AND

                                        THE ANOMALIES OF THE WORLD ECONOMY

 
                                                                                          by
 
                                                                             CHIH KWAN CHEN
                                                                                   (Dec. 1, 1998)
 

                                                                                       CONTENT

                                                                   1. Introduction
                                                                   2. Imports and Exports
                                                                   3. The superlow interest rate is the cause
                                                                       of the Japanese disaster
                                                                   4. Ripple effect: The bubble in The United
                                                                       States of America
                                                                   5. Rippel effect: The victims beyond Japan
                                                                   6. Where are we going?
                                                                   7. Conclusion

1. INTRODUCTION

       The economic crisis of Japan and other Asian and Latin American countries, and the anomalous prosperity of the United States of America can be understood by analyzing the flow of global capital. The core of the capital pool is the savings of the major lender of the world, Japan. Speculators may cause short term deviations of this flow of capital but have no power of changing its direction for long. It is the authority at the source of this capital pool that is responsible in shaping and directing the long term trend of this flow. When this pool of capital stays mainly within Japan and parcels out some portion of it as direct investments into the rest of Asia, the whole Asia prospers. When this capital pool is directed out of Japan and into the United States of America and Great Britain, Asia suffers whereas the two countries across the Atlantic Ocean experience bubble like prosperity. One may ask why the Japanese authority is foolishly pushing away this capital pool from Japan, and as the result is doing enormous harm to both Japan herself and the rest of Asia. The authority is preoccupied with outdated macroeconomic models which apply only to an isolated economic entity but fail to take into account the all important global capital flow of the real world. To shape the economic policies based on such outdated macroeconomic models is the surest way to invite a disaster, as now apply demonstrated in the case of Japan. The purpose of this article is to discuss where and why the traditional macroeconomic models fail by using the case of Japan as the illustration.

       The present global economy is based on the flow of goods and capital. To understand the nature of the global economy we need to study these two components in detail. In Section 2 the meaning of the flow of goods is examined and the misconception of the Japanese authority about the role of international trade (Ref.1) is discussed. In Section 3 the disastrous effects of the super low interest rate policy of Japan are traced out. In Section 4 the reason why the Japanese folly is creating a bubble like prosperity in The United States of America is explored. It is explained in Section 5 how the Japanese disaster is
triggering an economic domino effect throughout the developing countries in Asia and beyond. Section 6 is devoted to the consideration of the future prospect of the world economy, and Section 7 contains some concluding remarks.
 

2. IMPORTS AND EXPORTS

       The roles of imports and exports need to be examined carefully, because the amount of capital outflow from Japan equals her current account trade surplus. If this surplus increases, so does the capital outflow, and as a result Japan becomes poorer, not richer as many people claim erroneously. How does this misconception about the international trade come about? It is due to the careless reading of the way gross domestic production (GDP) is calculated. GDP equals the personal consumption plus the change of inventories, add fixed investments, minus imports and plus exports. It is the last two entries which lead many to think that imports are negative and exports are positive to GDP. However, those people are forgetting about the effects of imports and exports on personal consumption. When these effects are included, imports contribute positively and exports contribute negatively to GDP. This is why Japan sinks into a deeper and deeper recession as her trade surplus balloons, whereas The United States of America becomes increasingly prosperous as her trade deficit explodes. It is only when the currency of the excessive importer collapses, its economy will sink into a recession and the trade pattern will be reversed. If policies are adopted to uphold the value of the currency of the excessive importer, the anomaly that the excessive importer becomes richer and the excessive exporter becomes poorer can indeed continue for a long time as it is now playing out in front of our eyes. To study the roles of imports and exports and to derive the above conclusions, we assume that the central bank is only targeting the interest rates but not the total amount of money available to consumers as is the case for almost all the major industrialized nations today.

       Let us consider the case of an imported shirt which costs one dollar at the time of passing through customs and is eventually sold to a consumer for ten dollars. GDP increases by nine dollars, that is, the ten dollar increase of personal consumption minus the one dollar increase of imports. Of course, we need to consider the possibility that the imported shirt may replace a domestically manufactured shirt of ten dollars and idle the labor and the capital behind the production of this displaced domestic shirt. However, the labor and the capital idled by the imported shirt will eventually find their way into some other sectors not in competition with imports and will reproduce this lost ten dollar worth of wealth. In an ideal economy where this transition can occur instantaneously, GDP can really grow by nine dollars by importing a one dollar shirt. In a real economy, there will certainly be a time delay in this transition, and as the result GDP will grow less than the full nine dollars when a one dollar shirt is imported. Only in an economy with advanced arteriosclerosis this transition of the labor and the capital idled by the import will not take place and the import of the one dollar shirt will result in one dollar loss of GDP.

