The Sun Also Rises

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TREVOR GREETHAMIf official reports are to be believed, Japan was the world's strongest economy in the first quarter of 1999, growing at an annualized rate of 8%. To put this in perspective, that's twice as fast as the U.S. economy expanded over the same period and four times the rate of growth seen in Germany. Although some have their doubts about the sustainability of this surge, there are solid reasons to believe this is not just a flash in the pan. A major change in global economic leadership could be about to take place, with the U.S. economy slowing into 2000 while Asia recovers.

Investors have been pessimistic about Japan because they expect a strong yen to push it further into recession while deepening a deflation that has choked off domestic consumer demand. But Japan is not Sony. It is a big, closed economy like the U.S. with exports accounting for just 10% of GDP. Yen strength hurts Japan no more than dollar strength hurts America.

And contrary to the conventional wisdom, a strong yen can help Japan to recover. The Bank of Japan is far more influenced by the exchange rate than the Federal Reserve is. When the yen is strong, as it is today, the Bank of Japan tries to weaken it. It sells yen on the foreign exchanges and expands the money supply in Japan by printing more yen. It was just such a monetary expansion that led to the upturn in 1996, and, as long as the yen stays strong, could see Japan continue to grow much faster than expected into 2000.

If the yen weakens too much, the authorities stop printing money. This explains why the Japanese upturn in 1996 was so short-lived. The government tightened fiscal policy by raising the consumption tax and reined in government spending. The Bank of Japan also effectively tightened monetary policy. Broad money growth fell from 4% in real terms in 1996 to just .5% in 1997, to stem the yen weakness because it was causing trade friction with the U.S. and China.

Instead, the monetary clampdown had the opposite effect. The yen wasn't weakening because Japan's monetary policy was too loose; it was losing value against the dollar because the economy was a mess and Japanese investors were moving their money offshore. The more the economy collapsed, the more the yen plunged. Rather than pump money into the economy and get things moving, the Bank of Japan intervened to defend the yen and choked off the liquidity needed to break the recessionary spiral.

This time around there is every reason to believe that both fiscal and monetary policy will remain loose. On the budgetary side, the government is unlikely to raise taxes in what could be an election year for Prime Minister Keizo Obuchi. More importantly, the yen is now strong. In February the Bank of Japan announced plans to expand the money supply to offset yen strength. Broad money growth was strong in May. Recent intervention by the Bank of Japan to weaken the yen suggests this policy is still very much in force. Every leading indicator for Japan points to further economic strength in the second half of the year.

That is just what the Clinton administration has been demanding from Japan, but Washington may suffer the curse of the dream fulfilled. Japan's recession and the East Asian collapse have been very good news for Wall Street and the U.S. economy. Cheap Asian imports coupled with lower oil prices, a function in part of lower energy demand in crisis-hit East Asia, have helped cut U.S. consumer price inflation by half. The U.S. bull market of the last 20 years has been about falling inflation, falling interest rates and rising stock valuations. Since Thailand's 1997 devaluation the Standard & Poor's U.S. stock index is up 50% on relatively flat earnings per share.

But now Japan is recovering, the price of oil is halfway back to its 1996 highs and U.S. inflation figures are trending up. The Fed has already reversed one of last year's quarter-point interest rate cuts. Most analysts expect that to be it for the next 12 months, a mere tap on the brakes. Indeed, the Fed has indicated it has no intention of raising rates in the near term. But if Japan's economy surprises the world with its growth and Euroland demand firms up, a rising oil price could put upward pressure on U.S. inflation as it did in 1987. The risk must be that the Fed raises rates more than once to slow the economy and ease inflationary pressures.

That could mark the end of America's great bull market and in turn might finally derail the U.S. economic locomotive. But a U.S. slowdown could make Japanese recovery all the more likely if it causes the dollar to weaken. After the Fed raised rates in 1994, the dollar fell 25% against the yen as Japanese funds sold their U.S. assets and brought the money home. If history repeats itself, the Bank of Japan may need to print much more money to keep the yen from strengthening and that would mean more good news for Japan's depressed economy. If these trends continue, the baton of global economic leadership could be about to pass from the U.S. to Japan. What a surprise that would be.

Trevor Greetham is Global Strategist with Merrill Lynch in London