The Baker Crisis: Howard and Jim
Jude Wanniski
March 31, 1987


The BLAME for the trade war against Japan begun by the Reagan Administration lies with the President's Chief of Staff and with his Treasury Secretary. Howard Baker did not push for the Pearl-Harbor penalties dropped on Japan. But he did permit the clownish team of Japan bashers, Clayton Yeutter and Malcolm Baldridge, to run over him. Donald Regan, who had held Yeutter and Baldridge in check, would have modified the 100% tariff levies, knowing the implications for the financial markets in such blatant trade pugnacity. H. Baker's neutrality gave the protectionists a major victory, one not easily undone.

The even more serious problem is with the Treasury Secretary, who had the worst week of his six years on the RR team. As chairman of the Economic Policy Council, he let the Y-B team do their dirty work without a murmur. But worst of all, in the first test of the Feb. 22 Paris agreement at which he had agreed to defend the dollar/yen ratio at 150 he totally wimped out. As today's news analysis by Peter Kilborn of the NY Times (p. D5) certifies, Baker folded up, waltzing away from the 150 floor as if he'd never heard of it. It was Japan's willingness to deflate the yen to 150, to pacify Baker and congressional protectionists, that brought on the tensions over semiconductors: The Japanese chip manufacturers had built a huge inventory of chips expecting normal demand from an expanding Japanese economy. As domestic demand collapsed in Japan's deflated economy, U.S. chipmakers forced the US-Japan agreement of last summer, wherein the Japanese government promised that their private chipmakers would not sell at cut-rate prices. The pressure to unload the chips produced leaks to a grey market beyond the government's control. With Treasury officials knowing this to be true, they still stayed mum while Yeutter and Baldridge dropped their bombs.

Now, the Japanese have been hit from both sides. They have been punished for not keeping an agreement that couldn't be kept by a US government that has waltzed away from an agreement it made that can and should be kept. With Japanese industries that use semiconductors already battered by the high yen, adding tariffs to their problems simply increases the global chip surplus!

The largest downside risks are unlikely, but too dangerous to ignore. Japan could conceivably embargo exports of semiconductors altogether, flattening many US industries except those that are largely self-sufficient in semiconductors, IBM and TI. Japan may find a means to capitulate in insignificant ways that allow U.S. hardliners to save face. Yet Japan does not have to retaliate in order to hurt U.S. agriculture or to reduce Third World exports. Rising unemployment in Japanese export industries will do that. Japanese who own US stocks and bonds, as well as Americans who own Japanese stock, will suffer a loss of wealth and liquidity due to the "trade war risk premium" in world securities prices. With US assets thus marked down, the investment demand for dollars falls, dropping the dollar and raising interest rates.

What should the administration be doing? Secretary Baker should be defending the Paris agreement, mustering the resources necessary to push the dollar/yen ratio back to 150. The Bank of Japan has to be willing to push yen into the currency markets without draining domestic liquidity. And the Fed has to be willing to push up the Fed funds rate by at least 25, perhaps 50 basis points, to signal the US government's determination to defend the dollar. Our confident bet is that the markets would love this show of determination by Treasury/Fed to hold the 150 rate, would see it as a salve to the Japanese, politically and economically, would run up stocks and bonds, and send gold back to $400.

The Fed would be willing to do this, and is undoubtedly debating these points in the FOMC meeting even as this is being written. But the FOMC is not as confident as I am that the markets would enjoy seeing the dollar defended with higher short rates. It would help if Treasury would take some of the risk, with Jim Baker reaffirming a determination to set 150 as the yen floor. The markets this morning opened strongly, we think because of rumors that Baker was going to do so. His mid-morning statement about the dollar having fallen far enough (at 145) was another wimp, and the markets sagged. It's hard to see how Baker can ever regain his credibility among his fellow finance ministers and on Wall Street absent a successful defense of the Feb. 22 Paris accord.

Where has Richard Darman been in all this? JBIII's alter ego has to share the blame for the performance of his partner this past week. Darman, distracted by family and career concerns for several weeks, has allowed Baker to be unduly influenced by the American bureaucrats at the IMF who believe in devaluations and by congressional leaders who have also been sold the idea that a 120 dollar/yen would be just dandy. Will this go on?

I do have a tendency to look for blessings in disguise, and have found one here, just possibly. The ferocious response of the markets to the incipient trade war was wonderful to behold. The cold bath at minus 80 was so clearly connected to the threat of protectionism that it chastened many folks who were thrilling to that Siren Song. Clayton Yeutter, on the "MacNeil-Lehrer NewsHour" last night, was not smiling as he was when I saw him Saturday night at the Gridiron dinner in Washington, boasting of his trade victory. He could only assert that the markets were wrong, as his Smoot-Hawley forbears did in 1929-30. (In January, Julian Snyder's "Moneyline" was asserting that unlike 1929-30, protectionism now would be great for stocks and bonds!)

The market plunge has thus strengthened the hands of those whose resolve may have been weakening or whose attention may have been drifting. Surely the President will look with less confidence on the recommendations of the Yeutter-Baldridge team, with Regan no longer around to hold them in check. Howard Baker's skills as conciliator should now lean in the direction of finding a peaceful solution to the trade war. Darman, we know, seems revived and anxious to get this under control, getting the bull market back on track, using the crisis as an opportunity to push past protectionism. But there's no more room for mere speechmaking. We've got to see the White House, Treasury and Fed coordinate and effect a positive action plan with 150 yen and finessing of the 100% tariffs a minimum --  or we will get deeper into the soup.