RIETI Report May 2005

Resolving Global Economic Imbalances <RIETI Featured Fellow> Willem Thorbecke

Greetings from RIETI

Japanese cuisine is often seasonal and one of the most popular ingredients found in this season is hatsu-gatsuo, or "first bonito of the season." Bonito are born in South Pacific Ocean and migrate northward in pursuit of prey as they mature, until they eventually find their way to the coastal waters of Japan. Bonito are taken from the waters off southern Shikoku in March, the Kii Peninsula in April, and the Izu Peninsula in May. At one point during the Edo period (1603-1867), high demand for hatsu-gatsuo caused prices to rocket. It is said - no doubt, in jest - that men in those days would go so far as to pawn their wives to enjoy this pricey delicacy. Although going to such extremes would be frowned upon today, the voracious appetite for hatsu-gatsuo has long been considered an expression of the high spirits of Edokko, or natives of Tokyo.

A willingness to spend money for pleasure might be just what is needed to lift Japan out of its economic doldrums. On May 25th, "RIETI Report" spoke with RIETI Senior Fellow Willem Thorbecke about his current research, his views on the recent developments in Asian economies, and his suggestions for improving Japanese economic performance.

RIETI Fellows Now

RIETI Senior Fellow Willem Thorbecke is an expert in international, monetary, and financial economics. From 1998 to 2005 he was an associate professor of economics at George Mason University in the United States. He has held a wide range of academic and policy-related posts, including visiting scholar positions at the Asian Development Bank Institute, Yale University, and the U.S. Social Security Administration. Dr. Thorbecke's publications include Post-Crisis Development Paradigms in Asia (ADB-I Publishing: 2003), which he coauthored with RIETI President and CRO Masaru Yoshitomi, Iwan Azis, and RIETI Senior Fellow Li Gang-Liu; and Trade Protection in the United States (Edward Elgar Publishers: 1995), coauthored with Charles Rowley and Richard Wagner. He holds a B.A. in economics from Cornell University and a Ph.D. in economics from the University of California, Berkeley.


RIETI Report: Please tell us about your current research and how you became involved with RIETI.

Thorbecke: I am currently working on global imbalances and on how Asian countries can respond to them. The difference between what the U.S. buys from the rest of the world and what it sells to the rest of the world each year is almost $700 billion. The U.S. can only run such large deficits if the rest of the world is willing to finance them. Until 2000, foreign investors were happy to do this by investing in U.S. assets. However, with the stock market slowdown and the uncertainties related to terrorism and war, the U.S. has become a less attractive place to invest. Private investors are no longer willing to provide the U.S. with sufficient capital to pay for its trade deficits. Thus central banks, largely in Asia, have stepped in to buy U.S. assets, which has kept down the values of Asian currencies. Most people think that Asian currencies will have to appreciate. My job at RIETI is to study how such an appreciation would affect the U.S. current account deficit, and how it would affect Asia.

Asia is characterized by intricate production and distribution networks, and by what has been called "triangular trade patterns." More highly skilled workers in countries like Japan, Korea, and Taiwan produce intermediate goods and ship them to China and ASEAN countries for assembly by less highly skilled workers. The finished goods are then exported around the world. The large trade component of GDP in the region also suggests that relative exchange rate stability remains an important policy objective for East Asia as a whole. I am working with other researchers here to try to figure out how this objective can be attained in the face of the large currency appreciations that may be coming to Asia.

Before becoming involved with RIETI I was investigating monetary and financial policies in the U.S. and their socioeconomic effects. In the U.S. during the 1980s, contractionary monetary policies badly hurt uneducated workers, immigrants, single mothers, and others who tend to be on the lower rungs of the occupational ladder. The booming economy in the 1990s, on the other hand, was very good for these workers. As Alan Greenspan has said, because of the shortage of labor in the 1990s, these more marginal workers were hired and trained on the job. This in turn contributed to the productivity boom that allowed unemployment in the U.S. to fall to 3.8% without causing inflation.

During the Asian financial crisis, a researcher asked me if I was interested in looking at the socioeconomic effects of the crisis, and through that I got involved with projects at the United Nations, the World Bank, and the International Food Policy Research Institute. These projects involved modeling the financial aspects of the crisis, and then using an economy-wide (general equilibrium) model to investigate how the crisis affected different types of workers, households, and industries.

