American Enterprise Institute

Partners in Peril: How Will Japan's Economic Woes Affect the United States?

September 17, 2008

[Edited transcript from audio tapes] 

Proceedings:

Michael Auslin:  Good morning ladies and gentlemen.  We’d like to get started.  So if you could take your seats if you’re still coming in.  Welcome to the American Enterprise Institute.  My name is Michael Auslin.  I am a resident scholar here in Asian and Japanese Studies and I’m very pleased to be able to welcome you to a rather special event today, taking advantage of the brief presence in America of Robert Feldman, on one of his occasional visits here, to see if we could get him to come in and explain to us what was going on with the Japanese economy from a larger macro view, which is not something we hear quite as much about here in the States.  So, I’m very happy that Dr. Feldman has agreed to spend some time with us and talk about how Japan’s economic problems might affect the United States.

I think many of you in the audience who deal with these questions on a regular basis know Dr. Feldman.  He really doesn’t need much of an introduction.  But he is the director of economic research and the managing director at Morgan Stanley Japan.  He has been in Japan for over 20 years and I think it’s probably fair to say he’s recognized as the dean of Western commentators and practitioners of Japanese economic theory and policy for a very extended period.  He also has a distinguished career before joining Morgan Stanley, being both at Salomon Brothers and the IMF.

And I am equally pleased to be able to welcome, as our commentator for today, our own Desmond Lachman from AEI, who I realized, as we were putting together the bios, Dr. Feldman and Dr. Lachman have both paralleled their careers somewhat, being both at the IMF as well as Salomon and then diverging at this late stage, with Des joining us here, at AEI.  But both of them are truly keen observers of the global economy and macro conditions in both the United States, credit markets, looking at Japan as well.  So I’m sure this is going to be just a fascinating discussion.

And we’re going to start it off with Robert Feldman, who will give us his overview, and then a commentary from Des, and then both of our presenters here today were extremely interested in having a keen and robust Q&A session.  So we’re going to leave a lot of time for you to get involved here and open up a general discussion of what the economic conditions that are on everyone’s minds these days portend for both Japan and the United States.  So with that, I will turn it over to Robbie.  Thank you.

Robert Alan Feldman:  Thank you very much, Michael.  And thank you everyone for coming today.  I’m delighted at the turnout.  This is far beyond my expectations.

I’d like to talk about, essentially, three topics today.  One is the Japanese economy itself, sort of the medium term or short to medium term outlook and some structural things that are very interesting in the way the economy has evolved in the last few years.  I’d also like to talk a bit about some of the impact of global events on Japan and whether they may spur, sort of, the next phase of Japanese economic structural reform.  And finally, I’d like to talk a little bit about some of the demographics and the political response to what’s going on and what may lie down the road, particularly in terms of where asset markets in Japan may go.

So with that, let me move first to my overview slide here.  I’ve got a little structure on the front here where I’m trying to create different visions of Japan’s future.  And I think that two axes that you have to think of come down to, really, two factors.  On the horizontal axis there, I have an axis of what I call “Japan’s reaction,” whether it is an active reaction, a sort of a pro-reform active take of the -- sort of a bull-by-the horns-and-shake-it sort of reaction, pro-reform aggressive attitude on this side.

And then on the other side, the passive reform or a passive action.  For example, a couple of weeks ago, when oil prices had gone up very sharply, there was a one-day strike by fishermen saying, “We need more subsidies.”  And within a day, the LDP had caved in and given, I think, it was 70 billion yen of extra subsidies to the fishing industry.  Not bad for a day’s work.  That’s the sort of backward-looking passive response that is exemplified by what’s over on this side of the axis.  So that’s the Japan policy response axis.

The vertical axis here, and I meant it to be vertical, I must have tilted my head when I drew the diagram a little bit.  It’s not quite vertical but it should be.  This is what happens to global events.  That is, the global problems get easier, the oil prices at least stabilize, or the things just get worse.  This is an axis that Japan really has no control over or very little control over.  Those two axes essentially define environments in which Japan will be and Japanese asset prices will be determined.  The “blue sky” scenario is active reaction with global problems easing.  What I call the “shallows and miseries” quadrant is where things get worse globally and Japan just sort of sits back and is passive and accepts things.

And then on the axis, other two quadrants that is, we’ve got “Japan the fighter,” that is actively working in a worsening global environment.  And then what I call “back to complacency,” which seems to be sort of where we are right now, that is passive reaction as global problems are easing at least as they have in the last couple of weeks.

So those are the four sorts of quadrants that we’re dealing with.  And I want to leave that in the background as a sort of structure for today’s remarks.

On the economy itself, there’s a lot of spaghetti and a lot of small numbers on this table.  But I just want to point out a couple of things.  In the current Morgan Stanley forecast for Japan, we have GDP growth in the current fiscal year at 0.6.  Next fiscal year is 0.6.  These are very bad numbers.  0.6 for the current fiscal year is actually negative growth in terms of through-the-year growth.  We have a launch pad for the year that is slightly positive.  So what has already happened but also affects the growth rate gives a net positive effect.  But this basically means we have negative growth through the rest of the year.  And the recovery, in the subsequent fiscal year, in ’09-early ’10 is also very, very weak.

Now the story here is a little bit interesting.  Even with the global economic worries, Japanese exports slowed down.  Japanese imports also slowed down.  So we still have a net positive foreign contribution at 0.5 percentage points this fiscal year, 0.2 percentage points next fiscal year.  So there is still reliance on foreign trade as the support for growth.

Domestically, it’s a little more interesting.  We still have positive business investment.  And this is something I’d like to get Des’ comments on at some point.  But as the population ages, we’re going to need to have a higher capital-labor ratio to maintain output and maintain standards of living.  So what I’m claiming here is through, call it non-Keynesian factors, the capital stock will deepen as the population aging continues, and that will be a support for growth.  There’s also a little bit from the energy and food crisis as people change the nature of the capital stock, that is improve energy efficiency even more, and that would drive business investment a bit.

The problem area, of course, will be consumption.  We have consumption slightly positive in these two cases.  Even though real wages are essentially flat to declining, that implies a small decline of the savings rate as we go forward.  But they, essentially, have a flat consumption.  And that also has something to do with fear about the future.  As long as people do not see a solid future for the pension system, do not see a hopeful future for the country, it's going to be hard for people to loosen up the purse strings.  This is particularly clear among young people, where I understand the savings rates for people in their 20’s and early 30’s are up in the 20 to 25 percent range.  They just don’t want to spend money.  They’re not going abroad, they’re not buying cars because they are fearful for their future.  So that’s the consumption part of this.

One other thing on this slide that’s interesting is the gap between the GDP deflator, which we have minus 0.4 for the current fiscal year, and the consumer price index at plus 2.3.  Basically, what’s going on here is that the terms of trade shift against Japan, oil and food price movements are so large that they reduce both profits and wages inside Japan and that is reflected in the GDP deflator, which in the end, is just a weighted average of wages and profits.

The CPI of course reflects everything that people spend money on at the consumer level.  And of course, that can go up even while wages and profits are going down.  And one question I’d like to ask Des, if he can help me on the international front here, is how many countries in the world are there where we see the CPI going up, the consumer prices going up, but GDP deflator actually going down?  This might be one area where Japan is essentially unique in the world.  So if you can help me out with that, I’d be very grateful.  But that’s another thing we just have to focus on a little bit.  So those are the key things in the outlook, in the short-term outlook for Japan.

Let me go into a little bit more detail on some of these things.  One of the reasons that consumers are so worried is that employment is going down while prices are going up.  So that’s not going to do much to improve consumer sentiment.  And as you can see, it's falling like a stone.  We have actual wages per hour appearing to rise here.  That has to do, I think, with compositional shifts in the labor force rather than any fundamental things going on in the labor market.  After all, it's a little bit inconsistent to see employment going down this much and see wages per hour going up.  That’s kind of a strange combination.  What I think is happening there is that we are seeing a much smaller share of part-timers in the labor force.  They’re just falling out of the labor force.  So the people who are left, earning wages, are earning average higher wages.  But that is not necessarily the thing for the economy as a whole.  So those are some interesting data points.

