a need to balance the flow of money that accompanies the flow of materials Each enterprise obtains revenues from the goods that it delivers to the central authority or at the direction of the central authority to other enterprises It incurs expenses for the materials it receives for production It may have a surplus or a de cit as total revenue exceeds or falls short of total costs In the event of a de cit a subsidy from the planning authority is required In order to have a net transfer of resources to all enterprises for the purpose of capital formation the planning authority may have to run a de cit in its operation of all enterprises This de cit can be nanced by bor rowing from or taxing the public or by borrowing from abroad In any case a gov ernment budget has to be prepared in connection with the balancing of the materials to summarize the flows of money Accordingly in September 1980 o icials of the State Council of China presented for approval to the National People s Congress the National Economic Plans summarizing the production targets for major products for 1980 and 1981 the Final State Budget for 1979 the Draft State Budget for 1980 and the Projected State Budget for 1981 intimately related to the material and financial ows are the prices of various out puts and inputs controlled by the planning authority A de cit can become a surplus after certain price changes Prices in a free market are not controlled but a central planning authority has many options in setting prices including the use of market signals In China the prices of important consumer and producer goods that are distributed through the central planning system are centrally controlled Prices of products distributed locally are controlled by the local economic administrators The central planning authority can set prices to control consumption the distribu tion of income the nances of government enterprises and the rate of in ation Prices of certain consumer products are set very low to guarantee that each family can afford to purchase some specified quantities Rent for urban housing is extremely low prices of food grain are also low requiring government subsidies Prices of other consumer goods such as television sets are set very high during the period of central planning to discourage consumption in order to prevent inflation prices of certain materials are not allowed to change Prices of certain supplies to farmers are set high as a tax on farmers to support the process of industrial development and national capital formation At this point in our discussion we only indicate the moti vation of the Chinese planning authority for the setting of certain prices without implying that such practices are either good or bad We only note that the planning authority regards the setting of prices as a means to control the economy in the process of economic planning Experiments with Planning and Economic Disruptions 39 A description of the behavior of the planning authority would be incomplete with out discussing the administrative and political problems of the planning organization itself First the leadership of the planning authority may not correctly perceive the economic constraints that limit its economic choices Grossly unrealistic economic plans that cannot be implemented are not unusual especially if the person or per sons in power do not have the required knowledge of or professional advice on eco nornic matters The great leap in China in 1958 and a smaller leap in 1978 were illustrations of setting planning targets that could not be achieved Second even with a welltrained professional planning staff the problems of economic planning and balancing of resources for the entire country are extremely difficult as we saw in section 23 above One can appreciate the difficult mathematical and informational problems of central economic planning when there are thousands of products and perhaps millions of production units involved and when the production functions of the production units are not completely known by the economic planners Third assuming that a sound and detailed economic plan has been made the planning authority still faces the problem of supervising its administrative staff who will carry out its orders all the way down to the individual economic units There are incentive problems associated with the large bureaucracy required for central planning False reporting and receiving bribes for doing favors for the enterprises are not uncommon practices Often the appointment of staff is in uenced by political considerations and not by the candidates professional quali cations Once on the staff a person may use his administrative and economic powers to further his own interests which may differ from the interests of the central planning authority Fourth an additional complication on the Chinese scene is that the administrative units of different prov inces have their regional economic and political objectives Local powers have per sisted through Chinese history and the central planning authority has the problem of getting the provincial and local units to work for its national economic goals The self interest of lower level economic administrators often does not coincide with the interest of the national planning authority and creates serious problems in China We can brie y summarize the behavior of different economic units in our model of a centrally planned economy The planning authority has certain objectives which in theory can be summarized by a set of indifference curves showing which combina tions of products are equally preferred If the planning authority is assumed to func tion intelligently it tries to find the most preferred combination subject to the restriction of the productionwtransformation relations among the different products In the case of two commodities the relation is depicted by a production transforma tion curve A planner usually does not know the true productiontransformation curve and may seek a point beyond the productive capabilities of the economy In the process of mobilizing the different economic units to produce and to distribute products for consumption and for capital accumulation the central planning an thority sets production targets supplies materials necessary for production balances the supplies of materials with their requirements balances the nancial flows sets the Wage rates and prices rations the consumption of certain consumer goods and assigns jobs to the workers Given the wage system the employment system the rationing system and the setting of prices and production targets by the planning authority the other economic units consumers farmers workers farms and in dustrial enterprises respond accordingly in ways that we have previously analyzed 40 Historical Background and General Survey This is essentially how a centrally planned economy with features abstracted from the Chinese conditions of 195378 works In reality the effectiveness of planning and the degree of central control vary ac cording to political conditions In China tl1e above model is a good approximation of the situation in the period of the rst Five Year Plan 19537 After 1958 the proc ess of planning was often interrupted and annual plans were sometimes announced after the fact Even during the period of the first Five Year Plan central control of the economy did not cover all economic resources and activities Provincial and municipal authorities and local markets remained to exert in uences on the opera tion of the economy Furthermore the central planning units instead of giving di rections often relied on the autonomous workings of the bureaus and enterprises under their control to solve the production and distribution problems through batter and other arrangements As We have pointed out the control of supply of materials was partial and incomplete leaving much discretion to local authorities and allowing exchanges by barter between enterprises in certain instances Concerning the con trol of prices before 1966 deviations from the centrally determined prices were permitted within certain ranges in order to meet local demand and supply condi tions After 1966 because of the need to control the political and economic disorder resulting from the Cultural Revolution the centrally administered prices became more rigid and deviations were not permitted until 1983 26 Organization and Administration of Economic Planning The political power in China resides in the Chinese Communist Party The Party exercises power partly by placing its members in key positions in the government The executive branch of the Chinese government is headed by the State Council The State Council through its various ministries directs the economic activities of the country To appreciate the comprehensiveness of central economic planning one can examine the organization of the State Council The State Council is nomi nally responsible to the National People s Congress although in practice at least until the 19903 the People s Congress exercised little real power The State Council is headed by the Premier and as of 1984 two Vice premiers A list of the comrnis sions and ministries of the State Council as of April 30 1981 can be found in the Almanac of China Economy 1981 578 Some consolidations took place in the spring of 1982 The list below applies to the summer of 1982 and contains supple mentary material found in F11 1982 534 Two commissions were in charge of coordinating the activities of the ministries concerned with economics The State Planning Commission had overall responsi bility for economic planning including the drafting of ve year and other medium term economic plans The Economics Commission reviewed the ful llment of the annual economic plans and instituted economic reforms There were 27 ministries dealing with different segments of the economy They were Agriculture and Fisheries Coal Industry Water Resources and Electric Power State Bureau of Labor Forestry Petroleum Industry Experiments with Planning and Economic Disruptions 4l Railroads Commerce Chemical Industry Nuclear Energy Industry Transportation and Communications Foreign Trade Metallurgical Industry Aircraft Industry Posts and Telecommunications Light Industry Urban and Rural Construction and 3 Environmental Protection Textile Industry State Scienti c and Technological Machinobuilding Industry Commission Finance Geology and Mineral Resources Electronics Industry People s Bank of China Munitions Industry Family Planning Of ce Space Industry The following 13 bureaux were also concerned with the management of economic activities Bank of China State Bureau of Supplies I eople s Construction Bank State Administration of Standards General Administration of Travel and Industrial and Commercial Administra Tourism tion Bureau Agricultural Bank of China State General Administration of Ex Bureau of Drug Administration change Control under the General Administration of Customs People s Bank of China since Bureau of Import Export Control 1982 under Ministry of Foreign Trade Administration Bureau for Commodity State Statistics Bureau Prices The ministries and bureaux in charge of economic affairs greatly outnumber the remaining 11 ministries of the State Council Futeigi Affairs State Physical Culture and Sports Culture Public Security National Defense Cultural Relations with Foreign Education Countries State Nationalities Affairs Commission Civil A airs Public Health Justice The above classi cation of the Family Planning Office and the State Scienti c and Technological Commission as economic and of the ministries of Education and Public Health as noneconomic is arbitrary I have divided these four ministrylevel organizations equally between the two groups for the purpose of counting the min istties and to indicate the importance of economic administration in the affairs of the State Council Note that among the economic ministries those concerned with different industries outnumber the two concerned with agriculture and forestry As I am describing the organization of the State Council during the period of planning it is more convenient to use the present tense In part this 42 Historical Background and General Survey re ects the complexity of central economic planning for industry as compared with agriculture Generally speaking directions from the central government to the individual eco nomic units go through three intermediate levels of the Chinese government The first level consisted of 21 provinces 5 autonomous regions and 3 municipalities directly under the central government The 21 provinces are Anhui Fuiian Ganzu Qinghai Guangdong Guizhou Hebei Heiiongiiang Henan Hubei Hunan Iiangsu Jiangxi Jilin Liaoning Shaanxi Shandong Shanxi Sichuan Yunnan and Zhejiang The 5 autonomous regions are Guangxi Inner Mongolia Ningxia Tibet and Xinjiang The 3 municipalities are Beijing Peking Shanghai and Tianjin In the 1990s two provinces were added Haitian which was formerly a part of Guangdong and Chongqing which was formerly a part of Sichuan On the second level and under each province or autonomous region are large cities and prefectures On the third level and under each prefecture are counties and small cities The communes are administrative units under the counties There are over 2000 counties and over 50000 communes there is a list of counties in the Almanac of Ch239na s Economy 1981 5971 Also on the third level and under each large city are neighborhoods Which are further subdivided into streets and courtyards Factories are frequently controlled by units of the government at the level of counties and cities but smaller production and distribution units like restaurants and retail shops are frequently controlled at the level of neighborhoods Some large industrial enterprises are under the direct control of the corresponding industrial ministries or are controlled by corporations directly under the ministries Some enterprises are under the control of provincial governments Through the administrative units at different levels the central government pre pares and executes its economic plans The production and distribution of impor tant consumer and producer goods are centrally planned These goods include food grains vegetable oils pork beef lamb eggs consumer durable goods industrial raw materials and capital goods To achieve materials balancing in its annual plan the demand and supplies of the centrally planned commodities from each province are reviewed by the State Planning Commission de cits from some provinces will be balanced by surpluses from other provinces or by imports The provincial plans are assembled om economic units within the respective provinces through the ad ministrative units at the county or city level To execute its plan the State Planning Commission gives directions through the ministries In the areas of agriculture sh eries forestry commerce and light industry which are under the control of the com munes directions from the corresponding ministries pass through the provincial and county administrative units to the communes In the area of urban industry direc tions from the corresponding ministries pass through the provincial and citycounty administrative units to the factories or enterprises The exceptions are large enter prises directly controlled by the ministries and enterprises under the control of pro vincial governments Also very small enterprises like restaurants and retail shops are coritrolled by units below the level of cities such as neighborhoods or even streets An organization chart or a summary of the organizational structure does not fully describe how much authority the administrators at each level have in the preparation and execution of economic plans The State Planning Commission might simply assemble the production targets submitted by the individual communes or enter Experiments with Planning and Economic Disruptions 43 prises through the countywcity and provincial levels of the administration But the State Planning Commission might also use its great powers to order the individual communes and enterprises to change their production targets The reality is some where in between depending on the particular people in command of the commis slon and on the particular provinces andor enterprises involved Many industrial and commercial enterprises receive directions from two sources the ministry of the State Council and the administrative unit of the provincial government see Gao et al 1980 47 Interesting questions have arisen concerning the authority of the min istries and of the provincial governments In general provincial governments have more authority over the production and distribution of commodities for local con sumption but this general rule does not describe the in uence of the provincial government in any particular situation In any large organization never mind a country as large as China it is always difficult to specify precisely how administrators at different levels exercise their authority but this is not a topic that we need to go into In China the discussion of political control is complicated by the role of the commit tees of the Communist Party which run parallel to the organizations at the different levels of the Chinese government The Party committees are more powerful than the managers of enterprises and official heads of other state institutions such as univer sity presidents As reform towards a market oriented economy proceeded the role of central plan ning and of the State Planning Commission became less important In the mid l980s compulsory planning was changed to guidance planning This meant that the targets set by the State Planning Commission were not strict orders but only served as achievement objectives Even after central planning was gradually abandoned in the 19803 the convention of setting up Five Year Plans has persisted up to the tenth Five Year Plan of 20015 if only to provide broad targets to guide economic devel opment When Zhu Rongji took office as Premier in 1998 he tried to begin stream lining the State Council and to reduce government staff by half By 1999 the State Development Planning Commission the State Economics and Trade Commission the Ministry of Finance and the People s Bank of China were the four organizations in charge of overall economic functions to be assisted by eight ministries of Rail ways Communications and Transportation Construction Agriculture Xlater Re sources Foreign Trade and Economic Cooperation Information Industry and the Commission of Science Technology and Industry for National Defense In this chapter we have explained why and how the Chinese Communist Party came to power in 1948 In addition we presented a theory of economic planning and described how planning worked in China up to 1978 The experience of plan ning and the economic disruption under Communist role during this period con tributed to the desire for reform in 1978 a subject of the next chapter References zillmanctc ofChii1aquots Economy I 981 Hong Kong Modern Cultural Company Ltd Chitin Human Development Report 1999 Trrmsz39non and the State ch 2 sec 2 Published for the United Nations Development Program by Oxford University Press Hong Kong 2000 Chow Gregory C The Clvinese Economy ch 2 New York Harper amp Row 1985 2nd ed Singapore World Scientific 1987 44 Historical Background and General Survey Fu F C The Evolution and Operation of Central Economic Organization in Mainlancl China Economic Papers No I 9 Taipei Chunghua Institution for Economic Research 1982 Gao Guangli Che Li and Wang Yang Zhongquo SI71a7 iI 1IgjJ 239 Guonlixue Climate Busirzess Economic Adminz39stratz39oz Beijing People s University Publishing House i980 Komai Janos The Socz39czZ1ZttS32srem The Political Economy ofCommmzi39m2 Princeton Princeton University Press 1992 Li Kaixin How China Manages its Supplies Almanac of China s Economy 1982 Hong Kong Modern Cultural Company Ltd pp 61320 Lin Justin Yifu Fang Cai and Zhou Li The China M irocZe39 Development Srrazogv and Ezo rzomic Reform ehs 2 and 3 Hong Kong Chinese University Press 1996 Ma Hong and Sun Shangqing eds Zhongquo z39ng739z39j239egou W entz39cmjoo Studies of the Problems of China s Economic Structure 2 vols Beijing People s Publishing Society 1982 Neary J P and K W S Roberts The Theory of Household Behavior under Rationing European Economic Review 13 Jan 1980 pp 2542 Xue Muqiao Chincfs Socialist Economy Beijing Foreign Language Press 1981 1 Name three groups of people in Elaine who were harmecl or deceived it the 19503 by the Communist regime and the manner in Whitrh they were harmed What are the mayor differences between it planned economy and a market economy in solving the maiot economic problema of a society Start answering by listing the major problems 3 Name five major ideological beliefs which can serve to characterize Com ttitmistti ii What are the maior instittitiotts established under the Chinese plannitig system How and how wel1 did they functioti 5 Show and Kwati in two papers in 1996 tried to estimate how large Chi nzafs eeonomy would have been in 1999 if there had been no Great Iea1s Forward or no Cultural RiE amp gt39i 1 l1 E iQI i The first paper is discussed in chap tet 8 What was the method employed to find an answer Wliet was the estimate for each of these political events given in ehaptet 8 Answer this question only if you do not intend to Sttldy chapter 8 carefully but wish to understand the general method and major resaltls by glancing through that chapter 6 Imagine that you are the manager of a Chinese state enterprise in 1978 How would you perforrti your job as compared with the president of a modem corporation In what way was the fortune of the Chinese consumer in 1978 ditlerent from the situation it 1935 8 Name three difficult tasks that the Chinese planning authority had to l fw form to organize the productive activities of the country Explain why these task are dif cult l 9 Was the behavior of the Clhitzese consumer in the period of planning dif 5 J ferettt from consumer behavior in a market ECflI1IITly Explain 10 Describe the reward syzfstem for the Chittese farmer under the commune Experiments with Planning and Economic Disruptions 45 system Explain why there was a lack of incentive to work Describe the Working conditions facing the Chinese worker under central planning Explain why there was s lack of incentive to work Cite three pieces of evidence to show that the Chinese planned economy was not functioning Well The evidence should Show the failure or inef w ciziency of the economic planning system itself and cannot include the economic failures of the Great Leap Forward and the Cultural Revolu tion which were dismptione of the planning system 3 Economic Reform up to the Mid19905 Reasons for introducing major steps in and explanations for the success of economic reforms introduced in l978 are examined A comparison is made with Taivvarfs expe rience in transforming its economy The chapter also discusses whether the introduc tion and success of the reform process were inevitable 31 Why Economic Reform Started in 1978 Deng Xiaoping took over control of the Communist Party in 1978 He was respon sible for initiating reform of the planned economy towards a more marlltet oriented economy There were four reasons Why the time was ripe for reform First the Culm rural Revolution was very unpopular and the Party and the government had to dis tance themselves from the old regime and make changes to get the support of the people Second after years of experience in economic planning government offi cials understood the shortcomings of the planning system and the need for change Third successful economic development in other parts of Asia including Taiwan Hong Kong Singapore and South Korea known as the Four Tigers demon strated to Chinese government o cials and the Chinese people that a market economy Works better than a planned economy This lesson was reinforced by the different rates of economic development between North and South Korea and between coun tries in eastern and western Europe Fourth for the reasons stated above the Chi nese people were ready for and would support economic reform Given these four reasons was economic reform in 1978 inevitable My answer is yes The first two reasons alone were suf cient to motivate the government to initin ate reform The Cultural Revolution made the government so unpopular that both it and the people badly wanted change The direction of change was clear because economic planning was recognized to be a failure Given such a situation there was no other way for China to go The urgency of the case was such that it had to occur as soon as the political leadership was ready after Chairman lVlao s death The Chi Economic Reform up to the lvlicl199Oe 4 nese economic reforms of 1978 are an instance where it is possible to predict major social change by examining the prevailing conditions Such prediction is easy with hindsight but more difficult to do before the event In this chapter we will survey six major components of economic reform begin ning with agriculture The purpose of this is to provide the reader With an overall picture of China s reform process up to the middle of the 1990s That process con tinues and problems exist today In chapter 4 some major reform problems and prospects for further reform at the beginning of the twentyfirst century will be dis cussed The first four chapters aim to present an overall picture of Chinese eco nomic institutions In later chapters we will return to individual areas in more depth As an introduction to our discussion of economic reform it is useful to point out that the reform process has been spurred by a combination of the effort of central government and the natural desire of the Chinese people and lower 1evel govern rnent units to improve the economic institutions for their own bene t For example it was a combination of the efforts of the farmers and the government which changed the commune system As far as the role of central government is concerned the process has been a gradual and experimental one and has proceeded in steps This approach will be discussed in this and the following chapter and also examined later on in this book with regard to the reform of individual sectors The discussion will include housing reform labor mobility in the formation of human capital the bank ing and nancial sector state owned enterprises the nonstate sectors foreign trade foreign investment legal reform and education Reform of Chinese state owned enterprises is an example of a gradual approacli through experimentation In this case the following concepts were accepted and carried out step by step The first was to give state enterprises some autonomy it production decisions rather than simply forcing them to meet production targets under a system of central planning The second was to make them nancially inde pendent allowing them to keep profits after paying taxes to the state rather that treating it all as revenue belonging to the government The third was to introduce 2 contract responsibility system first to selected parts of enterprise under the impor tant reform decision of October 1984 and later to all enterprise in 1987 Under the Contract responsibility system a part or the entirety of an enterprise was allowed tc keep all the gain such as output produced or pro t after surrendering a fixed amoun of it to the enterprise controlling the part or to the government controlling the en terprise The fourth was a reform of the price system that gradually allowed prices tr be determined by market forces In the meantime a twotier price system was intro duced to allocate scarce resources formerly under the control of central planning including material inputs to state enterprises and foreign exchange Under such 2 system the government continued to distribute the scarce resource to designator users at an official belovflmarket price At the same time a second market was al lowed to trade the scarce resource at market prices The fth introduced in i997 was to restructure state enterprises into shareholding companies It will be useful tr keep this general picture in mind when studying China s reform process in genera or in a particular sector 45 Historical Background and Generai Survey 52 Agriculture The ine iciencies of Chinese agriculture under the commune system were generally recognized Farmers were more knowledgeable about what crops to plant on their land than political leaders and economic planners Farm workers had no incentive to work hard under the workpoint system because they were not rewarded for their labors There was a brief period after the land reform in the early 1950s when farm households owned land and were able to sell products in the market Reform of the commune system occurred initially in 1978 and 1979 when commune ieaders in some regions discovered through examples initiated by farmers that they could ful ll their output quotas by reorganizing the commune internally The reorganization followed and improved upon the practices in the 1960s In essence each farm house hold Was assigned a piece of land and was held responsible for delivering a given quantity of a speci ed product in order that the commune could satisfy its procure ment requirement After ful lling the delivery quota the farm household would be free to keep the remaining output for its own consumption or for sale in the market This household responsibility system has the economic characteristics of private farming in a market economy It amounted to each farm household leasing a piece of land and paying a xed rent in the form of the output quota The economic incen tives in this case are the same as those in the case of a Chinese American family renting a space in New York s Chinatown to operate a restaurant According to the account of Kate Xiao Zhou in How the Farmers Changed China 1996 45 Farmers attempted unorganized decollectivization or surreptitious grass root land reform in many parts of rural China throughout the 1960s and 197 0s Their efforts nally succeeded in the late 197 03 and came above ground when Deng Xiaoping eventually accepted this alternative to Mao s collectivisrn He named it the household production responsibility system in order to avoid the term decollectivization The household responsibility system was officially adopted by the Fourth Plenum of the Eleventh Central Committee of the Communist Party in September 1979 The rapid increase in agricultural output and in the incomes of the farmers in the years following provided support for this responsibility system After 1978 rural markets began to reopen Farmers were allowed to raise pigs chickens and ducks These activities were banned during the Cultural Revolution as capitalist activities They also engaged in sideline activities such as handicraft pro duction which were previously the preserve of the communes China s farm economy in essence returned to the private economy which had existed in the early 19503 before the organization of cooperatives and the establishment of the communes One difference pertained to the ownership of land Strictly speaking ownership of land was and still is collective it belongs to the commune or the village The right to use the land belongs to the farmer who is assigned the land As time went on the right to use the assigned land came to be guaranteed on a permanent basis and became transferable Hence the difference between this right to use and ownership is moot When we measure the extent to which China is a market economy by the percentage of national output produced by nancially independent and pI 0f1t II10lIl vated production units we can attribute almost all of agricultural output in this percentage China still has state farms but they produce less than 1 percent of agri Economic Reform up to the Mid19905 49 cultural output Thus reform in agriculture succeeded in allowing private farming to return to this sector 35 Reform of 51ate ownea Enterprises Besides the communes the second important production units were the stateowned enterprises Elements of reform of state enterprises were adopted by the Chinese l3eople s Congress in September 1980 In the opening of that session Vice premier Yao Yilin chairman of the State Planning Commission announced that experi ments with state enterprises with more autonomy and market competition would be greatly expanded in the following two years Industrial reform had begun in late 1978 with six pilot enterprises in Sichuan Province By the end of June 1980 6600 industrial enterprises that had been allowed to make certain output marketing and investment decisions through partial pro t retention had produced in value 45 per cent of the output of all stateowned industrial enterprises By the end of 1981 some 80 percent of stateowned industrial enterprises were involved in the reform experi ment The major elements of industrial reform in the early years include first some autonomy regarding the use of retained profits production planning sales of out put experimentation with new products and capital investment second adoption of features of an economic responsibility system by assigning identi able tasks to lowlevel units within an enterprise and paying them according to productivity third increasing the role of markets fourth streamlining the administrative system at locai levels for state enterprises under local control and fth the encouragement of col lectively owned enterprises For the purposes of designing and carrying out eco nomic reform a Commission for Reconstructing the Economic System was established in the State Council in 1981 The importance of this Commission was signaled by the facts that it was listed iirst in the organization chart of the State Council above the State Planning Commission and that the Premier himself rather than a Vice premier served as its chairman The main difference between reform of stateowned industrial enterprises and reform of Chinese agriculture is that privatization was not adopted for stateowned enterprises Reform of state owned enterprises turned out to be more difficult than that for agricultural production It was much easier to make small farm households behave like private enterprises in a market economy than to make large state enter prises so behave for several reasons First ideologically members of the Communist Party believed in the ownership and control of the major means of production by the state They were unwilling to surrender control of large state enterprises to nongovernment individuals and allow them to keep substantial pro ts for them selves as in the case of small farms Second politically government bureaucrats were unwilling to give up their power and vested interests by allowing the state enter prises to operate independently Economic ministers wanted to hold on to the state enterprises under their control The Bureau of Material Supplies wanted to retain its control over the distribution of major materials Third economically unlike small farms that are self suf cient large industrial enterprises were dependent on factors outside their control Given a piece of land a farm household can produce as it pleases subject to climatic conditions A large enterprise needs the supply of 50 Historical Background and General Survey equipment and material inputs produced by other enterprises The entire system of pricing and distribution of industrial products and material inputs had to be changed to enable a state enterprise to produce ef ciently once they are allowed to be finan cially independent Fourth administratively the efficient operation of a large state enterprise is much more difficult than the operation of a family farm which has a long tradition to draw upon Most stateenterprise managers did not have sufficient knowledge and experience to run a modern enterprise as an independent entity be cause they had been trained to obey production targets Even with additional train ing managers were reluctant to give up their old habits of dependence on the economic ministries The mode of operation of a large organization is difficult to change and this is equally true for a university or large American corporation Observing the limited success in the reform of state enterprises and the need to overhaul the entire economic system the Twelfth Central Committee of the Chi nese Communist Party adopted a major decision on October 20 1984 on economic reform It consisted of the following seven major elements First they resolved to give individual state enterprises autonomy in decisions regarding production sup ply marketing pricing investment and personnel to function as pro tseeking eco if nomic units Second to reduce the scope of central planning except in the case of certain major products and change the method from mandatory to guidance plan ning Third to allow prices of more products to be determined by the forces of demand and supply rather than central control Fourth to develop a macroeco nomic control mechanism through the use of taxes interest rates and monetary policy under an improved banking and nancial system Fifth to establish various forms of i economic responsibility systems within individual enterprises to promote efficiency and to institute differential Wage rates to compensate for different kinds of Work and levels of productivity Sixth to foster the development of individual and collective enterprises as supplements to state enterprises Seventh to expand foreign trade and investment and promote technological exchanges with foreign countries The slogan was invigorate the microeconomic units and control by microeconomic levers The reform of state enterprises unlike the privatization of Chinese agriculture requires an overhaul of the entire Chinese planned economy The price system has to be made more market determined Otherwise the pro ts of enterprises could not reflect economic efficiency Yet the notion of the government giving up price control was not acceptable to most economic officials in the early 1980s The planning ap paratus had to be scrapped or at least greatly modi ed which was also an unaccept able notion to many government officials Hence the steps taken in October 1984 were both revolutionary given the institutional and ideological tradition up to that point and limited in scope because it was not possible to go further for example by declaring China s economy to be a market economy giving up control of prices entirely and transforming state enterprises to modern corporations To return to the further reform of state enterprises two more major steps were taken after 1984 In 1987 the contract responsibility system was introduced to all state enterprises In that system each state enterprise signed a contract with the level of government which had control over it Under the contract the enterprise com mitted itself to pay the government a fixed annual tax and could retain all the re maining profits In practice the pro ts if any were up to the enterprise to distribute to the workers and managers as bonuses but the managers compensation was lim Economia Reform up to the Mid39905 51 ited by social pressure The incentive for the management to improve efficiency and take risks was therefore limited Profits were mainly distributed to workers in order to increase the popularity of and support for the management In September 1997 General Secretary Jiang Zemin announced in the Fifteenth Communist Party Con grass that state enterprises should be restructured by changing them to shareholding t otnpanies The restructuring has Continued and will be discussed in the next chap tar 34 Price Reform 111 important component of the October 1984 decision of the Central Committee of use Communist Party on economic reform is reform of the price system The main iihivective was to decontrol the administratively determined prices gradually and al low prices to be determined by market forces Without market determined prices the state enterprises do not receive correct signals to do their economic calculations in the choice of inputs and the planning of outputs However the administered gtrices cannot be decontrolled immediately First there is the problem of equity To allow the prices of basic consumer goods to increase would affect the Welfare of consumers who were subsidized Second there would be disruption in the produc tion of state enterprises which were supplied with loW price inputs under the plan sing system A compromise solution was to introduce a two tier price system One set of prices remained the same as before A second set for the same goods could be determitied by the market The state enterprises could still purchase the allotted s amounts of inputs and sell given amounts of outputs at the administered prices as before In addition each enterprise could purchase additional inputs and sell above tjuota outputs at prices determined by the market The prices in the second tier are tletermined by the market The two tier price system provides incentives for enterprises to economize on in puts and increase outputs for pro t Under this system if certain outputs were de sired by the market beyond the amounts that could be produced using the centrally allocated inputs prices would go up and the producers could produce more using more expensive inputs supplied in the market In producing more outputs the enter prises had to pay for the inputs at market prices and thus had to economize on the use of inputs Since only the prices of outputs sold at the margin and the prices of inputs purchased at the margin affect the marginal revenue and marginal cost of an enterprise the enterprise can make optimal economic decisions on the basis of these prices Receiving given quantities of inputs at below market prices amounts to re ceiving a fixed amount of government subsidy Having to surrender a given quantity of output at belowmarket price amounts to paying a lump sum tax Neither a xed subsidy not a lumpsuin tax affects the optimal output and input decisions of the rm Hence the twotier price system practiced in China in the 19803 was an eco nomically efficient system given that the existing enterprises had to continue pro ducing A possible economic inefficiency could result from the viewpoint of the functioning of a market economy if certain enterprises were operating at a loss with out government subsidies and should discontinue operation As time went on the administered prices were gradually changed to coincide with the market prices and 52 Historical ackground and General Eurvay by the 19903 when the majority of products in China were sold at market prices the W twotier price system was no longer needed Price reform in China was a gradual process beginning in the n1id 1980s After one decade most but not all prices were decontrolled How rapidly prices should he decontrolled was an important issue discussed at the top level of the Commission for p o Reconstructing the Economic System The maior concern expressed in allowing rapid deregulation was the adjustments that the producers and consumers had to absorb Once the government provided subsidies to producers in the form of low input prices and monopolistically protected output prices and to consumers in the form of low prices of food clothing and housing an attitude of entitlement was formed It would be politically difficult to change this without social protest In the case of the producers the twotier price system enabled them to keep the entitle ment while allowing market incentives to operate at the margin In the case of cons sumers the prices of food items did not increase rapidly after decontrol because of the rapid increase in food supply resulting from the successful reform in agriculture The extremely low price of housing in die order of several yuan per month for an apartment was adjusted upward very gradually until the turn of the century when most urban housing was privatized In the meantime there was also a twotier price