Chapter 10 and 11
Study Guide by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
The Future of Capitalism Main Page
Chapter 10: Japan: The Major Fault Line Across World Trade and the Pacific Rim
The fault line that dominated global trade in the 1990s was the combination of Japanese trade surpluses and American trade deficits. The Japanese account surplus was $130 billion in 1994, while the American account deficit was $145 billion. The problem is that everyone else also runs large trade deficits with Japan, but they finance those deficits by running even larger surpluses with the United States. China provides a typical example. In 1993 China ran a $17 billion trade deficit with Japan and paid for it with a $20 billion trade surplus with the United States. No country can run a trade deficit forever. Deficits must be paid for in some way, by borrowing money, or by selling assets to foreigners. The U.S. can run a trade deficit for a long period of time because the dollar has a unique position as the world's effective reserve currency, and the country has enormous wealth, but it cannot forever avoid the fundamental rules of economics. There are arguments that there is no danger of default because as the world's reserve currency, the U.S. only borrows in dollars, and everyone in the world wants an unlimited number of American assets. But this is all nonsense. At some point the world's capital markets will stop lending to Americans and the country will run out of assets that foreigners are willing to buy. When this occurs the economic pain will be extreme for Japan, the United States and the rest of the world.
The U.S. and Japan have enormous incentives to institute policy adjustments before they are forced upon them by the international financial markets. Americans need to be weaned away from a lifestyle based on borrowed funds. The Japanese have a closed market, but they have many incentives to open their markets. They know that running continuous trade surpluses with everyone is not a viable pattern of trade in the long run. In addition, the Japanese economy is so large it cannot forever continue to be run as an export-based economy. Japan needs to build a domestically pulled economy rather than an export-pushed economy. But neither Japan nor the United States is going to take the actions needed.
The current pattern of trade deficits will continue as long as someone (Japan) is willing to lend the deficit country (U.S.) the money necessary to pay for its trade deficits. Whatever the Japanese and Americans do, the rest of the world will eventually flee from the dollar.
There is a solution to closed markets. Thurow calls it the "principle of correspondence" referring to a forced relationship between what a country sells in America and what it buys from America. But the U.S. would also need to shift from a low-investment, high-consumption society to a higher-investment, lower-consumption society.
When the current pattern of structural deficits and surpluses ends, economic growth in the third world will also end. The four little Asian dragons (Hong Kong, Singapore, South Korea and Taiwan), and now China have all used the American market to support their economic development. Pacific Rim countries run big trade deficits with Japan, and finance them with trade surpluses with the United States. Without the U.S. as an open market, this intra-Asian trade will collapse unless Japan is willing to become a large net importer. Since Japan is unlikely to change, all the trading patterns on the Pacific Rim and third world in general will have to be rebuilt.
Note: U.S. trade deficits continue as indicated in the graphic below. How long can the U.S. run balance of trade deficits? No one knows, but the fact that the dollar is the world's effective reserve currency seems to be holding the global system together.
Chapter 11: Economic Instability
Business Cycles
Business cycles are a fundamental part of capitalism. Recessions occur for various reasons. Demand starts to rise or fall in some sector of the economy. Examples include cutbacks in military spending following World War II and the Korean War, an unsustainable boom in auto sales in 1958, and the Fed's very high interest rates in 1982. In some cases the dynamics of economic decisions leads to business cycles (the multiplier-accelerator model). Demand rises, factories increase production, firms along the delivery chain add inventories, factories further accelerate production, consumers buy more to avoid shortages, and the cycle feeds on itself. Eventually the cycle turns, sales stabilize, inventory orders fall, inventories build up, factories reduce production, and the economy spirals downward. Theoretically, capitalism should not have business cycles since prices and wages should fall and rise in response to changes in demand. But output adjust more quickly than wages and prices which leads to the inevitable economic booms and recessions.
Most post-World War II recessions have been short and shallow because governments (particularly the U.S.) have countered with Keynesian monetary and fiscal policies. The global capitalist system needs a dominant economic leader, but the U.S. is no longer willing to help the rest of the world recover from their recessions. Without the American economic locomotive, recessionary recoveries will be slow as they have been in Europe and Japan. National counter cyclical stimulus policies were absent in the mid-1990s as many countries (Italy, France, the United Kingdom) were raising interest rates to protect their currencies.
Governments that use counter cyclical policies must be willing to raise taxes and cut spending in booms so that they can reduce taxes and increase spending in recessions. But raising taxes after recessions has become politically impossible. Government counter cyclical policies to aid domestic needs are also blocked for most countries by global economic forces (exceptions include the U.S., Japan, and Germany). To avoid an outflow of funds, governments raise interest rates when their domestic economy calls for the opposite. What all this means is that in most countries, recessions can only be tolerated. Facing recessions, governments talk about stimulus, but adopt austerity measures instead.
