Executive Summary: At the peak of his popularity and with friendly fellow summiteers, President Reagan can hardly miss at the May 4-6 economic summit in Tokyo. With Jim Baker seasoned, we can expect him to win movement toward the concept of monetary reform in 1987, at least an endorsement of the Reagan State of the Union objective of stable exchange rates. Protectionism will abate, Japan and Germany should relax in their resistance to growth initiatives, and the confusion over the dollar/yen ratio should be worked out – moving it back in the direction of 180 yen to the dollar, easing anxieties in the U.S. bond market. If the Senate Finance Committee can produce its new tax reform bill in the next few days – with a 26 or 27% top income tax rate – the President's hand will be strengthened in urging parallel moves by the summiteers. With even modest success, we should see another leg of the bull market off the summit.
The Tokyo Summit: A Good Bet
The first five economic summit meetings of the Reagan presidency were relatively uneventful. At the first four, coordination of monetary policies was prevented by the dominance of the monetarists in the U.S. delegation, leaving the U.S. budget deficits to be blamed for the high worldwide interest rates. At the Bonn summit last year, the new Treasury Secretary, James Baker III, had his attempts at coordination sideswiped by Secretary of State George Shultz, who floated the dollar when he was the Treasury chief in 1973 and wants to keep it that way.
The President at least got to meet his peers of the industrial democracies, and they got to meet him, and by now they not only know each other fairly well, but for the first time ever there's not a socialist in the bunch. (Prime Minister Jacques Chirac now leads the French delegation.) The economic summits of the previous 15 years coincided with the one-term American presidencies of Johnson, Nixon, Ford and Carter, and while Nixon did have six such meetings, at the last two he was crippled by Watergate. Reagan, by contrast, goes to Tokyo at the peak of his popularity at home and, perhaps excepting Tripoli, he is at the peak of his standing abroad.
The Tokyo economic summit of May 4-6, we can practically say in advance, will be both eventful and successful. In this "Rare Moment for a Global Economy," as The New York Times put it April 27, in a report by Peter T. Kilborn, the seven leaders "are expected to try to get moving on something they have been toying with for several years: speeding up the arduous process of imposing a new formal order on the world economy."
Why eventful? How successful? While acknowledging that general expectations are not very high, we expect positive developments toward monetary reform, significant moves away from trade protectionism, and at least tacit agreements to consider fiscal and monetary policies that will expand the western economies sooner than later. Even if moderately successful, the Tokyo summit should produce another leg in the global bull market.
To begin with, the heads of state will celebrate the experience of their finance ministers, the G-5 (now to be expanded to the G-7, including Canada and Italy) in coordinating interest rate and exchange rate policies since last September's historic agreement in New York City. This is not the year for a "new formal order," but after the heads of state agree that so far so good, Jim Baker will be able to point them in the direction of an '87 accord on international monetary reform, at least in concept. He can't push too hard in Tokyo, but if he can get a general endorsement of the President's State of the Union call for a more stable exchange rate system and the idea of a conference in '87, he will have done well.
Its enormous importance is that it would formally end the debate on fixed versus floating exchange rates—pointing the West's economists and finance bureaucrats toward the goal, with a full year to debate the form of the system. This is plenty of time, given the fact that all the options had been debated and refined in the 1960s, and the range of realistic approaches is suitably narrow. The Germans are skeptical, but when they see the United States is prepared to move toward a currency bloc with Japan alone, if need be, they will begin thinking of the available options and which suits them the most.
We have not the slightest doubt that President Reagan, his White House team, and Baker-Darman at Treasury are committed to at least an attempt at formalizing a monetary agreement in 1987. A senior White House official tells us the commitment is so deep that "it wouldn't matter who the chairman of the Federal Reserve is next year," disputing my observation last month ("At the Fed, All's Well That Ends Well") that President Reagan would not replace Paul Volcker midstream of his monetary reform. The official asserts that the finance ministries have the jurisdiction on such matters, and "Baker could pull it off no matter who is at the Fed." Nobody is indispensable.
Japan and Protectionism
Appropriately, this year's summit is in Japan, whose trade surpluses, currency and growth policies are at the center of the global economic discussion. Japan's $65 billion trade surplus, half of which is accounted for in its trade flow with the U.S., was supposed to come down (according to Keynesian trade theory) with the dramatic appreciation of the yen following the September G-5 meeting. This would relieve the Reagan Administration of the protectionist pressures bearing down on it, especially as the fall elections approach. But the trade surplus has even increased a bit, running at $7 billion a month lately, and the forces of protection have been nibbling at the White House gates.