Let me go on to one piece called structural news about the business cycle.  And I think it’s very, very interesting, probably true elsewhere, but also quite interesting.  If you go back and look at the 1960’s, the long Izanagi cycle in the late 1960’s, you see a very interesting structure for that business cycle.  This is the orange line in this left-hand graph.  The horizontal axis here is the growth rate of shipments.  The vertical axis is the growth rate of inventories.  Now to read this graph, you start at 9:00 on the clock face and go counterclockwise around.  And typically, a business cycle will sort of go counterclockwise, sort of around like that.  Now what happened in the Izanagi cycle was when we hit 15 to 20 percent growth rate of shipments or production, we started going straight up on inventories.  That is, firms were uncertain about whether the shipments would continue to grow.  But rather than cut back on production and shipments immediately, they just built up inventories.  And they built them up at a pretty fast rate.  Fortunately, demand came through.  They pulled the inventories down and then we went through the rest of the cycle.  So there was vertical volatility, so to speak, here.

And if you think about it for a second, that sort of makes sense because when it is more expensive to adjust production than it is to adjust inventories, you’re going to let inventories absorb the uncertainty in the business cycle.  And that’s pretty much what happened.

Now every cycle in the post-war period had, call it a similar structure, relatively large circles and essentially, when there was volatility, it was vertical, until the current one.  I nearly fell of my chair in mid-2003 when I saw what looked like a normal business cycle begin to go bad and then reverse.  In the current business cycle, we do not have up-down, up-down, up-down volatility; we have left-right, left-right, left-right volatility.  That is, instead of allowing inventories to absorb the uncertainties of the business cycle, it’s now production and shipments.  People are holding inventories essentially flat and allowing uncertainty to be taken up in production. 

Why?  Well, I think what’s happening here is that the cost structure has now reversed.  It’s cheaper for firms to allow production to absorb the fluctuations.  Why would that be the case?  Well, first of all, we now have global production networks.  So instead of not knowing where your inventories are and not knowing who to tell to cut back, it’s very easy to send an email to your factory in Sri Lanka or in the Czech Republic and say, cut back a little bit.  So it's much easier.  That is, the cost of production adjustment is lower than it used to be.  And that also probably has something to do with labor and capital market flexibility as well.

In addition, it’s also more expensive to hold inventories.  Now that might sound a little bit funny in a world where we essentially have zero interest rates or had for a long time, at least in Japan.  But it turns out the problem isn’t the interest cost of holding inventories.  It’s the obsolescence cost.  Product cycles are so much faster now that you don’t want to get caught with unused inventories because they are not only worthless, they can be expensive to get rid of.  It’s true in the auto business.  It’s true in the electronics business.  It’s true in many, many businesses now. 

So that’s why we have this very different shape of the business cycle.  This is good news because it means that we will have smaller fluctuations of the business cycle.  It may not feel very good.  It never feels like we’re really recovering.  And so everybody always feels like they have bad news and things aren’t very good.  I’m expecting the “Good morning” or “Ohayou gozaimasu” to be replaced by “Keiki warui, ne?” or “Gee, business is bad these days, isn’t it?”  So we may have new “Good mornings” sometime soon.  But basically, this is good for the economy.  And the reason I think it’s good is it allows firms to spend more time thinking about how they allocate resources than about what they do with their inventory levels.  So that’s a fundamental piece of good news.

I mentioned the inflation outlook as well.  This brings up a very interesting theoretical point, which is do we really have inflation, when the CPI is going up by 2.3 percent but wages are, if anything, flat to falling in real terms, and the contributions to the CPI change are so focused on a small number of components?  Overall, CPI change in the latest figures, I guess this is July, 2.3 percent.  Is this inflation or not?  I would claim no, it's not.  And the reason I say it's not is that essentially, we’ve got autos, that is the gasoline component; utilities, the energy component, and food, essentially, the grain component, going up, essentially contributing all of the 2.3 percentage points, where everything else is basically flat.

I would claim that this violates an economic theory, grounded definition of inflation, which is essentially, all prices are moving together.  All prices flow in the economy, including wages.  So to me, what’s happening with the CPI now is an indication of deflation, not inflation.  And I’ll leave it to Des to comment on that.  So that’s basically what I have to say about the real economy.

Let me talk a little bit about global impact on Japan from various sections.  I think Des is going to talk in somewhat more detail.  It was very interesting to me to see the reaction when then Minister Watanabe went to Davos in March of this year and said, “Guys, don’t make the same mistakes we did, as I look on the financial system.  As I look at what’s happening abroad, I see some of the same mistakes being made.  Please learn from us.”  The response he got was, “Who, us?  Make the same mistakes you did?  No, no.  We’ll never do that.”  It was almost like they were insulted by the contention that the U.S. or Europe could make the same mistakes that the Japanese have made.  Well, now, more the story is out, and it's clear that some of those same mistakes were made and some of the lessons that Japan’s experience had to teach are actually being incorporated in the way that the U.S. and European authorities, particularly in the U.S., are responding to actions.

One of the things I think is important is that these difficulties that we’re having, as in Japan, stemmed from lenders, borrowers, and regulators.  So everybody has to keep their feet to the fire.  That’s the lesson, one lesson from Japan.  We have a different situation in some respects.  The BIS rules are well in place.  Everybody knows what Tier 1 and Tier 2 Capital is now.  Everybody knows that you have to measure potential losses against the capital base of financial institutions when you want to look at solvency.  These are important steps forward that will help us at least understand where we are on the court, so to speak, as we deal with the issues that come forward.

Another issue that was very serious in Japan was the issue of moral hazard versus market stability.  And this is always very hard to figure out.  It’s always a, sort of, a one step one way, another step, another way.  But I think, as I look at what’s happened globally now, things are beginning to get the right balance.  Japan didn’t even have a word for moral hazard in 1990.  Nobody would use the phrase.  It simply did not exist.  The phrase that’s in the dictionary sometimes is [speaking Japanese], but that’s kind of a bizarre translation.  Now people just say, “moraru hazado.”  But it’s kind of there.  People know what it is.  You don’t have a problem with that in the U.S. right now.  People understand what it is.  So I would say that some of the lessons from Japan are well understood.

Des has some stuff about Case-Shiller in his presentation as well.  When I put the data together, this is a real house price index and this is for residential.  The Japanese peak was higher than either the Case-Shiller or the OFHEO peak.  But we’re about two years into the process.  And the key thing at this point, which I think Des also has pointed out, in some of his written work, is that we establish a floor price for where housing is going to go.  That’s what got Japan out of its troubles. 

In the early 2000’s, after the Takanaka plan was introduced in October of ’02, we could finally get the real estate out on the market and establish a floor price so we knew what the losses would be.  And in the end, the taxpayer in Japan was a big beneficiary of the bailout of the Japanese financial institutions.  The Japanese government, that is us, the taxpayers, put a lot of money into Japanese financial institutions in return for a preferred stock or a sub-debt, basically, and made a good profit on it.  So that is a lesson that I think is now being incorporated in the way others are responding and it’s a good thing to happen.  The taxpayers are now, in Japan, I would say relatively happy.

One thing Japan did not do was take the workout all the way to the regional financial institution level.  So there are still some issues with the solidity of regional financial institutions.  But I would argue that those issues are less financial sector issues, although they are financial sector issues, than they are issues about the sustainability of regional economies.  So, one of the things I’ll be looking for, in upcoming economic measures, is whether we will see say agricultural reform or other structural reforms that will help the regions realize their economic potential.  So that’s also part of the reaction.

Let me talk a little bit about the food issue and how Japan is reacting or should react to that.  One of the structures I used to look at the food issue, that’s a very simple demand-supply diagram or Japan’s [inaudible] equation in grain.  We have grain demand and grain supply.  Grain supply is essentially the amount of land used times the output breaker or productivity or yield, so to speak.  There isn’t a lot more agricultural land in the world.  There’s just not that much more out there that can be used.  So that’s not going to go up very much.  But there is a lot of room to improve yields.

A colleague of mine told me that the output per acre of wheat in the Ukraine is 1/7th of the level in Western Europe.  And the issue there is pretty simple stuff, like infrastructure and development of hybrid varieties, just sort of better seeds.  That stuff can be done.  And it’s not like it’s hard to do, you just have to focus on it and get it done.  But it takes time.  So I think there is room for supply increase on the right-hand side of my equation but it’s just going to take some time.