       Exports have the opposite effect of depressing GDP. When a shirt is exported for one dollar, which would have fetched ten dollars if sold domestically to a consumer, the potential to gain nine dollars is deprived from the distribution system, that is, the service sector. The actual effect of exporting this one dollar shirt again depends on the situation of the economic entity. If the entire labor and capital employed to export this shirt are taken away from those of producing a domestically destined ten dollar product, then GDP loses nine dollars by exporting this one dollar shirt. On the other extreme if the labor and the capital for this exported shirt has been idle from the very beginning, GDP will gain one dollar by exporting this one dollar shirt.
How do we apply the above discussions about the effects
of imports and exports to the real case, Japan? It is best to let
data speak for itself (Ref.2). In Figure 1, the vertical axis
represents the annual growth rate of real GDP of Japan and
the horizontal axis represents the ratio of annual trade surplus
of goods to nominal GDP. For each year one data point can be
plotted on the figure. The yearly data is taken according to a
calendar year in order to smooth out the effects of sudden
policy changes at the start of a new fiscal year of Japan on
April 1. The data for the period after the burst of the
economic bubble of Japan (from 1991 to 1997) are plotted in
Figure 1. From this plot we can see a clear anti-correlation
between two variables, implying that larger the trade
surplus in goods slower the growth of GDP becomes.

       The data point of the year 1997 and the projected region
of 1998 in Figure 1 deserve close attention. The
anti-correlation curve in the figure seems to be shifting
downward, a clear sign of the onset of severe credit crunch in
which capital becomes extremely scarce, and the shift of any capital from the domestic consumption to export has amplified
negative effects to the overall economy. This credit crunch is a symptom of the Japanese economic death spiral which is
triggered by the sharp fall of the value of yen; the massive defacement of yen is in turn the consequence of the super low
interest rate policy adopted by the Japanese authority. Here rises another paradox for the outdated macroeconomic model which Japanese authority treasures; lower interest rates are actually depressing the Japanese economy and devastating her financial institutions instead of saving them. We will discuss in detail the effects of the super low interest rates on the Japanese economy in the next section.
 

3. THE SUPER LOW INTEREST RATE IS THE CAUSE OF THE JAPANESE DISASTER

       The proposition that higher interest rates will slow down the economy and that lower interest rates will stimulate the economy applies only to an isolated economic entity. In a global economy we can only say that globally lower interest rates will stimulate the economy all around the globe and that globally higher interest rates will depress the world economy. What happens if one entity of the global economy makes an uncoordinated and large interest rate move? The consequences need to be examined carefully since the drastic interest rate move by one influential entity will certainly change the global capital flow and invites unexpected results.

       If interest rates are lowered in an isolated economic entity, what is going to happen? As we all know that lower interest rates will ease the burden of borrowing, and both consumer and commercial borrowings will increase. Also lower interest rates will bail financial institutions out of their imprudent lending practices and will make banks more willing to provide loans. Furthermore lower interest rates punish savers, induce them to spend the money saved previously and reduce the incentive of future savings. Thus the economy will boom from the expanded borrowing and spending. On the other hand lower interest rates depress interest income of savers and will reduce the consumption of those who depend heavily on the interest income. On balance the power of lower interest rates to induce a consumption boom in a closed economic system is greatest if people save little and are used to heavy borrowings. However, the above discussion applies only to an isolated economy where the capital outflow can be ignored. When the capital outflow cannot be neglected as in today's real global economy, the negative effects of this capital outflow caused by the super low interest rates will overcome the positive effects of the lower interest rates and the economy will be weakened as is the case of Japan. It is interesting to see how this overall negative effect sets in from both the macroscopic and the microscopic views.

       The amount of capital outflow from Japan must equal the current account surplus of Japan. If the demand of the dollar within Japan exceeds the amount of dollar flowing in due to the current account surplus, the difference must be made up by inducing someone holding the dollar to sell it for the yen. When the interest rate gap between the dollar and the yen widens to a certain point, the desire to buy dollar and sell yen becomes so strong that a very potent incentive in the form of rapidly plunging yen must be introduced to induce dollar holders to sell their dollar for yen to make up the difference between the demand and the supply of the dollar. This falling yen will in turn, after some time lag, widen the current account surplus of Japan and allow more capital to flow out. The increasing trade surplus of Japan then depresses Japanese economy as discussed in the previous section. From the perspective that the Japanese authority will cling to the misguided super low interest rate policy in the face of the weakening Japanese economy, the desire of selling more yen for dollar intensifies within Japan which then pushes down the yen further; this added weakness of yen then widens the trade surplus even more, slows down the Japanese economy even more, and so on and so on. Thus a vicious death spiral is forming in Japan due to the ill fated super low interest rate policy.

