An Executive Summary -

It is understood on Wall Street that strong stock and bond markets in the United States of America are supported by the money from Japan, and are the pillar of the current consumption boom of this country. Since the net inflow of foreign money must equal the trade deficit by definition, the Wall Street wisdom is proclaiming that our perennial economic expansion is the result of our rampant trade deficit. However, such a notion is in direct contradiction with the standard economic models in which trade deficits are always assumed to be negative and trade surpluses are assumed to be positive to the economy.

An elaborate analysis has revealed that the basic assumption of the standard economic models with regard to the effects of trade balances is a vast oversimplification. In a matured economy where both labor and capital are nearly fully deployed, the economy can be boosted momentarily by the excessive imports which in essence is to borrow from foreigners to fuel the consumption boom; excessive exports can suppress the economy in the short run by pushing away domestically consumable goods and services to foreigners. Under a normal condition, it is the role of currency markets to check the imprudent attempt to use a trade deficit to boost the economy. The currency of the excessive importer will be punished severely and its economy ruined so that the process of accumulating a large trade deficit will be stopped. However, the role of currency markets as the policeman can be nullified by artificial manipulations of powerful central banks; the anomaly that an excessive importer becomes richer and an excessive exporter becomes poorer can be sustained for a long period of time. The economic crisis in Japan and the unusual economic prosperity in the United States of America are merely the manifestation of this artificially created anomaly, which was introduced by the reckless monetary policy of the Bank of Japan.

It is natural to ask why the Bank of Japan has created such an anomaly to mainly punish Japan herself. The monetary authority of Japan is simply following the standard economic models which claim that trade surpluses are positive to the economy. Japan has introduced super low interest rates to deface (i.e. devalue) the Yen, and thus has boosted her trade surpluses, hoping that the rapidly rising positive trade balances will lift her economy out of the anemic growth rates of the early nineties without the painstaking efforts of correcting her long term structural problems. Unfortunately the reality is just opposite from the economic models when it comes to the effect of trade balances, and Japan is caught in the trap created by herself.

The correlation between the weakening Japanese economy and the exploding trade surpluses can be demonstrated explicitly by data as shown in Figure 1 of the full length article, and is reproduced here. The anticorrelation curve between the growth and the trade surplus in the figure is a true correlation curve which constrains Japanese economy; as one parameter moves the other follows and vice versa. Such reversible correlation or anticorrelation relations are common existence in natural sciences, but are not widely accepted in economics; we need to note clear difference between such reversible correlation relations from the non-reversible gedanken curves commonly used in standard economics. Japanese authorities certainly understand that as their economy slows, their trade surplus will increase as implied by the standard economic models. However, they have failed to notice that in an anticorrelation relation empirically established as in the Figure, the reverse is also true, that is, as the trade surplus increases, the economy will slow down. As they started to deface Yen through their super low interest rate policy, the trade surplus surged, and Japanese economy slid down into a deep recession.

How will this crisis in Japan be resolved? The currency market will be the key. The artificial manipulation by the Bank of Japan to deface the Yen is against the natural trend and will invite sharp reprisal from the market sooner or later. The sudden reversal of the fortune of the Yen and the Dollar in August of 1998 is a good example. In that case, the ripple effect of the defacement of the Yen hit Brazil and triggered heavy losses among speculators who engaged in "Yen carry trade", and forced them to buy back Yen in a panic. Ironically, it is the strengthening of the Yen that has caused an economic recovery throughout Asia. Currently, Japanese authorities are again trying hard to deface the Yen to sustain her trade surplus, and as a result it will nullify the stimulative policy of Japanese government, which will prolong the agony of Japan. We should expect the tug of war between the market and the Bank of Japan to continue, but the market will win in the end; at that time the Yen will rebound sharply, the Japanese trade surplus will decrease, the Nippon economy will bounce back, the trade deficit of America will shrink, and the U.S. bubble will finally burst. Until that eventual outcome is realized, we should expect a very unsettled currency market, with violent reversals in the fortune of the Yen and the Dollar shocking stock and bond markets from time to time.

The unabridged version of Dr. Chih Kwan Chen's brilliant analysis may be seen at:
www.forcastglobaleconomy.com

Dr. Chih Kwan Chen

3 May 1999