On the left-hand side, I have demand.  And when I think about demand for grain, I think of it this way.  Partly, it’s due to population, which will continue to go up, globally.  Partly, it’s due to meat per person.  It takes a lot more grain to produce a pound of meat than it does a pound of grain.  And then there’s also the issue of how much grain used for different types of meat.  That’s a technical coefficient.  What we know is that the population will continue to rise.  As living standards continue to go up, meat per person will also rise and that will happen quickly.  So basically, demand is outstripping supply and that’s why we have agricultural prices or grain prices, in particular, stabilizing at higher levels relative to history.

And what does this mean for Japan?  Well, there are a couple of things.  One global implication which also will impact Japan is in a paper I did a couple of months ago called “Buy Chicken.”  The Japanese title was “Tori [speaking Japanese].”  One of the cleverer Japanese puns I have ever come up with.  It works pretty well. 

The basic idea here is just to go back to that demand equation and say let’s assume for a minute that we only have a certain amount of grain.  Supply is fixed.  Then you say population is going up and meat per person is going up, we have to do something to get the meat or the grain used per kilogram of meat or per pound of meat down.  Now we can’t ask the cows to eat less.  That’s not going to work.  So what we have to do is shift the composition of meat consumption toward less grain-intensive meats.  Now one way to do that is move away from grain-fed beef to grass-fed beef, but that takes a little more land, which we kind of don’t have.  So the real answer here is to move away from beef and pork, which are about a third each of the global demand, toward chicken.  So chicken is the Prius of the meat industry.  And if you look at the Japanese chicken industry, it’s pretty inefficient.  So there’s a lot of room for improvement in the way meat is produced and distributed in Japan.

Another issue is the efficiency of food production inside Japan.  I did a couple of diagrams here looking at the food industry.  This is a Japanese comparison, to Japan to Japan, over time.  I took listed food companies, of a given size, and I have a little comparison here of operating profits rate.  That is the margin, the operating margin, on the horizontal axis, so five percent, ten percent, whatever.  And on the vertical axis, that’s the horizontal axis, sorry, is the operating efficiency.  Vertical axis is asset efficiency or the return on assets.  And so that’s what this plate looked like in 1987.  That’s what it looked like in 2007.  It’s not very different. 

So there has been a lot of turnover inside the industry but the overall rates of return have really not improved.  So that’s an opportunity that we can take advantage of as grain prices stay high.  As the world agricultural trade changes in nature very deeply, this is an opportunity to reorganize the Japanese food industry to become more efficient.  What I hope to see happen is for this cloud to move to the northeast.

Now let’s do a little international comparison as well.  There’s a wonderful Bloomberg function called PVSP or Peer Valuation Scatter Plot.  And you can get different comparative groups, et cetera.  I did this for Global Brewers.  And so I did basically the same graph, operating profits over sales and return on assets.  The green dots are the global group of brewers.  And the black J’s are the four Japanese firms that are in that group, as defined by Bloomberg.  The Japanese companies are not really in a very good position.  Their operating profit margins are low, their return on assets are low.  And what this means, basically, is that there is enormous room for improvement in the Japanese industry if it moves up toward global norms.  So there is growth potential there.

Let me move a little bit now into the longer-term demographics and a couple of Japan issues.  This is an equation that is very similar to the one I was using before on grain.  And it’s one I’ve been using for what is it now, probably 15 years, on Japan.  Top line, output equals output per worker times number of workers.  So no rocket science there.  And the second line, I’ve just divided through by the population.  So you have Y/P, output per person in the country equals output per worker or productivity times labor, as a share of the population or the participation rate.  So standard of living, Y/P, equals productivity times participation.  We know the participation will fall.  It always reminds me of that scene in the movie Titanic.  They just hit the iceberg and the captain of the ship is talking to the architect, the ship’s architect.  And the captain says, “Isn’t there anything we can do?”  And the architect says, “She’s made of iron and she will sink.”  And that’s what’s going to happen to this participation rate.  There’s a lot that can be done to keep people in their 60’s in the labor force.  It should be done.  It is being done but it’s just not enough.  So that means that maintaining the standard of living is fundamentally dependent on raising productivity levels.

Now is that going to happen?  Well, we don’t know.  And that’s what the political debate, it’s going on right this minute as we talk, is about.  We have two political parties in Japan, neither of which has a basic economic philosophy.  And so what we have to figure out is what is going to happen in this political debate to make us choose the scenario of growth.  I outlined those four quadrants on my front page.  And this is sort of what the numbers look like.  The black line here is what happens to the labor force over time on the right-hand axis and numbers of people.  It goes down.  We’re looking at something like 0.7 percent per year decline of the employment, just from pure demographics.

If that’s going to happen, and growth, overall growth is growth of labor plus growth of productivity.  If that’s going to happen, we’re going to have to get a productivity growth rate that is improved over recent performance in order to maintain standards of living.  Now historically, through the ’80s, the called ten-year average growth or productivity was about three percent.  Higher in earlier years, but that was catch-up.  So three percent in the ’80s, about one percent in the ’90s, and it’s come up over the last four years after the Koizumi Takanaka reforms up to about one and a half.

What’s really at stake in the current political debate is whether we go back to the 1990’s and go back to productivity growth rates that are similar to what we had then or whether we go back to the ’80s with an aggressive reform program that at least gives us some hope that we go back to the three percent growth rate, as suggested by my graphs from the food industry, to be possible.

What are the different outcomes?  Well, “blue sky” is if we go back to three percent for our productivity growth rate.  Complacency is if we go back to the 1990’s.  But those aren’t the only two things to think of because remember, oil prices and grain prices are fundamentally higher now than they were before.  So what I’ve done about that is to create called somewhat subdued scenarios where I take half a percentage point off the overall growth rate of productivity to take into account the impact of the worsened terms of trade.  And I’d like to ask Des for his comment on whether half a point is enough or not.  It’s just something I thought would be a reasonable guess.

But basically, either we’re at three, we’re at two and a half, or we’re at one or one half, these are very different scenarios because remember, we’re losing 0.7 per year on the labor force.  If you translate these numbers into what they mean for GDP, it’s very different.  And that’s what the political debate today is really about.  We’ve just had the Democratic Party go into a negotiation with the Anti-Postal Reform Party, that is, the so-called People’s National Party, to incorporate the PNP people into the DPJ.  So basically, the DPJ, which ought to be a pro-reform party, is not.  They have people all over the map and they’re bringing in clearly anti-reform forces into that party. 

The LDP has the same group of forces inside itself.  Both of these parties are essentially all over the map.  This is what I often use to describe what I’m talking about.  This is a philosophy map: big government versus small government, active foreign policy versus passive foreign policy.  We can get to define that a little bit later on.  But the LDP is kind of all over the map, at least in terms of economic policy.  They’re mostly active foreign policy guys.  But they’re all over the map on economic policy.  The Democratic Party is even broader in the different philosophies of its different components.  So if you’re a Japanese voter, you got a problem.  When I talk to a Japanese audience, they’re always very sympathetic, and I’m sympathetic with them.  If you’re a Japanese voter and you go in to the voting booth and you vote for Party X or Party Y, do you really know what you’re going to get?  Koizumi won a landslide in September ’05 on a reform platform.  The LDP was elected very strongly and now we have the LDP moving in exactly the opposite direction.  So who do you vote for?  This is not so easy.

What has to happen here is that there essentially has to be a fundamental realignment of the political parties.  And what we don’t know is what’s the trigger and there are different things that could be the trigger for that and we don’t know how big any of those new parties it’s going to be.

The trigger could come in a number of different forms.  Postal reform is certainly one.  If the new LDP leadership decides they’re going to postpone the postal privatization, that could cause a firestorm inside the LDP and it could break up the party.  Other things in the DPJ could do the same thing.  So there will be some kind of event that triggers a breakup.  Who knows, in the next general election, my guess, and it’s just a guess, is that neither the LDP nor the DPJ will win a majority.  And that can also be a trigger for a blowup of the two, on a reorganization.  Once that happens, we still don’t know how big any of these different groups is going be.  And since we’re only going to have three groups, that means there are only two combinations that are possible for a coalition government.  None of those parties, I believe, is going to be big enough to control both houses. 