       This phenomena of the economic death spiral in Japan can also be explained from a microscopic point of view. Super low interest rates depress the important interest income of saving happy Japanese people and damp their desire to spend. Also many people in Japan are keeping a pile of cash in safe deposit boxes or just under mattresses to avoid the risk of depositing them into a failing bank, after all the interests paid by the banks are near zero; this process of cash hoarding diverts precious cash flow from the economy and nullifies the attempt of the Bank of Japan to ease. This kind of self defensive reactions
of Japanese savers and consumers to the super low interest rate policy are already enough to arouse a sustained down spiral of the Japanese economy. Furthermore, super low interest rates trigger precipitous fall of the yen and weaken Japanese banks in an unexpected manner. Let us consider one American and one Japanese multinational bank. At certain point let us assume that they have comparable amount of assets and self capital, but the assets and the self capital of the Japanese bank are mainly denominated in yen and those of the American bank are mainly denominated in dollar. When the yen starts to fall violently, both the assets and the self capital of the Japanese bank shrink rapidly compared to the American bank. A holder of dollar will naturally desire to lend to the more stable American bank if both banks pay him the same interest rates. Thus the Japanese bank must pay a higher interest rate than the American bank in order to borrow the dollar; this phenomena is called the "Japan premium". This "Japan Premium" increases the cost of borrowing of the Japanese bank, reduces its profitability, and weakens it
financially. This cycle will further increase the "Japan premium" due to the worsening credit worthiness of the Japanese bank, and so on until the Japanese bank is totally shut out of the international loan market. There is another onerous problem of the falling ratio of self capital to assets for the Japanese bank when the yen depreciates rapidly. The majority of the assets of the Japanese bank may be denominated in yen, but usually there is a non negligible fraction, say 30 percents, of the assets is
denominated in dollar. When the yen falls, the assets denominated in yen and the bank's self capital, which is overwhelmingly denominated in yen, both decrease with the yen, but the assets denominated in dollar will retain its value. This implies that the ratio of self capital to assets falls along with the yen. This ratio is important to judge the health of a bank. For a multinational bank, if this ratio falls below 8%, the bank will have trouble in borrowing money in the international loan market and will be forced to close its door. What is the Japanese bank going to do when its self capital ratio is pulled down by the falling yen?
The most common defensive method is to reduce the size of its assets, that is, to shrink its portfolio of loans. When this reduction of loans occurs to many Japanese banks, the credit crunch sets in, the Japanese economy weakens, the prices of stocks and real estates in Japan decrease, the self capital of Japanese banks which consists of a substantial amount of stocks shrinks further, and their real estate backed loans sink into deeper trouble. Also under the expectation of prolonged super low interest rates in the onset of a credit crunch the desire to sell yen for dollar intensifies and the yen falls more. All these
phenomena reduce the self capital of Japanese banks further, the banks are forced to shrink lending further to sustain the self capital ratio, and so on into the vicious self-destructive death spiral.

       It is important to know the threshold of the value of
yen over which the death spiral of Japanese economy has
started. For this purpose we draw Nikkei stock index
versus the value of yen in Figure 2; quarterly averages of
these two variables are plotted from the beginning of 1995
to the middle of 1998 (Ref.3). When the yen hit the peak
around 80 yen per dollar at the early part of 1995 (near the
position marked as "C" in the figure), the Japanese
authority started to lower the interest rates to the super low
level and intervened aggressively in the currency market
to bring down the yen. At the initial stage of this campaign
to deface the yen the Japanese stock market welcomed the
effort, so the stock index moved higher as the yen fell
until it reached about 110 yen per dollar (near the position
marked as "B" in the figure). Once the yen fell below the
110 yen level, the down spiral of "falling yen, weakening
stock market, falling yen, ----" started. We may conclude that the 110 yen level is actually the threshold over which the death spiral of Japanese economy has started. From many verbal and actual currency market interventions made by the Japanese authority, it is clear that they are targeting 120 yen per dollar as the ideal situation. Unfortunately this target of the Japanese authority is below the threshold of the death spiral. Once the yen has fallen below the threshold, probably with the blessing of the Japanese authority, it has kept tumbling through their target and has ended up below the 145 yen mark (near the position marked as "A" in the figure) in spite of all the desperate actions of the Japanese authority to hold the slide of the yen and to reverse the onset of the economic death spiral.

       At this juncture someone may say how about the long term structural problems of Japan which many analysts claim to be the cause of the current Japanese disaster. Certainly Japan encompasses many structural problems in her economic system. That is why the very high growth rate of her economy in the fifties and sixties has slowed down to an anemic growth rate in the nineties as will be discussed in detail in the next section. However, it is the misguided super low interest rate policy that has pushed the anemic but positive growth rate of Japanese economy into the current death spiral. In the onset of this economic death spiral created by the ill fated monetary policy, any attempt to correct the long term structural problems will only make the death spiral much worse; this is demonstrated by the disastrous move of the Hashimoto administration to raise the consumption tax to reduce the governmental budge deficit, which is indeed one of the serious long term problems of Japan.

       The massive change of capital flow forced by the super low interest rate policy of the major lender of the world, Japan, has enormous effects on other countries large and small. The target countries of this capital flow will benefit and see bubble like prosperity, but the countries from which the capital leaves will fall into severe hardship. However, due to the unstable nature of this capital flow created by the misguided Japanese monetary policy, the flow may suddenly change direction, and the seeming
beneficiaries may sink quickly into chaos and disaster. We will look into the major beneficiary of this Japanese fiasco, The United States of America, in the next section and the major victim besides Japan herself, that is, other Asian countries, in Section 5.
 