There is at the moment no serious threat of protectionist legislation being enacted in Washington, although a bill will be sent to the President for his veto sometime soon. But there is a problem with Japan that has to be dealt with at some point, and the summit may be the place where it begins.
The first fact about Japan that bears reminding is its relative isolation. It has no former colonial ties, no sphere of influence in the developing world. And it has little in the way of natural resources. It has twice the number of farmers as the U.S. with half as many people, producing a relatively small amount of subsidized grain and foodstuffs—the legendary $5 grapefruits and $10 beef, probably $6.50 and $13 with the yen's runup. Peter Drucker, who writes very little that isn't wise, says the Japanese "practice adversarial trade," i.e., they "only sell, they do not buy." This observation isn't wise.
They of course buy food and raw materials, because they have little of each, and of late they have been buying more and more stocks and bonds of enterprises and governments abroad. In order to buy more stocks and bonds they have to buy less merchandise out of their foreign earnings, which is why the trade surplus stays high. There are those in Washington who would prefer they "save less and consume more," which means they should buy more merchandise and fewer stocks and bonds. But the reason the Japanese as individuals lately have this appetite for foreign stocks and bonds is that their own economy has been steadily moving from high growth rates to low growth rates toward recession. In a Third World country this is termed "capital flight." In Japan it is a "too high savings rate" that becomes a "capital outflow." Investment opportunities have declined in Japan relative to the rest of the world, especially the United States.
Ironically, the appreciation of the yen was supposed to assure "that Japan's yawning trade surpluses and America's trade deficits will finally shrink," as the Times' Mr. Kilborn put it. Instead, it had the opposite effect. By embracing yen deflation, to satisfy the trade protectionists in the U.S., Japan reduced investment opportunities at home. The Keynesians theorized that the dearer yen would buy more in the U.S., and this would shrink the U.S. trade deficit. But the dearer yen could buy more U.S. stocks and bonds as well as merchandise, and the net effect was to increase the U.S. trade deficit.
Japan will not continue to increase its ownership of the rest of the world in this fashion. Last year, we're told, the average total savings of Japanese households exceeded the average annual income for the first time! Our assumption is that the Japanese are behaving as we would, prudently buying more insurance because they are isolated and resource poor and have been slowing their growth to placate U.S. protectionists. If they would begin to grow again, their trade surpluses would soon begin shrinking.
Because of the great capital outflow from Japan, it has now been proclaimed "The New Global Top Banker" by The New York Times. But as Robert Mundell observes, Japan has been acting not like a banker, but as a lender, largely avoiding the risk taking role of a banking intermediary and simply buying up U.S. Treasury bills and bonds and other safe investments in the industrial world. As the world banker of the 19th century, Britain risked capital throughout the Commonwealth and other undeveloped regions. The United States has played this role for half a century, especially since World War II. Japan may be on the threshold of such global risk taking, but it still sees its self interests in its current conservative mode. If it took higher investment risks, it would purchase fewer U.S. bills and bonds. But the Third World expansion would feed back into the U.S. economy with purchases of goods and services, lowering the trade deficit here, expanding the tax base and reducing the offerings of Treasury securities, Mundell suggests.
Stimulating Japan & Germany
The more immediate objective of the Reagan team at the summit is to persuade both Japan and West Germany to encourage economic growth in their stagnant economies. Industrial production in both countries has been declining so far this year, reflecting our fears of last fall that the steep appreciations of the yen and D-mark against commodities would cause the same adjustment problems the soaring dollar caused here in recent years.
Japan and Germany are reluctant to stimulate, for different reasons. Japan could easily use both monetary and fiscal spurs. Its discount rate is at 4 percent and overnight money closer to 5, and with the yen price indices in double-digit declines this year there is certainly no inflationary threat. (The yen price of oil has dropped to 2300 from 6700 in the last year, which is one big reason the Japanese see deflationary benefits amidst the stagnation.) Japan could cut its discount rate in half and add liquidity to the system to bring overnight money down apace. But there are institutional constraints that make such moves even more difficult at the Bank of Japan than at the Fed. Here too, the discussion at the summit should help nudge Prime Minister Nakasone in that direction. With the yen at 167 to the dollar, a bona fide recesssion will hit Japan unless it eases monetary policy, an argument we expect the Treasury team will be making.
Japan also has plenty of room for fiscal stimulation, but there is the same institutional skepticism of the Laffer Curve in the Japanese bureaucracy as in Washington. Susan Chira of the Times reports from Tokyo:
Proposals to generate economic growth by stimulating domestic demand also appear to contradict the Nakasone administration's main article of faith — to hold down Government spending so as not to increase Japan's already huge public debt.