system in housing Public private and foreign developers were allowed to build apartments to be sold at market prices for those who could afford them Urban workers maintained the apartments assigned to them by their employers or units at 39 low prices that were gradually increased with increasing wages 55 The Banking Syatem To exercise macroeconomic control as practiced in a market economy in lieu of central planning a modern banking system had to be established The People s Bank was a monobank that had branches to accept deposits from the public Its otlier functions were to issue currency and to extend loans to state enterprises according to the need speci ed and approved by the planning authority It had no authority to decide on these loans Commercial banks did not exist in the sense of being able to extend credit to enterprises according to the criterion of profitability In 1983 the People s Bank was nominally transformed into a central bank Specialized banks including the Industrial and Commercial Bank of China Agricultural Bank of China and the People s Construction Bank of China were established and given some autonomy in the extension of credit in the early 1980s in the same way that state industrial enterprises were given autonomy in making production decisions This led to a rapid increase in the supply of currency since the central bank had to honor the loans extended by the specialized banks by 50 percent in 1984 and an inflation rate of 88 percent in the overall retail price index in 1985 Reform of the banking system to serve a market economy the Central Committee of the Chinese Communist Party declared China s economy to be a socialist market economy in October 1992 progressed gradually in the late 1980s and early 1998s In November 1993 the Third Plenum of the Fourteenth Central Committee of the Communist Party decided to accelerate reform of the nancial sector by giving more independence to the People s Bank as a central bank and transforming the special Economic Reform up to the Mid19905 55 lead banks to commercial banks Two significant dates are March 18 and Nlay 10 i995 when the People s Congress passed the Law on the People s Bank of China sle ective on the same day and the Commercial Banking Law effective July 1 1995 iililltllough the provisions of these laws were not actually carried out in practice the provide a blueprint for the banking system and serve as a convenient framework us to understand the working of the system Banking reform is one important deltample which demonstrates the rule that institutions cannot be changed by legis lation alone The functioning of and problems facing the banking and financial sec Tier will be discussed in chapter 13 256 Foreign Trade and Investment China s economy was essentially a closed economy before the economic reform In i id the total volume of its foreign trade or the sum of the values of its exports and itnports amounted to only 7 percent of its national income Deng s open door policy ehcomaged the opening of China to foreign imports and the promotion of exports 1987 the volume of foreign trade increased to 25 percent and by 1998 to 37 faereent of gross domestic product Foreign trade is the topic of chapter 17 k Foreign investment the second component of the open door policy was pro iiiifittid through the opening of different regions of China First in 1982 the well itnown Shenzhen economic zone bordering Hong Kong was created Infrastructure an built Foreign investors could set up factories there to take advantage of the inexpensive and skilled labor and pay them at marketdetermined wage rates differ eat from the rates prevailing in other parts of China They also received special tax breaks In less than a decade Shen zhen developed from a piece of farmland to a tandem city Because of the difference in economic opportunities citizens of China could enter Sherizhen only with special permission Soon other economic zones and special areas were created for the convenience of foreign investors Foreign invest neat increased from an annual rate of less than U881 billion in 1978 to nearly 33330 billion in 1998 Foreign investment is the topic of chapter 18 37 The Nonetate Sectors While the reform of state enterprises was not entirely successful the collective and private sectors were dynamic and expanding Besides the state enterprises there are three other types of enterprise in China collective individual and overseasfunded the last having been established under the opendoor policy Collective enterprises include urban collectives and rural collectives Some previ easily state owned retail stores and small factories in urban areas were transferred to collective ownership To make the operation of retail stores more efficient they were leased to private or collective owners who operated the store for profit although the real estate remained state owned The operation resembled that of a restaurant owned lay partners or individuals who rent the space New collective commercial and indus trial enterprises were formed in urban areas Township and village enterprises in rural areas were established with the support 54 Historical Background and General Survey Table 31 China gross industrial output value by ownership in billions of current yuan Statearmed Collective armed Iud17zzduaLozvucd Other types Tomi i978 3289 948 423quot 1985 6302 3117 180 117 97126 1996 28361 39232 15420 16582 99595 of local governments that desired to increase revenue There were opportunities to make money as income increased after the successful reform of agriculture Unenis ployed labor could be used for nonagricultural production Local governments had the land capital and human resources to establish these enterprises They had con nections to cut through the red tape required to set up and run such enterprises As China did not have a sound modern legal system the personal position of an inflow ential local government official was important to make sure that contracts were honored The ownership rights of these enterprises were often unclear and yet they seemed to function well and were pro table The phenomenon of their success pro vides a puzzle for economists The collective and private sectors grew much more rapidly that the state sector The Statistical Yearbook of China 1997 p 413 provides the data in table 31 on gross industrial output value by ownership in billions of yuan From these data we can see that in 1978 individual and other types of industrial enterprises were none existent and state enterprises produced 32894237 or 3977 6 percent of total gross industrial output value By 1985 the share contributed by state enterprises was rem duced to 63029716 or 65 percent It was further reduced to only 28 percent in 1996 as compared with 39 percent contributed by collective enterprises One impor tant conclusion to be drawn from these data is that even if the state enterprises are not increasing their productivity China s economy can continue to grow rapidly if the nonstate sectors remain vibrant because the state sector accounts for only a small share of the total output The behavior of the state enterprises will be discussed in chapter 15 and that of the nonstate enterprises in chapter 16 38 Institutional lnfraetructure Ever since economic reform began China s educational system has been improving and gradually been returning to normal Universities were opened after the interrup tions of the Cultural Revolution Students were given opportunities to take examiner tions to enter universities and graduate schools Intellectuals who had been criticized and mistreated were restored to their previous status and given due respect People were eager to learn Not only students seized upon the educational opportunities and studied hard The population as a whole wanted to absorb new ideas and knowl edge from the outside world since they had been deprived of such knowledge when China was closed to the outside world Foreign scholars and professionals of all kinds were invited to China to lecture in schedules so full that even enthusiastic lecturers became exhausted The Ministry of Education or the State Education Economic Reform up to the Mid l9905 55 Vsnission from 198598 sponsored programs to cooperate with foreign educa institutions to improve education in China At the same time individual uni ies were given the freedom to invite foreign scholars to lecture Students were misread to study and were permitted to go abroad on their own initiative Mod textbooks were adopted in university courses Efforts were made to translate 1 are texts into and write new texts in Chinese As time went on the skill in deem languages and especially English improved rapidly and texts in English be S to be adopted Privately initiated and funded educational institutions have be to ourish and were encouraged in the late 1990s Schools from the primary 139 eel to colleges and professional schools have received support from overseas Chi China s education system and education policy are the subject of chapter 21 he government has made a serious effort to modernize the Chinese legal system A lie effort was motivated by the overarching agenda to modernize China and the P to Cooperate and deal with the international business community especially investors The llinistry of Education in the early 1980s began to set up fprogams for legal education Many lawyers have been trained There was also the to have a modern legal framework for domestic social order The People s Iflongress have created many laws governing individual and corporate behavior A system of courts was set up to enforce the laws On paper the Chinese laws today are 1 quite comprehensive and modern in content but as we will see in chapter 20 the behavior of the Chinese people has not changed greatly simply on account of the easement of the new laws 59 Reform Policies Similar to Those of Taiwan 3912 is interesting to note that several economic policies adopted by the leadership of mainland China during its reform process were similar to those adopted by the gov ernment of Taiwan over two decades earlier The first common feature in the growth process of both economies is the reduc tion of government intervention and the encouragement of private initiative The role that the government should play in a market economy is addressed in the last two sections of chapter 16 In both economies to initiate the development process the government had a set of general policy guidelines In each case the government reduced its intervention and allowed more private initiatives to assert themselves In Taiwan in the early 1950s the idea of a command economy was shared by the lead ership of the government of President Chiang Kaishek including one of his impor tant economic officials K Y Yin Vicechairman of the Taiwan Production Board l9514 and Minister of Economic Affairs 1955 Partly through the persuasion of the economists T C Liu ahd S C Tsiang Yin began to appreciate the efficient Working of the market mechanism He reduced the scope of government control initiated policies to liberalize imports lowered the exchange rate on Taiwanese cur rency and encouraged exports see Scott 1979 31445 In the case of the Chinese mainland the command economy modeled after the Soviet Union was modi ed in the late 1970s as we have described Economic reform began with the privatization of agriculture the increase in rural markets and the open door policy followed by urban reform to allow more autonomy of state enterprises and the establishment of 56 Historical Background and General Survey individual and collective enterprises Premier Zhao Ziyang deserved much credit for fostering the working of marketoriented economic institutions Essentially by d ing freedom and economic opportunities however incomplete to the Chinese petie ple the governments of both regions of China succeeded in developing the Cluneseil economy Economic liberalization took place in Taiwan through government encourages ment of private investment in the form of providing nancial services through H ernment banks the establishment of a stock market tax exemptions for cert39aitli industries relaxed controls over the establishment of factories and appropriately adjustments to the prices of governmentproduced commodities and services see Li 197 6 9l 1 An important step in economic reform on the mainland was the decis sion of the Central Committee of the Communist Party on October 20 1984 cord cerning reform of the economic system The key elements in this decision include granting individual state enterprises autonomy in decisions regarding productions supply marketing pricing investment and personnel as independent pro tseeking economic units reducing the scope of central planning allowing the prices of more products to be determined by the forces of demand and supply rather than by central control and fostering the development of individual and collective enterprises as supplements to state enterprises as described earlier in this chapter The second element common to the two economies is the importance of the agile cultural sector in the early stage of the growth process In both Taiwan and die mainland the increase in agricultural productivity was achieved mainly by redistribC uting land to the farmers In Taiwan from 1953 to 195 7 through the sale of public land to tenant farmers and the redistribution of private tenanted land to the tenant cultivators the percentage of total farm families which were OW l1 I39 fal Fl39l 139S increased from 36 in 1949 to 60 in 1957 Ownerfarmers and part ownerfarmers owned more than 83 percent of total farmland in 1957 see Kuo 1983 27 On the mainland through the assignment of the rights of land use to individual farm households under the household responsibility system beginning in 1978 and the abolition of the coin mune system of collective farming in the early 1980s almost all the households in China s rural areas had switched to the system of essentially private farming by 1983 see Lin 1988 S201 I use the term private fanning because although the Chi nese farmers do not own the land they have the rights to use the land and to a large extent to transfer its use to others They can sell all the outputs to market for profit after surrendering a xed amount of the product to the government procurement agent at belowmarket prices which amounts to paying a fixed rental for using the land The incentives are similar to those under private farming In both economies agricultural productivity increased and there were shifts in output from grain to more pro table cash crops See Kuo 1983 ch 3 for the case of Taiwan as well as Chow 1993 table XI The latter reference reports an increase in total agricultural pro ductivity from an index of exp00l 101 in 1980 to exp0436 E 1547 in 1985 which are estimates of the multiplicative factor in a Cobb Douglas production func tion for the agriculture sector in the Chinese mainland A third common feature is the promotion of exports as an important component of the development strategy The Taiwan experience is partly contained in the fol lowing quotation from a speech by K T Li in 1968 see Li 197 6 20 1 Economic Reform up to the MEd l99Ga 5 The growth of many of our industries in Taiwan has been made possible because of the development of overseas markets Several examples may be cited In 1966 the cotton textile industry exported 66 of its output the glass industry 47 and the plastics industry 44 The ratio for cement was 39 and for steel products 22 In such heavily export oriented industries as sugar canned products and plywood the ratios were higher than 90 Thus without the overseas markets the present scales of these industries would not have been attainable si wan s total exports rose from US1699 million in i960 to US5694 million in at an average annual growth rate of 22 Indeed the prosperity of the export Eitetiir has been a major cause behind the rapid growth of the economy The increase in exports accounted for 30 percent of the growth of the gross do product GDP in 1960 Its contribution rose to 42 percent in 1966 On the flli iainiand through the encouragement of joint ventures the decentralization of the fl 3tittol of exports from the central government to provincial and local levels and the promotion of private and collective enterprises mentioned above exports as a frac iliion of national income increased from 53 percent in 1977 to 151 percent in 1988 and 207 percent in 1990 see Statistical Yearbook of China 1991 pp 32 and 615 The fourth element is the government s emphasis on the stability of the general price level The governments of both regions learned from the bitter experience of hyperin ation in China prior to the establishment of the People s Republic of China 1949 as in ation was recognized to be an important factor contributing to the collapse of the government of the Republic of China on the mainland Great efforts Were made to restore price stability in Taiwan in the early 19508 From 1961 to 1972 the consumer price index in Taiwan increased from 4250 to 5812 or at an average annual rate of 29 percent see the S tcm39stz39cczZ Yearbook Oftke Republic 0fClzz39ea P 1980 pp 4501 From 197 7 to 1987 the general retail price index on the mainland increased from 1350 to 1980 or at an average annual rate of 39 percent see Statistical Yearbook of China 1991 p 230 Some in ation took place in Taiwan in P 1973 because of the world oil price shock Doubledigit in ation on the mainland took place in 1988 because of the failure of the government to control the supply of money and credit but price stability was restored by early 1990 mainly by contractionary monetary policy The fifth common element is the gradual lifting of restrictions on imports and the setting of an official exchange rate close to the free market level The official overvaluation of the New Taiwan dollar NT relative to the American dollar was gradually eliminated by increasing the effective exchange rate of NT8l555 to one US dollar to somewhere between NT81860 and NTE2043 in 1955 to NT82458 buying and 1lT2 l78 selling in April 1958 and further to an effective rate of about NT37 by the end of 1958 see Tsiang et al 1980 3299930 Gradual devaluation of the currency of mainland China took place when the official RMBUS dollar RMB stands for people s currency in Chinese exchange rate changed from 19 in 1980 to 293 in 1985 479 in 1990 and 540 in 1992 By 1992 the RMB was nearly convertible as the official exchange rate and the free market rate have almost con verged making it easy for people on the mainland to exchange RMB for US and Hong Kong dollars There are also differences in the degrees to which market forces are allowed to 55 Hietorioai Background and General Survey operate in the two economies of mainland China and Taiwan I will discuss this in more detail in sections 166 and 2211 but for now suffice it to say that the bureau cratic behavior of mainland government economic officials interferes with the worltal ing of free enterprise to a larger extent than that of their counterparts in Taiwan In the 1960s and 19703 foreign investors in Taiwan also experienced corruption but not to the extent that investors did in the 19803 and 1990s on the Chinese mainland The reason is that on the mainland there had been a planned economy and a C11llt tural Revolution making the bureaucrats very hungry for money As economic con ditions and government administration improve corruption and disruptive bureaucratic behavior will decrease Secondly as we will see in chapter 15 and sec tion 2211 the role of state enterprises is more in uential on the mainland where there is a socialist economy Nevertheless there are certain instances in which the mainland government is more open to the outside world These include permitting foreign investors to participate in the building of economic infrastructure such as snperhighways and permitting imports of foreign automobiles M both of which were not allowed in Taiwan One common policy has been restricting foreign commercial banks from entering the domestic market in competition with domestic banks As the economy on the mainland experienced rapid growth after 1977 it was being transformed mostly to a market economy in the sense that by 1990 a large proportion of national output was produced by pro t seeilting individuals and enter prises To estimate this proportion we multiply the percentage of national output produced by each of the ve sectors of agriculture industry construction transport and communications and commerce by the percentage of its output accounted for by prof1toriented producers and sum the five products In Chow 1988 I esti mated that profitoriented producers accounted for 97 20 51 8 and 63 percent of the outputs of the above ve sectors respectively in 198 6 and concluded that about 5 26 percent of the national income in the People s Republic of China in that year was produced by pro t seeking economic units If we apply the proiitmmotivated percentages of 97 40 51 8 and 63 respectively to the above ve sectors which contributed 3465 4581 576 489 and 895 percent respectively to national in come in 1990 see the Statistical Yearbook ofChz 7za 199 p 35 we would find 609 percent of national income being produced by these pro tseeking economic units The 40 percent gure for industry is based on the fact that state enterprises ac counted for only 546 percent of output of industry in 1990 ibid p 391 Hence by 1990 China was approximately 61 percent a market economy 510 Reasons for the Success of Ch na e Economic Reform Since economic reform started China s real output as measured by the gross do mestic product in constant prices has grown at an average rate of 96 percent per year This is a remarkable record Some people have questioned the accuracy of the Chinese official statistics on which the above rate of growth is based If official statis tics tend to overestimate or underestimate the level of output the errors cannot signi cantly affect the estimate of the rate of growth in a period of over two decades Official statistics aside travelers have witnessed the rapid improvement in the stand ard of living of the Chinese people and the rapid appearance of new buildings in Economic Reform up to the Mid19905 59 fihmese cities in the 19803 and 19903 Americans have witnessed a large variety of ntihsumer goods produced in China ooding department stores There is no ques that China has experienced a rapid rate of economic development since reform ed What explains the success of the reform P irst the Chinese leaders are pragmatic and not subject to ideological restraints e author was working with the Commission for Restructuring the Economic Sys ofthe State Council that had the responsibility to design strategies for reform in p 19805 At meetings with the top officials of the Commission any proposals could discussed One member made the following remark There is nothing of value in capitalist economic system that we cannot consider and adapt for China Of some policies were not proposed because Communist Party members were p ready to accept them at the time On the subject of pragmatism Deng Xiaoping that one should not care whether a cat is black or white as long as it catches arise s Second there was no blueprint to model the economic institutions after and poli eies were adopted through experimentation This is a process of learning by doing eras Deng put it of crossing the river while feeling the rocks The responsibility system was adopted because it had worked well Reform of state enterprises started by introducing partial autonomy to a small number of them A larger number and tters autonomy were tried later as the experiment proceeded Another example of experimentation was the policy to allow the Province of Guangdong in 1979 and the special economic zone of Shenzhen in 1982 to adopt more capitalist policies first iifhe advantages of experiments are two First they are used to find out what works econd by successful experiments Party members from the old guard could be in tradueed to the new ways and convinced to give their support to the reform pro years As the wise leader Deng advised Seek truth from facts He understood these two points well In this statement he asked the Party members not to let ideol ogy prevent them from accepting policies that were shown experimentally to be good Because of the lack of a predetermined blueprint and the use of experimentation reforms took place gradually and step by step This process has been characterized as gradualisni in contrast with the shock therapy adopted by some eastern Euro pear countries which attempted to change to a market economy almost immediately Third the reform had the support of the Chinese people and of government offi rials who had experienced the failure of economic planning They desired a change sf course They also desired a new system after the excesses of the Cultural Revolu tion As Premier Zhao Ziyang once remarked to the author the Cultural Revolu tion did great harm to China but it helped us get rid of many ideological restrictions Fourth there was political stability while the reform took place The Communist Party remained in power and was able to exercise leadership during the reform proc ess Fifth much credit must be given to the Chinese leaders themselves Deng in par ticular should take most of the credit for working behind the scenes to oversee the general direction of the reform He advocated pragmatism and experimentation He had to get the support of high level members of the Communist Party Some top ieaders were not willing to let China deviate from its traditional course and there was a difficult political balancing act at the top level of the Communist Party It is difficult to imagine another leader who could have done as well in leading China 60 Historical Background and Generai Survey during the first two decades of reform XYithout Deng the reform would not have been so successful even if it had taken a market oriented direction in the first place There were also Zhao Ziyang a brilliant economic thinker who served as the Pro mier and later Party General Secretary and who designed and carried out economic reform and Hu Yaobang the humane and highly respected Party Secretary The current Premier Zhu Rongji is also very skillful in managing the economy while General Secretary Jiang Zemin kept the country and the Party in order There have been numerous able officials in the Chinese government whose contributions cannot be enumerated here It should be pointed out that the political process practiced in China has been capable of selecting and promoting able and especially college educated people in the government but the process has not been perfect and the economic system itself has bred corruption At the beginning of this chapter we asked whether the initiation of economic re form in 1978 was inevitable After observing the success of the reform by the early 1990s one can also ask whether success was inevitable My answer is yes Given the pragmatic attitude and the ability of the Chinese ieaders and government o icials as weil as the willingness to experiment and the support of the people there was no way for the reform in China toward a market economy to fail unless a market economic system does not work better than a planned economy which no economist believes Why did almost no one in 1979 forecast the rapid transformation and growth of the Chinese economy that followed First very few people at the time understood that these were sufficient conditions for the success of the economic reforms Perhaps most of the able Chinese leaders themselves did not understand all the conditions They may have had con dence in their own ability but may not have known that the market economy could work so well They may not have known how much support they would get from the people Second note the in China part of the above state ment about inevitability The high degree of success of the reform process was partly due to the accompanying rapid growth of GDP to which able Chinese laborers and entrepreneurs contributed At a given stage of reform the human capital of the Chi nese people made the economy grow fast and the rapid growth itself pushed the reform forward The success is iudged mainly by the rapid economic growth and not mereiy by the extent to which the economy has been transformed to a market economy Even if institutional changes were limited when judged by the latter crite rion the reform would be considered successful if there were substantial growth Thus while Chinese laborers and entrepreneurs might not have contributed much to the reform process directly they contributed to it indirectly through their impact on the rate of economic growth Not many people in 1979 recognized the quality of China s human capital and its role in promoting economic reform indirectly through increasing China s national output Without h gh qual239zy human capital economz in st239ruIfr3901is and market zquotncent239oes alone cannot produce rapid economic g r390w2 i2 The impor tant contribution of the Chinese population to the economic performance of Indonesia Malaysia Thailand and Vietnam before the Vietnam War suffice to demonstrate this proposition The above positive features of China s economic reform process need to be bal anced by some qualifications The political stability and the ability of the govern ment to manage the economy were not perfect In the late 1980s the banking reforms and monetary policy allowed the rapid increase of the money supply by 50 percent Economic Reform up to the Mid19905 Si is 1984 and over 30 percent per year in 1986 8 leading to in ation at an annual rate of 30 percent in the fall of 1988 In the meantime reform provided opportunities for government officials to extract bribes through controi of state assets and the rights to issue permits required to perform economic activities Corruption became a seri ass problem In ation and corruption in the late 1980s created much discontent among the urban population Student demonstrations started in April 1989 at the memorial of the death of Party Secretary Hu Yaobang and lasted until June Tiananmen Square was occupied by thousands of students during the entire two atonth period with new groups of students coming from other parts of China con timxously There seemed to be no end to the student occupation as money was distributed to them from sources in Hong Kong and Taiwan and perhaps from merica as well The government lost control of the situation and anarchy was likely to result Failing to end the demonstration by other means Deng Xiaoping decided to send tanks to disperse the students in Tiananmen Square Hundreds of people were killed as the tanks approached the square including citizens of Beijing who tried to stop the tanks and members of the Chinese Red Army The whole world watched on television as the tanks approached Tiananmen Square but it was too dark and too far for television cameras to pick up the scene when the tanks arrived at the square The army and the tanks followed orders to disperse and not to kill the students in the square By the time the tanks reached the square about 2 am on June 4 the students were wise enough to withdraw as they saw the tanks approach ing Allover the world there was an immediate critical reaction to this incident prob ably to an extent unexpected by Deng The government officials and businessmen of many foreign countries refused to go to China Foreign investment and tourism declined The government suffered a big shock from internal disagreements on how to handle the demonstrations which became widespread in several major cities and from the negative reaction in many parts of the worid However the policy of reform toward a market economy continued its course contrary to the expectations of some foreign observers In February 1992 during his visit to Shenzhen Deng took the opportunity to reaffirm and in fact to push domestic economic liberalization and the opendoor poiicy further Later in the year the Party Congress deciared China s economy to be a socialist market economy By the end of 1992 China had resumed its rapid growth path after the disruption of the Tiananmen incident The incident served as a test of the stability of China s political system and the able leadership of Deng who managed to regain support after so much external and internal criticism In discussing the reasons for the success of the reform process I have mentioned the contribution of rniilions of resourceful Chinese entrepreneurs and skillful and hardworking Chinese workers to economic growth Chinese human capital contrib uted to growth once the reformed institutions permitted the people to utilize it effec tively Growth itself provides the momentum for more reform In addition to domestic human Capital both human and financial capital were supplied by thousands of overseas Chinese in Hong Kong and elsewhere in the world and by foreign inves tors The important contribution of human capital should not be surprising if one recalls that China was experiencing economic development in the 19203 and 1930s even when there was political turmoil because of the resourcefulness and energy of its people 62 Historical Background and General Survey The degree of institutional reform achieved can be measured by the contributions of the market institutions to national output at the beginning of the twenty rst EI1 tury The Statistical Yearbook nfCIn39mz I 997 p 42 provides the following breakdown of the 1996 GDP of 68594 billion yuan primary industry l388 4l secondary indus try 33613 087 industry and 013 construction tertiary industry 21097 026 trade 017 transportation and communication If all primary industry namely agri culture 3975 percent of industry since state enterprises account for less than 30 percent of gross industrial output and some of them are pro toriented and 50 percent of tertiary industry since much of retail trade is private are considered the output of pro tmaximi7ing producers then 13884 plus 25210 plus 10549 or a total of 49643 of the 68594 billion yuan are so produced This amounts to 7 24 percent of the Chinese economy being market driven and is a good index of the stage which market economic reforms have reached This 72 percent of Inarlltet driver1 gross do mestic product happens to coincide with the 28 percent of gross industrial output value produced by state owned enterprises reported at the end of section 37 311 Summary We began this chapter by explaining why China was ready for economic reforms in 1978 We then briefly reviewed the six aspects of economic reform l agriculture 2 state enterprises 3 banking 4 the opendoor policy 5 the nonstate secs tors and 6 institutional infrastructure Agricultural reform was initiated from the grassroots and succeeded rapidly in returning to private farming Reform of states owned enterprises went through different stages and is not completed Reasons have been provided for the cli culty in reforming state enterprises in contrast with the agricultural sector Efforts to transform the People s Bank and the specialised banks were outlined brie y but reform is far from complete Under the opendoor policy foreign investment and foreign trade rapidly increased both contributing to China s rapid development In the meantime the nonstate sectors experienced dye namic growth with the collective sector surpassing the state sector in industrial output China s reform policies are similar to those of Taiwan two and a half decw ades earlier in the promotion of market forces the reliance on the agricultural sec tor in the initial stage the encouragement of exports the emphasis on price stability and the gradual decontrolling of foreign exchange An interesting phenomenon was the blossoming of township and village enterprises operating without clear property rights and the protection of a functioning modern legal system The study of this phenomenon provides a challenge to economists accustomed to observing private enterprise in Western market economies The institutional infrastructure including the education and legal systems was also improved in the process of econornic reform During the two decades of reform economic growth took place at a phenomenal rate of 96 percent per year on average lhave given five reasons for the success of the reform including 1 the pragmatic approach of the economic reform officials 2 the use of experimentation 3 the support of the party and government officials as well as the population 4 political stability and 5 the capability of Chinese lead ers especially Deng Xiaoping The last point illustrates that events in China were Economic Reform up to the Mid19905 63 often influenced to a large extent by a small number of people But not all of the phenomenal economic growth can be attributed to economic reform The high qual ity and large quantity of human capital in China and the contributions of overseas Chinese and foreign friends have helped greatly once they were given the opportu nity to become involved after the reforms China s successful reform experience may or may not be relevant for other former Communist economies depending on the circumstances of each country I will mention two factors which contributed to the success of China s reform process and were absent from the former Soviet Union One is the support of numerous overseas Chinese including those living in Hong Kong and other parts of the world These people contributed large amounts of nancial and human capital to both the reform process and the development of the Chinese economy The second is the human capital retained by Chinese farmers who still remembered how to operate as private farmers in 1978 whereas it has been suggested that Soviet farmers in the early 1990s were all trained as collective farmers and did not know how to run a private farm Note also two favorable factors in the Chinese case which Russia could have adopted These are the maintenance of a stable political system under the Communist Party and the use of gradualism and experimentation rather than rapid privatization in the tcfonn of state enterprises Economists and historians can debate whether Russia s economic reform would have been much more successful if this alternative course had been taken The subject matter of chapters 3 and 4 and several later chapters on particular economic institutions is the dynamic process of transforming economic institutions Tile economics of transition dealing with this process has become an important topic in economics because of the reforms in China and in other formerly Socialist t ot1i391tries The field differs from much of traditional economics in not taking eco liitmnic institutions as a given The economics of transition deals with problems fac N economies in the process of institutional changes In the study of the transformation oi economic institutions two important issues are of particular interest One is the choice between gradual change and rapid change this is the issue of gradualism versus Shock therapy For example under the latter policy prices are decontrollecl al iost immediately and stateowned enterprises are privatized quickly The second the relative roles of the central government action and the nongovermnent sectors and the interaction of the two in the economic reform process how much action the government should take and where and when institutional changes should be al losses to evolve naturally by market forces China s reform has followed the course f gradualism Some institutions including the household responsibility system in agieulture and the growth of township and village enterprises resulted from natural market forces once the government allowed them to evolve As an appendix to this chapter I provide a brief description of China s geography together with a map of China In the next chapter I will discuss the problems and prospects of reform at the beginning of the twcnty first century Appendix China s Geography China is situated in the eastern and southeastern part of Asia with its coast border lag the Paci c Ocean It is the third largest country in the world after Russia and 64 Historical Background and General Survey n I I X NW 39l5quotJl Plr 5 U I Shenyang u rrl I W I Se iiA 1 5NCi V 2 4 zquot Kori 13 aaume Z E Hmong Ho Hahha 39 Chinese line 5 of control f rquot Baum xno1 No I g 39 2 39 U 1 asnsu rlsan I Y O S ai yWi f 1 Pi l39 ampf tn H V quot i IV htgiazhoang 595 W2 a ccW3 H Ifxrwyua S V Maj indian ciasm l gt33 I X 39 quot T 39 54 Goimud f397quotCNGX quot 3imNxu Q Ma ill 1 3l39l Qingdao 39 quot 39 l N 1 1 xx gtiquot4 i 5UGNw V x 1 I 3 nyon anI kg xenmcy 1quot i 7 u QNG A r V lan7ho V M 1 quotlt l quot iw E xrana qnrquot 739i M BF e 39 39Ihangzi1oz woso HENAN 2 K 39 K lt mg quot XPANG L A mu HUBEI SICHLJAN Chang Jiang Chaquot dU VlCiON OUiNQ gIi 0I Chongqmg quotquot9 n z x i a ZEEJ1Wf 2 I quot 6 4 3 g 9 z 3Changshavc xNaCii ar193 gt D 1quot wtquot zs39 Vimr 1 39 Z1 W quot i V nstxioxxr 39 quot 1 G35l vi039Cl VLJNNAN quot 1 4 intornatlonai boundary ww Provinceieval boundary Naiionalcapital Ptovincaieval capital 4 Railroad Road 0 509 km 0 500 mites wtquot 39E t vI Figure 51 Contemporary China Economic Reform up to the Mid19909 65 Qanada having 96 million square kilometers in land area It occupies onequarter efthe area of Asia and one fteenth of the area of the globe There are many climatic de es varying from tropical and equatorial in the south to frigidtemperate in the There are mountains and plateaus in the west and plains and hilly areas in the aaestaI regions along the Paci c ocean Two great rivers the Yellow River and the fangrze flow from the west to the east High rainfall is Concentrated in the coastal The eountry s farmland covers about one tenth of total land area It is found jaiainiy in the northeastern provinces the north areas around the Yangtze and the iquotear1 River Delta in Guangdong Province There are rich mineral deposits fadtninistratively China is divided into 27 provinces or autonomous regions and 41 municipalities directly under the supervision of the central government The former include 1 Hebei 2 Shanxi 3 Inner Mogolia in the central north 4 Liaoning 5 Iilin 6 Heilongjiang in the northeast 7 Jiangsu 8 Zhejiang 9 Anhui Fujian l 1 Jiangxi 12 Shandong along or close to the east coast 13 Eenan 14 Hubei 15IIunan 15 Guangdong 17 Guangxi 18Hainan in 4 middle and south 19 Sichuan 20 Guixhou 21 Yunnan 22 Tibet in the at and southwest 23 Shaanxi 24 Gansu 25 Qinghai 26 Ningxia and 7 Xinjiang in the northwest The last 9 listed provinces in the Western region are rlatively poor and targeted for more rapid economic development in a national anon to equalize the incomes of different regions Westem development will be recessed in chapter 10 The municipalities include Beijing and Tianjin in the north haaghai at the delta of the Yangtze River and Chongqing formerly the capital of if Chuan province and designated in 1999 as a municipality in order to serve as the tatdfninistrative center for developing the west See gure 31 for a map of China including these administrative divisions References P 2020 ch 1 Washington DC World Bank 1997 ilhew Gregory C Market Socialism and Economic Development in China Research 39139 Memorandum 340 Princeton Princeton University Econometric Research Program 1988 Chow Gregory C Capitai Formation and Economic Growth in China Qzrarrerlyjoumal of P Ectmom239cs 108 Aug 1993 pp 80942 iiilliiow Gregory C Understcmdmg China Economy part 1 Singapore World Scienti c Pub 0Z Iishing Company 1994 Ishihara Kyoichi Crz39na s Corzz ermlon to a AIarieez Economy Tokyo Institute of Deveiopment Economies 1993 Ken Shirley W Y The Taiwan Economy in Transition Boulder CO Westview Press 1983 K T The Experience of Dynamic Ecmrormr Gronirh in Taiwan New York Mei Ya Publica tions 1976 9 1111 Justin Yifu The Housiehoid Responsibility System in China s Agricultural Reform A Theoretical and Empirical Study Econonnr