4. RIPPLE EFFECT: THE BUBBLE IN THE UNITED STATES OF AMERICA

       Before looking into the current economic situation of The United States of America, we need to scan through the development stages of Japan. Many people believe wrongly that Japan has risen economically by running huge trade surpluses. To show how erroneous that view is, in Figure 3 the annual growth rate of real GDP of Japan versus the ratio of trade surplus in goods to nominal GDP is plotted for various periods (Ref.2). The period from 1963 to 1973, the high growth era of Japan, is covered in Figure 3(a). The annual growth rates of real GDP were around 10 percentage points during this period, but the trade balances alternated and
averaged out to be near zero. During this period
Japan did not borrow heavily from other
countries to fuel her high growth. She
rather grew strongly from the internal
drive supported by the diligence and a
collective sense of direction toward
prosperity of her people. The period
from 1974 to 1982 is plotted in
Figure 3(b). In this second period which
is punctuated by energy crises the growth
rates of real GDP of Japan had halved to
around 5 percentage points a year, but the
trade balances still alternated and averaged
out to be near zero. Figure 3(c) deals with
the period from 1983 to 1990, during which
Japanese trade surpluses ballooned, but
the growth rates stayed between 3
percentage to 5 percentage points a year,
showing no correlation to the trade
surpluses. Coming into this third period
Japanese economy had built up such a
strength so that in spite of her relentless shedding of her wealth through the exploding trade surpluses Japan was able to maintain a moderately strong growth rate. However, this hemorrhage eventually caught up with Japan, and from 1991 on, as depicted in Figure 1 and discussed in Section 2, Japan has become a normal matured economy and the anti-correlation between trade surpluses and growth rates has emerged.

       To have a comprehensive view about the current state of American economy, we need to turn our attention back to the early eighties. Before that time trade surpluses and deficits of all the countries were much smaller in scale and the global capital flow was not an important factor, so the American economy could be considered roughly as an isolated economic entity. The now outdated macroeconomic models were built for that period of preglobal economy. At early eighties the United States of America had just come out of the period of very high inflation and was posed to bounce economically. Two important
factors have appeared on the world economic scene and ushered in the global economy as we see today. The first factor was Reagan administration's borrow and spend policy which expanded the American trade deficit enormously and thus introduced the era of worldwide capital flow. The second factor was the emergence of Japan as the major lender of the world who supplied the capital desired by The United States of America. As the result of these two matching factors America imported, borrowed and spent into prosperity, while the dollar was kept strong because of the very high real interest rates due to the
relentless appetite of the American Government to borrow in the financial market. This high flying dollar devastated the manufacturing sector, and forced Reagan administration to change direction 180 degrees in 1985. In the gathering now known as the Plaza accord, America and other industrialized nations engineered an enormous devaluation of the dollar against the yen. The dollar fell sharply from around 250 yen per dollar to around 125 yen per dollar by the beginning of 1988. However, it took a long time before American trade deficit reached a high plateau; it finally started shrink in the fall of 1987. With the shrinking trade deficit, the real growth rates of American economy began to decrease, and both the falling trade deficit and the decreasing growth rate bottomed out around 1991. The crash of the stock market at the fall of 1987 correctly foretold this 1988 to 1991 slump. The American trade deficits in goods, and the real growth rates of GDP/GNP are plotted in Figure 4 for the eighties and the nineties to support the
above argument. We may look at the slump
of 1988 to 1991 from a different angle.
After the Plaza accord Japan was urged to
stimulate her domestic consumption, and
the Japanese authority complied. As the
Japanese economy boomed domestically,
Japan needed her savings to be spent within
her boundary; thus less capital outflow and
less trade surplus for Japan. This was the
cause of the shrinkage of American trade
deficit and the reason of the 1988 to 1991
slump in The United States of America.
As to the side of Japan the consumption
boom was not able to keep pace with the
monetary expansion due to the everlasting
meddling of Japanese authority over the
markets and also due to the existence of
various trade barriers to retard the free flow
of imports. The excess money flowed into
the assets market causing the stock prices
and the real estate prices to climb to
unreasonable highs; thus the infamous
Japanese economic bubble was formed.
Alarmed by the danger of this enormous bubble and the reckless lending of Japanese banks induced by the bubble mentality, the Japanese authority took measures to punctuate the bubble in 1990 and Japanese economy fell abruptly. The fall of Japan liberated her capital to flow out and Japanese trade surplus started to grow again. This meant that the trade deficit and the capital inflow started anew in The United States of America and the American economy started to pick up around 1991.