According to [Prime Minister Yasuhiro] Nakasone, a combination of tax cuts, participation by the private sector in public works and perhaps some Government- issued bonds could do the job.
But several private economists are skeptical as to whether the Japanese economy, already slowed by the yen's rise, could expand without direct Government spending. . . .
"What I object to is that if we are to stimulate domestic demand, some fiscal stimulus is needed, but Nakasone hasn't lifted his policy of fiscal restraint," said one senior Government official who asked to remain unidentified. "What is frustrating to us is that our hands and legs are bound and then they tell us to move."
This is a perfect time for President Reagan to be preaching supply-side marginal tax cuts, to both Japan and Germany. Japan has had a dramatic decline in its real income tax rates because of the yen appreciation—but backwards bracket creep via deflation is a very expensive way to cut tax rates. The 70 percent rate now hits at a threshold equivalent to $479,000, compared to $333,000 a year ago; 50 percent at $120,000, compared to $83,000; 30 percent at $48,000, compared to $33,000. Japan could cut the top rate to 30 percent with dynamic effects on domestic growth and a boom in government revenues. But there are the same demands for "revenue neutrality" in Tokyo as in D.C., and the Japanese consensus is as reluctant to cash out loopholes and subsidies as the Senate Finance Committee. Will Ron nudge his pal Yasu in this direction?
Germany's problem is that its government economists have "projected" growth of 4 percent this year and this growth will be greater than U.S. growth, so why should they expand. But the D-mark appreciation will shortcut the projected 4 percent growth in 1986, and even if it didn't, Germany needs a string of 5 and 6 percent years to cut into its 10 percent unemployment rate. What we are reading in the financial press about German intractability on this point reflects the unimaginative views of Helmut Kohl's finance and economics ministers, the German equivalent of David Stockman and Martin Feldstein. President Reagan will try to get Kohl himself to see the light, we think, and at least get Germany to accelerate its planned tax cuts.
A year ago, we reminded the senior Treasury officials that in 1962 it was the Germans who urged the United States to cut income tax rates (Ludwig Erhard suggesting that path to President Kennedy), and President Reagan should return the favor at the Bonn summit. But the State Department discouraged the idea of "interfering" in the domestic policies of our allies. We suspect Jim Baker will be more persuasive on this point than is expected.
The Dollar/Yen Exchange Rate
The confusion over where the Reagan Administration would like the dollar/yen ratio got to its silliest point when Chrysler chairman Lee lacocca made the financial wire with his "jest" that Jim Baker had told him he wouldn't mind seeing it at 150. Despite the denials from Baker, the number stuck in the craw of currency and bond traders. It didn't help that President Reagan offhandedly remarked about his preference for a weaker dollar at about the same time Baker was finally understanding that a cheaper dollar, in foreign exchange, was arguing against an easier monetary policy at the Fed. The yen climbed to 166, an ominous place with the dollar price of gold at $345. Prices and wages would have to decline to clear at these crunchy numbers, and we think a way will be found to get it back to 180 or better.
On the eve of the Tokyo summit, the bright side of all this is that it further undermines the arguments of the floaters. No doubt George Shultz will continue to argue in Tokyo that the "free market" should set the exchange rates, but it has become painfully obvious amidst the lacocca jests that currencies are not commodities. They are non-interest bearing debt of the governments that issue them, and their relative values in a world without a monetary standard can swing wildly on the expectations of currency speculators. The President and Secretary Baker don't have to nail down any kind of agreement on exchange rates in Tokyo, but the climate should be right to get the ball rolling, which Shultz will not be able to prevent.
It is barely possible that by the opening of the summit on Sunday the President will be able to tell Maggie and the boys that the Senate Finance Committee has agreed on a tax-reform package, with a top rate on personal income of 26 or 27 percent. All the world has been hearing for the last few weeks is that tax reform is moribund, tax reform is hanging by a thread, or tax reform is dead. By putting the tax horse out of its misery, which the Finance Committee had hobbled in public session, Chairman Packwood revived the original concept of tax reform, low rates and simplicity, and won back committee members who had given up in disgust. The one clear drawback, which we suspect caused the record 42 point drop in the Dow April 30, is the treatment of capital gains as ordinary income. Packwood did this to placate Senator Bradley and committee liberals.
But chances are now excellent that a decent bill will emerge from Finance, hopefully with some differential for capital gains. If it can make it in time for the summit, it only strengthens the hand of the President and Baker in urging parallel moves in Europe, Japan and Canada.
In any case, the stage is set for an eventful and successful summit. There's not much that can go wrong this trip, and great opportunities for global economic advance with any luck at all.
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