The US-Sino Currency Dispute: New Insights from Economics, Politics and Law

22. What should the US and China learn fromthe past US-Japan conflict?
Jenny Corbett and Takatoshi Ito
ANU, Oxford and CEPR; University of Tokyo and CEPR

One recently suggested impediment to China revaluing the renminbi is that the authorities
believe that a prime cause of Japan's 20-year stagnation was its caving in to US demand for
an appreciation of the yen. This paper argues that it was not caving in to US pressure but
resisting it that made monetary policy too lax and contributed to the asset bubble.
Although the rhetoric has recently softened, Chinese leaders have repeatedly said
that they would not allow a renminbi (RMB) appreciation while foreign countries,
notably the US, are demanding action. They have called the measure 'protectionist'and have made clear that it is the measure, as much as the economics of appreciation,
to which they object. However another impediment is that Chinese authorities
believe that a prime cause of Japan's 20-year stagnation was caving in to the US
demand on yen appreciation. .
We argue here that it is important to learn the correct lessons from Japaneseexperience for coping with US demands, managing the exchange rate, and avoiding
20-year stagnation. The key fallacies in the argument that US pressure for exchange
rate appreciation was a disaster for Japan are the timing and the other elements
contributing to the lost decades. While there are several important lessons to belearned from Japan's experience, they are about the importance of the appropriate
domestic monetary policy settings, about the need for a clear perspective on inflation
trends and about the dangers of unchecked asset bubbles. These are all lessonsrelevant to China's choice of currency regime.

So what did happen?
It is true that the US demanded many things of Japan when the bilateral tradeimbalances became large in the mid-1980s and one of the demands was anappreciation of the yen. It is true that the yen appreciated sharply from 260 yen to
the dollar in February 1985 to 155 yen to the dollar in August 1986, which was oneof the fastest appreciation episodes in history. It is true that Japan underperformed
its potential for most of the 1990s and 2000s. The average growth rate from 1993 to2003 was just above 1%, and the decade was marked by one crisis after another in thebanking sector. But it is too simplistic to say that the US pressured Japan into
accepting sharp yen appreciation and that, in turn, caused two lost decades.
The US pressure is most vividly remembered in the context of the Plaza Agreementof September 22, 1985. The yen appreciated from 240 yen to the dollar just before the177

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agreement to reach 200 yen to the dollar by the end of the year. The yen continued
to appreciate to 155 yen/dollar by the summer of 1986 - that is, a 45% appreciationin one year following the Plaza agreement. (See Ito, 1987 for details of the Plaza
Agreement and the aftermath.)

Was the Plaza Accord, the source of the 20-year stagnation?
Given the timing, if the pressure resulted in making the bubble larger than otherwise,
causality could plausibly be suspected. However, the truth is just the opposite.
• First, the Plaza Accord was to correct an overvalued dollar compared with several
other major currencies including the German mark, the French franc, and theBritish pound. So it was not really pressure on the yen but a demand for acoordinated action to change misalignments with the dollar.
• Second, the movement from 240 yen to the dollar to 200 yen to the dollar waswell within the range of correcting the overvalued dollar and Japan agreed withthe idea. Subsequently the US agreed to stabilise the exchange rates in theLouvre Accord in February 1987 and that, in essence, was the end of US pressure.

How much damage did the yen appreciation cause the Japanese
economy?
Exports declined due to the yen appreciation only after 18 months (according to theJ-curve) after the Plaza Agreement, and that acted to reduce the surpluses from a very
high to a normal level. But the appreciation in 1986 coincided with oil price declines,
so the cost of production in Japan was very much reduced, providing a cushion forthe squeeze on profits. There is very little evidence that the sharp yen appreciation
had major impacts on the Japanese economy in the second half of the 1980s. Those
were the famous bubble years - high economic growth with soaring asset prices.
In relating yen appreciation (which may have been partly the result of US pressure)and the bubble, the following observation is crucially important. Monetary policy
was relaxed from 1986 to 1987, and the record-low discount rate (at that point) of
2.5% was maintained from February 1987 to May 1989, in the hope that the lowinterest rate would stop or moderate the speed of yen appreciation. Hence, it was notcaving in to yen appreciation demand but resisting US pressure (or the US "wish" tobe more precise) that made monetary policy too lax and contributed to bubbleenlargement. The logic is just the opposite of what Chinese officials and those whodraw strong parallels between the Japan and China, appear to believe to be the case
The on-and-off, 20-year stagnation has been mainly due to the effects of thebubble burst and a series of policy errors, not a slump in the exporting sector resulting
from the yen appreciation. In fact, the export sectors continue to be an engine ofgrowth, despite the yen appreciation. Exports are now a much higher proportion ofJapanese output than they were in the 1980s. That is part of what made Japan's
industrial production so fragile in the face of the global financial crisis. Furthermore,during the period of the bursting bubble US pressure was mostly helpful in urging
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quick actions to repair banking fragility.
There was only one other episode of yen appreciation that could be seen as
resulting from US pressure. Trade conflicts in 1994 to 1995 led to US frustration anda heavy-handed approach but the yen appreciation pressure from 1994 to 1995 wasmore informal than the first episode. This took the form that the yen/dollar market
reacted with yen appreciation whenever Japan resisted US pressure for numericaltargets of "voluntary import expansion (VIE)." From a macroeconomic perspective
there were no factors requiring or supporting the sudden appreciation from 100 yen
to the dollar to 80 yen to the dollar that occurred over five months during this period.
The rapid V-shape adjustment - sharp appreciation and sharp depreciation - is also
evidence that the appreciation had no fundamental basis. Since appreciation was
only sustained for such a short a period, it is doubtful that exporting sectors sufferedpermanent damage. The US demands for voluntary import expansions - in apparent
violation of GATT/WTO rules - frustrated Japan but if they caused any further miseryto the already weakened Japanese economy it was not through the exchange ratechannel.