       Now came 1995, a pivotal year to understand the current situation of the economy of The United States of America and the world. Armed with the renewed inflow of capital from Japan and the improved flexibility in the economic system due to the painful corporate downsizing exercises, the American economy had bounced back quite a bit by that time. On the other hand in Japan the authority had stayed on to the tight monetary policy for too long and Japan was at the threshold of deflation. This meant very high real interest rates in Japan and the desire to hold the yen was stimulated enormously. As the result the yen strengthened to 80 yen per dollar, and Japanese manufacturers started to shift their facilities out of Japan to lower their production costs. Alarmed by this process of hollowing of the manufacturing base the Japanese authority made another 180 degree abrupt turn in the middle of 1995; they lowered the interest rates to the current super low level and intervened in the currency market aggressively to deface the yen. This new policy of the super low interest rates has forced the capital to flow out of Japan and into the United States of America in the form of expanding trade deficit for America. This expanding influx of imports has stimulated American economy through the mechanism discussed in Section 2, and has calmed the inflation. On the other hand the inflow of Japanese money has inflated the prices of American stocks and bonds. This American boom is sustained by the ever stronger dollar, the result of the super low interest rate policy of Japan and the ensuing death spiral of Japanese economy. We should say that the American prosperity is the direct result of, but not in spite of the Japanese disaster. When Japan succeeds in arresting her economic downfall, the American boom will end. The notion of a strongly expanding economy and a benign inflation environment is the natural result of an economic expansion fueled by the expanding trade deficit as is occurring in The United States of America. However, this notion is completely foreign to the outdated macroeconomic models of an isolated economic entity. Many students of the outdated macroeconomic models have been misled into
forecasting repeatedly the mirage of the pending higher inflation in America, which, of course, has never arrived. In order to explain this spectacular failure about the conjunction of the low inflation and the strong growth in America, some have turned to the idea of "new paradigm" of economy, which is to claim that we are in a new era of high productivity due to the emergence of the "high tech revolution." The problem of this "new paradigm" is that it is not supported by the objective data. Let us look into this aspect in detail.

       The lower inflation and the increasing
prosperity in America is a phenomena distinctly
apparent starting from 1995, the year of the
introduction of the super low interest rate policy in
Japan. The American productivity data does not
show any significant improvement at the vicinity of
1995. The believers of the "new paradigm" claim
that the productivity data is faulty. Let us entertain
this claim for a moment. The productivity data is
calculated using quite a few pieces of other
independently compiled statistics. As every student
of an objective science knows, if many pieces of
data, each one of which has certain degree of error
built in, are used in a calculation, the error in the
final result will be amplified and the resulting noise
may mask any meaningful trend in the final
outcome. However, we can look at several simpler
series of data to gauge the efficiency of American
economy without encountering this statistical
problem. In Figure 5 two varieties of ratios are
plotted for the eighties and the nineties: They are
the ratio of annual factory shipments to annual factory payrolls, and the ratio of annual business sales to annual private wages and salaries. The first ratio, factory shipments/factory payrolls, measures the efficiency of the manufacturing sector; there is a significant improvement from 1987 to 1995 due to the efforts of restructuring, but the improvement peaked in early 1995 and has started to decrease gradually since that time, in total contradiction to the claim of the "new paradigm". The second ratio, business sales/ private wages and salaries, measures the efficiency of the whole economy. Here again there is only a slight rise of efficiency from 1991 to 1995 and then a small fall starting from 1995. If we look with a longer time frame, we will see that the efficiency of the overall American economy has been crawling at the bottom since the late eighties.

       The above discussion implies that the claim of the "new paradigm" is not justified. If we look around our daily surroundings, we do see the improvement of productivity due to the wide spread usage of computers in some areas, but there are also many areas where the high tech revolution has rather created inefficiencies and more bureaucratic wrangling. For example, many telephone lines are now tied up by people directed by computers to push this button, that button, and finally ended up listening
endlessly to music over the phone while waiting to catch a real person to speak to on the other side of the line. The waste of enormous amount of productive hours due to the wide spread desire to gossip and to play games on cyberspace is certainly not the way to make an economy more efficient. The real data shows that the benefits and the draw backs of the high tech revolution have canceled out and amounted to a nonevent as long as the efficiency of American economy is concerned. The conjunction of the prosperity with the lowering inflation rate in the United States of America can only be explained from the aspect that the economic expansion is driven by the expanding trade deficit as discussed in this article.
 

5. RIPPLE EFFECT: THE VICTIMS BEYOND JAPAN

       Many developing and newly industrialized nations are victimized by the changed capital flow instigated by the super low interest rate policy of Japan. In contrast to the development of Japan in the fifties and the sixties, those countries have employed a development model which is literally based on excessive exports; this model may be called the "Taiwan model", since Taiwan is the one who used this model most successfully. Let us study this mode of development by using Taiwan as the example.
Taiwan imported foreign capital and combined it with her inexpensive labor to manufacture goods for exports. Since the outside capital was earmarked only for the manufacturing of exportable goods, it was equivalent to the idled domestic capital employed to boost exports. Thus the situation in Taiwan was equivalent to the extreme case discussed in Section 2, in which both the idled labor and the idled capital were used to manufacture exportable goods, and one dollar increase in exports meant one dollar increase in GDP. In a sense Taiwan served as a surrogate exporter of Japan by importing capital goods from Japan
to manufacture exportable goods, and then exporting those goods to other countries. Since the major export market of Taiwan was The United States of America, the currency of Taiwan should not have risen against the dollar to prevent Taiwan from the loss of price competitiveness of her exports. On the other hand the capital inflow was denominated in dollar, so the currency of Taiwan should not have devaluated against the dollar either, otherwise the capital flowed into Taiwan would have suffered currency related losses and the future inflow of direct investments would have been discouraged. Therefore, the currency
of Taiwan needed to be linked to the dollar for this model to work. Taiwan deployed this model of excessive exports successfully. When the storm of Japan's super low interest rate policy hit, Taiwan has already graduated from this "Taiwan model", has replaced the imported capital with her own domestic ones and has become a mini exporter of capital, to China, herself. That is why Taiwan's currency was able to come down versus the dollar in a measured manner in recent years without triggering a crushing economic disaster as other Asian countries have experienced.