Development and Czdmm Change 37 April 1988 s199224 Lin Justin Yifu Fang Cai and Zhou Li The China Zlliracle Development Strategy and Eco iom139c Reform Hong Kong Chinese University Press l996 i erkins Dwight Reforming China s Economic System jcmmal of Hccmomic Literature 26 lune 1988 pp 601 45 Reynolds Bruce L Ci7z39nese Ecommzic Reform How Far How Fast San Diego CA Academic Press 1988 66 Historical Background and Genera Survey Economic Reform up to the Mid39905 Scott Maurice Foreign Trade In Walter Galenson ed Ecmzomic G2390wr2 and Srmcrm czl Cuzmgc in Taizvcm Ithaca NY Cornell University Press 1979 Srarimcal Yearbook of Chma Beijing State Staustical Bureau Various years Statistical Yearbook 0f 2123 Republic of China Taipei Directorate General of Budget Accounv ing and Statistics various years Tsiang S C Klein L R and Nerlove M Exchange Rate Interest Rate and Economic Development Quamz39ran39ve Ecouomzcs and Ic7cZopmcnr New York Academic Press 1980 pp30946 Vogel Ezra One Step Ahead in China Gucmgdzmg Under Reform Cambridge MA Harvard University Press 1989 Zhou Kate Xiao Haw he Farmers Changed CFzina39 Power of the Peopfe Boulder CO Wcswiew Press 1996 1 Nama feur major econcamic institutions that needed 10 be refrrmd in 1978 for China tn bewme a market ecunamy Describe eat instimtian bris y 2 Ezra Vcagei in his bcmk Tim Step Ahead in China 1939 givas examplss af referm policies first allowed in the prcwince sfGuangt1img What are same czsf these pcalicies 3 Dwight Parking W88 discusses C lhimfs refmxn pmceisses in the 13893 What mpics dues he miss which art emitted in the discussian in this chap J tax 4 The househltgtId responsibility system in Chinesa agriculture amounts it having the farmers pay a xed rant ii least the land fbr farming Using 3 diagram with Qutput measured alcmg the hmiznntsl axis and revenue ami cast slung tbs vertical axis as in standard C1T1lt3IT1i texts axplaim Why ha iritmducticxn of a fixed cast does I1T s ct the cmtput sf 1 prgt tmmimiz ing fmrm When ihtt CrIquot1tfm t respunssibiliry system was ii 1 I Campd1IC quot1ifa 1987 Lxnder whieh 3 stars enterprise paid a fixed tax ta the gevemment and retained he remaining pmfits far itssif was the emnemic incentivs far tile manw ag ment of a state enterprise the same as far a farm hczusehald 1II1 Z1amp1quot tbs responsibility systarn XIquoth er Vh r1lt3 era the conditinns aff ting Cf l nomic afficiency the same Why or why not 6 China has had several 1ZiSdES mfin atiun bevween 1978 and that present Plot tbs in atitm rats 3 in percent per year against the percentage rate 3 increase 5 in the supply if mrrancy circzslstion sf aha same year and against the gatequot 2 If the 3i39 3 di3i ig yam in 21 saccxn diagram What are the slums sf these twu regressicsn liners sf cm x 7 In this hapter what is the priipmeci 2 3 1 3 1S11I 2 of the increase in ftsmign trade in China Can yma suggess an alternative measure 8 Simiiarlyg what is the prcmczaseci measure surf the inctreaser in fqtareign i V 1i mam Clan yau saggest an alternative 9 It has been suggested that the pmducrtiv z efficiency at statewewnad ntsrw A prises has grtavvn mom sicxwly than that crf coilectively 1WTI1 ti eznterpristas G3 fmm 19535 to 1997 How wmzld ycxu mcmsurc the ram of gmwth If pm ductive ef cienizy W113 data would be needed up ccyrnpute this measure Discuss the important steps takm in rsferming Chinzfs ed11catilt 11 system Discuss the important characteristics of the Chinese iegal system Citi threw czcmditions favurablet 10 the success of Chirxefs ezconnmic refcarm which were absent in the Smviet Unicm in the 19003 A Hi J mmwmmm wmwmaumama ii tgggg agi s a w Vm mmm I A M F an r W0 A mum U M 73 W xxmvn 39f f39 x 39K4Iquot V7 lVaHJVIVrrv nADX39V r N7 wmo nun mm warm V41gt W Y nwmw v Arzvuvwnv JAPAN S TRAP ihere was a time not that long ago when Americans were obsessed with Japan The successes of Japanese industry inspired both admiration and fear you couldn t enter an airport bookstore without encountering rows of dust jackets featur ing rising suns and samurai Warriors Some of these books promised to teach the secrets of Japanese management others prophesied or demanded economic warfare As role models or demons or both the Japanese were very much on our minds All that is gone now Japan still makes the headlines now and then usually when there s bad neWs a big fall in the Nikkei or a disruption of the carry trade in which hedge funds borrow cheaply in Japan and lend the money elsewhere But for the most part we have lost interest The Japanese vvererft that tough after all the public seems to have concluded so now we can ignore them This is foolish The failures of Japan are every bit as signi cant 56 JAPAN S TRA 57 for us as its successes VVhat happened to Japan is both a tragedy and an omen The world s second largest economy is still blessed with well educated and willing Workers a modern capital stock and impressive technological knowhow It has a stable government which has no difficulty collecting taxes Unlike Latin America or for that matter smaller Asian economies it is a creditor nation not dependent on the goodwill of foreign investors And the sheer size of its economy which means that its producers sell mainly to the domestic market should give Japan like the United Statesa freedom of action denied to lesser nations Yet Japan spent most of the 19903 in a slump alternating brief and inadequate periods of economic growth with everdeeper recessions Once the growth champion of the advanced World in 1998 Japanese industry produced less than it had in 1991 And even Worse than the performance itself was the sense of fatalism and helplessness the loss of faith in the ability of public policy to turn the situation around This was a tragedy a great economy like this does not need or deserve to be in a decadelong slump Japan39s woes were never as acute as those of other Asian nations but they went on far longer with far less justification It was also an omen if it could happen to the Japanese who was to say that it couldn t happen to usA11d sure enough it did How did it happen to Japan Japan as Number One No countrywnot even the Soviet Union in the days of Stalin s ve year plans had ever experienced as stunning an economic trans formation as Japan did in the highwgrowth years from 1953 to 1973 In the space of two decades a largely agricultural nation became the Worlds largest exporter of steel and automobiles greater Tokyo as The iiettirn of Depression Economics became the world s largest and arguably most vibrant metropolitan area and the standard of living made a quantum leap Some Westerners took notice As early as 1969 the futurist Herman Kahn published The Emerging jnpcmese Superstore pre dicting that Japan s high growth rates would make it the worlds leading economy by the year 2000 But it was not until the late 19705around the time that Ezra Vogel wrote his bestseller Japan as Number One that the realization of just how much Japan had achieved really dawned on the wider public As sophisticated Japa nese productsabove all automobiles and consumer electronics ooded into Western markets people began to wonder about the secret of Japan s success There was a certain irony in the timing of the great debate about Japan the truth was that the heroic age of Japanese economic growth ended just about the time Westerners started to take Japan seriously In the early 1970s for reasons that are still somewhat mysterious growth slowed throughout the advanced world Japan which had had the highest growth rate also experienced the big gest slowdownwfrom 9 percent a year in the 19605 to less than 4 percent after 1973 Although this rate was still faster than that of any other advanced country half again as fast as that of the United States at that rate the date of Japan s emergence as the worlds leading economy would have to be put off well into the twenty rst century Still Japarfs growth performance was literally the envy of other nations Many people argued not only that Japan had gured out a better way to run its economy but also that its success came at least partly at the expense of naive Western competitors We need not replay here the whole debate over why Japan was successful Basically there were two sides One side explained the growth as the product of good fundamentals above all excellent basic education and a high savings rate and as alwayS also JAAN S TRAP 59 engaged in a bit of amateur sociology to explain why Japan was so very good at manufacturing highquality products at low cost The other side argued that Japan had developed a fundamentally different economic system a new and superior form of capitalism The debate over Japan also became a debate over economic phi losophy over the Validity of Western economic thought in general and the virtues of free markets in particular One element of the supposedly superior Japanese system was government guidance In the fties and sixties the Japanese government both the famed Ministry of International Trade and Industry MITI and the quieter but even more influential Min istry of Financeplayed a strong role in directing the economy The economy s growth was at least partly channeled by the govern ments strategic designs as bank loans and import licenses owed to favored industries and rms By the time the West really focused on Japan the governments grip had been much loosened but the image of Japan Inc a centrally directed economy bent on domi nating world markets remained a potent one into the 19905 Another element of the distinctive Japanese economic style was the insulation of major companies from short term nancial pres sures Members of Japanese leeiretsu groups of allied rms orga nized around a main bank typically owned substantial quantities of each other s shares making management largely independent of the outside stockholders Nor did Japanese companies worry much about stock prices or market con dence since they rarely nanced themselves by selling either stocks or bonds instead the main bank lent them the money they needed So Japanese rms didn t have to worry about short term pro tability or indeed to worry much about pro tability at all One might have thought that the nancial condition of a keiretsu bank would in the end discipline corporate investment if the loans to the bank s af liates 60 Tire ieturn of Depression Economics looked unsound wouldn t the bank start to lose depositors But in japan as in most countries depositors believed that the govern ment would never allow them to lose their savings so they paid little attention to what banks did with their money The result of this system claimed both those who admired it and those who feared it was a country able to take the long view One by one the Japanese government would target strategic indus tries that could serve as engines of growth The private sector would be guided into those industries helped along by an initial period of protection from foreign competition during which the industry could hone its skills in the domestic market Then there would be a great export drive during which firms would ignore pro tability while building market share and driving their foreign competitors into the ground Eventually its dominance of the industry secured Japan would move on to the next one Steel autos VCRS semi conductors soon it would be computers and aircraft Skeptics poked holes in many of the details of this account But even those who absolved Iapan of the charge of predatory behav ior who questioned whether the wizards of MITI were really as allknowing as advertised tended to agree that the distinctive char acteristics of the Iapanese system must have something to do with Japanese success Only much later would those same distinctive characteristics the cozy relationship between government and business the extension of easy credit by governmentguaranteed banks to closely allied cornpaniescome to be labeled crony capi talism and seen as the root of economic malaise But the weaknesses of the system were actually evident by the late 1980s to anyone willing to see APAN S TRAP 61 Bubble Toil and Trouble At the beginning of 1990 the market capitalization of Japan the total value of all the stocks of all the nation39s companies was larger than that of the United States which had twice apan s popula tion and more than twice its gross domestic product Land never cheap in crowded japan had become incredibly expensive accord ing to a widely cited factoid the land underneath the square mile of Tokyo s Imperial Palace was worth more than the entire state of California Welcome to the bubble economy apan s equivalent of the Roaring Twenties The late 1980s represented a time of prosperity for japan of fast growth low unernployment and high pro ts Nonetheless noth ing in the underlying economic data justified the tripling of both land and stock prices during that period Even at the time many observers thought that there was something manic and irrational about the nancial boomthat traditional companies in slowly growing industries should not be valued like growth stocks with price earnings ratios of 60 or more But as is so often the case in manic markets the skeptics were without the resources or the courage to back their lack of conviction conventional wisdom found all sorts of justifications for the skyhigh prices Financial bubbles are nothing new From tulip mania to Internet mania even the most sensible investors have found it hard to resist getting caught up in the momentum to take a long View when everyone else is getting rich But given the reputation of the apa nese for long term strategic thinking the common perception that lapan Inc was more like a planned economy than a freemarket freeforall the extent of the bubble remains somewhat surprising Now apan s reputation for long sighted socially controlled investment always exaggerated the reality Real estate speculators 52 The iiietiirn oi f eiiressioii Economies often getting an extra edge by paying off politicians and another extra edge through yakuza connections have been a surprisingly important part of the Japanese scene for as long as anyone can remember Speculative investments in real estate came close to provoking a banking crisis in the 19705 the situation was saved only through a burst of in ation which reduced the real value of the speculators debts and turned bad loans good again Still the sheer extent of Iaparfs bubble was astonishing Was there some explanation of the phenomenon that ran beyond mere crowd psychology Well it turns out that Iapanfs bubble was only one of several outbreaks of speculative fever around the worid during the 19805 All of these outbreaks had the common feature that they were financed mainly by bank loans in particular that traditionally staid institutions started offering credit to risk loving even shady operators in return for somewhat abovernarket interest rates The most famous case was that of Arnericas savings and loan associationsminstitutions whose public image used to be de ned by the allAmerican earnestness of Jimmy Stewart s srnall town banker in Its a Wonderful Life but which in the 19805 became iden tified instead with high rolling Texas real estate moguls But similar outbreaks of dubious lending occurred elsewhere notably in Swe den another country not usually associated with speculative fever And economists have long argued that behind all such episodes lies the same economic principlemone like the basic baby sitting model of a recession that will reappear several times in this book The principle is known as moral hazard The term moral hazard has its origins in the insurance indus try Very early in the game providers of fire insurance in particular noticed that property owners who were fully insured against loss had an interesting tendency to have destructive res particularly APAN S TRAP 63 when changing conditions had reduced the probable market value of their building to less than the insurance coverage In the mid l980s New York City had a number of known arson prone land lords some of whom would buy a building at an in ated price from a dummy company they themselves owned use that price as the basis for a large insurance policy then just happen to have a fire Moral hazard indeed Eventually the term came to refer to any situation in which one person makes the decision about how much risk to take while someone else bears the cost if things go badly Borrowed money is inherently likely to produce moral hazard Suppose that Fin a smart guy but without any capital and that based on my evident cleverness you decide to lend me a billion dollars to invest any way I see fit as long as I promise to repay in a years time Even if you charge me a high rate of interest this is a great deal I will take the billion put it into something that might make a lot of money but then again might end up worthless and hope for the best If the investment prospers so Will I if it does not I will declare personal bankruptcy and walk away Heads I win tails you lose Of course that is why nobody will lend someone without capital of his own a billion dollars to invest as he sees fit no matter how smart he may seem Creditors normally place restrictions on what borrowers can do with any money they lend and borrowers are also normally obliged to put up substantial amounts of their own money in order to give them a good reason to avoid losses Sometimes lenders seem to forget about these rules and lend large sums no questions asked to people who put on a good show of knowing what they are doing We ll get to the amazing story of the hedge funds in Chapter 6 At other times the requirement that the borrower put up enough of his own money can itself be a source of market instability When assets lose value those who 54 Tire Return of iepression Economics bought them with borrowed money can be faced with a quotmargin call they must either put more of their own money in or repay their creditors by selling the assets driving the prices down still fur ther a process that has been central to the current financial crisis But leaving such market pathologies aside there is another reason why the rules sometimes get broken because the moral hazard game is played at taxpayers expense Remember what we said about the main banks of Japanese kai retsu that their depositors believed that their deposits were safe because the government stood behind them The same is true of almost all banks in the First World and most banks elsewhere Modern nations even if they do not explicitly guarantee deposits cannot find it in their hearts to let widows and orphans lose their life savings simply because they put them in the wrong bank just as they cannot bring themselves to stand aside when the raging river sweeps away houses foolishly built in the flood plain Only the most hardnosed of conservatives would wish it otherwise But the result is that people are careless about where they build their houses and even more careless about where they store their money This carelessness offers a tempting opportunity to unscrupulous businessmen just open a bank making sure that it has an impres sive building and a fancy name Attract a lot of deposits by paying good interest if that is allowed by offering toasters or whatever if it isn t Then lend the money out at high interest rates to high rolling speculators preferably friends of yours or maybe even yourself behind a different corporate front The depositors won t ask about the quality of your investments since they know that they are protected in any case And you now have a one way option if the investments do well you become rich if they do badly you can simply walk away and let the government clean up the mess Okay it39s not that easy because government regulators aren t messes rear 65 entirely stupid In fact from the 19303 to the 1980s this kind of behavior was quite rare among bankers because regulators did more or less the same things that a private lender would normally do before handing me a billion dollars to play with They restricted what banks could do with depositors money in an effort to prevent excessive risktaking They required that the owners of banks put substantial amounts of their own money at stake through capital requirements And in a more subtle perhaps unintentional mea sure regulators historically limited the amount of competition among banks making a banking license a valuable thing in itself possessed of a considerable franchise value licensees were loath to jeopardize this franchise value by taking risks that could break the bank But in the 19805 these restraints broke down in many places Mainly the cause was deregulation Traditional banks were safe but also very conservative arguably they failed to direct capital to its most productive uses The cure argued reformers was both more freedom and more competition let banks lend where they thought best and allow more players to compete for public sav ings Somehovv reformers forgot that this would give banks more freedom to take bad risks and that by reducing their franchise value it would give them less incentive to avoid them Changes in the marketplace notably the rise of alternative sources of corporate finance further eroded the profit margins of bankers who clung to safe oldfashioned ways of doing businesses And so in the 1980s there was a sort of global epidemic of moral hazard Few countries can be proud of their handling of the situationwsurely not the United States whose mishandling of the savings and loan affair was a classic case of imprudent short sighted and occasionally corrupt policymaking But Japan where all the usual linesmbetween government and business between 66 quotihe Return of Depression Econornics banks and their clients between what was and what was not sub ject to government guarantee were especially blurry was pecu liarly ill suited to a loosened nancial regime apan s banks lent more with less regard for quality of the borrower than anyone else s In so doing they helped inflate the bubble economy to gro tesque proportions Sooner or later bubbles always burst The bursting of the Japa nese bubble wasn t entirely spontaneous the Bank of japan con cerned about speculative excess began raising interest rates in 1990 in an effort to let some of the air out of the balloon At first this policy was unsuccessful but beginning in 1991 land and stock prices began a steep decline which within a few years brought them some 60 percent below their peak Initially and indeed for several years thereafter Iapanese author ities seem to have regarded all of this as healthy a return to more sensible realistic asset valuations But it gradually became appar ent that the end of the bubble economy had brought not economic health but a steadily deepening rnalaise A Stealthy Depression Unlike Mexico in 1995 South Korea in 1998 and Argentina in 2002 Iapan never went through a year of unmistakable cata strophic economic decline In the decade after the bubble burst japan experienced only two years in which real GDP actually fell But year after year growth fell short not just of the economy s previous experience but of any reasonable estimate of the growth in its capacity There was one year in the decade after 1991 in which Japan grew as fast as it did in an average year in the preced ing decade Even if you take a conservative estimate of the growth in apan s potential output the output the economy could have APAN S TRAP 67 produced with full employment of resources there was also only one year in which actual output grew as rapidly as potential Economists have one of their famously awkward phrases for what Japan was experiencing a growth recession A growth reces sion is what happens when an economy grows but this growth isn t fast enough to keep up with the econornys expanding capacity so that more and more machines and workers stand idle Normally growth recessions are rather rare because both booms and slumps tend to gather momentum producing either rapid growth or clear cut decline Japan however essentially experienced a decadedong growth recession which left it so far below where it should have been that it verged on a new phenomenon a growth depression The slowness with which apan s economy deteriorated was in itself a source of much confusion Because the depression crept up on the country there was never a moment at which the public clarnored for the government to do something dramatic Because apan s economic engine gradually lost power rather than coming to a screeching halt the governrnent itself consistently de ned suc cess down regarding the economy s continuing growth as a vin dication of its policies even though that growth was well short of what could and should have been achieved And at the same time both Japanese and foreign analysts tended to assume that because the economy grew so slowly for so long it couldnif grow any faster So apan s economic policies were marked by an odd combina tion of srnugness and fatalisrn and by a noticeable unwillingness to think hard about how things could have gone so very wrong apan s Trap There is nothing mysterious about the onset of apan s slump in 1991 sooner or later the financial bubble was bound to burst as The Return oiquot Depression Economics and when it did it would bring about a decline in investment in consumption and hence in overall demand The same thing hap pened in the United States after the US stock market bubble of the 19905 burst and again after the next decades housing bubble popped The question however is why apan s policymakers in particular its central bank weren t able to get the economy mov ing again It is time to return to the story of the baby sittiug co op Suppose that the US stock market were to crash undermining consumer con dence Would this inevitably mean a disastrous recession Think of it this Way when consumer con dence declines it is as if for some reason the typical member of the coop had become less willing to go out more anxious to accumulate coupons for a rainy day This could indeed lead to a slump but need not if the management were alert and responded by simply issuing more coupons That is exactly what our head coupon issuer Alan Green span did in 1987 Or suppose that the coupon issuer didn t respond quickly enough and that the economy did indeed fall into a slump Don t panic even if the head coupon issuer temporarily gets behind the curve he can still ordinarily turn the situation around by issuing more coupons that is with a vigorous monetary expansion like the ones that ended the US recessions of 1981 82199091 and 2001 What about all the bad investments made during the boom Well that was so much wasted capital But there is no obvious reason Why bad investments made in the past require an actual slump in output in the present Productive capacity may not have risen as much as anticipated but it has not actually fallen why not just print enough money to keep spending up so that the economy rnakesifull use of the capacity it has Remember the story of the co op tells you that economic APAN S TRAP 69 slumps are not punishments for our sins pains that we are fated to suffer The Capitol Hill co op didn t get into trouble because its members were bad inef cient baby sitters its troubles did not reveal the fundamental flaws of Capitol Hill values or crony baby sittingism it had a technical problem too many people chasing too little scrip which could be and was solved with a little clear thinking And so the co op s story ought to inoculate us against fatalism and pessimism It seems to imply that recessions are always and indeed easily curable But in that case Why didn t japan pull up its socks after the bub ble burst How could japan get stuck in a seemingly intractable slurr1p one that it didn t appear able to get out of simply by print ing coupons Well if we extend the co op s story a little bit it is not hard to generate something that looks a lot like Iapanls problems First we have to imagine a co op Whose members realized that there was an unnecessary inconvenience in their system there would be occasions when a couple would nd itself needing to go out several times in a row and would run out of coupons and therefore would be unable to get its babies sat even though it was entirely Willing to do lots of compensatory baby sitting at a later date To resolve this problem we ll suppose the coop allowed members to borrow extra coupons from the management in times of need repaying with the coupons received from subsequent babysitting We could move the story a bit closer to the way real economies work by imagining that couples could also borrow cou pons from each other the interest rate in this infant capital market would then play the role the discount rate of the coop manage ment plays in our parable To prevent members from abusing this privilege however the management would need to impose some penalty requiring borrowers to repay more coupons than they borrowed 70 The iieturn oi i epression Economics Under this new system couples would hold smaller reserves of coupons than before knowing that they could borrow more if nec essary The coop s officers Would however have acquired a new tool of management If members of the coop reported that it was easy to nd baby sitters hard to nd opportunities to babysit the terms under which members could borrow coupons could be made more favorable encouraging more people to go out If baby sitters were scarce those terms could be worsened encouraging people to go out less In other words this more sophisticated coop would have a cen tral bank that could stimulate a depressed economy by reducing the interest rate cool off an overheated one by raising it But in Japan interest rates fell almost to zero and still the econ omy slumped Have we nally exhausted the usefulness of our parable Well imagine that there is a seasonality in the demand and sup ply for babysitting During the Winter when it s cold and dark couples don t want to go out much but are quite Willing to stay home and look after other people s children thereby accumulat ing points they can use on balmy summer evenings If this season ality isn t too pronounced the co op could still keep the supply and demand for babysitting in balance by charging low interest rates in the Winter months higher rates in the summer But suppose that the seasonality is very strong indeed Then in the winter even at a zero interest rate there Will be more couples seeking opportuni ties to baby sit than there are couples going out which means that babysitting opportunities will be hard to nd which means that couples seeking to build up reserves for summer fun Will be even less willing to use those points in the Winter meaning even fewer opportunities to babysit and the coop will slide into a reces sion even at a zero interest rate JAAN S TRAP 71 And the 19905 were the Winter of Japarfs discontent Perhaps because of its aging population perhaps also because of a general nervousness about the future the Japanese public didn t appear willing to spend enough to use the economy s capacity even at a zero interest rate Japan say the economists fell into the dread liquidity trap And What you have just read is an infantile expla nation of What a liquidity trap is and how it can happen Japan Adrift The standard response to a recession is to cut interest ratesto allow people to borrow babysitting coupons cheaply so that they will begin going out again Japan was slow to cut interest rates after the bubble burst but it eventually cut them all the Way to zero and it still Wasn t enough Now what The classic answer the one that has been associated with the name of John Maynard Keynes is that if the private sector won t spend enough to maintain full employment the public sector must take up the slack Let the government borrow money and use the funds to finance public investment projects if possible to good purpose but that is a secondary consideration and thereby pro vide jobs which will make people more willing to spend which will generate still more jobs and so on The Great Depression in the United States was brought to an end by a massive de cit nanced public works program known as World VVar II VVhy not try to jump start Japanese growth with a more paci c version of the same Japan tried During the 19905 the government produced a series of stimulus packages borrowing money to build roads and bridges Whether the country needed them or not These packages created jobs directly and boosted the economy as a whole every time they were tried 72 iiie Return of Depression Economics The trouble was that the programs didn t get enough bang for the yen In 1991 Japan s government was running a fairly hefty bud get surplus 29 percent of GDP By 1996 it was running a quite nasty de cit of 43 percent of GDP Yet the economic engine was still sputtering Meanwhile the evepgrowing de cits were starting to Worry Japanfs Ministry of Finance which was concerned about the long term budget position The big concern was demographics which may also have a lot to do with apan s high savings and low investment demand Like other countries japan had a baby boom followed by a baby bust and faces the prospect of a rising ratio of retirees to Workers But apan s problem is extreme its WOIllI1g age population is actually declining steadily even as the number of retirees rapidly grows And since retired citizens are a heavy s cal burden on modern governmentsmrecipients of expensive pub lic pensions and health care standard scal principles said that Iapan should be building up a trust fund to meet the future bills not running evengrowing de cits In 1997 the voices of scal responsibility prevailed and Prime Minister Ryutaro Hashimoto increased taxes to reduce the budget de cit The economy promptly plunged into recession So it was back to de cit spending In 1998 Japan introduced a massive new program of public Works But the scal issue had now been raised and it refused to go away Investors soon noticed that japan was projecting a de cit of 10 percent of GDP and that the ratio of government debt to GDP was already above 100 per centThese are the kinds of numbers usually associated with Latin American nations at risk of hyperin ation Nobody really expected hyperin ation in japan but investors were getting at least a bit wor ried about the long term soundness of that governrnenfs nances In short the attempt to jump start the economy with de cit spend ing seemed to be reaching its limits APAN S TRAP 73 What other options were there If government spending is one standard response to a stalled economy pumping up the banks is another One Widely held View about the Great Depression is that it persisted so long because the banking crises of 1930 31 inflicted longterm damage to credit markets According to this view there were businessmen who would have been Willing to spend more if they could have gotten access to credit and Who would in fact have been quali ed borrow ers But the bankers who could have made those loans were them selves either out of business or unable to raise funds because the public s con dence in banks had been so shaken In terms of the babysitting coop this amounts to saying that there were people who would have been Willing to go out in the Winter and baby sit in the summer but who could not get anybody to lend them the necessary coupons Now Iaparfs banks made a lot of bad loans in the bubble econ omy years and the long stagnation that followed turned many other loans bad as well So one theory of apan s slump was that the country was in a liquidity trap mainly because its banks were nancially weak x the banks and the economy would recover And in late 1998 apan s legislature put together a 500 billion bank rescue plan Yet another option for Japan was to do whatever it took to get a 39 bit of in ation going This option needs some explaining The truth is that economists didn t think much about the sub ject of liquidity traps for a very long time Before apan s troubles in the 19903 the last time a major economy appeared to be in such a trap was the United States in the late 1930s And economic historians have tended to downplay the signi cance of that experi ence by arguing either that it Wasrrt a true liquidity trap that the Fed could have gotten us out if it had tried hard enough or that 74 quotfire iiietura of Bepression iiconomics we got into that trap only through extraordinary policy mistakes unlikely to be repeated So as the outlines of apan s trap became clear in the mid19903 economists were basically unprepared and if I may be critical of my profession uninterested I continue to be astonished at how few economists around the world realized just how important a problem apan s trap was both as a practical matter and as a challenge to our economic doctrines But economics is as the great Victorian economist Alfred Mar shall said not a body of concrete truth but an engine for the dis covery of concrete truth Or to put it in iess elevated language old models can be taught to perform new tricks As We saw in my revised version of the babysitting story a model designed to explain Why a central bank can normally cure a recession by cutting interest rates can also illuminate the circumstances under which this over thecounter remedy does not work And this revised parable also it turns out offers some guidance on ways to get out of a liquidity trap or at least on how to avoid getting into one in the first place Remember the basic problem with the baby sitting coop is that people want to save the credit they earn from babysitting in the Winter to use in the summer even at a zero interest rate But in the aggregate the co op s members can save up Winter babysitting for summer use so individual efforts to do so end up producing noth ing but a winter slump The answer as any economist should immediately realize is to get the price right to make it clear that points earned in the winter will be devalued if held until the summer say to make five hours of babysitting credit earned in the Winter melt into only four hours by summer This will encourage people to use their babysitting hours sooner and hence create more baby sitting opportunities You might be tempted to think that there is something unfair about APAN S ram 75 this that it means expropriating people s savings But the reality is that the coop as a whole cannot bank winter babysitting for sum mer use so it is actually distorting members incentives to allow them to trade winter for summer hours on a onefor one basis But What in the non babysitting economy corresponds to our coupons that melt in the summer The answer is inflation which causes the real value of money to melt away over time Or to be more precise one thing that can get an economy out of a liquidity trap is expected in ation which discourages people from hoarding money Once you take the possibility of a liquidity trap seriously and the case of Japan makes it clear that We should ifs impossi ble to escape the conclusion that expected in ation can be a good thing because it helps you get out of the trap I have explained the virtues of inflation in terms of the whimsical parable of the baby sitting co op but the same conclusion also pops out from applica tion of any of the standard mathematical models that economists conventionally use to discuss monetary policy Indeed there has long been a strand of thought that says that moderate inflation may be necessary if monetary policy is to be able to ght reces sions Still advocates of in ation have had to contend with a deep seated sense that stable prices are always desirable that to promote in ation is to create perverse and dangerous incentives This belief in the importance of price stability is not based on standard eco nomic modelswon the contrary the usual textbook theory when applied to apan s unusual circumstances points directly to infla tion as the natural solution But conventional economic theory and conventional economic Wisdom are not always the same thingma conflict that would become increasingly apparent as one country after another found itself having to make hard choices in the face of nancial crisis 76 The Return of Depression Econornics apan s Recovery apan s economy nally began to show some signs of recovery around 2003 Real GDP started growing at slightly more than 2 percent a year unemployment came down and the grinding deflation afflicting the economy and Worsening the liquidity trap abated although there was no sign of actual in ation What went right The answer mainly was exports In the middle years of this decade the United States ran huge trade de cits importing vast quantities of manufactured goods Some of these goods came from japan although the biggest growth came in imports from China and other emerging economies But Japan bene ted from Chinese growth too because many Chinese manufactured goods contain components made in Iapan One flip side of Americas import boom then was rising Japanese exports and a recovering Japanese economy apan s escape from its trap remained provisional however The call money rate in Japan the equivalent of the Federal funds rate the rate set by the Federal Reserve Was only 05 percent at the time of Writing This meant that the Bank of Japan had very little room to cut interest rates in the face of the recession that seemed to be looming And if the recession is deep Iapanwill be right back in its trap ASIA S CRASH Q quot iihailand isn t really a small country It has more citizens than Britain or France Bangkok is a vast urban nightmare P O Whose traffic is every bit as bad as legend has it Still the World economy is almost inconceivably huge and in the commer cial scheme of things Thailand is pretty marginal Despite rapid growth in the 19805 and 1990s it is still a poor country all those people have a combined purchasing power no greater than that of the population of Massachusetts One might have thought that Thai economic affairs unlike those of an economic behemoth like Japan were of interest only to the Thais their immediate neighbors and those businesses with a direct financial stake in the country But the 1997 devaluation of Thailands currency the baht trig gered a financial avalanche that buried much of Asia The crucial questions are why that happened and indeed how it even could have happened But before We get to why and how let s review 77 vs Tire Return of iepression Ecorioniics what the story of Thailands boom its crash and the spread of that crash across Asia The Boom Thailand was a relative latecomer to the Asian miracle Tradition ally mainly an agricultural exporter it started to become a major industrial center only in the 19805 when foreign rmsmespecially apanese began siting plants in the country But when the econ omy did take off it did so very impressively as peasants moved from the countryside into the new urban jobs as the good results experienced by the first wave of foreign investors encouraged oth ers to follow Thailand began growing at 8 percent or more per year Soon the famed temples of Bangkok lay in the shadow of office and apartment towers Like its neighbors Thailand became a place where millions of ordinary people were beginning to emerge from desperate poverty into at least the beginnings of a decent life and where some people were becoming very rich Until the early 1990s most of the investment associated with this growth came from the savings of the Thais themselves Foreign money built the big export factories but the smaller businesses were nanced by local businessmen out of their own savings and the new office and apartment blocks were nanced out of the bank deposits of domestic households In 1991 Thailand s foreign debt was slightly less than its annual eXports not a trivial ratio but one that was Well within normal bounds of safety In the same year Latin American debt averaged 27 times exports During the 1990s however Thailand s nancial selfwsuf ciency began to erode The push mainly came from outside The resolution