So we’re going to have to have a coalition government of some type.  We could go back to call it a Koizumi-type coalition, where you have my small government active foreign policy guys in control and a few guys from the old right coming in because they want to keep their seats.  You could also have a coalition of the old left and the old right, essentially going back to the Murayama Government.  That’s a perfectly possible outcome. 

So if you’re sitting in financial markets and you’ve got to do something to discount the different policy outcomes, it’s not so easy.  That’s why I think fundamentally, Japanese financial markets are in -- call it cold storage, at the moment.  People don’t really know what’s going to happen globally but they even more don’t know what’s going to happen domestically, and so that’s why we’re facing the, call it a structure, that we’ve got at the moment.

So let me end things there and turn it over to Des and then we’ll have, I hope, a lively Q&A.  Thank you.

Desmond Lachman:  Thank you very much, Michael, for inviting me to comment on this and thank you very much, Robbie, for your presentation.  What I propose to do is take a more global approach to this, to look at Japan within the structure of what is going on globally.  And when I do that, I’m afraid that I’ll come to a somewhat a gloomier assessment of where Japan might be headed in the short run than Robbie.  And I might also suggest that deflation is likely to come back to Japan.  I think in this sense, very much what is going on in financial markets is quite interesting, from a United States perspective, where we’re looking at an election campaign where candidates are talking about long-run issues when the truth of the matter is that come January 20th, they are going to be confronting the most difficult economic situation that this country has faced, probably, in the last 70 years.  And any idea of a long-term structure reform, good as that might be, is going to have to take a backseat to how exactly do you stabilize this economy?  How exactly do you clean the banks out?  How exactly do you get this economy going forward?

What I propose to do is just mention briefly how the United States economy could be affecting the global economy in general and Japan in particular.  That is the first set of remarks I’d like to make.  Then I’d like to just move on to the reasons why I think that the crisis that we’re facing is likely to deepen.  Aside from all of these rescue packages that we’ve had at the last few weeks and the shifts in policy, I don’t see that as doing that much to stop the fundamental forces working in the U.S. economy and affecting the global economy.  And finally, I’ll come back to just saying a word or two of how I think this affects Japan.

Now of course, developments in Japan affect the United States but it’s a little bit like Newton’s Law of Gravity that the size of the country has a greater impact on a smaller country then the other way around.  And I think that that is reflected perhaps as well in the trade patterns that you’ve got.  Japan, if you see from this first chart, that the United States is their principal export market.  The other principal markets are Europe and China.  But then, if things go wrong in the United States, things aren’t going to look too good for either Europe or China.  What we’re already seeing is we’re seeing that the European economies are having negative quarters, the second quarter, that this is warning that the third quarter is not going to be too hard either.  And we’re seeing China slowing as well. 

Look at the point of view from the United States.  United States’ main trade partners are Canada and Mexico and Europe.  Japan only accounts for something like six percent.  So the first way that I’d say that the United States can affect Japan is basically through the trade channel.  And if you get a slowing of the United States, that’s not going to be too good for Japanese exports, particularly given how dependent Japan is on its external sector to provide demand.

There are other ways though that the United States can affect global markets.  We’re seeing this in terms of financial market developments.  I’m struck by the strong correlation between the ways in which stock markets, the world over, are behaving in relation to the United States.  We’re seeing, if I look at Japan, the Nikkei is trading now down something to 11,000.  It has lost something like 30 percent at the time that the U.S. lost 20 percent, so financial market developments in the United States are important, and of course, in the credit markets, all the more so.

Japan, of course, is going to say that they don’t have a subprime problem.  But I couldn’t help but be struck when one saw who were the principal holders of Lehman Brothers’ debt.  You had a whole bunch of Japanese banks taking losses on the Lehman fiasco.  So I think that that channel works.  So that would be the second channel.  It would be a financial market channel.

A third channel would be the commodity channel.  And I think I would disagree with Robbie in terms of the inflation story.  What we’ve seen is that as the United States has slowed, as Europe has slowed, as the world has slowed, we’ve just had a major commodity price bust.  That oil prices which got as close as $150 a barrel, something like two and a half months.  The last time I looked, they’re trading at something like $95.00 a barrel.  That is a third decline in a very short space of time.  And if I look at food prices, the picture is not very different.  And metal prices, we’ve really just had a commodity bust.

So the notion that inflation is a problem for the global economy, certainly, in the United States and Europe and Japan, really boggles my mind because going forward, what we’re going to have is we’re going to have a weaker economy keeping core price inflation lower and we’re going to have non-core price inflation, which is food and energy, is going to be negative.  So what we’re going to have in the same way as we had headlined inflation above core we’re now going to have to reverse.  And I think that in Japan, this could be a problem because if I take what Robbie is saying, is that excluding food and energy, we’ve got prices declining.  Well, if food and energy, if I’m right, that food and energy are going to stay at this level, the next year, we’re going to see Japan having significant negatives on its headline inflation, which given Japan’s history, is not too good a thing.

Let me just mention a fourth factor, the way in which the United States can affect the Japanese economy, is basically through the exchange rate channel.  And here, what we’re seeing is that as the world financial markets come apart, the famous carry trade is being taken off.  Now what the carry trade, all it means is that people are borrowing in yen in order to get the high yield of more speculative currencies like the New Zealand dollar, the Australian dollar, any of this commodity-kind of currencies.  Well, that is what caused the Japanese yen to weaken when those trades were being put off.  But what we’re seeing is as those trades are taken off, we’re seeing the reverse process. 

So to cut a long story short, the Japanese yen that not too long ago was at roundabout 125 yen to the dollar is now 105 to the dollar.  So that’s another deflationary force.  It’s not going to be good either for Japanese export prospects that we’ve got the Japanese yen at something like 20 percent above where it was before and we’ve got this feeding through to deflation.

Let me go quickly to the reason that I’m pretty sure that we’re in for trouble not only in the United States but in the global economy at the next couple of quarters.  And that’s because I think that there’s a confluence of very negative shocks are hitting the U.S. economy right now.  The two shocks that I really want to talk about are of course the greatest housing market bust since the Great Depression and secondly, the credit crisis, which I noticed both Paul Volcker and Alan Greenspan, chairman of the Fed, who should know something about the matter, what they’ve been indicating is that this is the worst crisis that they’ve seen in their lifetime.  It reminds them of the 1930’s.  Greenspan, I should just parenthetically say, has the gall to say this, as if he had nothing to do with the problem in the first place.  But having said that, you’ve got really serious credit crisis going on, so the question is either the housing market crisis or the credit crisis, are they likely to attenuate anytime soon?  And I’ll establish that that is not the case.

But what I would like to mention, as well, is that the two additional shocks, the one shock is that stock markets now, globally, seem to be somewhat in freefall.  And this chart is a little bit dated, but if you look at the chart, you see that asset prices have gone down in the United States by something like ten percent in the last few months, which essentially, what it’s doing is when you take that together with the home prices and the bond prices, that’s wiping off something like 40 percent of United States’ GDP.

Just briefly, in terms of the reason that the house prices are unlikely to stabilize anytime soon, is we’ve had these prices falling by something like 16 percent.  You’ve got the -- forward prices are telling you that the home prices are going to be declining by another ten, 15 percent going forward.  And one shouldn’t be surprised when one sees what’s happening with enormous quantities of unsold inventories, that’s the red line is we’ve got 11 months excess supply on the market.  And what we’ve got right now is we’ve got an alarming increase in foreclosures.  And there’s no reason to expect that that declines as credit conditions are tight and as we’ve got unemployment and employment conditions being very much worse than they were before.  So I think that going forward, what we’re going to see is house prices continuing to decline, which is going to complicate the problems that we’ve already got in the financial market.