       South Korea, Malaysia, Philippines, and Indonesia followed Taiwan and tried to use this "Taiwan model" to grow, so all of them linked their currencies to the dollar as the model requires. When Japan started the super low interest rate policy and the yen was defaced severely, the currencies of those countries rose rapidly with the dollar to make manufacturing there uneconomical and to diminish their role as the surrogate exporters of Japan. The reason that they did not fall immediately into economic hardship was ironically due to the speculative money, like hedge funds, which those countries have blamed as the cause of their demise later on. What those speculators did was to borrow the yen at the super low interest rates, and to buy high yielding debt instruments of those Asian countries whose currencies were linked to the dollar. This influx of "hot" money, replacing the inflow of direct investments, created bubbles of consumption and assets price inflation. This kind of imprudent behavior, of course, could not have lasted for long and the day of reckoning finally arrived in the summer of 1997. First the "hot" money started to stampede out of Thailand to cause her economy to cave in almost over night. Once awakened to the risk of Thailand and started to notice that many other countries in Asia were in the same sad situation as Thailand, speculators naturally stampeded out of all the remaining countries, and that was the domino effect of Asia which we witnessed in the second half of 1997. Any country who ties her currency to the dollar and relies on the "hot" money to sustain her consumption will encounter the same fate as those fallen Asian countries. The longevity of the bubble of such a country depends on her underlying economic strength and the proximity to Japan, both geographically and economically. By this summer this domino effect has reached Russia and is now pounding on Brazil.

       China, Hong Kong and India have unique circumstances of their own and are weathering the economic storm from Japan according to their own designs. Since the open door policy in the eighties China has tried to grow in accordance with the "Taiwan model". The pace to follow the model has picked up after the official devaluation of her currency against the dollar and then the subsequent reestablishment of the linkage of her currency to the dollar at a lower level in 1994. However, China has
never let her currency convert freely with the dollar. Thus, for the outside investors it is easy to bring money into China but extremely difficult to get the money out again. Such kind of a setup, of course, has not attracted the speculative money into China. Nevertheless, the large and rapid influx of direct investments from outside had bubbled Chinese economy. Part of those investments were after the very low labor costs to manufacture exportable goods and part of them were dreaming to catch a portion of the one billion strong consumer's market there. As the process of defacing the yen has set in, the currency of China which has been linked to the dollar has also risen substantially versus the yen and the advantage of the 1994 devaluation has almost been nullified. However, thanks to the very low cost of manufacturing in China to start with China has retained some degree of the price competitiveness in her exports. Nevertheless both the capital inflow into China and the rate of growth of exports from China have slowed in recent months and the consumption boom has turned into a bust. Ironically it is due to the
entrapment of the outside capital in China that the Chinese currency is capable to hold the linkage with the dollar and to avoid an economic collapse as suffered by other smaller Asian countries.

       Hong Kong is a regional money center and is serving as the base camp for those who invest in China. The prosperity of Hong Kong is manifest in the large holding of the official foreign currency reserve and her high flying real estate prices. As the flow of the global capital is altered by the policies of Japan, Hong Kong is suffering mightily from the reduced flow of investment capital and "hot money" into other Southeast Asian countries, South Korea, and China. The currency of Hong Kong is also linked to the dollar, so her interest rate needs to be kept very high in order to defend the linkage. This high interest rate and the expensive currency have devastated her manufacturing, tourism and real estate sectors. What is going to happen to Hong Kong depends on what is going to happen to the global economy, especially the fate of the yen and China.

       India has never adopted the "Taiwan model", and has never invited outside capital in any significant way to flow in. Thus her currency does not need to be linked to the dollar and there is also no problem of the "hot" money stampeding out of the country. Before the disaster originated from Japan hit Asia, India was growing less rapidly than other developing countries who adopted the "Taiwan model". After the shock wave India is still growing just like she has been. The growth or the lack of growth of India is mainly influenced by her domestic factors. After the dust of this anomaly of the global economy settles, the India model will become increasingly significant for other developing countries.