of the Latin debt crisis described in Chapter 2 made investment in the Third World respectable again The fall of Communism by ASIA S CRASH 79 diminishing the perceived threat of radical takeover made invest ing outside the safety of the Western world seem less risky than before In the early 1990s interest rates in advanced countries were exceptionally low because central banks were trying to boot their economies out of a mild recession and many investors went abroad in search of higher yields Perhaps most crucial of all investment funds coined a new name for what had previously been called Third World or developing countries now they were emerging markets the new frontier of financial opportunity Investors responded in droves In 1990 private capital flows to developing countries were 42 billion and official agencies like the International Monetary Fund and the World Bank nanced more investment in the Third World than all private investors combined By 1997 however while the flow of official money had actually slowed the flow of private capital to developing countries had quintupled to 256 billion At first most of the money Went to Latin America especially Mexico but after 1994 it increasingly went to the apparently safer economies of Southeast Asia How did the money get from Tokyo or Frankfurt to Bangkok or Djakarta Most of the lending to Asia was Japanese or European mthrough wisdom or luck US banks mainly stayed on the side lines What did it do when it got there Let s follow the steps Start with a typical transaction A Iapanese bank makes a loan to a Thai finance company an institution whose main purpose is to act as a conveyor belt for foreign funds The nance company now has yen which it uses to make a loan at a higher interest rate to a local real estate developer But the developer wants to borrow baht not yen since he must buy land and pay his Workers in local currency So the nance company goes to the foreign exchange market and exchanges its yen for baht Now the foreign exchange market like other markets is gov so The Return oi Depression Economics erned by the law of supply and demand increase the demand for something and its price will normally rise That is the demand for baht by the nance company will tend to make the baht rise in value against other currencies But during the boom years Thai land s central bank was committed to maintaining a stable rate of exchange between the baht and the US dollar To do this it would have to offset any increase in the demand for baht by also increas ing the supply selling baht and buying foreign currencies like the dollar or yen So the indirect result of that initial yen loan would be an increase both in the Bank of Thailand s reserves of foreign exchange and in the Thai money supply And there would also be an expansion of credit in the economymnot only the loan directly provided by the nance company but also additional credit pro vided by the banks in which the newly created baht were deposited And since much of the money lent out would itself end up back in the banks in the form of new deposits this would nance yet fur ther new loans and so on in the classic money multiplier process taught in Econ 101 My description of Argentinas 1995 banking crisis was an example of this same process running in reverse As more and more loans poured in from abroad then the result was a massive expansion of credit which fueled a wave of new investment Some of this took the form of actual construc tion mainly of ce and apartment buildings but there was a lot of pure speculation too mainly in real estate but also in stocks By early 1996 the economies of Southeast Asia were starting to bear a strong family resemblance to apan s bubble economy of the late 1980s VVhy didn t the monetary authorities put curbs on the specula tive boom The answer is that they tried but failed In all the Asian economies central banks tried to sterilize the capital inflows obliged to sell baht in the foreign exchange market the Bank of ASIASS CRASH 81 Thailand would try to boy those baht back elsewhere by selling bonds in effect borrowing back the money it had just printed But this borrowing drove up local interest rates making borrowing from overseas even more attractive and pulling in yet more yen and dollars The effort to sterilize failed credit just kept on growing The only way the central bank could have prevented money and credit from ballooning would have been to stop trying to fix the exchange rate to simply let the baht rise And this is indeed what many Mondaymorning quarterbacks now say the Thais should have done But at the time this seemed like a bad idea a stronger baht would make Thai exports less competitive on world markets because wages and other costs would be higher in dollars and in general the Thais thought that a stable exchange rate was good for business con dence that they were too small a nation to endure the kind of widely fluctuating exchange rate the United States lives with And so the boom was allowed to run its course Eventually as an economics textbook would tell you the expansion of money and credit was selflimiting Soaring investment together with a surge of spending by newly affluent consumers led to a surge in imports while the booming economy pulled up wages making Thai exports less competitive especially because China an important cornpeti tor for Thailand had devalued its own currency in 1994 So export growth slowed down The result was a huge trade de cit Instead of feeding domestic money and credit those foreigncurrency loans started paying for imports And why not Some economists argued just as MeXico s boosters had argued in the early 1990s that the trade de cits of Thailand Malaysia and Indonesia were a sign not of economic weakness but of economic strength of markets working the way they were supposed to To repeat the argument as a matter of s2 The Return of Depression Economics sheer accounting a country that is attracting net in ows of capi tal must be running a current account de cit of equal size So as iong as you thought that the capital in ows to Southeast Asia were economically justi ed so were the trade de cits And why wasn t it reasonable for the world to invest a lot of capital in Southeast Asia given the regions record of growth and economic stability After all this wasn t a case of governments on a spending spree while Malaysia and Indonesia had their share of grandiose public projects they were being paid for out of current revenue and bud gets were more or less in balance So these trade de cits were the product of private sector decisions why should these decisions be second guessed Still a growing number of observers started to feel a bit uneasy as the de cits of Thailand and Malaysia grew to 6 7 8 percent of GDPthe sorts of numbers Mexico had had before the tequila crisis The Mexican experience had convinced some economists that international capital flows even if they represented the undis torted decisions of the private sector were not necessarily to be trusted The bullishness of investors about Asian prospects bore a disturbing resemblance to their bullishness about Latin America a couple of years earlier And the Mexican experience also suggested that a reversal of market sentiment when it came would be sharp and hard to deal with Vhat we also should have noticed was that the claim that Asian borrowing represented free privatesector decisions was not quite the truth For Southeast Asia like japan in the hubble years had a moral hazard problem the problem that would soon be dubbed crony capitalism Let s go back to that Thai nance company the institution that borrowed the yen that started the whole process of credit expan sion What exactly were these nance companies They were not ASIA S CRASH 83 as it happens ordinary banks by and large they had few if any depositors Nor were they like Western investment banks reposi tories of specialized information that could help direct funds to their most pro table uses So what was their reason for existence What did they bring to the table The answer basically was political connections often indeed the owner of the nance company was a relative of some govern ment of cial And so the claim that the decisions about how much to borrow and invest represented private sector judgments not to be second guessed rang more than a bit hollow True loans to nance companies were not subject to the kind of formal guaran tees that hacked deposits in US savings and loans But foreign banks that lent money to the ministers nephews nance company can be forgiven for believing that they had a little extra protection that the minister would nd a way to rescue the company if its investments did not work out as planned And the foreign lenders would have been right in roughly nine out of ten cases foreign lenders to nance companies did indeed get bailed out by the Thai government when the crisis came Now look at the situation from the point of View of the minis ter s nephew the owner of the nance company Basically he was in a position to borrow money at low rates no questions asked What then could be more natural than to lend that money at a high rate of interest to his friend the real estate developer whose speculative new office tower just might make a killing but then again might not If all went well ne both men would have made a lot of money If things did not turn out as hoped well not so ter rible the minister would nd a way to save the nance company Heads the nephew wins tails the taxpayer loses One way or another similar games were being played in all the countries that would soon be caught up in the crisis in Indonesia s4 The Return of Depression Economics middlemen played less of a role there the typical dubious transac tion was a direct loan from a foreign bank to a company controlled by one of the presidents cronies The quintessential example was the loan that broke Hong Kong s Peregrine Investment Hold ings a loan made directly to Suhartds daughters taxi company In Korea the big borrowers were banks effectively controlled by cbaebol the huge conglomerates that have dominated the nation s economy and until very recently its politics Throughout the region then implicit government guarantees were helping under write investments that were both riskier and less promising than would have been undertaken without those guarantees adding fuel to what would probably anyway have been an overheated specula tive boom Given all of this the development of some kind of crisis was not too surprising Some of us can even claim to have predicted cur rency crises more than a year in advance But nobody realized just how severe the crisis would be July 2 1997 During 1996 and the first half of 1997 the credit machine that had created Thailand s boom began to slip into reverse Partly this was because of external events markets for some of Thailand s exports went soft a depreciation of apan s yen made Southeast Asian industry a bit less competitive Mostly though it was simply a matter of the house beating the gamblers which in the long run it always does a growing number of the speculative investments that had been nanced directly or indirectly by cheap foreign loans went sour Some speculators went bust and some nance com panies Went out of business Foreign lenders became increasingly reluctant to lend any more money ASIA S CRASH 85 The loss of confidence was to a certain extent a selfreinforcing process As long as real estate prices and stock markets were boom ing even questionable investments tended to look good As the air began to go out of the bubble losses began to mount further reducing confidence and causing the supply of fresh loans to shrink even more Even before the July 2 crisis land and stock values had fallen a long Way from their peaks The slowdown in foreign borrowing also posed problems for the central bank With fewer yen and dollars coming in the demand for baht on the foreign exchange market declined meanwhile the need to change baht into foreign currencies to pay for imports continued unabated In order to keep the value of the baht from declining the Bank of Thailand had to do the opposite of what it had done when capital starting coming in it went into the market to exchange dollars and yen for baht supporting its own currency But there is an important difference between trying to keep your currency down and trying to keep it up the Bank of Thailand can increase the supply of baht as much as it likes because it can sim ply print them but it cannot print dollars So there was a limit on its ability to keep the baht up Sooner or later it would run out of reserves The only way to sustain the value of the currency would have been to reduce the number of baht in circulation driving up inter est rates and thus making it attractive once again to borrow dol lars to reinvest in baht But this posed problems of a different sort As the investment boom sputtered out the Thai economy had slowed there was less construction activity which meant fewer jobs which meant lower income which meant layoffs in the rest of the economy Although it wasn t quite a fullfledged reces sion the economy was no longer living in the style to which it had become accustomed To raise interest rates would be to discour as The iileturn of Depression Economics age investment further and perhaps push the economy into an unambiguous slump The alternative was to let the currency go to stop buying baht and let the exchange rate slide But this too was an unattractive option not only because a devaluation of the currency would hurt the governrnents reputation but also because so many banks nance companies and other Thai businesses had debts in dollars If the value of the dollar in terms of baht were to increase many of them would nd themselves insolvent So the Thai government dithered It wasn t willing to let the baht fall nor was it willing to take the kind of harsh domestic measures that would have stemmed the loss in reserves Instead it played a waiting game apparently hoping that something would eventually turn up All of this was according to the standard script it was the clas sic leadin to a currency crisis of the kind that economists love to niodeland speculators love to provoke As it became clear that the government did not have the stomach to turn the screws on the domestic economy it became increasingly likely that eventually the baht would be allowed to fall in value But since it hadn t happened yet there was still time to take advantage of the prospective event As long as the bahtdollar exchange rate seemed likely to remain stable the fact that interest rates in Thailand were several points higher than in the United States provided an incentive to borrow in dollars and lend in baht But once it became a high probability that the baht would soon be devalued the incentive was to go the other way to borrow in baht expecting that the dollar value of these debts would soon be reduced and acquire dollars expecting that the baht value of these assets would soon increase Local business men borrowed in baht and paid off their dollar loans wealthy Thais ASIKS CRASH 87 sold their holdings of government debt and bought US Treasury bills and last but not least some large international hedge funds began borrowing baht and converting the proceeds into dollars All of these actions involved selling baht and buying other cur rencies which meant that they required the central bank to buy even more baht to keep the currency from falling which depleted its reserves of foreign exchange even faster which further rein forced the conviction that the baht was going to be devalued sooner rather than later A classic currency crisis was in full swing Any money doctor can tell you that once things have reached that point the government must move decisively one way or the other either make a clear commitment to defend the currency at all costs or let it go But governments usually have a hard time mak ing either decision Like many governments before and no doubt many to come Thailand s waited as its reserves ran down trying to convince markets that its position was stronger than it was it made those reserves look larger through unannounced currency swaps in effect borrowing dollars now for repayment later But though the pressure sometimes seemed to abate it always resumed By the beginning of Iuly it was clear that the game was up On July 2 the Thais let the baht go Up to this point nothing all that surprising had happened The rundown of reserves the speculative attack on an obviously weak currency were right out of the textbooks But despite the recent experience of the tequila crisis most people thought that the deval uation of the baht would pretty much end the story a humiliation for the government perhaps a nasty shock for some overstretched businesses but nothing catastrophic Surely Thailand looked noth ing like Mexico Nobody could accuse it of having achieved sta bilization reform and no growth there was no Thai Cardenas so The Return of i3epression Economics Waiting in the wings to enforce a populist program And so there would not be a devastating recession They were Wrong Meltdown There are two somewhat different questions to ask about the reces sion that spread across Asia in the Wake of the Thai devaluation The first is one of mechanics How did this slump happen VVhy should a devaluation in one small economy have provoked a col lapse of investment and output across so wide an area The other in a Way deeper question is Why didn t governments or perhaps Why couldn t governments prevent the catastrophe V7hat hap pened to macroeconomic policy That second question will take some time to answer at least partly because it is a matter of very sharp disagreement among rea sonable people So let s leave it until the next chapter and simply try to describe what happened When all goes well nothing terrible happens when a currency is allowed to drop in value When Britain abandoned its defense of the pound in 1992 the currency dropped about 15 percent then stabilized investors gured that the Worst was over that the lower currency would help the country s exports and that it was there fore a better place to invest than it had been before Typicai calcu lations suggested that the baht would have to fall something like 15 percent to make Thai industry costcompetitive again so a decline of roughly that magnitude seemed likely But instead the currency Went into free fall the baht price of a dollar soared 50 percent over the next few months and would have risen even further if Thailand had not sharply raised interest rates ASEAJS CRASH 89 Why did the baht fall so far The short answer is panicquot but there are panics and there are panics Which was it Sometimes a panic is just a panic an irrational reaction on the part of investors that is not justified by the actual news An exam ple might be the brief plunge in the dollar in 1981 after a deranged gunman wounded Ronald Reagan It was a shocking event but even if Reagan had died the stability of the US government and the continuity of its policy could hardly have been affected Those who kept their heads and did not flee the dollar Were rewarded for their cool heads Much more important in economics however are panics that Whatever sets them off validate themselves because the panic itself makes panic justified The classic example is a bank run when all of a bank s depositors try to withdraw their money at once the bank is forced to sell its assets at distress prices causing it to go bankrupt those depositors who did not panic end up worse off than those who did And indeed there were some bank runs in Thailand and even more in Indonesia But to focus only on these bank runs would be to take the metaphor too literally VVhat really happened was a cir cular process a devastating feedback loopof nancial deterio ration and declining con dence of which conventional bank runs Were only one aspect The gure on the next page illustrates this process which occurred in some version in all of the afflicted Asian economies schematically Start anywhere in the circle say with a decline of confidence in Thailand s currency and economy This decline in confidence would make investors both domestic and foreign want to pull their money out of the country Other things being the same this would cause the baht to plunge in value Since the Thai 9e The Return 2 Depression Economics Loss of confidence Plunging currency rising interest rates slumping economy Financial problems for companies banks households The Vicious Circle of Financial Crisis central bank could no longer support the value of its currency by buying it on the foreign exchange market because it no longer had dollars or yen to spend the only way it could limit the currency s decline was to raise interest rates and pull baht out of circulation Unfortunately both the decline in the currency s value and the rise in interest rates created nancial problems for businesses both nancial institutions and other companies On one side many of them had dollar debts which suddenly became more burden some as the number of baht per dollar increased on the other many of them also had baht debts which became harder to service as interest rates soared And the combination of higher interest rates and troubled balance sheets with a banking system that often found itself unable to make even the safest of loans meant that companies had to slash spending causing a recession which in turn meant still worse news for profits and balance sheets All this bad news from the economy inevitably reduced con dence still further and the economy Went into a meltdown Leaving aside all the complicated details which are still being picked over by researchers this story seems fairly straightforward mespecially because something quite similar happened in Mexico ASiA S CRASH 91 in 1995 So Why did the disastrous effects of Thailand s devalua tion come as such a surprise The basic answer is that while many economists were aware of the elements of this story everyone understood that the feedback from confidence to financial mar kets to the real economy and back again to con dence existed in principle nobody realized just how powerful that feedback pro cess would be in practice And as a result nobody realized how explosive the circular logic of crisis could be Here s a parallel A microphone in an auditorium always gen erates a feedback loop sounds picked up by the microphone are ampli ed by the loudspeakers the output from the speakers is itself picked up by the microphone and so on But as long as the room isn t too echoey and the gain isn t too high this is a damped process and poses no problem Turn the dial a little too far to the right however and the process becomes explosive any little sound is picked up ampli ed picked up again and suddenly there is an earsplitting screech What matters in other words is not just the qualitative fact of feedback but its quantitative strength What caught everyone by surprise was the discovery that the dial was in fact turned up so high Indeed even now there are many people who find it hard to believe that a market economy can really be that unstable that the feedbacks illustrated in the gure can really be strong enough to create an explosive crisis But they are as we can see by looking at the Way the crisis spread Contagion There is probably a good reason why important meetings about international nance especially about international crisis manage rnent tend to take place in rustic resorts Why the postwar mon 92 The Return of Depression Economics etary system was hammered out at the Mount Washington Hotel at Bretton Woods Why many of the worlds nance ministers and central bankers gather each summer at Jackson Lake Lodge in Wyoming Perhaps the setting helps important people get away from the re ghting of their daily lives and focus at least brie y on the larger issues In any case in early October I99quot when the Asian crisis was Well underway but its severity was not yet clear a number of bankers officials and economists converged on Wood stock Vermont to take stock By then Thailand was already pretty clearly in deep trouble the currency of its neighbor Malaysia had also been battered and the Indonesian rupiah had depreciated about 30 percent The general sense in the room was that Thailand had brought its woes on itself and there was little sympathy for Malaysia which like Thailand had been running huge current account de cits in the past several years and whose prime minister had clearly made things worse with his denunciations of evil speculators But everyone agreed that while Indonesia had been right to let its currency slide incleed many good things were said about lndonesias economic management the rupialfs Weakness was not really justified After all Indonesias current account de cits had been nowhere near as large relative to GDP as its neighbors at less than 4 percent of GDP Indo nesia s I996 de cit was actually smaller than say Australias The country s export base part raw materials part laborintensive manufacturing looked solid and in general the economy looked fundamentally sound Within three months Indonesia was in even Worse shape than the rest of Southeast Asia indeed on its Way to one of the Worst economic slumps in World history And the crisis had spread not just across Southeast Asia but all the Way to South Korea a fan ASIPES CRASH 93 away economy whose GDP was twice as large as that of Indonesia three times as large as that of Thailand There are sometimes good reasons for economic contagion An old line says that when the United States sneezes Canada catches coldno Wonder when much of Canada s production is sold in the markets of its giant southern neighbor And there were some direct links among the afflicted Asian economies Thailand is a market for Malaysian products and vice versa A bit of extra traction may have been generated by the tendency of the Asian economies to sell sim ilar products to third parties when Thailand devalued its currency the clothing it exports to the West got cheaper and therefore cut into the pro t margins of Indonesian producers of similar items But all estimates of this direct quotgoods market spillover among the crisis economies indicate that it just can t have been a major factor in the spread of the crisis In particular Thailand s role either as a market for or as a competitor of South Korea was little more than rounding error for the far larger Korean economy A more potent source of contagion may have been more or less direct nancial linkage Not that Thais were big investors in Korea or Koreans in Thailand but the flows of money into the region were often channeled through quotemerging market funds that lumped all the countries together VVhen bad news came in from Thailand money owed out of these funds and hence out of all the countries in the region Even more important than this mechanical linkage however Was the way that Asian economies were associated in the minds of investors The appetite of investors for the region had been fed by the perception of a shared Asian rniracle When one coun try s economy turned out not to be all that miraculous after all it shook faith in all the others The wise men at Woodstock may have 94 The Return of Depression Economics regarded Indonesia as quite different from Thailand but the inves tor in the street was less sure and began to pull back just in case And it turned out that whatever the differences among all those economies one thing they did have in common was suscepti bility to selfValidating panic The wise men at Woodstock were wrong about Indonesia and the panicky investors right this was not because the wise men had misjudged lnclonesias virtues but because they had underestimated its vulnerability in Malaysia in Indonesia in Korea as in Thailand the market s loss of confi dence started a vicious circle of nancial and economic collapse It did not matter that these economies were only modestly linked in terms of physical flows of goods They were linked in the minds of investors who regarded the troubles of one Asian economy as bad news about the others and when an economy is vulnerable to selfwvalidating panic believing makes it so VVhy Asia why 1997 VVhy did Asia experience a terrible economic crisis and why did it begin in 1997 As Bill Clinton might have put it the answer depends on what you mean by why You might be asking about the specific precipitating events or you might more importantly be asking about the source of Asia s extraordinary vulnerability If you insist on placing the blame for the onset of the Asian cri sis on some speci c event there is a list of usual suspects One is the exchange rate between the yen and the dollar between 1995 and 1997 the yen which had rather mysteriously gone to skyhigh levels fell back to earth Since most Asian currencies were more or less pegged to the dollar this made their exports look more expen sive both in Japanese markets and in competition with Japanese products elsewhere contributing to an export slowdown China s ASIA S CRASH 95 1994 devaluation and more broadly growing competition from China s cheap labor likewise cut into Thai and Malaysian exports And there was a worldwide slump in the demand for electronics in general and semiconductors in particular an area in which Asia s economies had tended to specialize But Asia had shrugged off much bigger shocks before The 1985 crash in oil prices for example was a major blow to oil eXporting Indonesia yet the economy grew right through the bad news The 199091 recession which was not very severe but affected much of the industrial world reduced the demand for Asia s exports but did not slow the regions momentum at all So the important question is What had changed about Asia or perhaps the world such that these pieces of bad news triggered an economic avalanche Some of the Asians notably Malaysia s Prime Minister Mahathir had a ready answer conspiracy Mahathir indeed argued not only that the panic in Asia was deliberately engineered by big finan cial operators like George Soros but also that Soros himself was acting on instructions from the US government which wanted to cut assertive Asians down to size As time passed Mahathirs dernonization of hedge funds started to look a bit less silly than it did when he first began his ranting Indeed the role of hedge funds now looks important enough to rate a whole chapter in this book Chapter 6 But that role became important mainly in 1998 by which time incidentally the activities of Soros and others were very much contrary to US policy wishes as a story about how the crisis began conspiracy theory doesn t wash On the other side many Westerners have turned the story of Asia s crash into a sort of morality play in which the economies received their inevitable punishment for the sins of crony capital ism After the catastrophe everyone had a story about the excesses and corruption of the regionmabout those finance companies as Tine Return Depression Econoniics about Malaysia s grandiose plans for a technology corridor about the fortunes made by Suharto s family about the bizarre diversify cation of Korean conglomerates did you hear the one about the underwear company that bought a ski resort and eventually had to sell it to Michael lacksoni But this morality play is problematic on at least two counts First while cronyisrn and corruption were very real in Asia they were nothing new Korea s cbczebol were essentially family enter prises disguised as modern corporations whose owners had been accustomed to special treatment for decades preferred access to credit to import licenses to government subsidies And those were decades of spectacular economic growth It was not a pretty system by Western standards but it functioned very well for thirty five years The sarne may be said to a lesser extent of all the coun tries caught up in the crisis Why did their flaws become crucial only in 1997 And a related point if the crisis was a punishment for the sins of the Asian economies why did economies that were by no means equally far down the path of development all hit the wall at the same time Korea in 1997 was not far short of being a developed nation with per capita income comparable to that of southern European countries while Indonesia was still a very poor country where progress could be measured in terms of how many calories people managed to consume in a day How is it that such an ill rnatched pair could simultaneously be plunged into crisis The only answer that makes sense to me at least is that the crisis was not mainly a punishment for sins There were real failm ings in these economies but the main failing was a vulnerability to self fulf1lling panic Back to bank runs In 1931 about half the banks in the United States failed These banks were not all alike Some were very badly ASIA S CRASH 97 run some took excessive risks even given what they knew before 1929 others were reasonably Well even conservatively managed But when panic spread across the land and depositors everywhere wanted their money immediately none of this mattered only banks that had been extremely conservative that had kept what in nor mal times would be an excessively large share of their deposits in cash survived Similarly Thailand had a badly run economy it had borrowed far too much and invested it in very dubious projects Indonesia for all its corruption was much less culpable and truly had the virtues those wise men imagined but in the panic those distinctions did not matter Were the Asian economies more vulnerable to nancial panic in 1997 than they had been say live or ten years before Yes surely but not because of crony capitalism or indeed what would usually be considered bad government policies Rather they had become more vulnerable partly because they had opened up their financial marketsmbecause they had in fact become better free market economies not worse And they had also grown vulner able because they had taken advantage of their new popularity with international lenders to run up substantial debts to the out side World These debts intensi ed the feedback from loss of con fidence to nancial collapse and back again making the vicious circle of crisis more intense It Wasn t that the money was badly spent some of it was some of it wasn t It was that the new debts unlike the old ones were in dollars and that turned out to be the economies undoing Epilogue Argentina 2002 Argentina isn t an Asian country Duh But Argentina had an Asianstyle crisis in 2002 one that offered a painfully clear dernon 93 The Retrirn of Depression Economics stration of how widely praised economic policies can lead a nation into disaster I discussed Argentina s monetary history in Chapter 2 After generations of irresponsible use and abuse of the printing press in 1991 the Argentine government tried to put an end to all that by establishing a currency board that would supposedly provide a permanent link betweenathe Argentine peso and the US dollar Every peso in circulation was supposed to be backed by a dollar in reserves with no room for discretion And this monetary stability it was hoped would ensure continued prosperity As we saw in Chapter 2 Argentina had a close brush with disas ter in 1995 when the backwash from Mexicds crisis came close to bringing down the banking system But as that crisis ebbed con dence returned Foreign observers continued to shower high praise on the Argentine economy and its managers and foreign capital owed in much of it in the form of dollar loans to Argentine busi nesses and individuals In the late 1990s it all started to go wrong At first the problem was the rigidity of the exchange rate sys tem which set one peso equal to one US dollar This might not have been much of a problem if Argentina like Mexico did the great bulk of its trade with the United States But look at a map Argentina is no closer to the United States thaniit is to Europe and in fact Argentina does more trade both with the European Union and with its neighbor Brazil than it does with the United States And Argentinas currency system did not ensure stable exchange rates against either the euro or the real Brazils currency On the contrary the system actually tended to cause gratuitous fluctuations in these exchange rates and hence in Argentinas trade position If for example the dollar rose against the euro ASIA S CRASH 99 for whatever reason the effect was to price Argentine exports out of European markets And that s exactly what happened to Argentina starting in the late 19903 On one side the dollar soared against the euroat one point the euro was worth only 085 compared with 126 at the time of writing On the other Brazil caught in contagion from Russia s nancial crisis see Chapter 6 sharply devalued the real The combined effect of these exchange rate shifts was to leave Argentina s exports seriously uncompetitive pushing the country into a recession As Argentinas economy slumped foreign investors lost faith The flow of capital into the country went into reverse creating a credit crunch And as in 1995 the loss of foreign funds also caused a banking crisis Argentine officials tried desperately to contain the growing cri sis They slashed spending deepening the recession in the hope of regaining investor con dence abroad They limited Withdrawals from the banks a measure that provoked angry demonstrations out side the presidential palace with housewives banging pots and pans Nothing seemed to work And in late 2001 the government found itself unable to maintain the one peso one dollar rule The value of an Argentine peso quickly fell from one dollar to about thirty cents The initial results of the currency plunge were catastrophic just like the currency plunges in Asia Since many Argentine businesses and individuals bad debts in dollars the rise in the cost of a dollar in pesos had a crippling effect on balance sheets in many cases leading to bankruptcy The economy fell into a swoon real GDP fell 11 percent in 2002 after falling 4 percent in 2001 Overall the size of the Argentine economy declined 18 percent between 1998 and 2002 a Great Depressionmscale contraction 100 The Return of Bepression Economics Over the next five years Argentina made a strong recovery helped by a settlement in which the government paid only about thirty cents on the dollar of its foreign debt One of my favorite headlines ever from a Reuters report on the debt negotiations was Argentina to Creditors So Sue Us But the experience was terrifying And as this book Went to press Argentina was in crisis again The Deeper Question Most commentators on the Asian crisis would probably find some detail of the account in this chapter to quarrel with Some would argue that the damage done by moral hazard driven lending was greater than I suggest Some would argue on the contrary that the economies Were really in very good shape and that the crisis was wholly gratuitous The precise mechanism of crisis the respective roles of bank failures real estate prices exchange rates interest rates and so on will be the subject of much wrangling for years perhaps decades to come Nonetheless in a general sense I believe that this account would receive broad acceptance The real controversy the one that is heated and often personal because those who criticize the way the crisis was handled are also criticizing those who handled it concerns policyr Why wererft governments able to do more to limit the damage POLICY PERVERSITY L i 11 December 1930 just as it started to become obvious that the United States was in no ordinary recession Iohn May 3 y ih nard Keynes attempted to explain the causes of the slump to the general public We have magneto alternator trouble he declared It was in a Way a radical statement for he was declaring that the economic engine would not restart of its own accord that it needed a jump start from the government But in a deeper sense Keynes was being a conservative he was declaring that the trouble With the engine was not fundamental that it was amenable to a technical x At a time when many of the world s intellectuals were convinced that capitalism was a failed system that only by mov ing to a centrally planned economy could the West emerge from the Great Depression Keynes was saying that capitalism was not doomed that a very limited sort of intervention intervention that 101 L Rita nerfonrtwee ever pg 0 p J 2 itrrirrrrn r rtrrtrtrl p conornrsts emphasize rnternattonattttgj erg g or B h r o s E g V p source ofmany otthe benefits ot glr baliZa1iorarstWf P L 1 g 1 p The world s major nations have always been iintrewlginggppyagrioqgigw l quot if 0I t v n Kr xy ways in recent decades however dramatic improyemgeggrrtggjngpmmgp g N transportation telecommunications and internationalWrelaWtiS n g P P t have drawn the nations of the world ever closer togethgerlec W w t K nomlcally This process of globalization is often portrayed n W i something new But in fact it is not as is Globalization page i 686 points out A if is V 1 l vr r c 8 x p r Economic events in other countries affect the United X Rr macroeconomic and microeconornic reasons For example we learned in Paris VI Z I and Vll that the level of net exports is an important determinant of a nations out put and employment But we did not deive very deeply into the factors that deter mine a nation s exports and imports Chapters 34 and 35 will take up these macro 7 39 economic linkages in greater detail First however this chapter studies some of if the mioroeconomic linkages among nations How are patterns and prices of world is N trade determined How and why do governments interfere with foreign trade The central idea of this chapter is one we have encountered before in Chapters 1 and V 2 the principle of comparative advantage eel t t 4 s Peiiticai Factersirr rrrrezgnaeorrer rreee W X The Eriaey foveieed ire trtternefeeeeejtraee tgeoedirrrectetto 7 free roeeee cores rrrrelrcereeere M The Arithniette of Seneparatrtrre V Thegaeaphaoeof emperatttre Advazita ey Issue CornparetiverAdiratrtegerEx cheap Femignitaborfi Farieey A St3FPL fc liamprnri Ii errrte eerereiere s t renrreei oeeree ere ctrree rereaeeeee rwrtereeoe s t HcwTariffe and Ctiiotae were p T A Tariffs vereuefzeoteerv V iitiiti renrerrreeee l c Gaining e erree advantages irotectitgPferticr3 ar irtduetrf M ereee eeejuorenre eels eaorreerre rraeoaar Bete oeteeem thethieoecoeemi The inteet ineostrrArgireient it to soaregre quotneuter eerie i C9 scare serene eteeereeel die come IA ltgtlt ou eT M21 5 g G1 em m m arm rm39twvN1Mgtvt v ngtgtviv1 etyl4 r 3quot ll 1tFA Vn igt an gt rUxu K Wm W 4DA39 y1 9gt K39F4KW4 O l mWe oswrw WresNN I v3eQ gt gt3 M M A last Loar ar ecrzeagiorerg Labor tg 2 we V we va va nrran W e we W M 4 WW WHY Tues national marketplace deteriorated as wage levels in Europe and Japan began to ap proach our own Clearly then cheap foreign labor must not be a major obstacle to US sales abroad as a common sense View of the matter suggests In this chapter we will see precisely what is wrong with that view WHY TRADE The earth s resources are not equally distributed across the planet Although the United States can produce its own coal and wheat it depends almost entirebx on the rest of the world for such items as rubber and coffee Similarly the Persian Gulf states have little land that is suitable for farming but sit atop huge pools of oil something we are constantly reminded of by geopolitical events Because of the seemingly whim sical distribution of vital resources every nation must trade with others to acquire what it lacks Even if countries had all the resources they needed other differences in natural en dowments such as climate terrain and so on would lead them to engage in trade Americans could with great difficulty grow their own bananas and coffee in hot houses But these crops are grown much more efficiently in Honduras and Brazil where the climates are appropriate l The skills