Just in terms of the credit crunch, I think that this chart tells us quite a lot.  Basically, what this chart is doing is it’s telling us globally that banks have already written down something like $500 billion in terms of loan losses.  That is the chart on the left.  Yet the chart on the right is telling you that they’ve only managed to raise $350 billion in capital.  And that, really, is the essence of the credit crisis, that the reason why, if left alone, it has to worsen is that the banks, in order to try to raise the additional capital, what they’re doing is they are either reducing their loan portfolio or they’re selling assets.  And by so doing, they’re just compounding losses further on.  So that as they try to reduce their balance sheets, what they do is they increase the losses, which means that they now have to raise more capital, which means that they’re just having to sell off more assets.  So they’re in a vicious cycle.  This is just a very classic debt deflation process.  And I don’t see any reason that that declines.

What it’s leading to that is not very healthy is first, credit conditions that the banks just don’t want to loan money.  What you’re seeing in this chart, their intention is they don’t want to lend money.  And the second chart is just, in terms of bank credit now, if you just look at the red line, it’s contracting at the fastest rate in the past 50 years.  So we’ve really got a problem in terms of a global credit crunch, in terms of a United States housing bust.  And I think that that impacts on the Japanese economy.

Let me just conclude by pointing out that if you look at Japan’s growth, 2007-2008, you see that a fair amount of that is coming from the net exports of Japan.  So, if you do have exports grinding to a halt, as I expect that they will, you’re really going to get the Japanese economy slowing.  Robbie raised a question, in terms of his forecast, is he’s assuming that investment is going to be increasing in Japan at a rate because they’ve got certain demographic needs, certain structural needs.  I would view this rather differently.  I would say that in a cyclical context, if you are going to be getting a negative shock on the export side, you are going to be getting spare capacity all over the place.  I would think that investment turns down in that kind of environment and that what it does is it really compounds the recession.

This chart is really just indicating the export growth going with what we’ve seen as being pretty rapid.  I assume that that is going down.  So I would just repeat the point that I’ve made before is that U.S. economic outlook suggests that you could get commodity price deflation.  What that could do is it could cause deflation within Japan, which is not going to be too constructive.  And the exports are likely to get a hit very hard by both slowing of the United States economy and an appreciating export sector.  So in short, while I agree with Robbie qualitatively, in terms of his forecast that this is really going to be a rough period for Japan going forward, I think I would just differ in terms of degree.  I think that you could see a very much sharper contraction than he has, in his forecast.  Thank you.

Michael Auslin:  Des, thank you very much.  Before we open it up for Q&A, Robbie, would you like to respond at all to what Des brought up?

Robert Alan Feldman:  Sure, yes.  Thanks.  A few things, if I may.  One is on the question about the issue of pessimistic versus optimistic.  I have this little model that I have been using for years called the CRIC cycle, which, to me, is sending signals right now that we can’t be terribly pessimistic for too much longer.  So if I may, I’d just like to talk a little bit about that model, and then make a couple of other short comments.

Michael Auslin:  It’s also on Page 20 in your handouts from Dr. Feldman, Page 20.

Robert Alan Feldman:  There are basically two relationships between growth and reform.  Growth here is meant to be a variable showing the state of the economy, so where we are.  And reform is what we do about it, so a control variable, so to speak.  So the first relationship I have here is what I call the economic response curve, that is growth responds to reform but it takes a little bit of time.  So it’s upward-sloping but there’s a time lag involved.

The second relationship is the reform response line, that is, economic policy, particularly structural reform policy, also responds to the state of the economy but negatively.  The better things are, the less reform there is.  And that’s because we’re all just human.  You can see this in the United States.  You can see it in Japan.  I could see it when I was dealing with my blood pressure problem a few years ago.  It’s exactly the same issue here.  So that’s where my CRIC cycle comes from.  That’s Crisis Response Improvement and Complacency.

Now we’ve just gone through a number of crises around the world.  I believe that the U.S. response has been a bit on the slow side but it's certainly faster than it was in Japan.  And that’s why when I see things going on at the pace that they are going on in the United States, it says to me we are still in a crisis phase but we’re entering a more aggressive response phase.  There are political issues that need to be dealt with.  If we wanted to establish an RTC quickly, that’s not going to be very easy because of the Congressional schedule.  So what do you do?  Do you get the two presidential candidates in a room and say, “Guys, we got to do this now.  What can you guys both support that we can do now under current administrative authority?  And then when one of you two guys gets an office, then we’ll go ahead with the legislation for it.”  That’s the kind of quick response that we need right now, but at least, that sort of idea is beginning to come to the fore.  Then you have improvement for a while and complacency and you keep going around.

So the reason that I’m a little more optimistic than Des is, is that I have this model sort of glued into my mind from the Japanese experience of the 1990’s and the early 2000’s when we went through these cycles repeatedly.  So that’s one comment.

A second one, on the issue of whether deflation comes back to Japan, I don’t think it’s coming back to Japan.  I think we never got out of it.  The question in my mind is does it come to the United States?  And that has mostly to do with the strength of the policy response.

On the issue of gravity and Newton, it’s a good model but I think Des’ trade data also suggests that it’s the wrong model because this is not a two-body problem.  It's a three or more body problem, which is very, very difficult to solve and essentially has to be done, as far as I know, still by numeric methods.  So we have to sort of think of the global economy in a very different way, which is a multi-body problem.

On the issue of oil declining and a bust in commodities, I don’t see a bust.  Five years ago, oil was $30.00 bucks a barrel.  Today, it’s $95.00.  What bust?  Yes, it shot up to $150 because of various reasons a couple of months ago and is back down.  Maybe speculators pushed it down as well as pushing it up.  That’s also possible.  But I don’t see a bust.  And that’s also true I think for the commodities, the other commodities, the soft commodities.  So we can argue about that.

On housing in the U.S., I think there is something very -- an interesting parallel here that the United States, through various legal and structural issues, did with housing what Japan did with commercial real estate in the 1980’s.  It just overbuilt to an extraordinary degree and to a very inefficient degree.  When I see 4,000-square foot houses in the U.S., I say, “Huh?  Why would anybody want to buy something like that?”  You got to heat it.  You got to commute from it.  This just doesn’t make sense economic sense to me.

And so what the U.S. is going through right now is getting used to the idea that we don’t have so much non-performing loans as we have non-performing assets.  It’s the distinction that Glenn Hubbard made a few years ago and I think it’s a very important distinction to make because we overbuilt in the housing sector, in the U.S., and we’re going to have to come to a new valuation of those assets that sort of bring some back into more productive use.  And I don’t know how that plays out.  What happens to those 4,000-square foot homes?  Do they get broken up and rebuilt into two 2,000-square foot homes?  That’s going to be a big adjustment.

But the sort of thing that happened in Japan in working out the commercial real estate problem, and partially the residential but more commercial, the same thing is going to have to happen here in the U.S.  So let me end my rebuttal there.

Michael Auslin:  Thank you, Robbie.  We’re perfectly on time.  We have about half an hour for a robust discussion.  We do have a microphone that will be coming around.  So I ask when I call upon you, please wait for the mic.  Please introduce yourself then please do ask a brief question so we can get in as many questions as possible.  That said, however, I will take the moderator’s privilege and ask the first question.  I’m Michael Auslin from AEI, just to set the standard here.

Robbie, I’m wondering if you could very briefly, and I appreciate you bringing in the political aspect near the end, in particular, the real world effects of a lot of this.  I’m wondering if you could sketch out what, in your view, would be the two or three key structural reform policies that were either dropped after the Koizumi period and need to be taken up again or were not taken up in the first place?  Because it seems in a lot of the initial political problems that Abe and Fukuda faced was not coming up with any concrete plan that could be sold to the public.  So if you were in that driver seat, what are the two or three things that need to be done to start turning this around?

Robert Alan Feldman:  Thanks very much.  If I could ask people to look at Page 22 in the handout, I think I’ve got about 30 or 40 on that page.  When you said that it was the inability of the Abe or Fukuda governments to come up with and sell any reform plans, I don’t think they had a problem coming up with things.  There was a lot of stuff, if you read the minutes of the Council of Economic and Fiscal Policy, a lot of things were being proposed.  The problem was on selling them.  And I don’t think either Prime Minister Abe or Prime Minister Fukuda did as aggressive a job as they should have done in selling and forcing some of these new actions.