       The outside capital, an essential ingredient to make a "Taiwan model" work, is only looking for an environment of low production costs and short term political stability. When the country becomes richer and the cost of production rises, the outside capital will leave to search for alternative environments with lower production costs. The host country must graduate from the "Taiwan model" and shift into a course of self reliance when the exodus of the outside capital begins. Taiwan has performed this task of transition well, but many other fallen Asian countries have simply replaced the direct outside investments
with the "hot money" to support their consumption boom and as the consequence have become so vulnerable to the shock wave from Japan. The way that the International Monetary Fund (IMF) is handling the crises by urging the affected countries to delink their currencies from the high flying dollar, to raise their interest rates in order to reduce the outflow of capital, and to reform their financial and even political structures to prepare for the transition to the "India model" is the proper course to take.
However, we must be aware that by providing financial aid packages to those fallen countries to lessen their pain for the transition, IMF is also helping the speculators to reduce their losses and thus is encouraging them to flow into other countries, which are equally addicted to the "hot money" but has not yet fallen, to repeat the same fiasco again and again. We should also be aware that the largest addict to the "hot money" is no other than The United States of America, who clearly will be the last to topple due to her vast wealth accumulated through the course of her history. When and how the bubble of The United
States of America will burst, of course, have enormous significance to the economy of the whole world and is the topic of consideration of the next section.
 

6. WHERE ARE WE GOING?

       The question about the future course of the world economy naturally brings our attention back to the source of the whole trouble, Japan. As the Japanese trade surplus continues to grow and the Japanese economy continues to spiral down, more and more Japanese workers become idle. Will it come to a point that enough capital also becomes idle so that further increase of exports can be achieved by using the idled labor and the idled capital in Japan? If so, this will translate into increased GDP growth as for the extreme case discussed in Section 2 and the negative correlation in Figure 1 will be broken. Unfortunately, it is not going to happen as long as the credit crunch is going on. The lubrication of an economy is not just the total amount of money but the amount of money multiplied by the speed of circulation. The cash stacked under the mattress does not circulate and does not turn into capital. A characteristic of a credit crunch is that there may be plenty of cash in the system, but capital is still very scarce. In the current onset of the credit crunch in Japan any capital employed to increase exports will be taken out of already very tight supply of capital earmarked for domestic consumption; therefore, more exports means less domestic consumption and the further shrinkage of GDP.

       The economic death spiral is easy to trigger; the single minded super low interest rate policy has achieved this feast in the case of Japan. However, to stop an ongoing economic death spiral is extremely difficult. The reversal of the super low interest rate policy and the reduction of the trade surplus will take a long time lag to show any significant effect in restoring Japanese economy to the normal state, but such reversal of policies is essential for other measures to be effective. The additional urgent job that Japan must do is to break the negative consumer psychology so that the money pumped into the system can start to circulate and new capital can be formed from the increased domestic consumption. The recent attempt to inject public money into major Japanese banks is only a stop gap measure by preventing the chain reaction of bank failures and the resulting acceleration of the credit crunch. The measure by itself will not induce consumers to loosen the string of their purses. The stimulative fiscal packages which Japan has enacted or will enact are all through more spending by the government under the tight control of the bureaucrats, not by putting more money directly into the hands of consumers. Even the recent idea of issuing gift certificates is to prevent consumers to have real money which they can dispose as they want, but to allow the government bureaucrats to dictate what consumers must buy. It is this kind of disregard of the market economy and Japanese consumers on the part of Japanese authority, in conjunction with their misguided belief that the defacement of yen and the resulting explosion of Japanese trade surplus will save Japan, that has nullified the effects of all the stimulative packages in the past and will lender similar measures ineffective in the future. At present there is no indication at all that the Japanese authority has understood that the super low interest rate policy and the ensuing sever defacement of the yen are the source of the whole trouble, so we should prepare to see that the Japanese crises will linger on further.

       On the other hand as the trade deficit balloons, can the United States of America continue to become more and more prosperous as Japan sinks into an abyss? To answer this question we need to recall the argument in Section 2 that in order to take advantage of the expanding trade deficit the labor and the capital idled by increasing imports must transit swiftly to the sectors not in competition with foreign products. Once the ability of this transition is hampered, the slower growth of GDP will set in. It is only when this bottleneck is broken, the positive correlation between the trade deficit and the economic growth will resume. Ironically, it is at the extreme when the American manufacturing sector is totally wiped out by the competition from foreign products, further increase of imports will not cause further idling of any labor and capital, and the bottleneck discussed here will disappear completely. On top of this bottleneck of transition of labor and capital there is also the bottleneck of credit. The prosperity based on the rampant trade deficit is nothing but a spending boom fueled by borrowing from foreigners.
In order for this boom to continue, the influx of Japanese money must be distributed to American consumers. One way for this money to reach the consumers is for them to borrow, and another way is for the consumers to profit from the bubbling stock and bond prices which are pushed up and up by the inflow of Japanese money. In recent months the financial status of American consumers become quite shaky. The savings rate, which has been around five percentage points at the beginning of 1995, has dipped down literally to near zero. Only thing that is still holding up American consumers is the stock and bond prices. Once the stock and bond markets crash, the confidence of consumers can quickly turn negative and the consumption boom will cool rapidly.