of a nation s labor force also play a role If New Zealand has a large group of efficient farmers and few workers with industrial experience while the op posite is true in Japan it makes sense for New Zealand to specialize in agriculture and let Japan concentrate on manufacturing Finally a small country that tried to produce every product would end up with many industries that are simply too small to utilize modern massproduction tech niques or to take advantage of other economies of large scale operations For exam ple some countries operate their own international airlines for reasons that can only 39 be described as political not economic To summarize the main reason why nations trade with one another is to exploit the many advantages of specialization some of which were discussed in Chapter 2 International trade greatly enhances living standards for all parties involved because 1 Every country lacks some vital resources that it can get only by trading with others 2 Each country s climate labor force and other endowments make it a relatively efficient producer of some goods and an inefficient producer of other goods 3 Specialization permits larger outputs and can therefore offer economies of largescale production Mutual Gains from Trade Many people have long believed that one nation gains from trade only at the expense of another After all nothing new is produced by the mere act of trading So if one country gains from a swap it is argued the other country must necessarily lose One consequence of this mistaken belief was and continues to be a policy prescription call ing for each country to try to take advantage of its trading partners on the fallacious grounds that one nation s gain must be another s loss Yet as Adam Smith emphasized and as we learned in Chapter 2 both parties must expect to gain something from any oolzmtmry exchange Otherwise why would they agree to trade But how can mere exchange of goods leave both parties better off The answer is that although trade does not increase the total output of goods it does allow each party to acquire items better suited to its tastes Suppose Scott has four cookies and nothing to drink while Malcolm hastwo glasses of milk and nothing to eat A trade of two of Scott s cookies for one of Malcolrn s glasses of milk will not increase the 687 Specialization means that a country devotes its energies and resources to only a small proportion of the world39s pro ductive activities CHAPTER 33 IDEIIS FOR BEYOND THE FINM EXAM INTERNATIONAL TRADE AND COMPARATIVE ADVANTAGE total supply of either milk or cookies but it almost certainly will make both boys better off By exactly the same logic both the United States and Mexico must reap gains when Mexico voluntarily ships tomatoes to the United States in return for chemicals In general as We emphasized in Chapter 2 TRADE IS A WmWIN SITUATION Both parties must expect to gain from any voluntary exchange Trade brings about mutual gains by redistributing products so that both parties and up holding more preferred combinations of goods than they heid before This principle which is one of our Ideas for Beyond the Final Exam applies to nations just as it does to individuals NTERIIATIOIIIILVERSUSINTRANATIONAlTRADE The 50 states of the United States may be the most eloquent testimony to the gains that can be realized from specialization and free trade Florida specializes in growing oranges Michigan builds cars California makes computers and chips and New York specializes in nance All of these states trade freely with one another and enjoy great prosperity Try to imagine how much lower your standard of living would be if you consumed only items produced in your own state The essential logic behind international trade is no different from that underlying trade among different states the basic reasons for trade are equally applicable within a country or among countries VVhy then do we study international trade as a special subject There are at least three reasons Political Factors in International Trade First domestic trade takes place under a single national government whereas foreign trade always involves at least two governments But a nation s government is normally much less concerned about the welfare of other countries citizens than it is about its own So for example the US Constitution prohibits tariffs on trade among states but it does not prohibit the United States from imposing tariffs on imports from abroad One major issue in the economic analysis of international trade is the use and misuse of impediments to free international trade The Many Currencies Involved in International Trade Second all trade within the borders of the United States is carried out in US dol lars whereas trade across national borders almost always involves at least two curren cies Rates of exchange between different currencies can and do change In 1985 it took about 250 Japanese yen to buy a dollar now it takes only about 130 Variability in exchange rates brings with it a host of complications and policy pioblems 3 Impeclimenis io Mobility of Labor and Capital Third it is much easier for labor and capital to move about within a country than to move from one nation to another If jobs are plentiful in California but scarce in West Virginia workers can move freely to follow the job opportunities Of course personal costs such as the financial burden of moving and the psychological cost of leaving friends and familiar surroundings may discourage mobility But such relocations are not inhibited by immigration quotas by laws restricting the employment of foreign ers or by the need to learn a new language There are also greater impediments to the transfer of capital across national boundaries than to its movement within a counny For example many countries have rules limiting foreign ownership even the United States limits foreign ownership of broadcast outlets and airlines Foreign investment is also subject to special political 61 we THE IAW OF COWARATEVE ADVANTAGE risks such as the danger of outright expropriation or nationalization after a change in government But even if nothing as extreme as expropriation occurs capital invested abroad faces signi cant risks from exchange rate variations An investment valued at 250 mil lion yen is worth 1 million to American investors when the dollar is worth 250 yen but it is worth 2 million when it takes just 125 yen to buy a dollar 0 THE LAW OF COMPARATWE ADVANTAGE The gains from international specialization and trade are clear and intuitive when one country is better at producing one item and its trading partner is better at producing another For example no one nds it surprising that Brazil sells coffee to the United States and the United States exports software to Brazil We know that coffee can be produced using less labor and other inputs in Brazil than in the United States Lillte wise the United States can produce software at a lower resource cost than can Brazil In such a situation we say that Brazil has an absolute advantage in coffee produc tion and the United States has an absolute advantage in software production In such cases it is obvious that both countries can gain by producing the item in which they have an absolute advantage and then trading with one another VVhat is much less obvious but equally true is that these gains from international trade still exist even one country is more efficient than the other in producing everything This lesson the principle of comparative advantage is one we first learned in Chap ter 21 It is in fact one of the most important of our Idetzsfbr Beyond the Final Exam so we repeat it here for convenience THE SURPRISING PRINCIPLE OF COMPARATIVE ADVANTAGE Even if one country is at ah ab solute disadvantage relative to another country in the production of every good lt is said to have a comparative advantage in making the good at which it is least inefficient compared with the other country I The great classical economist David Ricardo 17721823 discovered almost 200 years ago that two countries can stilt gain from trade even it one is more efficient than the other in every thdushy that is even if one has an absolute advantage in producing every commodity In determining the most efficient patterns of production it is uumparativeadvantage not absolute advantage that mattersThus a country can gain by importing a good even if that good can be pro duced more efficiently at home Such imports make sense if they enable the country to specialize in producing guude at which it is even more efficient The Arithmetic of Comparative Advantage Let s see precisely how comparative advantage works using a hypothetical ex ample rst suggested in Chapter 2 Table 332 gives a somewhat exaggerated impression of the trading positions of the United States and Japan a few years ago We imagine that labor is the only input used to produce computers and television sets in the two countries and that the United States has an absolute advantage in manufacturing both goods In this example one year s worth of 689 One country is said to have an absolute advantage over another in the production of a particular good if it can produce that good using smaller quantities of re sources than can the other country One country is said to have a comparative advantage over another in the production of a particular good retatlve to other goods if it produces that good less inefficiently as compared with the other country I Alternative pg F One Year of labor can produce either 50 computers or 50 TV sets in the United States but only 10 computers or 40 televisions in Japan So the United States is the more ef cient producer of both goods Nonetheless as we will now show it pays for US Japan Computers M 50 10 W pg 4 Televisions 50 40 the United States to specialize in producing computers and trade with Japan to get the I V sets it wants To demonstrate this point we begin by noting that the United States has a com parative advantage in computers whereas Japan has a comparative advantage in pro ducing TVE Speci cally the numbers in Table 33 2 show that the United States can To review see pages 2728 690 P figainipgie ail the Gains item Trude CHAPTER 33 lNTERNAT OliAl TRADE AND COMPARATWE ADVANTAGE produce 50 televisions With one year s labor whereas Japan can produce only 40 so the United States is 25 percent more efficient than Japan in producing TV sets How ever the United States is five times as ef cient as Japan in producing computers It can produce 50 per year of labor rather than 10 Because Americas competitive edge is far greater in computers than in televisions we say that the United States has a com parative advantage in computers From the Japanese perspective these same numbers indicate that Japan is only slightly less efficient than the United States in TV production but drastically less effi cient in computer production So Japan s comparative advantage is in the television industry According to Ricardo s law of comparative advantage then the two coun tries can gain if the United States specializes in producing computers Japan special izes in producing TVS and the two countries trade Let s verify that this conclusion is true Suppose Japan transfers 1000 years of labor out of the computer industry and into TV manufacturing According to the gures in Table 332 its computer output will fall by 10000 units while its TV output will rise by 40000 units See the middle column of Table 333 Suppose at the same as jam may time the United States transfers 500 years of labor out C 25 06 O 000 15 800 of television manufacturing thereby losing 25000 1 Vs r iquoti iteiST Tlquot O 3 as 7amp1 W Jquot a and into computer making thereby gaining 25000 Teievisions 25000 i40000 15 JG9 computers Table 333 shows us that these transfers of resources between the two countries increase the world s production of both outputs Together the two countries now have 15000 additional TVs and 15000 additional computers surely a nice outcome Was there some sleight of hand here How did hath the United States and Japan gain hath computers and TVs The explanation is that the process we have just de scribed involves more than just a swap of a fixed bundle of commodities it is also a change in the production arrangements Some of Japan s inef cient computer production is taken over by more efficient American makers And some of Americas TV produc tion is taken over by Japanese television companies which are less inefficient at making TVs than Japanese computer manufacturers are at making computers The underly ing principle is both simple and fundamental when every country does what it can do best all countries can benefit because more of every com modity can be produced without increasing the amounts of labor and other resources used The Graphics of Comparative Advantage The gains from trade can also be displayed graphically and doing so helps us under stand whether such gains are large or small The lines US and j N in Figure 331 are closely related to the production possibili ties frontiers of the two countries but they differ in that they pretend that each coun try has the same amount of labor available In this case we assume that each has 1 million personyears of labor For example Table 33 2 tells us that for each 1 million years of labor the United States can produce 50 million TVs and no computers point U in Figure 331 50 million computers and no TVs point S or any combination between the line US Similar reasoning leads to line N for Japan America s actual production possibilities frontier would be even higher relative to Japan s than shown in Figure 331 because the US population is larger But Figure 331 is more useful because it highlights the differences in efficiency that determine both absolute and comparative advantage Let s see how The fact that line US lies above line 7N means that the United States can manufac ture more televisions and more computers than Japan with the same amount oflahsr This difference reflects our assumption that the United States has an absolute advan tage in both commodities 3 To review the concept of the production possibilities frontier see Chapter 2 THE lAW or COMPARATIVE ADVANTAGE Americas comparative advantage in computer pro 3 M duction and Japan s comparative advantage in TV 45 0t so a 5 production are shown in a different Way by the rela 39 rive slopes of the two lines Look back to Table 332 A which shows that the United States can acquire a g i depicted in Figure 33 1 by the slope of Japan s pro it i l 69l computer on its own by giving up one I V Thus the m i f 4 opportunity cost of a computer in the United States is i Pc P T s o r 1 n In I n l F I j I l E i i 3 one television set This opportunity cost is depicted PP j g 4 Ug55 gcgyhg r it e p graphically by the slope of the US production possi s 3 1jquot quotquot p U g ljl 339ffaoeeitigities rrqhtiegii q g M bilities frontier in Figure 331 which is OUOS E I iapgnes f E l f 5050 1 P B 2o 2 4 proouotipni 3 P 39 Table 332 also tells us that the opportunity cost of 39 J 39 prossibgggiae l N J 1 D a computer in Japan is four I Vs This relationship is P 51 39iti39l39i J iw duction possibilities frontier which is 0ON 4010 4 j 1 fl p T l y l l l i l l I l l I l a J H41 gt1 z a N p 254M 4 mi4 v 39 r w 4 2 p I I l l 1 39 I 1 W a an 1 x P 20 l js 5 i 3li 1 k 4k v W J A country s absolute advantage in production over another T l 2 country is shown by its having a higher peroapita production possibilities frontier The difference in the comparative aclranu tages between the two countries is shown by the difference in the slopes of their frontiers Because opportunity costs differ in the we countries gains are possible if the two countries specialize and trade with one another Speci cally it is cheaper in terms of real resources forgone for either country to acquire its computers in the United States By a similar line of reasoning the opportunity cost of TVs is higher in the United States than in Japan so it makes sense for both countries to acquire their televisions in Japan Notice that if the slopes of the two production possibilities frontiersN and US were equal then opportunity costs would be the same in each country In that case no potential gains would arise from trade Gains from trade arise from dr erences across countries not from similarities This is an important point about which people are often confused Some argue that two very different countries such as the United States and Mexico cannot gain much by trading with one another In fact Two very similar countries may gain little from trade Large gains from trade are most likely when countries are very different How the two countries divide the gains from trade depends on the prices that emerge from world trade which is the subject of the next section But We already know enough to see that World trade must in our example leave a computer costing more than one TV and less than four Why Becauseif a computer bought less than one TV its opportunity cost in the United States on the world market the United States would produce its own TVs rather than buying them from Japan And if a com puter cost more than four TVs its opportunity cost in Japan Japan would prefer to produce its own computers rather than buy them from the United States We therefore conclude that if both countries are to trade the rate of exchange be tween TVs and computers must end up somewhere between 41 and 11 Generalizing If two countries voluntarily trade two goods with one another the rate of exchange between the goods must fall in between the price ratios that would prevail in the two countries in the absence of trade To illustrate the gains from trade in our concrete example suppose the world price ratio settles at 211neaniug that one computer costs as much as two televi sions How much precisely do the United States and Japan gain from world trade in this case Figure 332 is designed to help us visualize the answers The blue production pos sibilities frontiers US in Panel b and N in Panel a are the same as in Figure 331 3 As an exercise provide this line of reasoning i H6 is ll E 33 Production Possibilities Frontiers for Two Countries per million years of labor 692 CHAPTER 33 lNTERNATl0NAE TRADE AND COMPARATEVE ADVAMAGE f1oo r it w e e 1oo f i 1 ii 90 r J so i i 39 i A at A so K U i V e so j5 oi15mfp nT J quot i g 3 possibilities 7o we S r e i 3 A 4 70 S 1J l i J 4 r K a 1 393 H 3 G3 05 39 X ltn 39 e i P es s anI jig n jaw J Y I W mi rd 3 E 0 l 3 1 Japanese consumptiom A 5 A g 30 J possibilitiesg K 30 Ug id iv 2 1 i J J J x 5 1 pro ucton E 2 J Japanese produetionl g A 20 2 P 53iP39l tie 1 Jpossibilities W l r 1f iquot w 10 g Lt m 5 W J jit l g gll39l lll slll oto 4 an so 40 so so 5 0 io 20 so 40 yea ep c lm A V i omputeis A l 39 J V V L E Cpgiiputersiquotiquot quot J 39 ff A l l3lquotPa3 S 7 J i x n 3 j Tf iquot3i39fiibI 1iieaes Q i NOTE Quantities are in millions HJGURE 332 The Gains from Trade J But the United States can do better than line US Speci cally with a world price ratio of 21 the United States can buy two TVs for each computer it gives up rather than just one which is the opportunity cost of a computer in the United States Hence if the United States produces only computers point S in Figure 332b and buys its TVs from Japan Americas consumption possibilities will be as indicated by the red line that begins at point S and has a slope of 2 that is each computer sold brings the United States two television sets Because trade allows the United States to choose a point on AS rather than on US trade opens up consumption possibilities that were simply not available before A similar story applies to Japan If the Japanese produce only television sets point in Figure 33 2a they can acquire a computer from the United States for every two TVs they give up as they move along the red line fl whose slope is 2 This re sult is better than they can achieve on their own because a sacri ce of two TVs in Japan yields only one half of a computer Hence world trade enlarges Japan s con sumption possibilities frorn N to P Figure 332 shows graphically that gains from trade arise to the extent that world prices 221 in our example differ from domestic opportunity costs 41 and 11 in our example So it is a matter of some importance to understand how prices in interns tional trade are established We shall do so shortly issue Resolved Comparative Advantage Exposes the Cheap Foreign Labor Fallacy But first let us observe that the principle of comparative advantage takes us a long way toward understanding the fallacy in the cheap foreign labor argument described at the beginning of this chapter Given the assumed productive efficiency of American labor and the inefficiency of Japanese labor we would expect wages to be much higher in the United States In these circumstances one might expect American workers to be apprehensive about an agreement to permit open trade between the two countries How can we hope to meet the unfair competition of those underpaid Japanese workers Japanese SUPPLY DEMAND AND PRICING IN Worm TRADE laborers might also be concerned How can we hope to meet the competition of those Americans who are so efficient in producing everything The principle of comparative advantage shows us that both fears are unjustified As we have just seen when trade opens up between Japan and the United States workers in both comztries will be able to earn higher real wages tcom befma because of the increased pi OdUCtiVlt Y that comes through specialization As Figure 332 shows once trade opens Japanese workers should end up with more TVS and more computers than they had before As a consequence their living standards should rise even though they have been left Vulnerable to competition from super efficient Americans Workers in the United States should also end up with more TVs and with more computers so their living standards should also rise even though they have been exposed to competition from cheap Japanese labor These higher standards of living of course reflect the higher real wages earned by workers in both countries The lesson to be learned here is elementary Nothing helps raise living standards more than a greater abundance of goods 0Z sumv DEMAND an more is warm TRADE How the two countries share the gains from world trade depends on the prices that emerge As usual price determination in a free market depends on supply and demand VVhen applied to international trade however the supplydemand model runs into several new complications First it involves at least two demand curves that of the ex porting country and that of the importing country Second it may also involve two supply curves because the importing country may produce part of its own consump tion Third equilibrium does not take place at the intersection point of either pair of supplydemand curves Vihy Because if the two countries trade at all the exporting nation must supply more than it demands whereas the importing nation must de mand more than it suppiies All three of these complications are illustrated in Figure 333 which shows the sup ply and demand curves of a country that exports wheat in Panel a and of a country that imports wheat in Panel b For simplicity we assume that these countries do not deal with anyone else Vihere will the two country wheat market reach equilibrium p FIG u RE 333 693 upplyDemand Equilibrium in ihe International Wheat Trude Exporting 3 countrfs Exporting 5 5 demand countrfs 3 wool 5 quot E F 33 5 325 fr a e to g 259 3 A B 0 3 yt i or L as g Exports g imports is ca imparting Importing countrws country s suppiy demand 0 o Quantity of Wheat Quantity of Wheat a Exporting country Ix importing Country 594 CHAPTER 33 h ercantilism is a doctrine that holds that exports are good fora country whereas imports are harmful rraas Q INTERNAUONAL TRADE AND COMPARATEVE ADVANTAGE Under free trade the equilibrium price must satisfy two requirements 1 The quantity of wheat exported by one country must equal the quantity of wheat imported by the other country 2 The price of wheat must be the same in both countries In Figure 333 these two conditions are met at a price of 250 per bushel At that price the distance AB between what the exporting country produces and what it con sumes equals the distance CD between what the importing country consumes and what it produces This means that the amount the exporting country wants to sell at 2 50 per bushel exactly equals the amount the importing country wants to buy at that p1 IC At any higher price producers in both countries will want to sell more and con sumers in both countries will want to buy less For example if the price rises to 325 per bushel the exporters quantity supplied will rise from B to P whereas its quannty demanded will fall from A to E as shown in Figure 33 3a As a result more wheat will be available for export EF rather than AB For exactly the same reason the price increase will cause higher production and lower sales in the importing country lead ing to a reduction in imports from CD to GH in Panel b But this means that the higher price 325 per bushel cannot be sustained in a free and competitive international market With export supply EF far greater than import demand GH there is pressure on price to fall back toward the 250 equilibrium price Similar reasoning shows that no price below 250 can be sustained Thus In international trade the equilibrium price is the one that makes the exporting country want to ex port exactly the amotrrrt that the importing country wants to import Equilibrium will thus occur at a price at which the horizontal distance AB in Figure 333a the excess of the exporters quantity sup plied over its quantity demanded is equal to the horizontal distance CD in Figure 3330 the excess of the importers quantity demanded over its quantity supplied At this price the worlds quantity de manded equals the worlds quantity supplied Des39pitei 39the mutual gains eomtimeraarional tradequot nations often interfere with the operation of free markets In fact until the rise of the freetrade movement about 200 years ago with such economists as Adam Smith and David Ricardo as its vanguard it was taken for granted that one of the essential tasks of government was to impede trade presumably in the national interest Many argued then and many still argue today that the proper aim of government policy was to promote exports and discourage imports for doing so would increase the amount of money foreigners owed the nation According to this so called mercantilist view a nation s Wealth consists of the amount of gold or other monies at its command Obviously governments can pursue such a policy only within certain limits A country must import vital foodstuffs and critical raw materials that it cannot supply for itself Moreover mercantilists ignore a simple piece of arithmetic It is mathemat ically impossible for every country to sell more than it buys because one country s ex ports must be some other country s imports If everyone competes in this game by cutting imports to the bone then exports must go the same way The result is that everyone will be deprived of the mutual gains from trade Indeed that is precisely what happens in a trade War After the protectionist 19303 the United States moved away from tnercantilist policies designed to impede imports and gradually assumed a leading role in promot To keep things simple we ignore such details as the costs of shipping wheat from one country to the other TAREFFS QUOTAS AND Oren INTERFERENCES WITH TRADE 695 rtt f3i l 31 1 t quotit iLi3 X3 quot 39 tree T S anyidE reet39 Hes 39iilte39years to complete norm ing free trade Over the past 50 years tariffs and other trade barriers have come down dramatically In 1995 the United States led the world to complete the Uruguay Round of tariff reductions and just before that the country joined Canada and Mexico in the North American Free Trade Agreement NAFTA The latter caused a political firestorm in the United States in 1993 and 1994 with critic and 1992 presidential candidate Ross Perot predicting a giant sucking sound as American workers lost their jobs to com petition from cheap Mexican labor Does that argument sound familiar Today most of the world s trading nations are engaged in a new rnultiyear round of trade talks under guidelines adopted at an important meeting in Doha Qatar in Novem ber 2001 See Liberalizing World Trade The Doha Round Modern governments use three main devices when seeking to control trade tariffs quotas and export subsidies A tariff is simply a tax on imports An importer of wheat for example may be charged 1 for each bushel brought into the country The United States is generally a low tariff country with only a few notable exceptions such as the recently imposed tariffs on steel products of as much as 30 percent However many other countries rely on heavy tariffs to protect their industries Indeed tariff rates of 100 percent or more are not uncommon A quota is a legal limit on the amount of a good that may be imported For example the government might allow no more than 25 million bushels of wheat to be imported in a year In some cases governments ban the importation of certain goods outright a quota of zero The United States now imposes quotas on a smattering of goods includ ing textiles meat and sugar Most imports however are not subject to quotas An export subsidy is a government payment to an exporter By reducing the ex porter s costs such subsidies permit exporters to lower their selling prices and com pete more effectively in world trade Overt export subsidies are minor in the United States but some foreign governments use them extensively to assist their domestic in dustries a practice that provokes bitter complaints from American manufacturers about unfair competition For example years of heavy government subsidies helped years So expect the A tariff is a tax on imports A quota specifies the maxi mum amount of a good that is permitted into the country from abroad per unit of time An expert subsidy is a payment by the government to exporters to permit them to reduce the selling prices of their goods so they can cora pete more effectively in for eign markets 696 Cams 33 Quotas and Tariffs in Inter national Trade INTERNATIONAL TRADE AND COMPARATWE ADVANTAGE the European Airbus consortium take a sizable share of the world commercial aircraft market away from US manufacturers like Boeing and McDonnell Douglas More recently the Europeans have argued that certain aspects of the US tax code amount to an unfair export subsidy P How Tariffs and Quotas Work Both tariffs and quotas restrict supplies coming from abroad and drive up prices A tar iff works by raising prices which in turn cuts the demand for imports The sequence associated with a quota is just the reversea restriction in supply forces prices up The supply and demand curves in Figure 334 illustrate how tariffs and quotas work Just as in Figure 333 the equilibrium price of wheat under free trade is 250 per bushel in both countries At this price the exporting country produces 125 mil lion bushels point B in Panel a and consumes 80 million point 1 So its exports are 45 million bushels the distance AB Similarly the importing country consumes 95 million bushels point D in Panel b and produces only 50 million point C so its imports are also 45 million bushels the distance CD Now suppose the government of the importing nation imposes a quota limiting im ports to 30 million bushels The free trade equilibrium with imports of 45 million bushels is now illegal Instead the market must equilibrate at a point where both ex ports and imports are only 30 million bushels As Figure 334 indicates this require A ment leads to different prices in the two countries Imports in Panel b will be 30 million bushels the distance QT only when the price of wheat in the importing nation is 325 per bushel because only at this price will quantity demanded exceed domestic quantity supplied by 30 million bushels Similarly exports in Panel a will be 30 million bushels wthe distance RSwonly when the price in the exporting country is 200 per bushel At this price quantity supplied exceeds quantity demanded in the exporting country by 30 million bushels Thus the quota mixes the price in the importing country to 325 and lowers the price in the ex porting country to 200 In general An import quota on a product hermalty reduces the volume of that product traded raises the price in the importing country and reduces the price in the exporting country OV V FU R U U U U U quafnujtyfforgawgxeat e E sg p L p9P P R p L t t V p Pb u31 5 i 1 1 o gN ta tram L 0 N us quotsat uN I 39 5 T M M M NOTE Quantities are in miitions at busheis TARIFFS Quous AND OTHER lNTERFERENCES WETH TRADE A tariff can accomplish exactly the same restriction of trade In our example a quota of 30 million bushels led to a price that was 125 higher in the importing country than in the exporting country 325 versus 200 Suppose that instead of a quota the importing nation imposes a 125 per bushel tari quot International trade equilibrium then must satisfy the following two requirements I 1 The quantity of wheat exported hyone country must equal the quantity of wheat imported by the other I 2 The price that coonsiumers in the importing country pay for ivheat must exceed the priceithatsup pliers in the exporting country receive by the amount of the tariff 1 25 in this example By consulting the graphs in Figure 334 you can see exactly Where these two re 39 quirements are met If the exporter produces at S and consumes at R while the irngt porter productes at Q and consumes at 7 then exports and imports are equal at30 millionbushe ls andthe two domestic prices differ by exactly 125 They are 3 25 and 200VVl39lE1tW39 have just discovered is a general result of international trade theory Any restriction ofimlports that is accomplished by a quota normally can also be accomplished by a tariff In this case the tariff corresponding to an import quota of 30million bushels is 125 p Iquotlt1Sl1 lU I I I I 392 i a Tariffs versus Quotas Although tariffs and qiuoitas can accomplish the same reduction in international trade and lead to the same dornestic prices in the two countries there are some important differences between thetwo types of restrictions t 0 i 39 First under a quota pro ts from the price increases in theimporting country usu ally go into the pockets of the foreign and domestic sellers of the product Beccaufse supplies are limited by quotas customers in the importing country must pay more for the product So thesuppliers whether foreign or domestic receive more for every unit they sell For example the right to sell sugar in the United States under the tight sugar quota has been extremely valuable for decades Privileged foreign and dotnestic firms can make a lot of money p L t On the other hand when tradesis restrictedbyva tariff some of the pro ts go in stead as tax revenues to the government of the importing country In effect the goV ernment increases its tax revenues partly at its own citizens expense and partly at the expense of foreign exporters which must accept a reduced price for their wares Do mestic producers again benefit because they are exempt from the tariff In this re spect a tariff is certainly a better proposition than a quotafrom the Viewpoint of the country that enacts it Another important distinction between the two measures arises from their differ ent implications for productive efficiency Because a tariff handicaps all foreign sup pliers equally it awards sales to those firms and nations that can supply the goods most Cheaplywpresumably because they are moreef cient A quota by contrast neo essarily awards its import licenses more or less capriciously perhaps in proportion to past salesor eVen5based39on political favoritism There isno reason to expect the most efficient suppliers to get the import permits For example the US sugar quota was for years suspected of being a source of corruption in the Caribbean If acountry must inhibit lmpports Q impprtantr reason support a preference for tariffs over qtlOlaS 1 Some of the revenues resultlnglfrom tariffs go to the government of the importing country rather than to foreign and domestic proclucers 2 Unlike quotas tarEffsotfer special benefits to more efficient exporters 697 698 CHAPTER 33 INTERNAHONAL TRADE AND COMPARATIVE ADVANTAGE WHY lNHlBlT TRADE To state that tariffs provide a better way to inhibit international trade than quotas leaves open a far more basic question VVhy limit trade in the first place It has been estimated that trade restrictions cost American consumers more than 70 billion per year in the form of higher prices Why should they be asked to pay these higher prices A number of answers are commonly given Let s examine each in turn 0 Gaining a Price Advantage A tariff forces foreign exporters to sell more cheaply by restricting their market ac cess If they do not cut their prices they will be left with unsold goods Suppose as in Figure 33 4b that a 125 tariff on wheat raises the price in the importing country from 2 50 to 325 per bushel This higher price drives down imports from an amount represented by the length of the red line CD to the smaller amount represented by the blue line QT In the exporting country this change means an equal reduction in exports as illustrated by the change from AB to R8 in Figure 3 3 4a As a result the price at which the exporting country can sell its wheat is driven downfrom 250 to 200 in the example Meanwhile producers in the importing Country which are exempt from the tariff can charge 325 per bushel So in effect the tariff amounts to government intervention to rig prices in favor of domestic producers Not bad you say However this technique works only as long as foreigners accept the tariff exploitation passivelywhich they rarely do More often they retaliate by imposing tariffs or quotas of their own on imports from the country that first began the tariff game Such titfor tat behavior can easily lead to a trade war in which no one gains more favorable prices but everyone loses through the resulting reductions in trade Something like this happened to the world economy in the 1930s and it helped prolong the worldwide depression Preventing such trade wars is one main reason why nations that belong to the World Trade Organization WTO pledge not to raise their tariffs Tariffs or quotas can benefit particular domestic industries in 3 country that is able to impose them without fear of retaliation But when every country uses them everyone is likely to less in the long run it Protecting Particular Industries The second and probably more frequent reason why countries restrict trade is to protect particular industries from foreign competition If foreigners can produce steel or shoes more cheaply domestic businesses and unions in these industries are quick to demand protection And their governments may be quite willing to grant it as the recent steel case illustrates The cheap foreign labor argument is most likely to arise in this context Protec tive tariffs and quotas are explicitly designed to rescue rms that are too inefficient to compete with foreign exporters in an open world market But it is precisely this harsh competition that gives consumers the chief benefits of international specialization better products at lower prices In our numerical example of comparative advantage we can well imagine the in dignant complaints from Japanese computer makers as the opening of trade with the United States leads to increased imports of American made computers At the same time American TV manufacturers would probably express outrage over the flood of imported I Vs from Japan Yet Japanese specialization in televisions and US speciai individual workers of switching to the product lines that trade makes pro table OTHER Aaoumaos FOR PROTECTION ization in computers is precisely what enables citizens of both countries to enjoy higher standards of living If governments interfere with this process consumers in both countries Will lose out Industries threatened by foreign competition often argue that some form of pro tection against imports is needed to prevent job losses For example the US steel in dustry has made exactly this argument time and time again since the 19603 most re cently in 2001 when world steel prices plummeted and imports surged And the US government has usually delivered some protection in response Basic macroeconotn ics teaches us however that there are better ways to stimulate employment such as raising aggregate demand A program that limits foreign competition will be more ef fective at preserving employment in the particular protected z rz dmtrjr but such job gains typically come at a high cost to con sumers and to the economy Table 334 estimates some of the costs to American consumers of using tariffs and quotas to save jobs in selected industries In every case the costs far exceed the wages of the workers in the protected industriesmranging as high as 600000 per job for the sugar quota Nevertheless complaints over proposals to reduce tariffs or quotas are justified unless something is done to ease the cost to K SGURCE Gary C ilofbuuar and i rnberly Ann Elliott Measurrng the Costs of Profectromsm in the United States Washington DC Institute for iniarno onoi Economics January l994 Table i 3 pp l2I 3 The argument for free trade between countries cannot be considered airtight if governments do not assist the citizens in each country who are harmed whenever patterns of production change drasticaliywas would happen for exampie if governments suddenly reduced tariff and quota barriers Owners of television factories in the United States and of computer factories in japan may see large investments suddenly rendered unprofitable Workers in those industries may see their special skills and training devalued in the marketplace Dis placed workers also pay heavy intangible costs they may need to move to new loca tions and or new industries uprooting their families losing old friends and neigh bors and so on Although the majority of citizens undoubtedly gain from free trade that is no consolation to those who are its victims To mitigate these problems the US government follows two basic approaches First our trade laws offer temporary protection from sudden surges of imports on the grounds that unexpected changes in trade patterns do not give businesses and Workers enough time to adjust Second the government has set up trade adjustment assistance programs to help workers and businesses that lose their jobs or their markets to imports Firms may be eligible for technical assistance government loans or loan guarantees and permission to delay tax payments Workers may qualify for retraining programs longer periods of unemployment compensation and funds to defray moving costs Each form of as sistance is designed to ease the burden on the victims of free trade so that the rest of us can enjoy its considerable bene ts 0 GTHER ARGUMENTS FOR PROTE l0ll National Defense and Gther Nonecoaomic Considerations A third rationale for trade protection is the need to maintain national defense For ex ample even if the United States were not the most efficient producer of aircraft it might still be rational to produce our own military aircraft so that no foreign govern ment could ever cut off supplies of this strategic product 699 P t p p Trade adjustment assis tance provides special un employment benefits loans retraining programs and other aid to workers and firms that are harmed by foreign competition 700 CHAPTER 33 WTERNATEONAL TRADE AND COMPARATWE ADVANTAGE The national defense argument is fine as far as it goes but it poses a clear danger Even industries with the most peripheral relationship to defense are likely to invoke this argument on their behalf For instance for years the US watchmaking industry argued for protection on the grounds that its skilled craftsmen would be