The U.S. is unique in that it doesn't care what happens to its currency. Exporters price in dollars and hold those dollar prices constant when the value of the dollar falls. In addition, the rest of the world lends to America in its own currency, allowing America to finance balance of payments deficits longer than those who borrow in someone else's currency.
The United States, Japan, and Germany could coordinate their fiscal and monetary policies to become a joint world economic locomotive, but the U.S. is not willing to shift from its high-consumption society to a high-saving and investment society, Japan is not willing to reduce its trade surplus, and Germany is not willing to have low interest rates and risk more inflation. Without an American, or a coordinated economic locomotive, the world will have more frequent, longer, and deeper recessions, and much slower recoveries.
Stronger Financial Shocks
Theoretically, financial crises should not occur in capitalism since long run investors should be buying and selling in financial markets to offset the instabilities caused by the herd mentality of short-run speculators. But financial shocks are a part of capitalism. In addition to the stock market crash of 1929, the twentieth century was full of smaller financial panics. Some examples include the collapse of the American savings and loan industry, the stock market crash of October 1987 in the U.S, and similar financial panics in Taiwan and Japan. How do market prices reach such high unsustainable levels when the only questions are when, and how fast the market will fall.
The answer is greed. The potential profits are irresistible. As prices (of stock, tulips1, land) continue to rise, investors jump in knowing that prices are too high and will eventually fall. They believe they will be smart enough to get out before the end comes. But it is impossible to predict the timing of the peak, and most don't get out before everyone rushes to sell as prices fall.
After the Great Depression many regulations were enacted to prevent it from happening again, but many were rescinded in the 1970s and 1980s. New technologies would have made them ineffective in any case since money can now be moved instantly on a personal computer making capital controls and financial regulations unenforceable. Regulations on financial activities in one country will simply cause a movement of those activities to some place where they are not regulated. Global capital markets electronic trading systems move more money in a couple of days than the world's economies move in a year. This connects national markets together making it more likely that they will crash together.
In 1971 it was believed by most economists that a movement from fixed to flexible exchange rates would result in financial and economic stability. Theoretically, flexible exchange rates should lead to more frequent, but smaller changes in exchange rates. But it did not work. Rapid swings in currency values became more frequent.
The Mexican financial crisis in 1994 and 1995 illustrates the problem. The Mexican peso was overvalued and a balance of payments deficit had to be financed with short-term capital flows. Foreign exchange reserves fell and the Mexican government had to devalue the overvalued peso. This caused foreign capital to flow out of Mexico. The IMF and the United States developed an enormous rescue package (over $52 billion), but charged 60 percent interest rates for peso loans to the Mexican government, and 100 percent for consumer credit. In addition, the international community demanded fiscal austerity that involved large cutbacks in government spending. As the value of the peso fell, inflation accelerated to an annual rate near 60 percent, and the standard of living of the average Mexican fell by as much as 50 percent. Although macro-economic stability was reestablished, the economic prescription took a heavy toll on the Mexican people. For Mexico the short-run cost of the bailout package exceeded the short-run benefits.
What all this means is that sooner or later some country will refuse to take the prescribed domestic austerity medicine necessary to satisfy the international lenders. What happens then is not known, but it might cause a loss of confidence in the world's financial markets and a subsequent collapse. The global financial system needs to be managed, but a single country cannot become the global regulator because it cannot enforce its own rules on other countries. The most likely crisis is a run against the dollar. Some Americans will move their money abroad to make enormous capital gains. Some will be unable to repay their yen or mark-denominated loans. But since a falling dollar causes little pain in the U.S., political support for the necessary remedial actions will not exist.
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1 Tulip mania is considered the first recorded speculative bubble. At its peak, one tulip bulb was worth 10 times the annual income of a skilled craft worker, or three homes in Amsterdam.
Go to the next Chapter. Thurow, L. C. 1996. The Future of Capitalism: How Today's Economic Forces Shape Tomorrow's World. William Morrow and Company. (Chapter 12)
Related summaries:
Friedman, T. L. 2005. The World Is Flat [Updated and Expanded]: A Brief History of the Twenty-first Century. Farrar, Straus and Giroux. (Note).
Martin, J. R. Not dated. A note on comparative economic systems and where our system should be headed. (Note).
Martin, J. R. Not dated. The Beer Game. Management And Accounting Web. (Summary).
Milanovic, B. 2019. Capitalism, Alone: The Future of the System That Rules the World. Harvard University Press. (Summary).
Oser, J. 1963. The Evolution of Economic Thought. Harcourt, Brace & World, Inc. (Summary).
Porter, M. E. and M. R. Kramer. 2011. Creating shared value: How to reinvent capitalism and unleash a wave of innovation and growth. Harvard Business Review (January/February): 62-77. (Summary).