As to what should be done going forward, there is a bunch, which are listed here.  If I had to go through these and just mention a few that I think would be quite important, one would be an open sky agreement with the EU or the further opening or quick opening of the Haneda-Hong Kong route.  Nakagawa Hidenao’s plan for ten million immigrants, I mean, I nearly fell of my chair when I heard him say this in public.  Ten million immigrants in Japan, and he wants them.  You don’t hear senior politicians talking a lot like that, but there it is.  Okay, good.  And he is saying that because he’s hearing people from constituencies say, “We need these people in here now.”

I got called down to a little, essentially, a hospice in Kyoto a few months ago and they wanted to ask me about how to lobby the government so that they could set up a nursing care school in the Philippines and bring in nurses.  And the reason they’re doing this is they’re seeing people die in hospitals because they can’t get good nursing care.  This is something that doesn’t make your constituents happy.  So therefore, we’re seeing a lot of push for that kind of immigration reform.

Agricultural reform, same thing.  People were very scared, very scared in March and April this year when they saw grain prices going through the roof.  And Japan is so heavily dependent on global agricultural markets.  There is only one solution to that for Japan, which is to raise domestic agricultural productivity.  And that cannot be done without a lot of plot amalgamation, a lot of huge reform of the way that the Ag business works in Japan, not just growing but also distribution.  So there is a lot that could be done there.  For example, abolishing what they call the “nogyo inkai” or the small regional committees that basically have a say over who can sell whose land to whom.

I think the Sovereign Wealth Fund idea is still a very interesting and important one.  Japan actually has had a sovereign wealth fund for many, many, many, many years.  It's called the Fiscal Investment Loan Program.  It just didn’t work very well.  And so making that work more efficiently is something that METI is pushing right now through a very innovative and interesting idea for an innovation corporation, without going to details.

A lot to be done in civil servant reform.  Do you know how many people Japan has overseeing the approval of medical devices?  30.  A grand total of 30.  This is in a country that’s aging rapidly and is going to need a lot more in that area and they have 30.  Next question:  Do you know how many people there are in the Hokkaido Development Agency?  Five thousand eight hundred.  There is a misallocation here and it’s got to be corrected.

Let’s see, a lot to be done in tax reform.  I think separating the National Tax Authority from the Ministry of Finance is probably a good step forward.  NTA has begun to work more actively in getting private sector input into the way taxes are designed.  That’s a good step forward, but a lot more needs to be done.  We have to reallocate seats in the Upper House.  Why is the Upper House so much more conservative than the Lower House?  It’s because they never really did a serious seat reallocation for the Upper House.  And we need to cut seats in the National Diet, both Houses, quite substantially.  That really works on the hustings these days.  People love it when you say that.

We could have a national E-education project, Super Mario teaching calculus.  That one is necessary because we don’t have enough teachers anymore.  There are not enough students either.  But certainly, the teacher issue is very, very serious.  And animation and educational software is something Japan is pretty good at, and a lot of people are working on that now.  I would love to see, if there are any experts on education in the room, whether there have been studies here, for the U.S. or other countries that create essentially a production function for the education biz.  That is, how much capital, how much labor, how much technology is necessary to create a better outcome in education?  I don’t know of a lot of studies and the education experts I’ve talked to don’t know a lot of studies like that.  If we could find something like that, that would be, I think, immensely helpful in figuring out just how much money we want to spend on education and where we should spend it.  So any educational software developers I think have a good future.

Medical reform, same kind of idea, and a lot of little ideas.  Closing low-use facilities.  I talked to a heart surgeon a couple of weeks ago, just for a regular lunch.  It had nothing to do with anybody I know.  This is a guy, a Japanese guy, who went to Germany and got a German doctor’s license after getting a Japanese doctor’s license and set up a clinic there, which was one of the most successful heart surgery clinics in the country, in Germany, came back to Japan a few years ago.  And he discovered that the capacity utilization rate for heart surgery facilities in Japan is something on the order of 15 percent.  And the mortality rates, even the stated mortality rates, which in Japan, are probably understated, are double what they are in Germany.  So the capital is being misallocated, the services are not very good, and in addition, the doctors don’t get enough practice.  So that kind of stuff also has to be addressed.  So there are lots and lots of things that could be done.

Michael Auslin:  Great, thank you.  We are now open for questions from the floor.  So if you’ll raise your hand, we will call on you.  And again, please wait for the mic.  Yes sir, right here in the middle.  Can you keep your hand up so our assistant can find you?

Hideki Wakabayashi:  Thank you very much for your presentation.  My name is Hideki Wakabayashi.  And I agree with you that none of the parties will get the majority for the next election and we are likely to see the simultaneous election between [indiscernible]

Michael Auslin:  Can you speak up a little please?

Hideki Wakabayashi:  And I think a coalition will be the next target.  And DPJ and the Komei Party will make the next coalition.  It could be, I don’t know.  But do you see any impact on the stock market and how do you see the economic situation how it’s going to -- how are you going to see this kind of political turmoil after the coalition we will make?

Robert Alan Feldman:  I think that the stock market probably doesn’t care who is running the government.  What they care about is what the government does.  And if we can have Nixon going to China, we could have Ozawa shifting back toward a very aggressive reform policy.  But it’s kind of hard to see that happening, given everything that he’s said in public so far.  So I think the markets are going to wait and see.  But they will not give any slack.  That is, they will not give the new government any benefit of the doubt because they have been disappointed too many times.  So I think we’re going to have to look at the manifestos that are published by the different parties.  And then once the governments take office, we’ll have to look at the personnel that go in the different slots. 

So for example, if this PNP coalition with the DPJ is done and then Mr. Kamei from the PNP comes in as the new Minister for General Affairs, the “soumudaijin”, that’s a signal about where they want to go with postal reform.  And so the markets will respond first to the manifestos, but then to the personnel, and what the markets are looking for is an environment in which earnings can grow.  And so that’s the basis on which I think the response will be done.

Michael Auslin:  Other questions?  Yes, over here. 

Ira Shapiro:  Ira Shapiro with Greenberg Traurig.  I have sort of a two-part question that both the speakers might address.  The first part is kind of as a former trade negotiator and someone who follows trade, my supposition basically, frankly and this is an admission against interest, but my supposition is that what we’re seeing in the global economy at the moment really has quite little to do with the success or failure of trade negotiations.  Namely, the Doha Round which has gone on for so long and has been such a disappointment, it was a part of the backdrop when the global economy was looking rather healthy, and it’s part of the backdrop now.  So my supposition is it doesn’t have a whole lot to do with the other things that are at work.  So I’d like you to comment on that.

But the second question is more, sort of, generally about the coupling of the U.S. economy and the global economy.  Within recent memory, like six or eight months ago, perhaps ten months ago, the global economy looked pretty robust.  You could read about -- in Economist, you could read reviews that suggested it was the only time that everything in the world was moving forward, including the developing countries.  And now we’re facing a rather severe -- well, facing a terrible situation here but a severe situation around the world, slowing down. 

So my question is, is the coupling of the U.S. economy and the world economy, is it still that we’re the locomotive more than we might have expected?  Or is it just that our financial failures, and particularly the subprime failures, have really infected a lot of the global economy?  So that’s kind of two questions.

Desmond Lachman:  Yes, let me talk to both of those questions.  As a trade negotiator, I think I would be rather depressed that the Doha Round failed in a good global environment.  I think that historic experience would tell you that in a bad global environment, you’re not going to have too much of a constituency for wanting trade liberalization.  I would have thought exactly the reverse.  That my concern is that as the United States’ economy really goes into recession at the same time that Europe is in recession, this isn’t going to be too good for the Chinese who are expecting to export an additional 30 percent each year.  So I think that you’ve already got something like 60 bills within Congress to deal with Chinese exports. 

But I think that there would be a greater fear about is globalization that great an idea?  We’re in recession.  We’re losing jobs et cetera.  All of the kind of things that we had in the ’30s, I would expect them to manifest themselves right now.  That I think that protection, I didn’t mention that as a risk, but I think that that is something that one really has to be concerned with.  I’m very concerned with when I listen to the presidential debates within the United States, that certainly, amongst the Democrats, that there was a lot of appetite for doing something about keeping markets open.  They really wanted to turn the clock back.  And I’m suggesting that if we do go, if I’m right that we do have a recession in the fourth quarter of the year, something that is more akin to what we had in the early 1980’s, rather than your run-of-the-mill recession, it’s going to be a problem for trade.  Because what’s occurring is that you’ve got this occurring at the same time in the United States as in Europe.

