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ON JAPAN: A Deficit Difference

Author: Edward J. Lincoln, Director, Center for Japan-U.S. Business and Economic Studies, New York University
October 13, 2004
Newsweek Japan

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Like fellow contributor Steve Vogel, I have been deluged in the past several months with visitors from Japan worried that if John Kerry wins the presidential election, bilateral relations will deteriorate because American trade policy would become more protectionist. I thoroughly agree with Steve's conclusion that since U.S. trade policy will not change very much if Kerry is elected, this concern is groundless. However, in this column I want to offer a different perspective on how the election matters to Japan economically.

What concerns me is that Japanese observers of the election are focused very narrowly on trade policy, while the real importance of the election outcome for Japan lies in macroeconomics. As the largest economic partner for Japan, what happens to the U.S. economy has a significant impact on the Japanese economy. The question for Japan, therefore, is which candidate offers the best choice for the future health and growth of the American economy.

Domestic economic policy is normally a dry, technical subject that

hardly motivates voters. And certainly this year the war in Iraq has been a major campaign issue. But domestic economic policies are also stirring controversy, and the choices faced by American voters may have important implications for Japan over the next decade.

President George W. Bush successfully pursued a large tax cut as his main domestic economic policy in the past four years, motivated by a belief that lower taxes stimulate economic activity. However, because Bush did not simultaneously cut government spending, the federal deficit has ballooned to over four percent of GDP this year— from a surplus when he took office. The percentage may look low, but for this particular ratio, the change has been large and rapid. Furthermore, the Bush tax cut mainly benefited the wealthy, angering groups in American society worried about the widening gap between rich and poor. Of course, the tax cut also has ardent supporters, and the argument between the two political parties has been loud and acrimonious.

Unlike Japan, the United States does not generate enough domestic

savings to finance a deficit of this size, so the financing must come from abroad. As a result, the rising fiscal deficit has led to a widening current-account deficit, which will be over five percent of GDP this year. When the current-account deficit reached similar levels in the mid-1980s, the result was a sudden, large drop in the value of the U.S. dollar. If Bush is reelected, the fiscal policies of his first term will continue. He wants to make the tax cuts permanent while continuing to expand government spending. Therefore, the probability of a hard landing for the dollar in the near future will rise.

The Democrats argue in favor of reducing the government deficit. Carrying out their goal will be difficult since this will require higher taxes and reductions in government spending— something that is always difficult to accomplish and could cause some short-term pain in the economy. The Clinton administration faced a similar dilemma and succeeded, but the task facing Kerry is more difficult, especially since the Republicans will probably continue to have the majority in Congress. Nevertheless, Kerry is more likely to follow a macroeconomic policy consistent with the long-term health of the U.S. economy.

A continuation of the Bush macroeconomic policies could hold serious negative consequences for Japan. When the hard landing of the dollar takes place, the yen will rise significantly against the dollar, harming the major holdings of dollar-denominated assets by Japanese investors-including commercial banks and life insurance companies. At the end of 2003, Japanese investors had 15 trillion yen ($140 billion) in direct investments in the United States and a much larger 644 trillion yen ($600 billion) in portfolio investments. Meanwhile, Japanese exports will become less price competitive in American markets, harming export industries. Japan could easily be pushed back into recession should the dollar's fall be substantial.

Japanese observers of America can reach their own conclusions about the implications of the election outcome for Japan and bilateral relations. But I believe that the economic differences between the parties are significant and that Bush's macroeconomic policies would harm Japan. Of course, I am a Democrat. But I am also an economist, and my conclusions here rest on my economics training and not my political orientation.

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