       Presently there is no sign that the trade deficit of the United States of America is peaking, so the inflow of capital is holding up strong. As long as Japanese money is continuing to flow in, the underlying uptrend of stock and bond prices will be sustained, the above mentioned bottlenecks can be overcome, and the economy can maintain its strong growth in spite of short lulls here and there. The question of how long this flow of Japanese money will continue depends on the sustainability of the strength of the dollar. In recent months the dollar has tumbled sharply against the yen, from above 145 yen per dollar to less than 120 yen per dollar within a rather short time span. This sharp fall of the dollar is partly attributable to the debacle of the hedge funds and partly attributable to the hope that Japan may do something right to pull herself out of the economic death spiral. If the weakness of dollar continues, the trade deficit will start to peak, probably with the time lag of around one year, and then the American economy will start to slow down. Since the value of the dollar plays such an important role, let us look
into the cause of the recent abrupt movement more closely.

       The defacement of the yen after the introduction of the super low interest rate policy in Japan has proceeded with three waves. The first wave is the speculators, best represented by hedge funds and other financial institutions, who borrow the yen at the super low interest rates, sell those borrowed yen for the dollar, and use the dollar to buy high yielding debt instruments to profit from the interest rate gaps; this process is called the "yen carry trade" and has pushed the yen down sharply. The second wave consists of Japanese institutions like insurance companies and banks, who sell the yen of theirs for the dollar and use
the dollar to buy American treasury bonds and stocks, causing the prices of American stocks and bonds to go through the roof. Though this second wave is a mere imitation of the first wave, due to the size of the yen held in the hands of the Japanese institutions, it has pushed down the yen steadily until it reached 145 yen or more per dollar. The third wave is caused by Japanese individual savers. Disgusted by the near zero interest rates of the yen, and emboldened by the ever rising dollar, more and more Japanese savers are converting their yen savings into dollar deposits. This third wave is gathering momentum. If
the Japanese authority continues to hail the increase of their trade surplus and foolishly holding on to the super low interest rate policy, the third wave will become a torrent and will drain a substantial fraction of wealth out of Japan to make her collapse like an empty shell.

       When the ripple effect of the Japanese folly reaches Russia and starts to threaten Latin America the debt instruments of which the hedge funds hold aplenty, the speculators in the first wave have suffered heavy losses. They are forced to sell American stocks to make up their losses and unwind their "yen carry trades", triggering corrections in the stocks and the dollar. We should be aware that the movement of the dollar will effect the trade balance with a delay of about one year. The high flying dollar in the time span from the summer of 1997 to August of 1998 will make American trade deficit explode until the summer of 1999, and the American economy will continue to grow strongly until that time. However, the sharp fall of the dollar starting from August of 1998 will translate into the slow down of the expansion of American trade deficit and thus the slow down of American economic growth starting from the fall of 1999.

       What is going to happen to American economy in the year of 2000 depends on what is going to happen to the dollar from now on. If the desire of Japanese to hold dollar is sustained and the Japanese economy continues to spiral down into a bottomless hole, the dollar will move higher versus the yen again, and American trade deficit and American economy will grow anew in the new century. If Japan manages to reverse the course of her economic death spiral, or the crises renews in Latin America to prompt the Federal Reserve Board to cut interest rate aggressively to prevent a credit crunch, the interest rate gap between the dollar and the yen will diminish and the dollar will fall precipitously. At that occasion the Japanese money will leave and the American bubble will burst in the year of 2000. What will happen to those Japanese money which leaves the United States of America? It may flow to Europe to create a new bubble there, or it may flow back to Japan and may stimulate Japanese consumption depending on the situation and policies of that time. The worst case scenario is that the returned Japanese money may not join the circulation and just be stacked away under the mattress or in safe deposit boxes in reaction to the continuing super low interest rate policy. If that happens, the Japanese predicament will continue at the same time as the American agony; then we may say that finally the whole world is under the siege of a depression thanks to the reckless monetary policy of the lender of the world, Japan.
 

7. CONCLUSION

       The current global economic system is not stable, because the authorities of the major players of the system have neglected to coordinate their policies. The reckless monetary policy of one authority can throw the whole system into chaos as discussed throughout this article. In the age of the global economy, monetary policies become much more complicated than the old time before the globalization. The time of simply rising or lowering interest rates to retard or advance the growth of an isolated economic entity is gone. Monetary authorities must constantly watch the value of their currencies when conducting monetary policies, and must encounter the difficult task of determining what is the proper value of their currencies relative to others. Such difficulties will only dissipate when a truly global economy with one global currency and one global monetary authority emerges. Under such a truly global economy the whole world can be considered as an isolated economic entity and the happy days of simpler monetary policy and the outdated macroeconomic models will return. However, before we reach that utopia, we
must struggle to learn how to stop the economic death spiral of Japan and how to deflate the bubble of the United States of America with minimum pain.
 

REFERENCES:

1. Chih Kwan Chen, Weekly Diamond, March 28, 1998 issue, page 94 (1998), (in Japanese).

2. All the data about Japanese GDP and trade surpluses are taken from National Accounts section of Major Economic Indicators category of Nikkei Telecom's Japan News & Retrieval. The annualized growth rates of real GDP are the average of the growth rates of four quarters within a calendar year.

3. Data are taken from the monthly tabulation of Nihon Keizai Shimbun.