The European, or should I say the coupling, I was always skeptical of whether we could de-couple from the largest economy on the globe that has always provided, as you say, the locomotive for growth, something like the United States total 25 percent.  Its current account deficit is really what’s been fueling growth both in Europe and abroad.  They’re not too good at encouraging domestic demand.  So they rely very much on the United States.  What we’ve had is we’ve had -- the United States has had -- and incredibly, if I look at Europe, the Euro, going from wherever it went, originally, it was at 82.  It landed up at 160.  That’s not too good for European exports and that’s what you’re already seeing right now is that European exports are slowing abruptly because of too strong a euro.

But what the United States has been very good at exporting is toxic waste in the form of subprime mortgages.  That if you look at the Federal Reserve’s numbers, their estimate is that there’s something like $800 billion of the subprime toxic waste that is sitting in banks abroad that it’s mainly European banks, and I showed you a chart which showed that whereas the United States banks have so far recognized something like $250 billion in loan losses, what you’ve got is you’ve got the European banks that have recognized something like $230 billion, so tightening credit conditions are there.  So I think that there are very many reasons why we’ve got global coupling.  I should also mention the oil issue should come back to that. 

I don’t think -- I think that when oil runs up to $150 barrel, when people are talking about $200 a barrel and when oil comes back down to $90.00 a barrel, in the same way as the run-up of oil to $150 a barrel caused United States inflation to go up from something like three percent to five and a half percent, I’m suggesting that going forward, what we’re going to see, if we look at the next 12 months, if oil stays at these levels the next 12 months, what we’re going to see is United States inflation, at most, at something like one percent.  I don’t understand the inflation fetish at the Fed right now, when the United States economy already -- the financial market is looking as if in a meltdown.  I would highly recommend an article this morning by Paul Volcker on the financial market in the Wall Street Journal just indicating that if things don’t get done, if we don’t move to resolution trust quickly, this is really going to be very ugly.

Robert Alan Feldman:  I’m basically in sympathy with those answers, but let me just add one thing.  In the context of my CRIC Cycle, when the global economy is going per-flooey, do you go toward a restricted trade or a more open trade?  This is a leadership decision.  There’s going to be a response of some kind.  Whether it's a good response or a bad response, that’s a matter of, I think, leadership.  And the issue about whether we go back to the 1930’s or have the same kind of response as occurred in the 1930’s, actually, I think Smoot-Hawley was 1928, wasn’t it?  I forget exactly.  When was Smoot-Hawley?  [Cross-talking]

Male Voice:  Thirty four.

Robert Alan Feldman:  Thirty four?  Okay, thank you.  But anyway, let’s call it the ’30s.  The problem with going back to the ’30s is that they were followed by the ’40s, which weren’t so good, at least for the first five years.  And to the extent that people still understand that, then I think we’re more likely to at least keep things more or less under control.  One thing, if you read McCain’s essays, is that he’s very clear about that and that he thinks open trade is the way to keep the world a more peaceful place.  And even if you look at Obama’s positions, they’re not really very different.  I mean, he says a few things about NAFTA here and there, but he understands this.  So I think that probably, we have learned the lessons of that period.

On the issue of infection versus locomotive, that’s a very nice word, infection.  I like that word.  The question is do you want a well-connected network globally which always has the downside that when one part of it shakes, everything else shakes too?  Or do you want a disconnected network which if there’s a shake in one place, it doesn’t shake anywhere else but the gains from trade are lost?  That’s the decision that we have to make.  I’m in favor of infection.  And the reason I say that is that the more we get to know each other, the less likely that the infections that occur in different places will cause a systemic problem.  The books that I like on this are Rats, Lice, and History and Plagues and Peoples.  They basically talk about -- call it a biological metaphor for this sort of thing.  I mean, for example, would you not send your kids to kindergarten because they might pick up a cold they’ve never had before?  That’s what happens when kids go to kindergarten.  They come back with all kinds of diseases.  Pardon?

Male Voice:  And then you get them too.

Robert Alan Feldman:  And then you get them too, right.

Male Voice:  There is a common carrier.

Robert Alan Feldman:  Yes, common carriers, yes.  So do you not send your kids to kindergarten because they might come home with a disease?  And the answer is no.  Of course you send them to kindergarten.  This process, I think the contagion that we see in financial markets is probably a cost of the prosperity that trade brings.  And I still think it’s a good trade.  So at least, that’s my view of it.

David Asher:  I have a question.  This is David Asher, Medley Capital.  Robbie, do you see much chance that Japanese are going to take advantage of the heaven-sent opportunity of low yen, long-term financing, strong yen versus the dollar, and cheap U.S. asset markets to increase their merger and acquisition activity in the United States?

Robert Alan Feldman:  We’ve seen a few signs of it already.  There are some Japanese financial institutions that have gone abroad already to buy things and we just did an offsite with some of our large clients in Japan, where the people in the room said that they really thought that their companies really ought to do more of that.  And so yes, they are relatively well capitalized.  They have a few problems that are -- the contagion problems.  But they’re well enough capitalized that they can do that and they do see the opportunity.

The next question I asked was would you personally walk up to the CEO of your company and recommend that the company do something like that?  And we didn’t get nearly as high a yes component on that as we did people who thought it would be a good idea but they just didn’t want to say anything about it.  But what I see from the evidence, and I like this stuff to be evidence-based, is that actually, they are going out a little more aggressively, at this point.  So I think the answer is probably yes but they’ll be a little more cautious than they were, say in the 1980’s.  Thank goodness.

David Asher:  Robbie, to follow on that, in your concrete ideas for reform page, unless I missed it, I didn’t see a call for increasing foreign direct investment in Japan, which was both a political goal of the past couple of prime ministers, including Prime Minister Fukuda, who wanted to double it but Japan lags dramatically behind, I think, peer countries in that.  Can you talk about that a little bit?

Robert Alan Feldman:  Yes, I think the FDI Initiative is alive.  It’s one of the things that Minister Ota wanted to push and Prime Minister Fukuda agreed to that.  They did a nice report a few months ago.  I think we’re still teetering on whether it’s a good or a bad thing in the public mind.  Maybe I should have put it in here.  I can add it, certainly as a part of this.  But I don’t think that FDI itself is going to be the catalyst for this.  I mean, I think it might be a catalyst in one sense, but if Japan is going to raise say the productivity in the food industry, it’s probably going to be Japanese who do that rather than foreigners. 

Since Japan is still a cash-rich, current account surplus country, it doesn’t strike me that it’s necessary to have foreigners come in and do that if domestics finally gets some incentives through better corporate governance rules to get that job done themselves.  I’m very much in favor of foreign investment in Japan.  I think it stirs things up.  And certainly, the Japanese public, in general, kind of likes the idea because they are not too happy with the management of their own companies themselves.  It does belong on the list.  I should probably add it on.  But again, I don’t think it’s the do-all and end-all.  I think it’s more incentives for Japanese managers to behave more rationally with the resources that they have.

Michael Auslin:  We have time for a few more questions.  So are there questions?  Yes, Tom?

Tom Oku:  Tom Oku of Bank of Tokyo-Mitsubishi.  A question about the future of investment banking industry.  Looking back ’97-’98, in Japanese four major security houses, Yamaichi is gone, Nikko is under Citi, and Daiwa is under Mitsui-Sumitomo Bank.  Nomura is independent now.  And what happened in the last couple of weeks or in this year, the top five, among top five investment banks in U.S., [indiscernible], and Merrill Lynch is under Bank of America, so only two remains.  But my question really is not just the future of investment banking business but whether it's appropriate to have more regulations.  It’s not over a discussion about should be more investment banking business or derivatives or whatever should be much more regulated to protect customers, protect the financial system.  But what happened in Japan is the last ten years, more and more regulation by FSA and something wrong with consumer interest rates and it’s called [indiscernible].  It’s the depression caused by the much or inappropriate regulations.  So Dr. Feldman, what do you see or what would be appropriate for U.S. regulation on financial industry, particularly on investment banking business?