Policy mistakes
What caused the bubble to expand and become more dangerous was the low interest
rate policy of 1987-1989. What brought the onset of the slow growth period was thebelated and aggressive tightening of monetary policy from late 1989 to 1990 wheninterest rates were raised from 2.5% to 6 %. There is still a debate about the full listof causes of the prolonged stagnation in Japan from the early 1990s but it wascertainly a complex mix of factors. Among them were the fragility of the banking
system, which suffered near collapse over a 5 year period, resulting in a credit crunchat least for small- and medium-enterprises over at least a couple of years in the late
1990s. Worse yet, problems in the banking sector were not addressed properly by thesupervisory authority in the early stages. At the same time an ageing population,
falling labour force participation and slow productivity growth hampered the supply
side of the economy while political inertia was unable to deliver significant
deregulation permitting structural change. Major policy failures, such as an aggressive
fiscal tightening in April 1997, undermined confidence at moments when recovery
might have taken off (see Corbett and Boltho, 2000). Throughout the whole of the
1990s and early 2000s monetary policy was excessively tight, as evidenced bycontinuing deflation. Though the economy faced a liquidity trap with nominalinterest rates at zero, real interest rates in a deflationary environment were high. (SeeIto and Mishkin, 2006, for a fuller discussion of monetary policies in the 1990s andearly 2000s.)

Deflation and the lost decade
Deflation has also been a chronic problem for Japan for over a decade and, oncedamaging deflationary expectations set in, credible policy becomes more difficult. It
has been argued that continuing reluctance by the US to allow depreciation of the179

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yen during the lost decades created these deflationary expectations. This is a more
subtle version of the "US pressure argument".
There are two versions of theargument. One focuses on wage setting and the other on international interest
parity conditions. In the first version an expectation of a continuously appreciating
currency requires that wage growth be moderated to maintain competitiveness, soemployers will hold down wages below productivity increases to maintain profits (seeMcKinnon, 2006). Wages and prices fall and a deflationary spiral results. But in fact
the link between currency movements and wage changes is notoriously unpredictableand the decline in Japanese wages during the 1990s is more likely to have been theresult, not the cause, of slow growth. It is virtually impossible to distinguish thecausality but with growth falling and unemployment rising to historic highs, thedownward pressure on wages was inevitable. Further evidence of the unpredictablelink between currencies and wage setting comes from Britain, where wage inflation
was expected to undo the real depreciation of sterling after the exit from theEuropean monetary system. It never happened and the depreciating currency turned
out to be a benefit for British growth. The link between exchange rate policy andwhat might happen in labour markets seems an uncertain argument on which to basea currency strategy for China that might have other undesirable consequences.
With mobile capital a similar story can be told via interest rates and international
arbitrage. Here the expectation of appreciating exchange rates drives interest rates
and price expectations down (McKinnon and Ohno, 1997; McKinnon, Ohno andShirono, 1999; McKinnon 2000). In this story zero interest rates and a liquidity trap
come not from independent policy actions by the Bank of Japan, but from theexpectation of falling prices driven by rising exchange rates. Equally plausible
however, and borne out by survey evidence, is that deflationary expectations camefrom the continuing failure of monetary policy to commit to fighting price declines
for reasons more to do with political economy than with the value of the exchange
rate. Svensson (2001, 2003) argued that the best way out of deflation and liquidity
trap for Japan does involve a depreciating currency but that can follow, rather thanlead, the change in monetary policy: "the optimal way to escape from a liquidity
trap, which involves expectations of a higher future price level, would directly lead toa corresponding depreciation of the currency. Indeed, absence of a currency
depreciation indicates a failure to induce such expectations." (Svensson, 2003, p 17).
Even if both these routes contributed to creating deflationary expectations inJapan they were a small component compared with the lack of confidence in thepolicies of the Bank of Japan. Furthermore, the "pressure" in this case was a desireby trading partners to avoid Japan using beggar-my-neighbour policies to recoverfrom recession. The concern may have been misplaced, but it is common andwidespread and is different from the concerted pressure for yuan or yen appreciation
aimed at reversing trade imbalances. A critical difference is that Japan was alreadyhopelessly mired in a banking crisis, deflation and stagnation when the yen
depreciated from 1995 to 1998, while the Chinese economy is booming as thepressure for appreciation is applied.