invaluable in wartime Similarly the United States has occasionally banned either exports to or imports from nations such as Cuba Iran and Iraq on political grounds Such actions may have important economic effects creating either bonanzas or disasters for particular Amer ican industries But they are justified by politics not by economics Noneconomic reasons also explain quotas on importation of Whaling products and on the furs of other endangered species p The lnfuntndustry Argument Yet a fourth common rationale for protectionism is the so called in mt z397zdumj argrae ment Promising new industries often need breathing room to ourish and grow If we expose these infants to the rigors of international competition too soon the argu ment goes they may never develop to the point where they can survive on their own in the international marketplace b This argument although valid in certain instances is less defensible than it seems at first Protecting an infant industry is justifiable only if the prospective future gains are sufficient to repay the up front costs of protectionism But if the industry is likely to be so profitable in the future why doesn t private capital rush in to take advantage of the prospective net profits After all the annals of business are full of cases in which a new product or a new firm lost money at first but profited handr somely later on The infantwindustry argument for protection stands up to scrutiny only if private funds are unavailable for some reason despite an industry s glowing pro t prospects Even then it may make more sense to provide a government loan than to provide trade protection In an advanced economy such as ours with welldeveloped capital markets to fund new businesses it is difficult to think of legitimate examples where the infant industry argument applies Even if such a case were found We would have to be care OTHER Aaoumems FOR PROTECTION 701 iirspsniee to try ziiiomfpeiistic itoe39gh39 i1erecon139ess the 3ef t39eeiJihem si39n39retaliation on quotateveir3 ts3 na39i39ee itisa way of saying to ihete iitZh39reete39art V 8I p 3939 signs trading partners You hereibent 39 39 hen iyetii39piaetieeetoconfermtothe agf eB upon l own medisirie lssl p 0 dH g e iiedej theorists The demand iltSfr5Ivh39at rote39etixiie reaction is f10t qem 39glt5 uery not by Z ffefeaitii39g7 Gtheeon rary thetoversees biftates of pro exeriiplarspef h ipfefism need to be 39tatxg39hgt l39basi c lesson isiirede whichis e s yP zP l l P l s r s i g a mceiHswisy sveer The NetizMa li39Ch1397 983 is The Nee YjmkTimes Cempfzn y Ftgapririteciquot byquot permission ful that the industry not remain in diapers forever In too many cases industries are awarded protection when young and somehow never mature to the point where pro tection can be Withdrawn We must be wary of infants that never grow up ea Strategic Trade Policy A stronger argument for temporary protection has substantially in uenced US trade policy Proponents of this line of thinking agree that free trade for all is the best system But they point out that we live in an imperfect world in which many nations refuse to play by the rules of the freetrade game And they fear that a nation that pursues free trade in a protectionist world is likely to lose out It therefore makes sense they argue to threaten to protect your markets unless other nations agree to open theirs The United States has followed this strategy in trade negotiations with several countries in recent years In one prominent recent case the US government threatened to impose high tariffs on a variety of European luxury goods unless 702 CHAPTER 33 Dumping means selling goods in a foreign market at lower prices than those charged in the home market NTERNATlONAt TRADE AND COWARATIVE Aovarnacr Europe opened its markets to imported bananas from the Americas A dangerous trade war was narrowly averted when an agreement was struck at the eleventh houn The strategic argument for protection is a difficult one for economists to counter Although it recognizes the superiority of free trade it argues that threatening protec tionisrn is the best way to achieve that end See Can Protectionism Save Free Trade Such a strategy might work but it clearly involves great risks If threats that the United States will turn protectionist induce other countries to scrap their existing protectionist policies then the gamble will have succeeded But if the gamble fails protectionism increases iquot iP lquot l quot V One of the most curious and illogical features of the protectionist position is the fear of low import prices Countries that subsidize their exports are accused of dumping of getting rid of their goods at unjusti ably low prices Economists nd this argument strange As a nation of consumers we should be in dignant when foreigners charge us big9 prices not low ones That common sense rule guides every consumer s daily life Only from the topsymturvy viewpoint of an indus try seeking protection are low prices seen as being against the public interest Ultimately the best interests of any country are served when its imports are as cheap as possible It would be ideal for the United States if the rest of the world were willing to provide us with goods at no charge We could then live in luxury at the ex pense of other countries But of course bene ts to the United States as a whole do not necessarily inure to every single American If quotas on say sugar imports were dropped American con surners and industries that purchase sugar would gain from lower prices At the same time however owners of sugar elds and their employees would suffer serious losses in the form of lower pro ts lower wages and lost jobs losses they would ght ercely to prevent For this reason politics often leads to the adoption of protection ist measures that we would likely reject on strictly economic criteria A last look at the quot heup Foreign Labor Argument The preceding discussion reveals the fundamental fallacy in the argument that US workers should fear cheap foreign labor The average American workers living stan dard must rise if other countries willingly supply their products to us more cheaply As long as the governments monetary and scal policies succeed in maintaining high levels of employment how can we possibly lose by getting world products at bargain prices This is precisely what happened to the US economy in the late 1990s and into 2000imports poured in at low prices while unemployment in the United States was at its lowest rate in a generation We must add some important quali cations however First our macroeconomic policy may not always be effective If workers displaced by foreign competition can not find new jobs they will indeed suffer from international trade But high unern ployment re ects a shortcoming of the governments monetary and fiscal policies not of its international trade policies Second we have noted that an abrupt stiffening of foreign competition can hurt US workers by not allowing them adequate time to adapt to the new conditions If change occurs fairly gradually workers can be retrained and move on to the indusw tries that now require their services Indeed if the change is slow enough normal at trition may suffice But competition that inflicts its damage overnight is certain to im pose real costs on the affected workers costs that are no less painful for being CAN CHEAP IMPORTS Hun A Counnvt 703 crease ea aiaa the erisejef e Parisian cafe iiiEs be quot raises heat dees for fine one quotwhat theethger c3939niy ob quot asii7 iaeeqeen i3quotexpeasiv6 eaei 39 39 ees netargt 1 e39 irie39e39t i39ieaais iiefi iecheek as yen 39CiGi39ilil im goedeoi idreign n391annfacture39rnere39ly P e approaches 39tere39 whiie at reely 3tiii1fit 39eiii iiaithieatiiilirnitatiarithe l39igittoi the39f ur p some reasaa Z Yo ri ei7eiuinam sisans 1922 N temporary That is why our trade laws make provisions for people and industries dam aged by import surges5 r But these are after all only quali cations to an overwhelming argument They call for intelligent monetary and scal policies and for transitional assistance to unem ployed workers not for abandonment of free trade In general the nation as a whole need not fear competition from cheap foreign labor In the long run labor will be cheap only where it is not very productive Wages will be high in enun tries with high labor productivity and this high productivity will enable these countries to compete effectively in international trade despite high wages It is thus misleading to say that the United States held its own in the international marketplace until recently despite high wages Rather it is much more accurate to hate that the higher wages of American werkers were a result of higher worker pro ductivity which gave the United States a inaier competitive edge Remember in this matter it is absolute advantage not compmntive advantage that counts The country that is most efficient in producing every output can pay its work ers more in every industry 5 It was precisely these provisions that President Bush used to justify the steel tariffs in 2092 704 Imports 686 Exports 686 Specialization 687 Mutual gains from trade 68 Absolute advantage 689 CHAPTER 33 lraseNAT1oNAL TRADE AND COMPARATIVE ADVANTAGE HUMMARYEH Countries trade for two reasons because differences in their natural resources and other inputs create discrepan cies in the efficiency with which they can produce different goods and because specialization may offer them greater economies of largescale production Voluntary trade will generally be advantageous to botlr par ties in an exchange This concept is one of our I ll lS f07 Be your the Final Exam International trade is more complicated than trade within a nation because of political factors differing national cur rencies and impediments to the movement of labor and capital across national borders Two countries will gain from trade with each other if each nation exports goods in which it has a comparative advan tage Even a country that is inefficient across the board will benefit by exporting the goods in whose production it is learnt irze ficztvzt This concept is another of the Iderzsfbr Be yond tye Fz39mz1Exam When countries specialize and trade each can enjoy con sumption possibilities that exceed its production possibilioles The prices of goods traded between countries are deter mined by supply and demand but one must consider ex plicitly the demand curve and the supply curve of early country involved Thus the equilibrium price must make the excess of quantity supplied over quantity demanded in the exporting country equal to the excess of quantity de manded over quaritity supplied in the importing country Mercantilism 694 Tariff 695 Quota 695 You have a dozen shirts and your roommate has six pairs of shoes Worth roughly the same amount of money You de cide to swap six shirts for three pairs of shoes In nancial terms neither of you gains anything Explain Why you are nevertheless both likely to be better off In the 18th century some writers argued that one person in a trade could be made better off only by gaining at the ex pense of the other Explain the fallacy in this argument Country A has a cold climate with a short growing season but a highly skilled labor force What sorts of products do 10 11 12 Comparative advantage 689 Cheap foreign labor argument 692 The cheap foreign labor argument ignores the principle of comparative advantage which shows that real wages Which determine living standards can rise in both import ing and exporting countries as a result of specialization Tariffs and quotas aim to protect a country s industries from foreign competition Such protection may sometimes be advantageous to that country but not if foreign coun tries adopt tariffs and quotas of their own in retaliation Although the same trade restrictions can be accomplished by either a tariff or a quota tariffs offer at least two advan tages to the country that imposes them some of the gains go to the government rather than to foreign producers and they provide greater incentive for efficient production VVhen a nation eliminates protection in favor of free trade some industries and their workers will lose out Equity then demands that these people and firms be compensated in some way The US government offers protection from import surges and various forms of trade adjustment as sistance to help those Workers and industries adapt to the new conditions Several arguments for protectionism can under the right circumstances have validity They include the national de fense argument the infantindustry argument and the use of trade restrictions for strategic purposes But each of these arguments is frequently abused Dumping will hurt certain domestic producers but it ben e ts domestic consumers iv o 7 7ngt 37F a r Export subsidy 695 Trade adjustment assistance 699 Infarwindustry argument 700 Strategic trade policy 701 Dumping 702 you think it is likely to produce Vihat are the characteris tics of the countries with which you would expect it to trade After the removal of a quota on sugar many US sugar farms go bankrupt Discuss the pros and cons of removing the quota in the short and long runs Country A has a mercantilist government that believes it is always best to export more than it imports As a conse quence it exports more to Country B every year than it int ports from Country B After 100 years of this arrangement both countries are destroyed in an earthquake IVhat were the advantages or disadvantages of the surplus to Country A To Country B The following table describes the number of yards of cloth and barrels of wine that can be produced with a week s worth of labor in England and Portugal Assume that no other inputs are needed V Z la39Entl1ind39 3939iquot li39i tirtug39cliquot Q 39Coth3939 8 yardsfnl 1392iya39rds39iquoti a If there is no trade what is the price of wine in terms of cloth in England b If there is no trade what is the price of wine in terms of cloth in Portugal 3 Suppose each country has 1 million weeks of labor available per year Draw the production possibilities frontier for each country d Villich country has an absolute advantage in the pro duction of which goods VVhich country has a corn parative advantage in the production of which goods e If the countries start trading with each other which country will specialize and export which good f What can be said about the price at which trade will take place Suppose that the United States and Mexico are the only two countries in the world and that labor is the only pro ductive input In the United States a worker can produce 12 bushels of wheat or 2 barrels of oil in a day In Mexico a worker can produce 2 bushels of wheat or 4 barrels of oil per day a What will be the price ratio between the two con11nodi ties that is the price of oil in terms of wheat in each country if there is no trade b If free trade is allowed and there are no transportation costs whi39ch commodity would the United States im port What about Mexico c In what range would the price ratio have to fall under free trade Vihy d Picking one possible post trade price ratio show clearly how it is possible for both countries to bene t from free trade QUESTIONS FOR REVIEW 785 8 The following table presents the demand and supply curves 10 for microcomputers in Japan and the United States U S S 2D pO T M cO dT S dT 39 Pri e pe39r Dsmanded Sappliedj Dei1Hi d iSUppli d I q PSS 39 Csrziiputsrg in UiS39i39pi 39irj39EJiipan 39ii1i39upsn 39 of O aN 0 O J PN tN pK O P L t P p 8 O p1M O s I 0 C R 60 s j N f M M I I K N 611 0N ac N 55 c quot Nofe Price and quantity are in thousands a Draw the demand and supply curves for the United States on one diagram and those for japan on another one b If the United States and Japan do not trade what are the equilibrium price and quantity in the computer market in the United States In japan c Now suppose trade is opened up between the two coun tries VVhat will be the equilibrium price in the world market for computers Vihat has happened to the price of computers in the United States In Japan d Which country will export computers How many e When trade opens what happens to the quantity of computers produced and therefore employment in the computer industry in the United States In Japan VVho bene ts and who loses initially from free trade Under current trade law the president of the United States must report periodically to Congress on countries engag ing in unfair trade practices that inhibit US exports How would you define an unfair trade practice Suppose Country X exports much more to the United States than it imports year after year Does that constitute evidence that Country X s trade practices are unfair VVhat would consti tute such evidence Suppose the United States nds Country X guilty of unfair trade practices and penalizes it with import quotas So US imports from Country X fall Suppose further that Country X does not alter its trade practices in any way Is the United States better or worse off VVhat about Coun try X thelntetntlonal U Monetarvlste m Ordelor Disorder hiss Prism the Victorian tutor may P O point In the summer of 1997 therupiahfell and economlc daster in Indonesia quickly followed The elnyterr39la T y ttortal Monetary Fund rushed to the rescue withb lllO I 0U W Q lars and pages of advice But its plan failed and 8 a R c I K may even have helped precipitate the bloody riots thatilecltoy 7 J pmA r g kF p a quotH V the fall of the Indonesian government This chapter does not concentrate on G sehnsaiioinalhhpioglnitihchal tlp C T heavals Rather it focuses on a seemingly mundane topic B deter A s8 mines rates of exchange among different national c39urrenties39i hhNevertheltess P3 T events in Southeast Asia in 19971998 in Brazil a39ndjFlllssia lnle9s 39t9g99t and 8 most recently in Argentina in 2001 have amply demonstrated that n9 ex T 2 change rate movements can have severe human as well as tisnanciaTll o0ese T 4 quences This chapter and the next will help us tlrlclerstandh39whyj Cecily you will read your Political Economy in my absente the rhapter an the Fall of the Ropes you may omit If is somewhat too sensational y T Mlsstlttsll llt DSARWltDE S THE T if 1 IMPORTl4NCE OF BEING EARNEST htsttt iPuuiet Whatever appened hfolAr 31entiatra1t f quot In ts t g i tithttt i Z quot7EE3quot g 39 eseeeteess sees esteeststeestesss tee gs sees eseessst e g t T T interest Rates and Exchange Rates The Short Hurt The Medium Rim Eeoeomie Activity arld Excttarlge Flates The PtrehasingPewer Parity Theory the Long Run Market Determstation of Exchange Rates Summaiy 39 E ii s a ttsi R ft rtt fei eleeestee P es eesteeets Detquotlning the Batance of Payments in Practice 39 A 3 t t R t TEE Q l3e quoteampel ttt see quotT eeeetese Etd 39 s The Classical Gotd Standard l The Breiton Woods System g tttttseststetesv tsestsetetstss ttseee estee T ettsttseee testes States set to ex eseeettes eeeees t i 39 sEti tquot e ts e 39 I s it The Role of the39l39llIF The VolatiteDoIlarI g g The Birth ofthelEyurol 39 39 39 T Puzzle Resolved T heIlateof the Arg htine T Currency Board I 707 708 CHAPTER 321 The exchange rate states the price in terms of one cur rency at which another cur rency can be bought A nation s currency is said to appreciate when exchange rates change so that a unit of its currency can buy more units of foreign currency A nations currency is said to depreciate when exchange rates change so that a unit of its currency can buy fewer units of foreign currency THE INTERNAHONAL MONETARY SYSTEM ORDER ore DiSORDER3 Puzzle Whatever Happened to Argentina The international monetary system seems to lurch from one crisis to another In 2001 Argentina was at the center of attention Only a decade earlier Argentina was considered a model of success The Argentine government had overcome its long unhappy history of inflation by a seemingly sim ple device tying the value of the Argentine peso rigidly to the US dollar Speci cally Argentina created a currency board which meant that anyone with an Argen tine peso could trade it in for a US dollar with no limits By decree then the peso a currency with a checkered in ationary history became the equivalent of the dol lar the well trusted currency of a lowin ation country The Argentine currency board worked extraordinarily well for a while In ation was vanquished and the Argentine economy grew strongly But troubles came to Ar gentina following the Mexican crisis of 19941995 the country endured a painful re cession Then it all happened again following the Brazilian crisis of 1999 The econ omy weakened unemployment rose and investors began wondering whether the currency board could last In fact it did not Argentina abandoned its currency board amidst political and economic turmoil in January 2002 and the value of the peso tumbled VVhat Went so badly wrong VVhat forced Argentina off the currencyboard system leaving the peso to find its own value in the market We will learn some of the an swers in this and the following chapter But first we need to understand what deter mines exchange rates wtrrrnr EXCHANGERATES We noted in the previous chapter that international trade is more complicated than domestic trade There are no national borders to be crossed when say California let tuce is shipped to Massachusetts The consumer in Boston pays with dollrzrs just the currency that the farmer in Modesto wants If that same farmer ships her lettuce to Japan however consumers there will have only Japanese yen with which to pay rather than the dollars the farmer in California wants Thus for international trade to take place there must be some way to convert one currency into another The rates at which such conversions are made are called exchange rates There is an exchange rate between every pair of currencies For example one British pound is currently the equivalent of about 140 The exchange rate between the pound and the dollar then may be expressed as roughly 140 to the pound meaning that it costs 140 to buy a pound or about 7l pence to the dollar mean ing that it costs 71 British pence to buy a dollar Exchange rates visavis the United States dollar have changed dramatically over time In a nutshell the dollar soared in the period from mid1980 to early 1985 fell relative to most major currencies from early 1985 until early 1988 and then fluctu ated sometimes sharply with no clear trend until the spring of 1995 Since then the dollar has mostly but not alWays been on the rise This chapter seeks to ex plain such currency movements Under our present system currency rates change frequently VVhen other currenm cies become more expensive in terms of dollars we say that they have appreciated relative to the dollar Alternatively we can look at this same event as the dollar buying less foreign currency meaning that the dollar has depreciated relative to another currency What is e depreciation to one country must he an appreciation to the other F or example if the cost of a pound rises from 140 to 2 the cost of a US dollar in terms of pounds simultaneously falls from 71 pence to 50 pence The United King SOURCE international Fnoncioi Stcriistltzs and The Wall Sfreeflournol A E t p34pl p Eixrl1onge Rates witlillie M pE pM f p p pM Cost in Dollars ountry Currency Symbol July 1980 Feb 1985 June l995 April 2002 39 Australia dollargmg so 116 074 072 053 camshaft coHar r s b s I rosis ass France 9 mo 1 a FFTMTEE 02350 0100 g 1020 All it rceprmany g p no on 030 00711 st up ma t s oooi2 raoooao s quotorooo1 0 0 lavas p P 0ii0945ilii li QO381ii p 00111118 i5e iOi75 Mexico A A new peso 3 44or 50 are if 0211 Sweden We pR K 024 on 014 a mo 1 Switzerland 0 A franc T Sfr A 062 M 39O8t3 PA A 00 uaieaxragaam annals 4 0144 n R O 0 P Po NOTE Exchange rates are in US dollars per unit oi Foreign currency These exchange rates were locked together or the star oi the euro in January 1999 lOn January 1 1993 the peso was rede ned so that 000 old pesos were equal to one new peso Hence the numbers 44 and 5 llsied for iuly 1980 and Febru ary l985 were actually 0044 and 0005 on the old basis dom has experienced a currency appreciation whereas the United States has experi enced a currency deprecz39atz39on Notice also that when many currencies are changing in value the dollar may be appreciating with respect to one currency but depreciating with respect to another Table 341 offers a selection of exchange rates prevailing in July 1980 February 1985 June 1995 and April 2002 showing how many dollars or cents it cost at eachof those times to buy each unit of foreign currency Between February 1985 and April 2002 the dollar depreciated sharply relative to the Japanese yen and most European curren cies For example the British pound rose from 110 to 144 During that same period the dollar appreciated dramatically rciativc to the Mexican peso it bought about 02 pesos in 1985 but more than 9 in 20021 Although the terms appreciation and depreciation are used to describe move ments of exchange rates in free markets a different set of terms is employed to de scribe decreases and increases in currency values that are set by government decree VVhen an officially set exchange rate is altered so that a unit of a nation s currency can buy fewer units of foreign currency we say that a devaluation of that currency has occurred When the exchange rate is altered so that the currency can buy more units of foreign currency we say that a revaluation has taken place We will say more about devaluation and revaluation shortly but first let s look at how the free market deter mines cxchange rates A p w txuuuct an orrraurutnorr as 1 FREE auto At the beginning of 1999 eleven European countries adopted a new common cur rcncy the euro In early 2002 euro coins and paper money replaced the old curren cies in general circulation But why does a euro now cost about 086 and not 080 or 100 In a world of oating exchange rates with no government interferences the answer would be straightforward Exchange rates would be determined by the forces of supply and demand just like the prices of apples computers and haircuts 39wL39xmAmAu ltx xuumwcumtu 39Auu5tyA5sALwpampvx xQ I In fact the dollar bought about 200 pesos in February 1985 but that is because the old peso was replaced by a new peso in January 1993 which moved the decimal point three places EXCHANGE RATE DETERMHNATION IN A FREE MARKET 709 A devaluation is a reduc tion in the official value of a currency A rayaiuation is an in crease in the official value of a currency oating exchange rates are rates determined in free markets by the law of supply and demand 710 CHAPTER 34 THE INTERNATEONAL MONETARY SYSTEM ORDER oR DsoRDER3 In a leap of abstraction imagine that the dollar and the euro are the only currencies on earth so the market need de termine only one exchange rate Figure 341 depicts the de termination of this exchange rate at the point denoted E in the gure where demand curve DD crosses supply curve SS 0 3 At this price 090 per euro the number of euros demanded 2 is equal to the number of euros supplied E egg in a free rearket exchange rates are eeterei eee ey supply and ae menu at a rate eaten the eeuii erieei Bevel the number ef euree ee uiaueee weuld eaeeed the uereiier supplied and the price in a eure ereaid ea are up er a rate aeeee the eeeileriem level euantity enn nee eeaid ereeea eueatiiy eeeiaeeed and the price at a eure weuid tail Qely at the aaui ieriure exeiiaege rate is there an tendency fer the Number of Eu eachange rate re ehange As usual supply and demand determine price But in this if H6 U H 3439 case we must ask VVhere do the supply and demand come D9l9TmlquotUli Of EX h 99 from VVhy does anyone demand a euro The answer has three parts Rates in a Free Market e International trade in goods and services This factor was the subject of the pre vious chapter If for example Jane Doe an American wants to buy a new BIVIVV she will first have to buy euros with which to pay the dealer in Munich Thus ane s demand for a European car leads to a demand for Eu ropean currency In general demcmdfar oz coiiiitryiv exports leads to demimdfor its cuWei2cy3 e International trade in nancial imtmmeiits suc2 as stories and bonds If American investors want to purchase Italian stocks they will first have to acquire the eu ros that the sellers will insist on for payment In this way demand for Euro pean financial assets leads to demand for European currency Thus demimdfor at country 3 mz7zcial assets leads to d 7 I lz5l7 ld 7quot its currency e Purchases afpaysicizl assets sue9 izsfizctorier and machinery overseas If IBM wants to buy out a smali French computer manufacturer the owners wilianc doubt want to receive euros So IBM will first have to acquire European currency In general directforeign investmerzt leads to demand w 61 country currency Now where does the supply come from To answer this question just turn all of these transactions around Europeans who want to buy US goods and services in vest in US financial markets or make direct investments in the United States will have to offer their euros for sale in the foreign exchange market which is mainly run through banks to acquire the needed dollars To summarize The demand fur a eeuetry s eurreney Es e erivee freequot the eemauae at tereigriers far its expert genes and serviees and far Ere assetswineieeiug i nene ei aeeete eeeii as eteeee and Faeries and real ae eets each as iaeieries and reeehineryfhe eepeiy at a eeeeinfs eurreney arieee freer ire ieieerts and item fereign iaeeeeneet ey its earn eitizene To illustrate the usefulness of even this simple supply and demand analysis think about how the exchange rate between the dollar and the euro should change if Euro peans become attracted by the prospects of large gains on the US stock markets To purchase US stocks foreigners will first have to purchase US dollars which means selling some of their euros In terms of the supply dernand diagram in Figure 342 the increased desire of Europeans to acquire US stocks would shift the supply curve for euros out from S18 the black line in the figure to 25 the red line Equilib 3 Actually she will not do so because banks generally handle foreign exchange transactions for consumers An Ameri can bank probably will buy the euros for her Even so the effect is exactly the same as ifjane had done it herself 3 See Review Question 2 at the end of this chapter EXCHANGE RAFE DETERMINATEON N A FREE MARKET riurn would shift from point E to point A and the exchange rate would fall from 090 per euro to 080 per euro Thus the increased supply of euros by European citizens would cause the euro to depre ciate relative to the dollar Of course this is what happened during the US stock market boom of the late 19905 Price of a Euro in dollars in a 9 re 9 e o Exertise Test your understanding of the supply and demand analysis of exchange rates by showing why each of the following events would lead to an appre ciation of the euro a depreciation of the dollar in a free market f 1 American investors are attractedquot by prospects for pro t on the German stock market Name of Euros 2 A recession in Italy cuts Italian purchases of American goods IG U RE 342 3 Interest rates on government bonds rise in I 3 The Eff3fofgS139gdMgr France but are stable in the United States Hzrzt VVhich countrys citizens 300m on the Exchange R Wlll be attracted to invest by high interest rates in the other country Tb say that supply and demand determine exchange rates in a free market is at once to say everything and to say nothing If we are to understand the reasons why some currencies appreciate whereas others depreciate we must look into the factors that move the supply and demand curves Economists believe that the principal determi nants of exchange rate movements differ signi cantly in the short medium and long runs So in the next three sections we turn to the analysis of exchange rate move ments over these three runs beginning with the short run 7 interest Estes and Extlisnga Rates Ilia Sher his Most experts in international nance agree that interest rates and financial flows are the major determinants of exchange rates certainly in the short run and probably as we shall see next in the medium run as well Speci cally one variable that often seems to call the tune in the short run is interest rate di erevztz39rzZs A multitrilliondollar pool of so called not moneywowned by banks investment funds multinational corpo rations and wealthy individuals of all nationsmtravels rapidly around the globe in FIGURE 343 search of the highest interest rates The Effect of G Rise in US As an example suppose British government bonds pay a 5 percent rate of interest when yields on equally safe American government securities rise to 7 percent British investors will be attracted by the higher interest rates in the United States and will offer pounds for sale in order to buy dol lars planning to use those dollars to buy American securities At the same time American investors will find it more attractive to keep their money at home so fewer pounds will be demanded by Americans VVhen the demand schedule shifts inwrzrd and the supply curve shifts outward the effect on price is predictable The pound will depreciate as Figure 343 shows In the figure the supply curve of pounds shifts outward from 88 to S282 when i I rxteresf Rates 160 Price of 2 Pound British investors seek to sell pounds in order to pur Hume of pounds chase more US securities At the same time 712 CHAPTER 34 THE lNTERNATlONAL MONETARY SYSTEM ORDER oR DISORDER American investors wish to buy fewer pounds because they no longer desire to invest as much in British securities Thus the demand curve shifts inward from DID to DZD2 The result in our example is a depreciation of the pound from 160 to 140 In general Other things equal countries that otter investors higher rates of return attract more capital than CGllt39t tries that offer lower rates Thus a rise in interest rates elteh will lead to an appreciation of the cur reney and a drug in trtterest rates will lead to e deerectatlen Interest rate differentials certainly played a predominant role in the stunning movements of the US dollar in the 19805 In the early 19803 American interest rates rose well above comparable interest rates abroad In consequence foreign capital was attracted here American capital stayed at home and the dollar soared Similarly a na tion that suffers from capital flight as did Argentina in 2001 must offer extremely high interest rates to attract foreign capital lhe Medium Run Economic Activity and Exchange Rates The medium run is where the theory of exchange rate determination is most unset tled Economists once reasoned as follows Because consumer spending increases when income rises and decreases when income falls the same thing is likely to hap pen to spending on imported goods So u connt7ry s imports will rise qniclely when its economy booms and rise only slowly 7109672 its economy stozgnlztes is I For the reasons illustrated in Figure 344 then 0 5 a boom in the United States should shift the de mand curve for euros outward as Americans seek to acquire more euros to buy more European goods And that in turn should lead to an appreciation of the euro depreciation of the dollar In the figure the euro rises in value from 90 cents to Q 95 cents I I 2 However if Europe was boomingaat the same time Europeans would be buying more American 51 exports which would shift the supply curve of euros f 5 outward Europeans must offer more euros for sale to get the dollars they want On balance the value c Number of Euros of the dollar might rise or fall It appears that what matters is whether exports are growing faster than I F I e u R E 344 imports The Elle l 539 E quot 39 i h country whese aggregate demand grows faster than the rest at the worlds normally finds its the B90 Alquot l 0quot lhe ports growing faster than its exports Thus its demand curve for foreign currency shifts outward Exchange Rule more rapidly than tts supply curve Other things equal that will make its eurrertcy depreciate 090 quotquotquotquot quot39quot quot quot quotquot quotquot quot quot T quot quotquot quot quotquot Price of a Euro This reasoning is sound so far as it goes And it leads to the conclusion that a strong economy might produce a weak currency But the three most important words in the preceding paragraph are other things equal Usually they are not Specifically a booming economy will normally offer more attractive prospects to in vestors than a stagnating onem higher interest rates rising stock market values and so on This difference in prospective investment returns as We have seen should at tract capital and boost its currency value So there appears to be a kind of tug of war As we see thinking only about trade in goods and services leads to the conclusion that faster growth should weaken the currency But thinking about trade in nancial assets such as stocks and bonds leads to precisely the opposite conclusion F aster growth should strengthen the currency VVhich side Wins this tug of war EXCHANGE RATE DETERMINATEON N A FREE MARKET In the modern world the evidence seems to say that trade in financial assets is the dominant factor For example rapid growth in the United States in the second half of the 1990s led to a sharply appreciating dollar even though US imports soared as in vestors from all over the world brought funds to America We conclude that Stronger economic performance appears to lead to currency appreciation because it improves prospects for investing in the country cw lire PurthosingPcwer Purity Theory The long Run We come at last to the long run where an apparently simple principle ought to gov ern exchange rates As long as goods can move freely across national borders ex change rates should eventually adjust so that the same product costs the same amount of money whether measured in dollars in the United States euros in Germany or yen in Japan except for differences in transportation costs and the like This simple statement forms the basis of the major theory of exchange rate determination in the long run The purchasing power parity theory of exchange rate determination holds that the exchange rate hetween any two national currencies adjusts to reflect differences in the price levels in the two countries An example will illustrate the basic truth in this theory and also suggest some of its limitations Suppose German and American steel is identical and that these two na tions are the only producers of steel for the world market Suppose further that steel is the only tradable good that either country produces QzIesrz39o72 If American steel costs 180 per ton and German steel costs 200 euros per ton what must be the exchange rate between the dollar and the euro 1m39we39r Because 200 euros and 180 each buy a ton of steel the two sums of money must be of equal Value Hence each euro must be worth 090 VVhy Any higher price for a euro such as 1 would mean that steel would cost 2 00 per ton 200 euros at 1 each in Germany but only 180 per ton in the United States In that case all foreign customers would shop for their steel in the United States which would increase the demand for dollars and decrease the demand for euros Similarly any exchange rate below 090 per euro would send all the steel business to Germany driving the value of the euro up toward its purchasing power parity level iiiteriiise Show why an exchange rate of 080 per euro is too low to lead to an equilib rium in the international steel market The purchasing power parity theory is used to make long run predictions about the effects of inflation on exchange rates To continue our example suppose that steel and other prices in the United States rise while prices in Europe remain constant The purchasing power parity theory predicts that the euro will appreciate relative to the dollar It also predicts the amount of the appreciation After the US inflation suppose that the price of American steel is 220 per ton while German steel still costs 200 euros per ton For these two prices to be equivalent 200 euros must be worth 220 or one euro must be worth 110 The euro therefore must have risen from 090 to 110 According to the purchasingpower parity theory differences in domestic inflation rates are a major cause of exchange rate movements if one country has higher inflation than another its exchange rate should he depreciating For many years this theory seemed to work tolerably well Although precise nu merical predictions based on purchasingpower parity calculations were never very accurate see Purchasing Power Parity and the Big Mac nations with higher 713 714 CHAPTER 34 TllE JNTERNATIONAL MONETARY SYSTEM ORDER OR DisoRoER39r Purchosing P0wer Ptlrilyond 1l1E39BlgMH I iti ierraljlte exchangerate theory more digestibie P i the39hambarger39petttiy theory the 9 0 ittsori to theory the iocat price at a Big Mac when 0 39 9 yuan wasgrosslyfLindervalued terriety iaretl Y 9 TheEconomist tnagazine has been using a well39 tChaog T3115 311 the lime 01 8281 1 ktioitirr ihterrtationalr eerrrmedity the Big lUiae to assess the 0U p if 1 yitan to the cl0llar lhatamQunted R Tjfquot5 gpatehasingpower parity theory of exchange rates or as the t39ojisti12t39Thas aocordingto 1t i li d393315t 3ESd39altais39ia rtheexchange rate should be the same 39 quotBy how 39much The price in i 39iev 39the39jweri39quoti39he following namisjers show that thetheory China was justquot 47 percent of 1 39 39 quot 39 Vi i quotthe price iri the 39Uriited States g g 3 Egggxeirapie alttieirgh quota Big itlaccosts an average of 259 in the Iquot j 13921259 So the39y39u39ahi was c siaTid39iotisst iO39yuan in China Usingthe official ex4 ii 7 39 53 percent below itsBig Mac a R E Ha a E R 5 p 1 1 1 PA parity alnd quottherefore sheuid p 0 BigMocPi3rtchosing Power j II atPi3r8Ciaf9 The Gilliequot UmR Y 200 XX L p P 0hV here in the tablet have similar V t 39 1 Z fY iinterpretattohs R T P9109311 Y P Z Hquot I 39 True Big Mac aficionados may find these data helpful when plan Bggggi orquotn equot it quot 0hY W nirtg internationalquottraveli39Btitcan deviations from Big Mac parity predict wnVe39ed valumm T 9 pg F4 exchange rate movements39Surprisingly they can 1 Country to dollars Against Dollar fquot o Q Wheneconorriist Robert Curnby studied Big Mac prices and ex 39 M y P R N E J y change rates in tg4oountri39es overatenyear period he found that devi l iiiiiiiiiiiii7i5iiWi5 itirf ii i K l if 39iquotquotii39l39ationsfrom harhbiaper parity were transitory Their halilife was just a I H xC l 393939539939 PmH I ZI E 39 289 12 E r H H P H H E year meaning that 510 iperoeht of the deviation tended to disappear E Eri1 grea Ema 289 i712 739 0 9 1 I 8 within a year Thus the uquotnderva39lued currencies in the accompanying il i539 quot39 R E 23942 at quot7 t I I 39 itlable iivouidbe predicted to appreciate during 2002 whereas the over ff J iSi39R Rgatp9miit P 9 13980 731 R R f I R w valued ourrjehbies waldo be expected to depreciate China 121 M53 v SQu CE39ThegEconomist iecember 22 2tJO1p130 and Robert Cumby Forecast 18 7 6 6 25 p 0 398 p 5 Pt in ation did at least experience depreciating currencies But in the 19805 and 19905 even this rule broke down For example although the US in ation rate was consis tently higher than both Gern1any s and Japan s the dollar nonetheless rose sharply relative to both the German mark and the Japanese yen from 1980 to 1985 The same thing happened again between 1995 and 2000 Clearly the theory is missing something Vi hat Many things But perhaps the principal failing of the pnrchasing power parity the ory is once again that it focuses too much on trade in goods and services Financial assets such as stocks and bonds are also traded actively across national bordersand in vastly greater dollar volumes than goods and services In fact the astounding daily volume of foreign exchange trar1sactions rnorc than 15 trillionwexcecds an entire mom 9 worth of world trade in goods and services The vast