Trade War With Japan Jude Wanniski March 4, 1994

As recently as one week ago, it still seemed as if the Clinton Administration would find a way to finesse its confrontation with Japan on the trade issue. With the President's growing problems regarding Whitewater and the steady decline of popular support for his health care plan, however, the line of least resistance at the White House is in the direction of Japan bashing. The President's revival of the Super 301 provision of the demonic 1988 Trade Act may cloud the world economy for the rest of the year. 

Unhappily, a Catch-22 in the public opinion polls is driving the two most important trading partners on earth toward a collision. Because Republicans are reading the same polls as the Democrats, neither party is explaining the downside of trade warfare. The new USA Today-CNN-Gallup Poll finds 60% of Americans think Clinton "has not been tough enough" on Tokyo, which reflects the fact that they have been hearing nothing else from their political leaders. Only Democratic Sen. Bill Bradley and Republican Jack Kemp have been saying otherwise, but their voices have been drowned out by their party leaders. There was a similar situation as the stock market crashed in the last week of October 1929, when GOP leaders were blaming the crash on the Democratic Party for dragging its feet on the Smoot-Hawley Tariff Act. The free-trade forces in Congress at that time were also submerged in the public discussion.

Revival of Super 301 was as cruel and crude a diplomatic blow as we have ever witnessed by an American government to a friendly nation, a kick in the groin. It came even as the Tokyo government of Morihiro Hosokawa was preparing a package of proposals designed to pacify the trade warriors in the Clinton Administration. It can only mean that the White House doesn't wish to resolve differences with Japan, real or imagined, because it sees continued confrontation as popular politics in a dicey moment of the Clinton presidency. 

The financial markets are increasingly being forced to hedge against the possibility of a trade war, even if it doesn't come until September 30, the date when Japan would be officially targeted for reprisal. That is, if Japan is going to be exporting less to us in the future, they will get fewer dollars with which to buy U.S. goods or U.S. dollar assets. As we saw in 1929, the markets do not wait for bad news it sees on the horizon to arrive before discounting. The yen now grows stronger against the dollar, and U.S. government bonds must be priced lower to sell somewhere in the world market. An avowed admirer of Franklin Roosevelt, President Clinton now finds himself following in the footsteps of Herbert Hoover. If a trade war does occur and is severe enough, it would eliminate the Japanese trade surplus with the United States by inducing a major recession in the United States. We would simply be too poor to buy more than we sell while offering dollar financial assets to make up the difference.

As far as we can tell, there is no one even within shouting distance of the President who can explain to him that Japan's trade surplus with the United States is the residual of positive capital flows. The fact that the professional economists within the administration understand this is of little consequence. The official line is that what we are doing is forcing open a closed Japanese market, when in fact the forces bearing down upon the President are those corporate interests that want to keep Japanese goods out of the U.S. market. The arguments were identical in 1929, with Hoover describing Smoot-Hawley as free-trade legislation. There is still plenty of time to short-circuit a trade slugfest with Japan. It would help if Senate Minority Leader Bob Dole would show more concern. He seems to treat this as a foreign-policy issue and Clinton as commander-in-chief, whereas it should be treated as an economic issue with consequences at home.

The weakness in the bond market is also being fed by continued uncertainty about the intentions of Federal Reserve policy. With a prospective trade war cutting against bonds -- the dollar financial asset of choice in Japan -- Fed Chairman Alan Greenspan can only get the market back under control by reducing the risk of holding dollar assets. We decided earlier this week ["Bonds: Easy Does It," 3-2-94] that it is now too late for the Fed to deflate in order to squeeze out the inflation implied by a gold price in the $380 range. It could have been done without any damaging consequences to the real economy even last fall, but once the bond market began turning down on October 15, Greenspan began running out of room. A careful explanation is in order:

Gold began turning up last summer from its benchmark of $350 even as bonds continued to strengthen. Our explanation at the time was that the gold market is a market for liquidity, the gold price rising or falling on expectations of the supply and demand for non-interest bearing U.S. debt, i.e., dollars. The bond market is a market for interest-bearing U.S. debt. The price of gold can rise as it did with Iraq's invasion of Kuwait, expecting the Fed to accommodate a rising oil price with easier money. When the Fed does not, the gold price retreats. When the gold price began its rise last summer, it could have retreated for any number of reasons, one being a snugging up by the Fed -- which is what Governors Wayne Angell and Larry Lindsey were arguing, although for differing reasons. The bond market on October 15 could no longer ignore the fact that the gold price was not coming down, and began its retreat. In the real economy, producers of goods and services began factoring in a rising general price level, as implied by gold at $380 instead of $350. Profits margins would increase within a new term structure for interest rates. The robust statistics for the 4th Quarter reflected this burst of short-term economic activity, even as interest rates rose and the broad stock market receded. A 10% rise in the general price level over time would reduce both the real value of bonds and equities, the latter not protected against monetary inflation by indexation of capital gains.

In The New York Times today, Anthony Ramirez advises us that there can't be an inflation on the horizon, because the price of gold is steady and even inching down off its recent peak. The bond market is smarter, though, knowing that gold's advance since last summer will show up in the lagging inflation indicators -- and when they do the conventional wisdom will be that the Fed will have to tighten to combat inflation! This is why Greenspan is the only guy around who can assure the bond market that he knows the numbers will look worse down the line, but he won't deflate when they occur. Will he? If he doesn't, the bond market has to discount the possibility until the numbers show up. It has been on this cycle at least since 1971, when President Nixon broke the dollar/gold link, with the Fed always well behind the curve in fighting inflations and deflations. 

If I were Greenspan, I would tell the market that my personal preference is that the gold price rise no higher than, say, $390, and that it fall no further than, say, $350. As long as gold is within those benchmarks, the bond market could expect no change in Fed policy. The economy could grow as fast as it wants, and it is chomping at the bit, as the steady stream of positive economic news indicates. Greenspan is right when he says the fundamentals are in better shape than they have been in decades. The inflation hawks would have him tighten now, though, pushing up Federal funds and the discount rate and driving gold to $350 -- establishing a ceiling at that price instead of a floor. At this stage of the game, it would be like shock therapy. Given the burden on bonds of a potential trade war with Japan, it's too much to ask. It would be better for Greenspan to watch the gold price move after he sets the starting parameters, lowering the ceiling and/or raising the floor until the price is ready to be fixed. It might take two years, which is how much time he has left to his chairmanship, but if he got on this track, the secular bull market in bonds would resume and continue, and in 1996 the markets would demand that he be reappointed. 

If we were to suggest this scenario a month ago, we would risk universal ridicule. Greenspan, though, has since brought gold into the intellectual arena by citing its valuable, unique informational properties before the House Banking Committee. He's only one question away from our scenario: At the moment, what does he think is the optimum price of gold, or at least, in what range does he remain comfortable? He knows, I'm sure, that sooner or later some inquisitive member of Congress will put that question to him in committee, and it will not hurt to have an answer. It would go a long way to ironing out the anxious uncertainties in all the world's financial markets.