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The advice for China
Refusing to accept yen appreciation (not caving in to yen appreciation) was one of
the causes of the bubble economy toward the end of the 1980s in Japan. This was agrave policy error for Japan with long term consequences. So, the lesson is precisely
the opposite of the one most people take from Japan's experience. Do not resist thecurrency appreciation when the economy is booming. Keeping interest rates low andproviding large liquidity, through interventions, in order to prevent the currency
appreciation will produce a property bubble and eventual burst - a disaster. There isalready a risk that China is underestimating the extent of its property bubble (see Ito,2010). The fact that appreciation may help global imbalances is an added bonus but
need not be a factor in China's decision. China should be looking carefully andcritically at the right lessons from Japan and also at lessons from successful
appreciations which achieved precisely the alleviation of inflationary pressures andstructural changes that China needs. One such example is Australia in the 1980s.
And China should keep in mind that many of the factors that led to Japan's lostdecades either do not apply to China (which is not a mature, post-industrial economy
with no "catch-up" possibilities left) or were avoidable policy mistakes. Currency
appreciation was not the major factor.

References
Corbett, Jenny and Andrea Boltho (2000), ""The Assessment" in "Special Issue:
Japan"", Oxford Review of Economic Policy, Vol 16 , Summer.
Ito, Takatoshi (1987), "The Intra Daily Exchange Rate Dynamics and Monetary
Policies after the Group of Five Agreement", Journal of the Japanese and International
Economies, vol. 1:275 298.
Ito, Takatoshi (2010), "China's property bubble worse than it looks", Financial Times,
17 March.
Ito, Takatoshi and Frederic S Mishkin (2006), "Two Decades of Japanese MonetaryPolicy and the Deflation Problem," in Takatoshi Ito and Andrew Rose, (eds.),
Monetary Policy with Very Low Inflation in the Pacific Rim, NBER-University ofChicago Press: 131-193.
McKinnon, Ron (2006), " China's Exchange Rate Trap: Japan Redux?", SIEPR Policy
Brief, Stanford Institute for Economic Policy Research, April.

About the authors
Jenny Corbett is the Executive Director of the Australia-Japan Research Centre,
Crawford School of Economics and Government at the Australian NationalUniversity and the Associate Dean for Research in the College of Asia and the Pacific,
ANU. She is also Reader in the Economy of Japan at the University of Oxford and a
Research Fellow of the Centre for Economic Policy Research (CEPR, London). She hasa PhD in economics from the University of Michigan. Her research centres on current
macro-economic and financial policy issues in Japan, regional financial integration
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and trade in financial services. In 2007 she contributed to the Asian Development
Bank's flagship study on regional integration. Since 2008 she has been contributing
to research projects on regional integration for ERIA (Economic Research Institute for
ASEAN and East Asia) and she is a member of ERIA's Research Institute NetworksExperts Group. She is a member of the Australia-New Zealand Shadow Financial
Regulatory Committee.
Her recent publications include an edited volume withMagnus Blomstrom, Fumio Hayashi and Anil Kashyap, Structural Impediments toGrowth in Japan, Chicago University Press for NBER, 2003 and another with Anne
Daly, Hisa Matsushige and Dehne Taylor, Laggards and Leaders in Labour MarketReform: Comparing Japan and Australia, London: Routledge, July 2009. In 2006 shereceived a Commendation from the Foreign Minister of Japan for contribution toAustralia-Japan relations presented by the Embassy of Japan in Canberra during theAustralia-Japan Year-of-Exchange.
Takatoshi Ito is a Professor at Graduate School of Economics, University of Tokyo,
and a CEPR Research Fellow. He has taught extensively both in the United States andJapan in the past, including at University of Minnesota, Hitotsubashi University, andHarvard University after finishing Ph.D. in economics at Harvard University in 1979.
Ito also served as Senior Advisor in the Research Department, IMF (1994-97) and asDeputy Vice Minister for International Affaires at Ministry of Finance, Japan (19992001). He is an author of many books including The Japanese Economy, The PoliticalEconomy of the Japanese Monetary Policy and Financial Policy and Central Banking inJapan, and more than 50 academic journal articles on international finance and theJapanese economy. He was President of the Japanese Economic Association in 2004.
He was a member of the Council of Economic and Fiscal Policy from October 2006 toOctober 2008. The Council, which consists of 11 members including Prime Ministerand Finance Minister, decides the framework of the budget each year.

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