majority of these trans actions arc financial If investors decide that say US assets are a better bet than Japanese assets the dollar will rise even if our in ation rate is Well above Japan s For this and other reasons iiitest eeannmists tisttsva that other tasters are traioh stare important than relattse prise levels tar arm ehange rate dsterrritnatipa in the short ran out in the tent ran ptsrstiasirtgwpoarer parity piays art int patient role FIXED EXCHANGE RATES AND THE BALANCE or PAYMENTS itieritet heiermieetien ei Extitenge iietes Summary You have probably noticed a theme here International trade in financial assets cer tainly dominates shortrun exchange rate changes may dominate rnediumrun changes and also in uences long run changes We can summarize this discussion of exchange rate determination in free markets as follows i We expect to tied appreciating currencies in eeentries that offer investors higher rates of return heceese these eetmtries wiil attract capitai from all ever the world 2 in some extent these are the countries that are growing faster than average because strong growth tends to produce attractive investment prospects However such iast growing countries tliiiil aise he imparting reiatiireiy mere than other countries which tends to pull their currencies dawn 3 Currency satires gerreraliy vrriil appreciate in countries with lower inflation rates than the rest of the rvertde hecatrse buyers in foreign countries vvili demand their goods and thus drive up their ctrrrencies Reversing each of these arguments we expect to find deprrecintzng currencies in countries with relatively high inflation rates low interest rates and poor growth prospects iilliiimillhi W5 Willi WW DFPAYMENTS Some exchange rates today are truly oating determined by the forces of supply and demand without government interference Many others are not Furthermore some people claim that exchange rate fluctuations are so troublesome that the world would be better off with fixed exchange rates For these reasons we turn next to a system of xed exchange rates or rates that are set by governments Naturally under such a system the exchange rate being fixed is not closely watched Instead international nancial specialists focus on a country s balance of pay rmenrr a term we must now define to gauge movements in the supply of and de mand for a currency To understand what the balance of payments is look at Figure 345 which depicts a situation that might represent say Argentina in the winter of 2001 2 002 an over valued currency Although the supply and demand curves for pesos indicate an equi librium exchange rate of 050 to the peso point E the Argentine government is holding the rate at 100 Notice that at 1 per peso more people supply pesos than demand them In the example suppliers offer to sell 8 billion pesos per year but purchasers want to buy only D 4 billion This gap between the 8 billion pesos that some people wish to sell and the 4 billion pesos that oth ers wish to buy is what we mean by Argentina s bal ance of payments de cit 4 billion pesos or 4 billion per year in this hypothetical case It appears as the horizontal distance between points A and B in Figure 345 How can governments flout market forces in this way Because sales and purchases on any market must be equal as a simple piece of arithmetic the 5 excess of quantity supplied over quantity de A rnanded or 4 billion pesos per year in this exam plemmust be bought by the Argentine government Price of a Peso 050 39 393939 39391 N5 Fixed exchange rates are rates set by government decisions and maintained by government actions The balance of pay ments deficit is the amount by which the quantity supplied of a country s cur rency per year exceeds the quantity demanded Balance of payments deficits arise whenever the exchange rate is pegged at an artificially high level FIGURE 345 A Balance of Payments Deficit S ittaiarsee at peyrnettte rtie39iirit 1 p m w H 0 p5 eat it I I I I l l l i i 3 3 3 3 5 i l D 8 Billions of Pesos per Year 716 CHAPTER 34 THE NTERNATONAi MoNtiARv SYSTEM ORDER oR D1soRDER3 To purchase these pesos it must give up some of the foreign currency that it holds as reserves Thus the Bank of Argentina would be losing about 4 billion in reserves per year as the cost of keeping the peso at 1 Naturally this situation cannot persist forever as the reserves eventually will run G U 35 34 6 out This is the fatal flaw of a fixed exchange rate system Once speculators become A SP9CUlGliVe RUN On convinced that the exchange rate can be held for only a short while longer they will ille P950 sell the overvalued currency in massive amounts rather than hold on to money whose value they ex pect to fall That is precisely what began to happen to Ar gentina in 2001 The supply curve of pesos shifted outward as shown in Figure 346 as both domes tic and foreign holders sought to get out of pe sos This exodus from the peso caused a sharp rise in the balance of payments de citmfrom 4 billion to 8 billion pesos in the example The numbers are fictitious Lacking sufficient reserves the Argen tine government first reacted by blocking with drawals from banks but then succumbed to market forces and let the peso oat in early 2002 It promptly depreciated For an example of the reverse case a severely undervalued currency let us go back in history to The haianca 91 pay the case of West Germany in 1973 Figure 347 depicts demand and supply curves for meats surplus is the marks that intersect at an equilibrium price of 5 0 cents per mark point E in the dia 8m0Uflli by Which the qualllliy gram Yet in the example we suppose that the German authorities are holding the demamed laC V 5 Cur rate at 33 cents At this rate the quantity of marks demanded 50 billion greatly quoteLjr1 nl tilpeSLye 2 delgs gighg exceeds the quantity supplied 40 billion The difference is Germany s balance of gaymexts SpUS39eS arise payments surplus shown by the horizontal distance Whenevmhe exchange rate Germany can keep the rate at 33 cents only by p1 0V1lII1g the marks that foreigners is pegged aian amnggaiiy low want to buy 10 billion marks per year in this example In return the country re Ievel ceives US dollars British pounds French francs gold and so on All of this activity serves to increase Germany s reserves of foreign currencies But notice one important difference between this case and the overvalued peso Price of a Peso to quot ca 0 Billions of Pesos perYear The accumulation of reserves rarely will force a central bank to revalue in the way that losses of re G U R E 34397 serves can force a devaluation A Balance of Payments Surplus This asymmetry is a clear weakness in a xed ex change rate system In principle an exchange rate dise uilibrium can be cured either b a dewzlmition q Y by the country with a balance of payments deficit or by an upward rewlzmtioia by the country with a balance of payments surplus In practice though only de cit countries are forced to act VVhy do surplus countries refuse to revalue One 3 reason is often a stubborn refusal to recognize W a some basic economic realities They tend to view l V E er the disequilibrium as a problem only for the de cit itmiif countries and therefore believe that the deficit l l I l 3 050 a 033 e Price of a Mark countries should take the corrective steps This view of course is nonsense in a worldwide system S D of xed exchange rates Some currencies are over 390 50 valued becazzse some other currencies are underval ued In fact the two statements mean exactly the same thing Biiiions of Marks per Year A Bar or HlSTORY THE GOLD STANDARD AND THE BRETTON Wooos SYSTEM The other reason why surplus countries resist upward revaluations is that such ac tions would make their exports more expensive to foreigners and thus cut into their sales And export industries often have the political clout to make their preferences stick befitting the Balance of Payments to Practice The preceding discussion makes it look simple to measure a nation s balance of pay ments position Just count up the private demand for and supply of its currency and subtract quantity supplied from quantity demanded Conceptually that is all there is to it But in practice the difficulties are great because we never directly observe the number of dollars demanded and supplied Actual market transactions show that the number of say US dollars pureJared al ways equals the number of US dollars sold Unless someone has made a bookkeeping error this must be so How then can we recognize a balance of payments surplus or deficit Easy you say Just look at the transactions of the central bank whose pur chases or sales must make up the difference between private demand and private sup ply If the Federal Reserve is buying dollars its purchases measure our balance of pay ments deficit If the Fed is selling its sales represent our balance of payments surplus Thus the idea is to measure the balance of payments by exrludmg o icial tmnmcriom rzmorzg g 0 ve739zzme725 That is more or less what is done In practice the balance of payments accounts come in two main parts The cur rent account totes up exports and imports of goods and services cross border pay ments of interest and dividends and cross border gifts The United States has been running large current account de cits for years But that represents only one part of our balance of payments for it leaves out all purchases and sales of assets Purchases of US assets by foreigners bring foreign cur rency to the United States and purchases of foreign assets cost us foreign currency Netting the capital flows in each direction gives us our surplus or deficit on capital account In recent years this part of our balance of payments accounts has registered persistently large s mpluser as foreigners have acquired US assets In what sense then does the overall balance of payments balance There are two possibilities If the exchange rate is oating all private transactions current account plus capital account must add up to zero dollars purchased dollars sold But if instead the exchange rate is xed as shown in Figures 345 and 347 the two ac counts need not balance one another Government purchases or sales of foreign cur rency make up the surplus or deficit in the overall balance of payments A Eli SF HISIGRY THE l SHNEARD AW llquotl lEBRETl0ll WOGDS SYSTEM It is difficult to find examples of strictly fixed exchange rates in the historical record About the only time exchange rates were truly fixed was under the old gold standard at least when it was practiced in its ideal form 39 iiie ilassital Sold Standard Under the gold standard governments maintained fixed exchange rates by an auto matic equilibrating mechanism that went something like this All currencies were de fined in terms of gold indeed some were actually made of gold Vhen a nation ran a balance of payments de cit it had to sell gold to finance the de cit Because the domestic L As a matter of fact although the gold standard lasted on and off for hundreds of years it was rarely practiced in its idea form Except for a brief period of fixed exchange rates in the late 19th and early 20th centuries governments pe riodically adusted exchange rates even under the gold standard 4 T K 717 The current account bal ance includes international purchases and sales of goods and services cross border in terest and dividend payments and cross border gifts to and from both private individuals and governments The capital account bat ance includes purchases and sales of financial assets to and from citizens and compa nies of other countries The goid standard is a way to fix exchange rates by defining each participating currency in terms of gold and allowing holders of each par ticipating currency to convert that currency into gold 7l8 CHAPTER 34 THE lNTERNATONAL MONETARY SYSTEM ORDER OR DISORDER money supply was based on gold losing gold to foreigners meant that the money sup ply fell rzutomatzmlly which raised interest rates The higher interest rates attracted for eign capital At the same time this restrictive monetary policy pulled down output and prices which discouraged imports and encouraged exports The balance of pay ments problem quickly recti ed itself This automatic adjustment process meant however that under the gold standard no nation had control of its domestic monetary policy The same problem arises in any system of xed exchange rates regardless of whether it makes use of gold tinder iixeti axenaagge rates monetary eetiey rriust ea eeeicatati to nagging the exchange rate it can net tneretera ne natal in manage aggregate demand The gold standard posed one other serious difficulty The world s commerce was at the mercy of gold discoveries Major gold finds would mean higher prices and booming economic conditions through the standard monetary policy mechanisms that we studied in earlier chapters Vihen the supply of gold failed to keep pace with growth of the world economy prices had to fall in the long run and employment had to fall in the short run iiia Etatteii ifiaads System The gold standard faltered many times and nally collapsed amid the financial chaos of the Great Depression of the 19305 and World War II Without it the world strug gled through a serious breakdown in international trade As the war drew to a close representatives of the industrial nations met at a hotel in Bretton Woods New Hampshire in 1944 They sought to establish a stable mon etary environment that would restore world trade Because the United States held the lion s share of the world s reserves at the time these of cials naturally turned to the dollar as the basis for the new international economic order The Bretton Woods agreements reestablished fixed exchange rates based on the free convertibility of the US dollar into gold The United States agreed to buy or sell gold to maintain the 35 per ounce price that President Franklin Roosevelt had established in 1933 The other signatory nations which had almost no gold in any case agreed to buy and sell clollars to maintain their exchange rates at agreedmupon levels Thus all currencies were indirectly tied to gold A holder of French francs for example could exchange these for dollars at roughly 5 francs per dollar and then ex change the dollars for gold at 35 per ounce In this way the value of the franc was fixed at 175 francs per ounce of gold 5 francs per dollar times 35 per ounce The Imermztiomzl Moizerary Fund IMF which has been much in the news of late was established in 1944 to police and manage the Bretton Woods system Using funds contributed by member countries the IMF was empowered to make loans to countries that were running low on reserves Letting the exchange rate adjust was viewed as a last resort for it was believed that xed exchange rates were essential to world trade The Bretton Woods system inherited the flaws of any xed exchange rate system A change in exchange rates was to be permitted only in the case of a fundamental disequilibrium in a nation s balance of payments for it was believed that only rela tively fixed exchange rates could provide the stable climate needed to restore world trade Of course the Bretton Woods conferees did not de ne clearly what a fundamen tal disequilibriurn was nor could they have As the system evolved it came to mean a chronic de cit in the balance of payments of sizable proportions Such nations would then be allowed to devalue their currencies relative to the dollar So the sys tem was not really one of fixed exchange rates but rather one where rates were fixed until further notice Because the IMF sanctioned devaluations only after a long run of balance of payments deficits had depleted the country s reserves these devaluations could be clearly foreseen and normally had to be large Speculators ADJUSTMENT MECHANGMS UNDER Furs EXCHANGE RATES therefore saw glowing opportunities for profit and would attack weak currencies with waves of selling This problem led many economists to question whether the system of fixed ex change rates really provided the stable climate for world trade that had been intended Was a system where rates remained constant for long periods and then were altered by large amounts really more conducive to international trade than one in which overvalued currencies would gradually depreciate as they would under a system of oating rates A second problem arose from the asymmetry mentioned in the previous section Deficit nations could be forced to devalue while surplus nations could resist upward revaluations Because the value of the US dollar was fixed in terms of gold the United States was the one nation in the world that had no way to devalue its currency The only way exchange rates between the dollar and foreign currencies could change was if the surplus nations revalued their currencies upward relative to the dollar They i did not adjust frequently enough so the United States developed an overvalued cur rency and chronic balance of payments deficits The overvalued dollar finally destroyed the Bretton Woods system By August 1971 the depletion of Americas reserves and the accumulation of foreign debts forced President Richard Nixon to end fixed exchange rates which he did by an nouncing that the United States would no longer buy or sell gold at 3 5 per ounce After some futile attempts to reestablish fixed rates the Bretton Woods system died in 1973 Under the Bretton Woods system devaluation was viewed as a last resort to be used only after other methods of adjusting to payments imbalances had failed What were these other methods We encountered most of them in our earlier discussion of exchange rate detern1i nation in free markets Any factor that imrmses tire dcrmartd for say Argentine pesos or that reduces the supply will push the value of the peso upward if it is free to adjust But if the exchange rate is pegged the balance of payments deficit will do the adjusting instead Specifically the Argentine balance of payments deficit will sl9rz3972le if either the demand for pesos increases or the supply decreases The two panels of Figure 34 8 illustrate these adjustments In each case Argentina has a payments deficit because the official exchange rate 1 peso 1 dollar exceeds 100 100 050 050 Price of a Peso in Doliars Price of a Peso in Doiiars FIGURE 348 adjusting to Balance of Payments Deficits Number of Pesos a Number of Pesos lb 719 720 CHAPTER 34 THE INTERNAHONAL MONETARY SYSTEM ORDER oR DISORDER the equilibrium rate 1 peso 3 5 0 cents The deficit starts at A8 in each diagram Then either the demand curve moves outward as in Panel a or the supply curve moves inward as in Panel b With the exchange rate held at 1 peso to the dollar the balance of payments de cit shrinks to CB in Panel a or to AC in Panel b Recalling our earlier discussion of the factors that underlie the demand and supply curves we see that one way a nation can shrink its balance of payments de cit is to re duce its aggregate demand thereby discouraging imports and cutting down its demand for foreign currency Another is to lower its rate of in ation thereby encouraging ex ports and discouraging imports Finally it can raise its interest rates to attract more for eign capital In other words de cit nations are expected to follow restrictive monetary and s cal policies voluntarily just as they would have done automatically under the classical gold standard However just as under the gold standard this medicine is often un palatable A surplus nation could of course take the opposite measures pursuing expanrio7a ary monetary and scal policies to increase economic growth and lower interest rates By increasing the supply of the country s currency and reducing the demand for it such actions would reduce that nation s balance of payments surplus But surplus countries often do not relish the in ation that accompanies expansionary policies and so once again they leave the burden of adjustment to the de cit nations The gen eral point about xed exchange rates is that Under a system of fixed exchange rates a country s government loses some control over its domes tic economy Sometimes balance of payments considerations may force it to contract its economy so as to cut down its demand for foreign currency even though domestic needs call for expansion At other times the domestic economy may need to be re ned in but balance of payments considerations suggest expansion That was certainly the case in Argentina where interest rates soared to attract for eign capital and the government pursued contractionary scal policies to curb the country s appetite for imports Both contributed to a long and deep recession Ar gentina took the bitter medicine needed to defend its xed exchange rate for quite a while But high unemployment eventually led to riots in the streets toppled the gov ernment and persuaded the Argentine authorities to abandon the xed exchange rate W ilRVl i39 EXCHANGE WE5 Then it39s agreed Until the doliar firms up we let the clamshell float In view of these and other problems with xed exchange rates why did the interna tional financial community work so hard to maintain them for so many years And why do some nations today still fix their exchange rates The answer is that oating exchange rates also pose problems Chief among these worries is the possibility that freely oating rates might prove to be highly variable rates thereby adding an unwanted element of risk to foreign trade For example if the exchange rate is 090 to the euro then a Parisian dress priced at 200 euros will cost 180 But should the euro appreciate to 110 that same dress would cost 220 An American department store think ing of buying the dress may need to place its order far in advance and will want to know the cost in dollars It may be worried about the possibility that the value of the euro will rise making the dress cost more than 180 And such Worries might inhibit trade There are two responses to this concern First freely oating rates might prove to be fairly stable in practice Prices of most ordinary goods and services for ex ample are determined by supply and demand in free markets and do not uctu ate unduly Unfortunately experience since 1973 has dashed this hope Exchange rates have proved to be extremely volatile which is why some observers favor greater xity in exchange rates SOURCE The New Yorkercoilectlon 1971 Ed Fisher from cartoonlianitcom Ali Rights Reserved THE CURRENT NoNsrsiEM A second possibility is that speculators might relieve business firms of exchange rate risksmfor a fee of course Consider the department store example If each euro costs 090 today the department store manager can assure herself of paying exactly 180 for the dress several months from now by arranging for a speculator to deliver 200 euros to her at 090 per euro on the day she needs them if the euro appreciates in the interim the speculator not the department store will take the nancial beat ing Of course if the euro depreciates the speculator will pocket the profits Thus speculators play an important role in a system of oating exchange rates The widespread fears that speculative activity in free markets will lead to wild gy rations in prices although occasionally valid are often unfounded The reason is simple To make profits international currency speculators must buy a currency when its value is low thus helping to support the currency by pushing up its demand curve and sell it when its value is high thus hclding down the price by adding to the supply curve This means that successful speculators rnust come into the market as buyers when demand is weak or when supply is strong and come in as sellers when demand is strong or supply is scant In doing so they help limit price fluctuations Looked at the other way around speculators can destabilize prices only if they are systematically will ing to lose money Notice the stark and ironiccontrast to the system of fixed exchange rates in which speculation often leads to wild runs on currencies that are on the verge of de valuation as happened in Mexico in 1995 several Southeast Asian countries in 19971998 Brazil in 1999 and Argentina in 2001 Speculative activity which may well be destaI7z39lz39zz3972g under fixed rates is more likely to be stabilizing under floating rates5 We do not mean to imply that speculation makes floating rates trouble free At the very least speculators will demand a fee for their serviceswa fee that adds to the costs of trading across national borders In addition speculators will not assume all exchange rate risks For example few contracts on foreign currencies last more than say a year or two Thus a business cannot easily protect itself from exchange rate changes over periods of many years Finally speculative markets can and do get carried away from time to time moving currency rates in ways that are difficult to understand that frustrate the intentions of governments and that devastate some people as happened in Mexico in 1995 and in Southeast Asia in 1997 Despite all of these problems international trade has ourished under floating exchange rates Perhaps exchange rate risk is not as burdensome as some people think W7 8 P 9 7 8 069 p 6 9 T he international nancial system today is an eclectic blend of fixed and floating ex change rates with no grand organizing principle Indeed it is so diverse that it is of ten called a nonsystern Some currencies are still pegged in the old Bretton Woods manner One example is Hong Kong which maintains a fixed value for its currency by standing ready to buy or sell US dollars as necessary China also seems to peg its currency to the dollar but has not enunciated that as its official policy A few small countries like Panama and Ecuador have taken this theme even further by actually adopting the US dollar as their domestic currencies Other nations tie their currencies to a hypothetical bas ket of several currencies rather than to a single currency See Review Question 13 at the end of the chapter After their respective currency crises in i995 and 1999 both Mexico and Brazil oated their currencies Each has weathered the subsequent internationai financial storms rather nicely At this writing Argentina is still struggling 721 722 CHAPTER 34 THE lNTERNATlONAL MONETARY SYSTEM ORDER or DISORDER More nations however let their exchange rates float although not always freely Such oating rates change slightly on a day today basis and market forces generally determine the basic trends up or down But governments do not hesitate to intervene to moderate exchange movements whenever they feel such actions are appropriate Typically interventions are aimed at ironing out what are deemed to be transitory fluctuations But sometimes central banks oppose basic exchange rate trends For ex ample the Federal Reserve and other central banks sold dollars aggressively in 1985 to push the dollar dawn and they bought dollars in 1994 and 1995 to push the dollar up As we will discuss in the next chapter the Japanese have been debating whether to drive the value of the yen down The terms dzrty flour or managed oat have been coined to describe this mongrel system The Rule of the IMF The role of the International Monetary Fund in the current nonsystem is quite dif ferent from what it was under the old Bretton Woods system No longer the police officer of fixed exchange rates the IMF has evolved into a generalpurpose interna tional fre and rescue squad instead The IMF examines the economies of all its member nations on a regular basis VVhen a country runs into serious financial difficulties it may turn to the Fund for help The IMF typically provides loans but with many strings attached For example if the country has a large current account deficit as is normally the case when coun tries come to the IMFwthe Fund will typically insist on contractionary fiscal and monetary policies to curb the country s appetite for imports Often this mandate spells recession During the 19903 the IMF found itself at the epicenter of a series of very visible economic crises in Mexico in 1995 in Southeast Asia in 1997 in Russia in 1998 and in Brazil in 1999 Most recently Turkey and Argentina have run into trouble and ap pealed to the IZVIF for help VVhile each case was different they shared some common elements Most of these crises were precipitated by the collapse of a fixed exchange rate pegged to the US dollar In each case the currency plummeted with ruinous conse quences Questions were raised about the country s ability to pay its bills In each case the IMF arrived on the scene with both money and lots of advice determined to stave off default In the end each country suffered through a severe recession or worse The IMF s increased visibility has naturally brought it increased criticism Some critics complain that the Fund sets excessively strict conditions on its client states re quiring them for example to cut their government budgets and raise interest rates in a recession which makes a bad domestic economic situation become even worse Other critics worry that the Fund is serving as a bill collector for banks and other financial institutions from the United States and other rich countries These banks loaned money irresponsibly these critics argue and therefore deserve to lose it By bailing them out of their losses the IMF simply encourages more reckless behavior in the future Suggestions for reform are everywhere see Does the International Monetary Sys tem Need Reform and some changes have been made in the IMF s procedures But the debate rages on The Volatile Dollar As mentioned earlier oating exchange rates have not proved to be stable exchange rates No currency illustrates this point better than the US dollar See Figure 349 In 1977 and 1978 the international value of the dollar plummeted until a con certed effort by central banks to buy dollars stopped the fall The dollar then stabi lized for almost two years before rising like a rocket for a period of almost five years As Table 341 showed in July 1980 a US dollar bought less than 2 German marks wx obert Rubin Arnerica s former Treasury secretary wants to modernize the architecture of the international financial markets Eisuke Sakakibara Japan s top international fi nance official is thinking of a Bretton Woods ll Aian Greenspan chairman of the Federal Reserve wants to review the patchwork of arrangements governing international finance After East Asia s crisis activism is in the air it is easy to see why Policymakers worry that today s financial architecture designed at Bretton Woods in 1944 for a world of limited capital mobility may not be capable of dealing with an ever more giobal capital market For international finance has been revolutionised For merly closed economies have cast off controls and embraced foreign funds Better technology and financial innovation have made it easy to move money instantaneously The benefits are obvious the expansion of private flows to develop ing countries But vast inflows can quickly become huge outflows And financial crises can spread overnight between apparently uncon nected markets The five worstaffected Asian economies South Ko rea Indonesia Thailand Malaysia and the Philippines received 93 billion of private capital flows in 1996 In 1997 they saw an outflow of 12 billion One reform to reinforce capital markets is better regulation Countless banking crises in rich and poor countries alikehave shown that the combination of free capital flows and badly regulated banks is disastrous Others go much further arguing that a global capital market needs global financial regulation not a hotch potch of national supervisors of varying quality For many conservatives parttcolarty in Americas Congress the an swer is to curb or even eliminate the IMF it is the prospect of bailouts they argue that encourages governments to profligacy and investors to recklessness about 4 French francs and about 830 Italian lira 1985 the mighty dollar could buy more than 3 By the time it peaked in February German marks about 10 French The UPS and DOWNS Of 723 THE CURRENT HNONSYSTEMquot POUCY DEBATTET j oe siltelniernuti iiitl Monef rySysfem Need Refornt SOURCE QC Serge Attalf Getty imagesGamrnaLiaison For those who see East Asia s crisis primarily as one of panic far more urgent is the need to control the capital flows themselves For those who are uneasy with the speed with which funds flow around the globe the perennial idea of a tax on currency transactions has sur faced again With such an array of possible reforms it is hardly surprising that in ternational officials are confused and uncertain whereas their political masters demand quick action SOURCE The Perils of Global Capital The Economist April 11 1998 The Econo mist Newspaper Group Inc Reprinted with permission Further reproduction prohibited wwweconornist corn Authors note Potrtioians may have wanted qurc39rlt actionquot in i998 but few of the items on this list have actuaily happened The debate goes on HGURE 349 francs and more than 2000 Italian The DOHUT lira Such major currency changes af fect vvorld trade dramatically 130 The rising dollar was a blessing to Americans who traveled abroad or 16 who bought foreign goodsm because 3 140 foreign prices when translated to 5quot dollars by the exchange rate looked iii 12 39quot flak cheap to Americans7 But the arith E is 109 PJ I 3 mx pg 1 metic Worked just the other way 2 5 B around for US firms seeking to sell 3 0 AW their goods abroad foreign buyers 50 d Ollllllllllllllllllllllllilll i lii 1974 1978 1932 1986 1990 1994 1998 2001 H Erer r391r 39 How much does a 600franc hotel room years in Parts cost in dollars when the franc is worth 20 9 cents 16 cents 10 cents NOTE Exchange rate relative to major currencies ivlarch 1973 00 724 CHAPTER 34 L quot Hr39s mood is THE ENTERNATEONAL MONETARY SYSTEM ORDER eR DrsoRDEa8 found everything American very expensivefi It was no surprise therefore that as the dollar climbed our exports fell our imports rose and many of our leading manufac turing industries were decimated by foreign competition An expensive currency Americans came to learn is a mixed blessing From early 1985 until early 1988 the value of the dollar fell even faster than it had risen The cheaper dollar curbed American appetites for imports and alleviated the plight of our export industries many of which boomed However rising prices for imported goods and foreign vacations were a source of consternation to many American consumers Since 1988 the overall value of the dollar has not changed much on average But quite a few appreciations and depreciations have occurred that were sharp enough to am the attention of the world s nancial markets and central banks In recent years the dollar has been mostly rising The international currency markets are anything but boring Tire Eirtii ei tits Eats As noted earlier oating exchange rates are no panacea One particular problem con fronted the members of the European Union EU As part of their long range goal to create a unified market like that of the United States they perceived a need to establish a single cur rency for all member countries a monetary union The process of convergence to a single currency took place in steps more or less as prescribed by the Treaty of1V1aastricht over a period of years Member nations encountered a number of obstacles along the way But to the surprise of many skeptics all such obstacles were overcome and the euro became a reality in 1999 Electronic and checking transactions in 11 of the 15 EU nations were denominated in euros rather than in national currencies as ofjanuary 1999 The number of participating countries rose to 12 when Greece joined the monetary union and the new euro coins and paper money were introduced successfully in January 2002 By now French francs German marks Italian lira and nine other national currencies have been withdrawn from circulation and will soon be relics of the past Each of these transformations has taken place remarkably smoothly The establishment of the euro and the withdrawal of the other national currencies is a great economic experiment that marks a giant step beyond merely xing exchange rates A fixed exchange rate regime can be abolished at any time by decision of the re1 evant governments And as we have seen speculators sometimes break fixed ex change rates even when governments want to maintain them Europe s monetary union was created by an international treaty however and it is more or less invulnerm able to speculative attack because it rzbolisyeti exchange rates among the participating nations Just as there has long been no exchange rate between New York and New Jersey now there is no exchange rate between Germany and France Monetary unions may create other problems but exchange rate instability should not be one of them But a monetary union fixes the exchange rate only witz39r2 the union The common currency in this case the euro continues to fluctuate in value visa vis other curren cies Since its introduction the euro has fallen significantly relative to the US dollar In January 1999 one euro was worth about 117 As of this writing it is worth only pegged to the dollar SOURCE J The New Vanlto39Coiclt1ian from carteennankmm Aii Rights Resewed 839 Ete39rf39c 39 How much does 1 55 39 tn1erican caiuera cost a er1nan consumer when the 139nark is worth 55 cents 4 cents 3333 cents U As of this writing three EU members Sweden Denmark Jncil the United ilt i1ig39titgti11 have chosen not to join the monetaly union SUMMARY 086 This large depreciation of the euro has had its usual positive stimulating ex ports and negative in ationary effects on Europe s economies But it has also wounded European pride futile Resalved Allie Fate ti the Argentine Currenty Beard 39VVhat we have learned in this chapter helps us understand what went wrong with Ar gentina s fixedexchange rate system in 2001 and 2002 The story actually begins at the time of the Mexican crisis in 1995 When the Mexican peso fell international investors began worrying about other Latin American currencies that were pegged to the dollar including the Argentine peso They offered pesos for sale and demanded dollars in return which Argentina was bound to provide under the terms of its currency board Argentina was deter mined to maintain parity between the dollar and the peso which it viewed as the key to its conquest of in ation So it followed the orthodox prescription for currency de fense It raised interest rates and cut its budget deficit The medicine worked the value of the peso was preserved But this remedy brought a painful cost a serious recession Unfortunately for Argentina the US dollar then rose in value against most of the world s currencies over the next six years pulling the Argentine peso with it As a re sult Argentine goods became increasingly expensive Bad luck struck again in 1999 when Argentina s largest neighbor Brazil was forced to abandon its own fixed ex change rate system The Brazilian real plunged in value making the Argentine peso which was tied to the dollar terribly expensive by comparison Argentina soldiered on for several more years successfully maintaining its currency board at the cost of a multiyear recession But in the closing months of 2001 as we have seen chaos erupted in the streets and the currency board was doomed Argentina now has a oating exchange rate 725 Exchange rates state the value of one currency in terms of other currencies and thus translate one c0untry s prices into the currencies of other nations Exchange rates there fore influence patterns of world trade If governments do not interfere by buying or selling their currencies exchange rates will be determined in free mar kets by the usual laws of supply and demand Such a system is said to be based on oating exchange rates Demand for a nation s currency is derived from foreigners desires td purchase that country s goods and services or to invest in its assets Under oating rates anything that in creases the demand for a nation s currency will cause its ex change rate to appreciate Supply of a nation s currency is derived from the desire of that country s citizens to purchase foreign goods and ser vices or to invest in foreign assets Under oating rates anything that increases the supply of a nation s currency will cause its exchange rate to depreciate Purchasing power parity plays a major role in very long run exchange rate movements The purchasing power parity theory states that relative price levels in any two countries determine the exchange rate between their cur rencies Therefore countries with relatively low in ation rates normally will have appreciating currencies Over shorter periods however purchasing po39wer parity has little influence over exchange rate movements The pace of economic activity and the level of interest rates ex ert greater influence Capital movements are typically the dominant factor in ex change rate determination in the short and medium runs A nation that offers international investors higher interest rates or better prospective returns on investments will typically see its currency appreciate An exchange rate can be fixed at a nonequilibrium level if the government is willing and able to mop up any excess of quantity supplied over quantity demanded or provide any excess of quantity demanded over quantity supplied In the first case the country is suffering from a balance of pay ments de cit because of its overvalued currency In the second case an undervalued currency has given it a bal ance of payments surplus 726 10 11 12 Exchange rate 73908 Appreciation 708 Eepreciation 708 uevaluation 709 Revaluation 709 Floating exchange rates 709 CHAPTER 34 The gold standard was a system of xed exchange rates in which the value of every nation s currency was fixed in terms of gold This system created problems because na tions could not control their own money supplies and be cause the world could not control its total supply of gold After World War II the gold standard was replaced by the Bretton Woods system in which exchange rates were fixed in terms of US dollars and the dollar was in turn tied to gold This system broke up in 1971 when the dol lar became chronically overvalued Since 1971 the world has moved toward a system of rela tively free exchange rates but with plenty of exceptions We now have a thoroughly mixed system of dirty or managed oating Which continues to evolve and adapt Floating rates are not without their problems For exam ple importers and exporters justifiably worry about fluctu ations in exchange rates N5 715 THE INTERNATTONAL MONETARY SYSTEM ORDER oR DTSORDERE Current account H Capital account 17 13 14 15 Purchasingpower parity theory 713 Fixed exchange rates H5 Balance of payments deficit and surpars Under floating exchange rates investors who speculate on international currency values provide a valuable service by assuming the risks of those who do not wish to speculate Normally speculators stabilize rather than destabilize ex change rates because that is how they make profits The US dollar rose dramatically in value from 1980 to 1985 making our imports cheaper and our exports more expensive From 1985 to 1988 the dollar tumbled which had precisely the reverse effects Since then the dollar has fluctuated in value with no clear trend although lately it has mostly been rising The European Union has recently established a single cur rency the euro for most of its member nations use standard 7 Bretteu Weeds system 2213 Eriieraatieaat Monetary Feed iiiF We Sirty er Tuaeagedquot float M2 Esra 2ti What items do you own or routinely consume that are pro duced abroad From what countries do these items come Suppose Americans decided to buy fewer of these things How would that affect the exchange rates between the dol lar and these currencies If the dollar appreciates relative to the euro will the Ger man camera you have wanted become more or less expen sive lVVhat effect do you imagine this change will have on American demand for German cameras Does the Ameri can