While working in this area, I visited the Asian Development Bank Institute in Tokyo. There I worked with Masaru Yoshitomi (now president and CRO of RIETI), Li-Gang Liu (now a senior fellow at RIETI), Professor Iwan Azis, and others on the book Post-crisis Development Paradigms in Asia. This book looked at the "Asian Miracle," the Asian crisis, and the way forward for Asia. The work I am doing at RIETI is a natural follow-up to that work.

RIETI Report: There has been a great deal of discussion about China's currency peg recently. Do you see a major change coming in China's exchange rate policy? If so, what are its likely effects?

Thorbecke: I think everyone knows that there will be changes in China's exchange rate policies. The changes will come more quickly, though, if the U.S. refrains from pressuring China openly. The Chinese government does not want the Chinese people to think that it is caving in to pressure from the U.S. Thus, overt pressure is counterproductive.

Before this latest round of U.S. pressure, my bet was that China would announce a 10% revaluation of its currency. It would claim that that was enough to allow future movements in the currency up or down. This would prevent a situation where speculators could make a one-way bet that the renminbi would only rise.

With the U.S. demanding publicly that China revalue by 10%, I think it is less likely that China will do so. They might make a small move, say a 3%-5% revaluation, followed by another small move later. Regardless of whether it is 3%, 5%, or 10%, however, I don't think it will have a large effect on the underlying imbalances. The significance is more political than economic.

RIETI Report: Recently, the U.S. announced new quotas on imports of Chinese textiles. How will this affect Chinese exports to Japan? Do you have any suggestions for how the present U.S. trade imbalances with Asia can be dealt with?

Thorbecke: I think the quotas will have a couple of effects. First, quotas generate something called "quota rents" that help the exporting country. What this means is that when the government of the importing country artificially restricts supply, it enables producers to sell at a higher price. This higher price generates extra profits for the producer. Thus, while China may sell fewer products to the U.S., it may find that what it sells is more profitable. If it makes more profits selling to the U.S., it may be able to lower prices for what it sells in Japan. Second, the goods that were previously going to the U.S. will go to other markets, and Japan will be a natural choice. Thus Chinese exports to Japan are likely to increase. This is even more likely to happen if the European Union also restricts Chinese exports.

Concerning U.S. trade imbalances with Asia, I think the basic problem is excess spending in the U.S. In an accounting sense, the trade deficit is the difference between investment and national saving. National saving, in turn, equals the sum of private saving and government saving. U.S. households save 1% of their income while some Asian households save more than 40% of theirs. In addition, the budget deficit (government dis-saving) as a share of gross domestic product in the U.S. far exceeds that in many Asian countries. These spending and saving patterns will naturally produce trade deficits. Exchange rate changes alone will probably not be enough to correct these imbalances. To rebalance the global economy, I think that saving will have to increase in the U.S. Both the government and households will have to save more.

The problem in the U.S. is that housing prices have almost doubled over the last five years. This means that even if households do not save, their wealth is increasing. It is very easy for consumers in the U.S. to access this wealth through home equity loans and to use these loans for consumption. I think it is necessary for interest rates in the U.S. to rise in order to check some of the speculative excesses in the housing market and the resulting spending boom.

The irony is that U.S. interest rates these days may be determined as much by Asian central banks as by the Federal Reserve. The Fed controls the rate on overnight loans to banks. When it increases this rate, longer-term rates do not necessarily follow. Thus, the Fed may have a limited ability to raise mortgage rates and reduce excesses in the housing market. Asian central banks, on the other hand, hold maybe two trillion dollars in Treasury securities. If they were to sell some of these, longer-term U.S. interest rates would rise.

There are two extreme possibilities. One is that Asian central banks continue to accumulate large quantities of U.S. Treasury bonds, keeping U.S. interest rates artificially low and stimulating housing prices. The other is that they unload Treasury bonds and generate a panic, causing U.S. interest rates to soar. I wonder if there is an intermediate option, whereby Asian central banks sell enough bonds to allow U.S. interest rates to rise without "killing the goose that lays the golden eggs."

I also think that ideas can play a role in resolving the global imbalances. Debates on this topic in the political arena or the popular press tend to be at the lowest common denominator intellectually: It is always argued that some country is cheating and needs to be forced to trade fairly. But I think many thoughtful people would agree that there is something wrong when households in the richest country in the world consume more than 99% of their income. This is compounded when its government also runs large budget deficits just as it is confronted with looming social security and health care liabilities. Economists and commentators should make the point clearly that policy in the U.S. should be geared towards increasing national saving. Ideas may affect the political process slowly, but ultimately they are very powerful. In the U.S. the concept that inflation is harmful took a long time to take hold, but now it has become a cornerstone of monetary policy.