Robert Alan Feldman:  I’m not an expert on that issue, certainly not for the United States.  I’ve written a lot about it for Japan.  I think the issue with regulation is not more or less.  It’s, call it time appropriate, that is, do we have people who are running the system and redesigning the regulatory structure, who understand how markets work and how they’re evolving?  One of the reasons that Japan got into so much trouble in the 1990’s is that the regulatory structure had fallen so far behind the needs of the economy at that time.  And I think, certainly, there is a consensus in the U.S. that the regulatory structure was highly Balkanized, too many little regulators all over, doing too many different things, and that was one of the reasons that we got into the trouble we did.

The distinction I’d like to make in analyzing different regulatory structures is one that was actually proposed by a Democratic Party member, an Upper House member who’s actually an old colleague of mine.  And what he said is that there are really three ways to do this.  One is what you’d call, I guess, the SEC model or the U.S. model where you have a given regulator for each particular market.  So the SEC is in charge of the securities industry, a couple of guys, they call it the Federal Reserve and Treasury and maybe some state guys in charge of banking, each state in charge of insurance, et cetera.  So that’s called an industry-by-industry regulatory model.

Then you have call it the U.K. model, where you have one guy who is in charge of design, another guy who is in charge of oversight, and a third in charge of, call it adjudication.  So you essentially split up between legislative, administrative, and judicial functions.  But each of those functions covers all of the industries.

And then the third is called the Japanese model, where you have all three functions for all industries in one big pot, and that’s the Japanese model.  My view is that the U.K. model, at least so far, has probably been the most successful.  It adheres to the idea of separation of powers so you don’t have one guy being sheriff, judge and jury over everybody.  And one of the issues that’s often brought up by my Japanese counterparts is they just don’t feel comfortable going to the FSA in Japan and discussing the future of the industry or regulatory problems that might be coming along because they’re always afraid that somebody else in the FSA somewhere else is going to use that information against them.  So it has been not really very good for the quality of the regulatory structure.  Back in the old days, they could go out drinking together and kind of get things, get the information across.  They can’t do that anymore. 

But that said, I think the U.S. needs to think very seriously about whether we want to move from a vertical to a horizontal or a U.K., FSA-type situation.  I think my personal view is that, at least on evidence, is a more effective solution.  But we have to design it in a way that we have people involved who really are talking with markets closely and creating incentives that get us to the right place.  So that’s where I think we need to go.

Desmond Lachman:  Just to add something, your question might be a hypothetical question because there are not too many investment banks still standing.  But assuming that we do have investment banks continuing, there has to be regulation, just in the sense that you can’t have them, the investment banks, having access to the Federal Reserve’s discount window in a free manner without regulating them like you’re regulating the commercial banks.  Otherwise, what you’re doing is you’re just creating another model of a government-sponsored entity where what we’re doing is we’re privatizing the profits and socializing the losses. 

So, so long as you’ve got that window open, you’ve got to have regulation.  The fear of course, I think that the issue of regulation is going to be a much wider issue than just the investment banks.  I’d be amazed if there’s not a backlash against financial markets in general.  And the real fear is that we’re going to make the same mistake as we made in the wake of the WorldCom-Enron busts with Sarbanes-Oxley; that we’re going to go from a situation where we had no regulation to a situation where we’ve got too much regulation. 

What we’re looking for here, in my view, is the golden mean.  Markets require a certain amount of regulation.  You don’t want excessive regulation but, if anything, then we should have learned from what had gone on the last couple of years is the Federal Reserve being totally asleep.  I don’t think they were asleep at the wheel.  I think they were comatose at the wheel.  While this party was going on, they weren’t regulating at all.

Michael Auslin:  We have time for one more question.  A question from the audience.  One more.  Jim, did you have a --?

Jim Fatheree:  Yes.  Jim Fatheree, U.S.-Japan Business Council.  Tom stole my thunder on how the United States could go around hectoring Japan or other countries about emulating our financial regulatory model and that sort of thing.  But I’ll ask a quick one in terms of the much debated consumption tax.  The previous instances in which Japan has hyped the consumption tax, the timing has been notoriously bad.  I gather that Mr. Aso has perhaps put that off into the future sometime, but I wonder if you could comment on that, and more broadly, with consumption in Japan being so feeble, why they continue to focus on those kinds of things as revenue raising measures as opposed to some other alternatives which actually might not be so harmful to consumption?

Robert Alan Feldman:  Just to add, I was not aware that anybody ever thought the U.S. had a good regulatory model for the financial system.  If anybody can show me a statement that says that, I’d love to see it.  On the consumption tax, certainly, what Mr. Aso has said would tend to postpone it.  The question is, how do you raise revenue in the long term in the face of this demographic issue?  Because we do need more revenue.  We can’t just keep piling up the deficits.  I’m not aware that Mr. Aso has come up with a structure or a solution to that, but he just thinks the timing is wrong, so let’s wait.

If you look at other parts of the debate, you see, “No, we should not do this yet.”  But what we do need to do is generate a reform agenda that will raise growth fast enough to generate more tax revenue.  Or there are some ideas floating around right now to end double taxation on dividends, which allegedly, if things work out right, would be net tax positive.  So there are some alternatives.

Why they’re harping on this, at this point, that is keeping talking, continuing to talk about the consumption tax hike, I think that has a lot to do with a lot of economic policymakers who don’t know a lot of economics.  They come from the law faculty and they don’t really think about growth.  They just seem to think of the economy as a buy-in.  If you take more in tax, then everything else will stay the same.  So it’s kind of a lack of, to me, economic common sense about why that’s still happening.

What it does point out though is that there is a real problem in people trying to figure out what the tradeoff should be between taking more in taxes and say other, say growth factors that affect other policies that affect other people in the economy.  Do you want to take money away from consumers in general to pay old people who already get a very, very large portion of total welfare cost?  This is a difficult political tradeoff.  So I think that’s why the question is still in front of us.

As far as I can tell, a consumption tax hike doesn’t work very well when you still have, what is it, 30 million pension records that are still lost?  Et cetera, et cetera.  So I think that in effect, the growth group has won that debate in terms of not doing the consumption tax until we get the reforms.  What the growth group has not won is the debate about whether to do the reforms or not.  So we’re still at an impasse on that particular one.  But I do not think they are going to hike the consumption tax before they get some growth policies in place because the population or the voters just won’t let it happen.

Desmond Lachman:  If I could just add something, I think that it would be economic madness to be raising taxes at a time that the economy is getting shocked abroad and going into a downturn.  This is something that you really don’t do in a downturn.  If anything, what you want to do is ease fiscal policy.  The reason that I’d be -- what adds to my pessimism about Japan’s long-run outlook is that, effectively, Japan doesn’t have the policy instruments to deal with negative shocks that interest rates have run up about half a percent.  It’s very difficult to make them negative interest rates.  You run out of room on the monetary policy side.  And at the fiscal level, with a large deficit, with very high debt ratios, why the United States will engage in deficits spending to get the economy moving again, it’s something that Japan doesn’t have.  So if Japan does get shocked the way in which I think it is going to get shocked, to me, it doesn’t look like it’s got the instruments that a normal country has got to cushion the blows that you’re going to get from abroad.

Robert Alan Feldman:  If I can add to that, in one sense, this is a debate between call it Keynes and Solow.  That is, I agree with Des that Japan does not have the macroeconomic tools to deal with a downturn.  The tools they do have are growth tools.  That is, there is a lot they could do to foster higher CAPEX just by making structural changes in the economy.  So I think it’s the growth agenda, that is, call it the Solow agenda, that needs -- is their only hope for getting the GDP growth rates up a little bit, but even for maintaining living standards.  So it’s sort of Keynes versus Solow.

Michael Auslin:  Well, I think it’s clear why Robbie Feldman is held in such high esteem on both sides of the Pacific and can also make all of these, not only intelligible but interesting, to us hard-power types who don’t often get the chance to delve into what’s going on with chicken feed in Japan literally.  So Robbie, thank you so much for your time.  We know it’s very limited when you’re here in the States.  Des, thank you for your insight and thank all of you as well for taking time out of your morning.  And please join me in thanking our two panelists.

[Applause]

[End of transcript]