demand curve for euros therefore slope upward or downward Explain During the first halfof the 19805 inflation in West Ger many was consistently lower than that in the United States VVhat then does the purchasingpower parity theory pre dict should have happened to the exchange rate between the mark and the dollar between 1980 and 1985 Look at Table 34 1 to see what actually happened Use supply and demand diagrams to analyze the effect of the following actions on the exchange rate between the dollar and the yen P japan opens its domestic markets to more foreign competition 6 b Investors come to believe that values on the Tokyo stock market will rise c The Federal Reserve raises interest rates in the United States d The US government to help settle the problems of the Middle East gives huge amounts of foreign aid to Israel and her Arab neighbors e Japan has a recession while the United States booms f Inflation in the United States exceeds that injapan How are the problems of a country faced with a balance of payments deficit similar to those posed by a government regulation that holds the price of milk above the equilib rium level Him Think of each in terms of a supply demand diagram For each of the followin trarisactions indicate how it 11 g g 1 would affect the US balance of payments if exchange rates were fixed a You spent the summer traveling in Europe b Your uncle in Canada sent you 20 as a birthday present Exchong Rates and the llilacroeconomy No man is an island entire of itself p 0 T T P p t OHltli0N39 urveying the problems afflicting a nembefiigttthet 3 I J p P N world s economies a few years ago Federal if g T serve Chairman Alan Greenspan famously declared P 39 g y 3 United States could not long remain an oasisof prosperity 7gyini 43 PN T T i a troubled world The nations of the world are indeed locked p i gether in an uneasy economic union Fluctuations in foreign f if Qrowth inflation and interest rates Drofoundly affect the US in Pm f economy Economic events that origioate in our country reverberate p 1 fggitetf i i T tteeteeteeteeetet teeeet ateiteeeeeeegeeieiteeg see y I it 5 E E g tyeeeeeeefte eeetsete y The macroeconomic model we developed in earlier chapters does not I Fielative Prices Exports and imports The39Etfects otchanges in Exchange Rates go far enough In particular it ignores such crucial influences as exchange rates g m m gfg WWW gg gm E m g gg y and international financial movements The previous chapter showed how major r 7t ttE eeeceeeeeeeeeeeeeeaets ee eseeeeees if t 39 eeeee c y do 39 t J gs 39 quotinterest Rates and ltitetnational Capital Flows I globeAnyone who ignoresthese international lirtkages39can39notlquotiope ygguegshouydthe y n apm iap g 0 6 K T stand how the world economy works i 0 H 39 macroeconomic variables such as gross domestic product GDP prices arid in terest rates affect exchange rates to this chapter we complete the circle by stttdy tite ei ieet te iiet te t Pttii twst te ttft fete w tti s eyeoeaoee if t mg how changes in the exchange rate affect the domestic economy Then we Fgscay POW 39R vE itd39 P 0 p bring international capital flows into the picture and learn how monetary and fiscal T M0 et3W Policy FquotleVtSltedt quoti g e 4 quot ttt t tTt7tteett t39ettes ete tW t39 st quot t3te tt tt t ti ttt3ittt t t pohcy Work m 3 pe e my39 The Loose liquotnk betweensthequot39Buctget Deficit and the T Defi39ctt 39 A 39 i39te t ttE39quott 39tettW eeeiort e Wt3tg t39t39ttittiei39i ore tttttt t5 quott tttEZ5 teeee peetett T Change the Mix of Fiscal and Monetary Policy More Rapid Economic Growth Abroad Raise Domestic Saving or Reduce Domestic lnvestme Protectiontsme t3 3itt tt3t 3tvt ti restttaet t5 tatit titzttarittitt Issue Revisited The Yen 395 Effect on Smaller Asian Economies 730 CHAPTER 35 An open eoorioroy is one that trades with other nations in goods and ser vices and perhaps also trades in financial assets FIGURE 351 The Effects of Higher Net Exports Price Level EXCHANGE RATES AND THE MACROECONOMY issoe ilioeio the ion eptstiote The value of the Japanese yen has fluctuated substantially relative to the US dollar in recent years At its peak value in April 1995 it took only about 80 yen to buy a dol lar But by June 1998 it took more than 145 yen to buy a dollarwhich meant that the yen had lost 55 percent of its value By October of that same year the yen had sky rocketed to as high as 111 yen to the dollar As of this writing it takes about 130 yen to buy a dollar VVhile these currency fluctuations were occurring the Japanese economy was go ing from bad to worse By 2001 Japan was suffering through yet another recession and an active debate was in progress Should the Japanese government take steps to reduce the value of the yen And if so how low should the yen go A number of economists argued that Japan and perhaps the whole world would be better off with a cheaper yen that would boost Japanese exports and therefore help Japan s ailing economy But most Japanese government officials were not convinced that a lower yen was whatJapan needed And some of Japan s neighboring countries feared the competition from cheaperJapanese goods Who was right We will examine this question as the chapter progresses ital iiiiiiii Exi iiiiiitii Ri1fifiiANMGGREAiE EEMANQ We know from earlier chapters that a country s net exports X IM are one com ponent of its aggregate demand C i I G X IM It follows that an au tonomous increase in exports or decrease in imports has a multiplier effect on the economy just like an increase in consumption investment or government pur chases Figure 35 1 depicts this conclusion on an aggregate demand and supply dia gram A rise in net exports shifts the aggregate demand curve outward to the right pushing equilibrium from point A to point B Both GDP and the price level there fore rise But what increases net exports One factor mentioned in Chapter 24 was a rise in foreign incomes If foreign economies boom their citizens are likely to spend more on a wide variety of products some of which will be American exports Thus Figure 351 illustrates the effect on the US economy of more rapid growth in foreign countries Similarly a recession 5 abroad would reduce US exports and shift the US ag gregate demand curve inward Thus as we learned in Chapter 2 5 Booms or recessions in one country tend to no transmitted to other countries through international trade in goods and services One other important determinant of net exports was mentioned in Chapter 24 but not discussed in depth the relative prices of foreign and domestic goods This idea involves a simple application of the law of demand Namely if the prices of the goods of Country X rise people everywhere will tend to buy fewer of them and more of the goods of Country Y As we will see next this simple idea holds the key to understanding how ex R al GDP 6 change rates affect international trade An appendix to Chapter 25 showed that international trade iowers the numerical value of the muitiplier Au tonomous changes in C I G and X W KiI ail have the same multiplier lNERNATONAl TRADE EXCHANGE RATES AND AGGREGATE DEMAND p teietive Prices Experts end imparts First assume just for this short section that exchange rates are xed VVhat happens if the prices of American goods fall while say Japanese prices are constant With US products now less expensive relative to faparzese products both Japanese and American consumers will buy more American goods and fewer Japanese goods As a result Americas exports Will rise and its imports will fall adding to aggregate demand in this country Conversely a rise in American prices relative to Japanese prices will decrease US net exports and aggregate demand Thus A fell in the retattve prices er a ceuntrye experts tends tn increase that enuntrye net experts and hence to raise its real GDP Anelegeusly a rise in the relative prices rat a ecicrntrye experts wit ea crease that eeuntrye net experts and GDP Precisely the same logic applies to changes in Japanese prices IfJapanese prices rise Americans will export more and import less So X M will rise boosting GDP in the United States Figure 35l applies to this case without change By similar reasoning falling Japanese prices decrease US net exports and depress our economy Thus Price increases abroad raise a eeuntrye net experts and hence its ens Price eecreaees earned trees the apposite effects in Fire Effects sf Changes in Exchange Rates From here it is a simple matter to figure out how changes in exchange rates affect a coun 731 Z A 3 ll 35ll Exchange Rates and Home Currency Prices try s net exports for ezmterzcy appreciations or ale sgggiggg Japanese SL999 gs pr39ecz39arz39om change irrterarational relative prices TV Set Home Eompmer Recall that the basic role of an exchange E h xc unge PTICG In Price m Price m Pnce In rate 13 to convert one countrys pI 1C S 1I1tO Rm Japan heU5 heU5 Japan another country s currency Table 351 uses two examples of USJapanese trade to re 351 120 Ye 30r0OO 250 1900 12OrOOO mind us of this role Suppose the dollar 1 3 100 V9 30900 300 L000 100000 depreciates from 120 yen to 100 yen Then 39 from the American consumers viewpoint a television set that costs 30000 in Japan goes up in price from 250 that is 30000120 to 300 To Americans it is just as ifJapanese manufacturers had raised TV prices by 20 percent Naturally Zu N3 U R5 354 Americans will react by purchasing fewer Japanese products so American imports The Effects of Exchange will decline Rate Changes on Aggregate Now consider the implications for Japanese con Demand sumers interested in buying American personal com puters that cost 1000 VVhen the dollar falls from 120 yen to 100 yen they see the price of these computers falling from lZ0000 to 100000 To them it is just as if American producers had offered a 167 percent mark down Under such circumstances we expect US sales to the Japanese to rise so US exports should increase Putting these two ndings together we conclude that Price Level a currency deweetatien eneeld raise net errperts and tneretere ehenld reduce net experts and therefore decrease aggregate demand 5 The aggregate supply and demand diagram in Figure increase aggregate demand Cenirersely a currency appreeratren reg tee r Z tr 9 9 9 D0 A is my a r u rfrrrrrtampstEerrft 35 2 illustrates this conclusion If the currency depreci ates net exports rise and the aggregate demand curve shifts outward from DOD to DD Both prices and out Real GSP 732 CHAPTER 35 EXCHANGE RATES AND THE MACROECONOMY I put rise as the economy s equilibrium moves from Eg to E1 If the currency appreci ates everything operates in reverse Net exports fa l the aggregate demand curve shifts inward to DZDZ and both prices and output decline This simple analysis helps us understand why the US trade de cit grew so enor rnously in the late 19905 We learned in the previous chapter that the international value of the dollar began to climb in 1995 According to the reasoning we have just completed within a few years such an appreciation of the dollar should have boosted US imports and damaged US exports That is precisely what happened In constant dollars American imports soared by 40 percent between 1997 and 2000 while Amer ican exports rose just 15 percent The result was that a 113 billion net export de cit in 1997 turned into a monumental 399 billion deficit by 2000 AGGREGATE SUPPLY llll AN OPEN ECONOMY FIGURE 353 The Effects of Exchange Rate Changes on Aggregate Supply quotas 3 I 0 2 in CI So far we have concluded that a currency depreciation increases aggregate demand and that a currency appreciation decreases it To complete our model of macroeco nomics in an open economy we turn now to the implications of international trade for aggregate supply Part of the story is already familiar to us As we know from previous chapters the United States like all economies purchases some of its productive inputs from abroad Oil is only the most prominent example We also rely on foreign suppliers for metals such as titanium raw agricultural products such as coffee beans and thousands of other items used by American industry Vihen the dollar depreciates these im ported inputs cost more in US dollars just as if foreign prices had risen The consequence is clear With imported in puts more expensive American firms will be forced to charge higher prices at any given level of output Graphically this means that the aggre gate supply curve will claz upward or inward to the ieft z When the dollar depreciates the prices of imported in puts riseThe US aggregate supply curve therefore shifts inward pushing up the prices of Americanmade goods and services By exactly analogous reasoning an appre ciation of the dollar makes imported inputs cheaper and shifts the US aggregate supply curve outward thus D pushing American prices down See Figure 353 o 1 tiplepreeiaitieul quot5 llACR E M39C W5 0 EX 5EWi5 m Beyond this a depreciating dollar has addi tional in ationary effects that do not show up on an aggregate demand and supply diagram which depicts the price of domestic product on its Vertical axis Most obviously prices of imported goods are included in US price indexes like the Consumer Price Index CPI So when the dollar prices of Japanese cars French wine and Swiss watches increase the CPI goes up even no American prices rise For this and other reasons the inflationary impact of a dollar depreciation is even greater than that indicated by Figure 353 Real GDP Let us now put aggregate demand and aggregate supply together and think through the macroeconomic effects of changes in exchange rates THE MACROECONOFWC EFFECTS or EXCHANGE RATES First suppose the international value of the dollar falls Re ferring back to the red lines in Figures 352 and 353 we see that this depreciation will shift the aggregate demand curve 0Z lquotZU l7 ii and the aggregate supply curve inward The result as Figure 354 shows is that the US price level certainly rises But whether real GDP rises or falls depends on whether the supply or demand shift is the dominant in uence The evi dence strongly suggests that aggregate demrmd shifts are usu ally larger so we expect GDP to rise Hence A currency depreciation is inflationary and probably also expansionary The intuitive explanation for this result is clear VVhen the dollar falls foreign goods become more expensive to Ameri cans That effect is directly in ationary At the same time ag gregate demand in the United States is stimulated by rising net exports As long as the expansion of demand outweighs the adverse shift of the aggregate supply curve brought on by cur rency depreciation real GDP should rise But wait By this reasoning the massive depreciations of several Southeast Asian currencies in 1997 and 1998 should have given these economies tremendous boosts Instead the socalled Asian Tigers suffered horri c Price Level Real GDP FlGUllE 354 The Effecls of u Currency Depreciation slumps as did Mexico when the peso tumbled in 1995 VIhy The answer is that our simple analysis of aggregate supply and demand omits a detail that although unim portant for the United States is critical in many developing nations Countries that borrow in foreign currency will see their debts increase whenever their currencies fall in value For example an Indonesian business that borrowed 1000 in July 1997 when 1 was worth 2500 rupiah thought it owed 25 million rupiah But when the dollar suddenly be came worth 10000 rupiah the company s debt skyrocketed to 10 million rupiah Many businesses found themselves unable to cope with their crushing debt burdens and sim ply went bankrupt Now let s reverse direction and look at what happens when the currency appreciates In this case net exports fall so the aggregate demand curve shifts immrd At the same time imported inputs become cheaper so the aggregate supply curve shifts outward Both of these shifts are shown in Figure 355 Once again as the diagram shows we can be sure of the movement of the price level It falls Out put also falls if the demand shift is larger than the supply shift as is likely Thus A currency appreciatien is disiriflaiionary and probably also centractinnary This analysis explains why many economists and nan cial experts cringe whenever the yen appreciates Japan is already experiencing both de ation and recession The Price Level F l G U R E 355 The Effects of 0 Currency Appreciation Real GDP last thing it needs they argue is a decrease in aggregate demand and further de a tionary pressures 3 inleresl Rules and lniernuiienul Cupilcil Flaws One important piece of our international economic puzzle is still missing We have analyzed international trade in goods and services in some detail but we have ignored international movements of capital 734 CHAPTER 35 international eapitni tinnrs are purchased and sales of financial assets across national borders A stoned eennnrny is one that does not trade with other nations in either goods or assets EXCHANGE RATES AND THE MACROECONOMY For some nations this omission is inconsequential because they rarely receive or lend international capital But things are quite different for the United States because the vast majority of international nancial ows involve either buying or selling assets whose values are stated in US dollars In addition we cannot hope to understand the origins of the various international financial crises since the 19905 without incorpo rating capital flows into our analysis Fortunately given what we have just learned about the effects of exchange rates this omission is easily recti ed Recall from the previous chapter that interest rate differentials and capital flows are typically the most important determinants of exchange rate movements Specifi cally suppose interest rates in the United States rise while foreign interest rates re main unchanged We learned in the previous chapter that this change in relative in terest rates will attract capital to the United States and cause the dollar to appreciate This chapter has just taught us that an appreciating dollar will in turn reduce net ex ports prices and output in the United States as indicated in Figure 355 Thus A rise in interest rates tends to contract the economy by appreciating the currency and reducing not exports Notice that this conclusion has a familiar ring VVhen we studied monetary policy in Chapter 29 we observed that higher interest rates deter investment spending and hence reduce the I component of C I G X IM Now in studying an open economy with international capital ows we see that higher interest rates also re duce the X IM component Thus international capital flows strengthen the negative ef ectr of interest rates on aggregate demand If interest rates fall in the United States or rise abroad everything we have just said is turned in the opposite direction The conclusion is it decline in interest rates tends to expand the economy by depreciating the currency and raising net exports frterttse Provide the reasoning behind this conclusion Wit iliiiliiiliil P9 l5 E539l ii 995 ECGWV We are now ready to use our model to analyze how fiscal and monetary policies work when the exchange rate oats and capital is internationally mobile Doing so will teach us how international economic relations modify the effects of stabilization poli cies that we learned about in earlier chapters Fortunately no new theoretical appara tus is necessary we need merely remember what we have learned in the chapter up to this point Specifically n A rise in the domestic interest rate leads to capital in ows and makes the ex change rate appreciate A currency appreciation reducer aggregate demand and raises aggregate supply see Figure 355 n A fall in the domestic interest rate leads to capital out ows and makes the ex change rate depreciate A currency depreciation 7 arses aggregate demand and re dacer aggregate supply see Figure 354 p iisrol Polity Revisited With these points in mind suppose the government cuts taxes or raises spending Ag gregate demand increases which pushes up both real GDP and the price level in the usual manner This effect is shown as the shift from DODO to the red line DID in Fig ure 35 6 In a closed economy that single shift is the end of the story But in an open economy with international capital flows we must add in the macroeconomic effects that work through the exchange rate We do this by answering two questions HSCAL AND MONETARY POLICIES IN AN OPEN ECONOMY 7 3 First what will ha en to the exchan e rate We pp g know from earlier cha ters that a fiscal ex ansron P P pushes up 1I1t I St rates At higher interest rates Ameri can securities become more attractive to foreign in vestors who go to the foreign exchange markets to buy dollars with which to purchase them This buying pres sure drives up the value of the dollar Thus Price Level A fiscal expansion netmaily makes the exchange rate appreciate Second what are the effects of a higher dollar We know that when the dollar rises in value American goods become more expensive abroad and foreign goods become cheaper here So exports fall and imports rise driving down the X M component of aggregate de mand The fiscal expansion thus winds up increasing both America s crzpz39trzl czccomzt surplus by attracting for eign capital and its cuwent account deficit by reducing net exports In fact the two must rise by equal amounts H G U RE 356 because under oating exchange rates it is always true that A Fi5 l EXP 5l in 9quot Open Economy Real GDP Current account surplus Sauital accaunt surplus 2 9 Because a fiscal expansion leads in this way to a trade de cit many economists be lieve that the large US trade de cits of the 19803 were a side effect of the large tax cuts made early in the decade We will return to that issue shortly For now note that the induced rise in the dollar will shift the aggregate supply curve onward and the aggregate demand curve imvard as we saw in Figure 355 Fig ure 356 adds these two shifts in blue to the effect of the original scal expansion in red The nal equilibrium in an open economy is point C whereas in a closed econ omy it would be point B By comparing points B and C we can see how international linkages change the picture of scal policy that we painted earlier in the book Two main differences arise First a higher exchange rate makes imports cheaper and thereby offsets part of the inflationary effect 01 a fiscal expansion Second a higher exchange rate reduces the expansionary effect on real GDP by reducing X1 IM Here we have a new kind of crowding out different from the one we stud ied in Chapter 31 There we learned that an increase in G will crowd out some private imzestmevIt spending by raising interest rates Here an increase in G by raising both interest rates and the exchange rate crowds out net exports But the effect is the same The fiscal multiplier is reduced Thus we conclude that International eapitai flows reduce the newer at scal peiicy Table 35 Z which shows actual US data suggests that this TABLE 352 Percentage Shares of Real GDP in the new international variety of crowding out was much more im Unned States 198 and N86 portant than the traditional type of crowding out in the 19805 7 Between 1981 and 1986 the share of investment in GDP Year C I 6 X I IM barely changed despite the rise in the shares of both consumer 1981 64 59 14 3g 20 50 O 20 spending and government purchases Only the share of net ex 1986 673 D 145 21 2 p y 2398 0 ports X IM fell from 02 percent to 28 percent Change 28 63quot n 3E American economists learned this important lesson in the E In w many ecgngmigts Wgffied that large ggvefnw NOTE iotuis do not add up because of rounding and deiietion ment budget de cits would crowd out private investment By the end of the decade most were more concerned that de cits were crowding out net exports and producing a massive trade deficit Vamp 3 if you need review turn back to Chapter 34 page 717 736 CHAPTER 35 EXCHANGE RATES AND THE MACROECONOMY quot lttattetaty Fairy Revisited Now let us consider how monetary policy works in an open economy with oating ex change rates and international capital mobility To remain consistent with the history of the 1980s we consider a tightening rather than a loosening of monetary policy As we know from earlier chapters contractionary monetary policy reduces aggregate demand which lowers both real GDP and prices This situation is shown in Fig ure 357 by the shift from DODO to the red line DD1 and it looks like the exact opposite of a scal expansion With out international capital flows that would be the end of the story But in the presence of internationally mobile capital we must also think through the consequences for inter est rates and exchange rates As we know from previous chapters a monetary contraction raises interest rates just like a fiscal expansion Hence tighter money at tracts foreign capital into the United States in search of higher rates of return The exchange rate therefore rzlves The appreciating dollar encourages imports and dis courages exports so X IM falls America therefore winds up with an in ow of capital and an increase in its 15 u R 35 trade de cit In Figure 357 the two effects of the exchange rate appreciation appear in blue aggregate supply shifts onrtmrd and aggregate demand shifts inward This time as you can see in the gure as 5 I 4 2 I n Rea GDP A Monetary Contraction in an Open Economy international capital flows increase the power of monetary peliey In a closed economy higher interest rates reduce irzvestment spending 1 In an open economy these same higher interest rates also appreciate the currency and reduce net exports X W IM Thus the effect of monetary policy is enhanced It may seem puzzling that capital flows strengtyen monetary policy butrweaem fiscal policy The explanation of these contrasting results lies in their effects on interest rates The main international repercussion of either a scal exprzmion or a monetary comme tion is to raise interest rates and the exchange rate thereby crowding out net exports But that means that the initial effects of a fiscal expansion on aggregate demand are weozkened whereas the initial effects of a monetary contraction are 57 mgr967zed llllilllill llllllilffli if EFlf lWl l 9 V We have now completed our theoretical analysis of the macroeconomics of open economies Now let us put the theory to work by applying it to the events of the 1990s when fiscal policy was tightened and monetary policy TA 3 393 353 Expecled Elle 5 Of POECY was eased Should reducing the budget deficit or raising the A m 2 surplus strengthen or weaken the dollar swl Monetary quot As discussed in Chapter 31 the US government transformed variable contraction Expansion tfrtttt 3 ttrr rm its mammoth budget de cit into a notable surplus during the 19905 by raising taxes and cutting expenditures Column 1 of Table 353 reviews the predicted effects of a scal contraction It should lower real interest rates make the dollar depreciate re Rea interest rate W Exchange rate M Net exports if if duce real GDP and be less disinflationary than normal because Real GDP it of the falling dollar This information 18 recorded by entering ln a on W i a 7 signs for increases and W signs for decreases iNt RNArioNAi ASFECTS or DEHCIT REDUCTION Eliminating the budget de cit reduced aggregate demand But the Federal Reserve restored the missing demand by lowering interest rates so that the economy would not suffer a slump According to the analysis in this chapter such a monetary expan sion should lower real interest rates make the dollar depreciate raise real GDP and be a bit more in ationary than usual because of the falling dollar These effects are recorded in Column 2 of Table 35 3 Column 3 puts the two pieces together We conclude that a policy mix of fiscal commction and monetary expczmion should reduce interest rates strongly push down the value of the dollar and strongly stimulate our foreign trade The net effects on output and in ation are uncertain however The balance depends on whether the s cal contraction overwhelms the monetary expansion or vice versa What actually happened First interest rates did fall just as predicted The rate on ten year US government bonds dropped from almost 7 percent in late 1992 to just over 45 percent in December 1998 and by 1998 American households were enjoying the lowest home mortgage rates since the 19605 Second the US economy expanded rapidly between 1992 and 1998 apparently the monetary stimulus overwhelmed the scal contraction Third in ation fell despite such rapid growth As we explained in Chapter 26 one major reason was a series of favorable supply shocks that pushed in flation down But what about the exchange rate and international trade Here the theory did less well The dollar generally declined from 1993 to 1995 as the theory predicts But then it turned around and rose sharply from 1995 to 1998 just when the budget deficit was turning into a surplus America s trade performance was even more puzzling Accord ing to the theory a lower budget deficit should have led to a lower exchange rate and therefore to a smaller trade de cit But in fact Americas real net exports sagged from just 20 billion in 1992 to 22 1 billion in 1998 What went wrong The Loose link between the Budget Deficit and the Trade Deficit To answer this question let s explore the connection between the budget deficit and the trade deficit in more detail To do so we need one simple piece of arithmetic Begin with the familiar equilibrium condition for GDP in an open economy YCIGXIM Because GDP can either be spent saved or taxed away3 Y3 C i S T Equating these two expressions for Y gives J CIGXmIMCST Finally subtracting C from both sides and bringing the I and G terms over to the right hand side leads to an accounting relationship between the trade deficit and the budget deficit xmwn mwn Notice that this equation is a matter of zmsozmting not economics It must hold in all countries at all times and it has nothing to do with any particular economic the ory In words it says that a trade de cit 39a negative value of X Il4 can arise from one of two sources a government budget deficit G larger than T or an excess of in vestment over saving I larger than S Now let s apply this accounting relationship to actual US events in the 19903 As we know the government de cit G 7 fell precipitously Other things equal that 7 If you do not see why recall that GDP equals disposable income DI plus taxes T Y DI 7 and that disposable income can either be consumed or saved DI Lquot C S These two de nitions together imply that Y C S 1 Y A country s trade deficit the excess of its imports or its exports If instead expi exceed imports the countr has a trade surplus 738 CHAPTER 35 EXCHANGE RATES AND THE MACROECONOMY should have reduced the trade deficit But other things were not equal The equation reminds us that the balance between saving and investment matters too As shares of GDP business investment boomed while household saving declined from 1992 to 1998 So S I moved sharply in the negative direction And that change as our equa tion shows should mise the trade de cit reduce net exports In brief taken by itself deficit reduction would have increased net exports But in reality sharp changes in private economic behavior specifically less saving and more investment overwhelmed the government s actions and made net ex ports fall instead The link from the budget deficit to the trade deficit can be a loose one x TRADHEVDEHCIT A PROBLEM The preceding explanation suggests that the United States large trade deficits over the past decade are a symptom of a deeper trouble The nation as a wholewincluding both the government and the private sector has been consuming more than it has been producing for years The United States has therefore been forced to borrow the difference from foreigners The trade deficit is just the mirror image of the required capital in ows Those who worry about trade deficits point out that these capital inflows create debts on which interest and principal payments must be made in the future In this view Americans have been mortgaging their futures to finance higher consumer spending But another quite different interpretation of the trade deficit is possible Suppose foreign investors come to see the United States as an especially attractive place to in vest their funds Then capital should flow here not because Americans need to Ivor row it but because foreigners are eager to end it The desire of foreigners to acquire American assets should push the value of the dollar up which should in turn push America s net exports down In that case the trade deficit would still be the mirror image of the capital in ows But it would signify America s economic streugt7 not its weakness Each view holds elements of truth but the second raises a critical question How long can it go on As long as the United States continues to run large trade deficits foreign investors will continue to accumulate large amounts of US assets At some point economists and nancial experts fear these investors may conclude that they have acquired about all the American assets they want If and when that day arrives the US trade de cit must be eliminated The only question is how owcumms THE TRADE DEFICIT How can we cure our foreign trade problem and end our addiction to foreign bor rowing There are four basic ways Chan e the Mix of Fiscal and Monemr Polic 9 Y The fundamental equation X 1Mms I G T suggests an increase in the budget surplus turning G T sharply uegutive as one good way to reduce the trade deficit According to the analysis in this chapter a reduction in G or an increase in Twould lead to lower real interest rates in the United States a depreciating dollar and eventually a shrinking trade deficit ON CURING THE TRADE DEFICIT When the government curtails its spending or raises taxes aggregate demand falls If we do not want a larger budget surplus to slow economic growth we must there fore compensate for it by providing monetary stimulus Like contractionary scal pol icy expansionary monetary policy lowers interest rates depreciates the dollar and should therefore help reduce the trade de cit So the policy recommendation actually amounts to tightening fiscal policy and loosening monetary policy As we have noted the US government after years of vacillation changed the policy mix decisively in this direction in the 1990s But our trade de cit rose anyway because private investment spending soared while private saving stagnated Vihat else might work More Rapid Etersamit Growth Ahmad One factor behind the growing US trade deficit in the 1990s was that the economies of many foreign nationswmthe customers for our exports grew slowly while the US economy boomed until 2000 If foreign economies would grow faster the US government argued they would buy more American goods thereby raising US exports and reducing our trade deficit So we urged our major trading partners to stimulate their economies and to open their markets more to American goodsmwith only modest success When the US economy slowed down in 20002001 our trade de cit did recede a bit but no one thinks that is a very good remedy Raise Dsmsstic Saving er Reduce Domestic investment Our fundamental equation calls attention to two other routes to a smaller trade de cit more saving or less investment The US personal saving rate saving as a share of disposable income has hit post war lows in recent years The 1 percent saving rate recorded for the year 2 000 was the lowest since the Great Depression of the 19305 If Americans would simply save more we would need to borrow less from abroad This solution too would lead to a cheaper dollar and a smaller trade deficit The trouble is that no one has yet found a reliable way to induce Americans to save more The government has implemented a variety of tax incentives for saving and more are suggested every year But little evidence suggests that any of them has worked Instead large increases in stock market wealth in the second half of the 19905 convinced Americans that it was prudent to save even less than they nor mally do If the other cures for our trade deficit fail to work the deficit may cure itself in a particularly unpleasant way by reducing US domestic investment The 2001 reces sion accomplished this to some extent reducing the share of investment in real GDP from 192 percent in 2000 to 176 percent in 2001 It also curbed our appetite for im ports That effect is only temporary however and there is a potential longer rnn problem As our trade deficits and foreign borrowing persist foreigners wind up holding more and more US dollar assets At some point their willingness to acquire yet more dollar assets will begin to wear thin and they will start demanding higher inter est rates At best higher interest rates will lead to lower investment in the United States At worst foreigners will cease lending to the United States interest rates will skyrocket and we will experience a severe recession liretetiisriisnn We have saved the worst remedy for last One seemingly obvious way to cure our trade deficit is to limit imports by imposing stiff tariffs quotas and other protectionist 740 CHAPTER 35 EXCHANGE RATES AND THE MACROECONOMY devices We discussed protectionism and the reasons why almost all economists op pose it in Chapter 33 Despite the economic argumentsagainst it protectionism has an undeniable political allure It seems super cially to save American jobs and it conveniently shifts the blame for our trade problems onto foreigners In addition to depriving us and other countries of the bene ts of comparative ad vantage protectionism might not even succeed in reducing our trade deficit One reason is that other nations may retaliate If we erect trade barriers to reduce our imports 1will fall But if foreign countries erect corresponding barriers to our exports X will fall too On balance out not exports X IM may or may not im prove But world trade will surely suffer This game may have no winners only losers Even if other nations do not retaliate tariffs and quotas may not improve the US trade deficit much IVhy If they succeed in reducing American spending on imports tariffs and quotas will thereby reduce the supply of dollars on the world market which will push the value of the dollar up A rising dollar of course would hurt US exports and encourage more imports The fundamental equation X IMmS I G T reminds us that protectionism can raise X IM only if it raises the budget surplus raises saving or reduces investmentfi Cl 539 W9 395 A MD The poet john Donne wrote that no man is an island Similarly no nation is iso lated from economic developments elsewhere on the globe Instead we live in a World economy in which the fates of nations are intertwined The major trading countries are linked by exports and imports by capital flows and by exchange rates VVhat happens to national income prices and interest rates in one country affects other nations No events make this point clearer than the international financial crises that erupt from time to time rnost recently in Argentina see the previous chapter As We noted in Chapter 34 one root cause of almost all of these crises was the countries deci sions to fix their exchange rates to the US dol lar Unfortunately for such nations as Thailand Indonesia and South Korea the dollar rose spec tacularly from 1995 to 1997 With their ex change rates tied to the dollar the Thai baht the Indonesian rupiah and the Korean won automat ically appreciated relative to most other curren cies rnaking their exports more costly Soon these onetime export powerhouses found them selves in an unaccustomed position running large trade de cits Then the crisis hit and all four of these countries watched their currencies tumble in value The sharp depreciations restored their international competitiveness but it also impoverished many of their citizens Naturally the shrinking Asian economies curbed their appetites for American goods so our exports to the region fellmwwhich contributed to further deterioration in the US trade deficit But we re not just talking about buying a car we re talking about confronting this country39s trade deficit with Japan SOURCE 9 The New Yorker Collection 1992 Mort Gerberg from carmonbaniltcom All Rights Reserved w sm wmx 3 Here tariffs which raise revenue for the government have a clear advantage over quotas which do not SUMMARY 741 Thus a primarily American development the rise of the dollar harmed the Asian economies and then a primarily Asian development deep recessions in the Asian tigers hurt the US economy issue MisifgedThelen sEffectanimallerAs angEconopmiesg p o pp A Recall the question with which we began this chapter Would it be better for the Japanese yen to depreciate We have already mentioned the main argument for yen depreciation Japan s sluggish economy desperately needs more aggregate demand and a cheaper yen is one way to get it But many analysts worry about possible reverberations on the smaller Asian economies For example if the yen depreciates further South Korea will find itself at a competitive disadvantage in export markets and might be forced to devalue the won again So in this case it is feared that a seeminglyjapanese event a deprecia tion of the yen might inflict serious harm on neighboring economies For better or for worse we all live in one world The nations of the world are linked together economically because national income prices and interest rates in one country affect those in other countries They are thus open economies Because one country s imports are another country s ex ports rapid or sluggish economic growth in one counw try contributes to rapid or sluggish growth in other countries A country s net exports depend on whether its prices are high or low relative to those of other countries Because ex change rates translate one country s prices into the curren cies of other countries the exchange rate is a key determi nant of net exports If the currency depreciates net exports rise and aggregate demand increases thereby raising both real GDP and the price level A depreciating currency also reduces aggregate supply by making imported inputs more costly If the currency appreciates net exports fall and aggregate demand real GDP and the price level all decrease An ap preciating currency also increases aggregate supply by making imported inputs cheaper International capital ows respond strongly to rates of return on investments in different countries For example higher domestic interest rates lead to currency apprecia tions and lowerinterest rates lead to depreciations Contractionary monetary policies raise interest rates and therefore make the currency appreciate Both the higher in 10 11 I2 terest rates and the stronger currency reduce aggregate de mand Hence international capital flows make monetary policy more powerful than it would be in a closed economy Expansionary fiscal policies also raise interest rates and make the currency appreciate But in this case the interna tional repercussions cancel out part of the demandexpand ing effects of the policies Hence international capital flows make fiscal policy less powerful than it would be in a closed economy Because eliminating the budget deficit in the 1990s com bined tighter fiscal policy with looser monetary policy it lowered interest rates That should have pushed the dollar down and led to a smaller trade de cit in the United States However changes in private economic behavior specifically lower saving and higher iI1V StII1 I1tOffSt3t the presumed international effects of deficit reduction Budget deficits and trade deficits are linked by the funda mental equationX M S W I M G v T It follows from this equation that the US trade deficit must be cured by some combination of lower budget deficits higher savings and lower investment Protectionist policies might not cure the US trade deficit because a they will make the dollar appreciate and b they may provoke foreign retaliation