RIETI Report: In your view, what role can Japan play in helping to prevent another financial crisis in Asia?

Thorbecke: I think Japan is taking positive steps to help prevent another crisis. Through the Chiang Mai Initiative, Asian central banks such as the Bank of Japan can provide short-term foreign exchange support to other Asian countries experiencing speculative attacks. In addition, the Asian bond market initiative is seeking to establish a long-term bond market in Asian currencies. This can help mitigate the "double mismatch" problem that was at the center of the Asian crisis. Asian firms and banks had borrowed short-term in dollars and invested long-term in assets denominated in local currencies. When Asian currencies started to fall, firms had to quickly convert local currencies into dollars, which increased the downward pressure on the currencies. Foreign lenders then refused to roll over the short-term loans, depriving Asian firms of the breathing room they needed to restructure. Thus they were forced to cut back on production, resulting in huge recessions. If a long-term bond market denominated in Asian currencies emerges, this can reduce the double mismatch problem.

The more fundamental problem is that economists and policymakers tend to fight the last war. Paul Krugman talks about how all of our currency crisis models were developed after the fact. If another financial crisis hits Asia, it will probably be different from the last one. Thus, it is important to try to discern and correct fault lines and risks to the financial system before they develop into full-blown crises.

RIETI Report: Although Japan's financial sector has largely recovered from the post-bubble crisis, deflation remains a problem in the Japanese economy. Why is deflation so stubborn and what can be done about it?

Thorbecke: As an outsider, I know much less about the Japanese economy than the many experts working here. Observing people in Japan, though, I find them to be disciplined, hardworking, resourceful, and willing to sacrifice. Some of these very qualities, however, can cause deflation to persist. For instance, housewives who see economic uncertainties and economize drastically on household spending can have a deflationary impact on the economy. I think the goal needs to be to build a fundamentally sound economy in which consumers have the confidence to spend.

The work I am doing at RIETI is related to one aspect of the deflation problem. A large appreciation of the yen could be very deflationary. It would lower the price of imported goods and thus cause consumer prices to fall. It would also reduce net exports, causing a further slowdown in economic activity. In some ways, it would be exactly the wrong prescription for the Japanese economy.

It thus seems important to try to prepare ways to mitigate the fallout from a rise in the yen. Perhaps this could be done by putting pressure, quietly and behind the scenes, on the U.S. to increase its national saving rate. Perhaps this could be done by encouraging businesses to prepare strategies to deal with a strong yen. Perhaps this could be done through harmonizing exchange rate adjustments throughout Asia. However it is done, though, it seems like an important problem to address.



Brown Bag Lunch Seminars

Coming Soon
All BBLs run 12:15 - 13:45, unless otherwise stated.

05/30 SUGITA Sadahiro (Director, Trade Finance and Economic Cooperation Division, METI)
"The Advent of Public-Private Partnerships Era in Japan and Asia" (in Japanese)

06/07 HOSODA Eiji (Professor, Faculty of Economics, Keio University)
"On Resource Circulation in the East Asian Region" (in Japanese)

06/08 NISHIMIZU Mieko (Consulting Fellow, RIETI)
"Governance and Development Assistance Strategy: From the Grass-Roots Reality of South Asia" (in Japanese)

06/10 Richard G. WHITMAN (Head, European Programme, Chatham House)
"European Integration: What Future Prospects?"

06/14 TANAKA Hitoshi (Deputy Minister for Foreign Affairs, MOFA)
"The Challenges of Japanese Diplomacy in Asia" (in Japanese)

06/15 YAMASAKI Tatsuo (Director, Research Division, International Bureau, Ministry of Finance)
"The Second Phase of Asian Monetary Cooperation and China-Japan Relations" (in Japanese, off the record)

06/16 SUGIYAMA Yasuo (Professor, Graduate School of Economics, Kyoto University)
Title: TBA (in Japanese)

06/21 KUSAKABE Satoshi (Director, Industrial Organization Division, Economic and Industrial Policy Bureau, METI)
Title: TBA (in Japanese)

06/29 KIMURA Shigeki (Director, Office of the Vice Minister of Finance for International Affairs, Ministry of Finance)
Title: TBA (in Japanese)

For a complete list of past and upcoming BBL Seminars, http://www.rieti.go.jp/en/events/bbl/index.html

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This month's featured article

Resolving Global Economic Imbalances <RIETI Featured Fellow> Willem Thorbecke

Willem THORBECKESenior Fellow, RIETI

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BBL Seminars

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