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Is Trade Between the United States and Japan Off Ballance?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1994
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CONTRARY to popular views, an IMF study shows that Japan’s current account surpluses are a reflection of trends in saving and investment rates rather than predatory behavior of Japanese producers and government. Moreover, Japanese trade patterns appear to be as responsive to market forces as those of other major industrial countries.

“If the [trade] balance would be in favour of France, it would by no means follow that such a trade would be disadvantageous to England…. If the wines of France are better and cheaper than those of Portugal, or its linens than those of Germany, it would be more advantageous for Great Britain to purchase both the wine and the foreign linen which it had occasion for of France, than of Portugal and Germany....Nothing can be more absurd than this doctrine of the balance of trade, upon which almost all [trade barriers]…are founded.”

Adam Smith, The Wealth of Nations.

As in Adam Smith’s time, many view trade balances as a sign of national power, score cards in the conflict between nations. Japan’s manufacturing trade surpluses, in particular, have caused much consternation in the United States. Many policymakers and commentators blame US trade deficits on barriers to imports in Japan, predatory behavior by Japanese producers, and overly dedicated Japanese workers. Japanese commentators often respond with criticisms of US work habits and the US educational system. Although they disagree on the validity of these various incriminations, most economists would view them as largely irrelevant to the determination of overall and sectoral trade balances. There is legitimate controversy over the degree of openness of the Japanese market, but this has little bearing on trade balances.

What, then, are the factors behind overall and sectoral trade surpluses and deficits and what is the alleged role of Japanese barriers? Economic theory suggests that trade balances by sector are influenced by both macroeconomic and microeconomic factors. The overall current account balance is determined by macroeconomic factors, namely the level of aggregate demand in relation to output (or equivalently the relation between saving and investment), as well as the degree of international capital mobility. Shocks to aggregate demand and supply are transmitted to the current account through real exchange rates and relative outputs, although the former operate with a substantial lag.

At the microeconomic level, sectoral trade deficits and surpluses are influenced by comparative advantage: those sectors with particular advantages relative to other industries and other countries—in the form of either higher productivity, lower costs, and government aid—will tend to be net exporters even when a nation’s overall trade balance is zero. Those at a comparative disadvantage will, of course, tend to be net importers. But sectoral trade balances also reflect the macroeconomic factors discussed above, as the overall current account balance must manifest itself in individual sectors. In particular, real exchange rate changes alter absolute advantage (i.e., the competitiveness of all sectors is affected simultaneously). For example, if the US dollar appreciates in real terms, industries in which the United States has a comparative advantage will experience declines in their sectoral surpluses, and some may even move into deficit, while sectors where the United States has a comparative disadvantage will suffer greater deficits. The combined effect of these sectoral effects is a larger overall current account deficit.

Overall current account balance

The most meaningful measure of a country’s net international transactions is the overall current account. The merchandise trade balance omits the increasingly important role of trade in services. Bilateral trade balances should not be a cause for concern, as the quote from Adam Smith suggests. To update Smith’s example, Japan could have a bilateral deficit with oil-exporting countries, while it has a surplus with the United States, all of which reflects Japanese comparative advantage. The popular fixation on bilateral merchandise trade balances is therefore misguided on both counts.

The current account balance of a country is identically equal to the difference between national saving and investment, and is also equal to the net lending or borrowing of that country. For example, a country with a current account deficit is necessarily incurring liabilities or selling off assets to finance this deficit, and its investment exceeds its saving by an amount which is equal to the funds raised from other countries. These net capital flows could have favorable effects through a more efficient global allocation of resources over time. The creditor countries receive a higher return on their saving than they would if confined to domestic investment opportunities, whereas the borrowing country is able to obtain funds for investment or consumption at lower costs than otherwise. If the country’s investment prospects are attractive due to a strong outlook for long-run growth and sound policies, the resulting net capital inflows (and current account deficit) can be regarded as a sign of national strength rather than weakness. On the other hand, if the current account balance reflects an unsustainable consumption boom caused by inappropriate macroeconomic policies, it is likely to be detrimental. The welfare effects of current account balances cannot be assessed independently of their overall macroeconomic context. This article will not attempt to pass judgment on US and Japanese macroeconomic policies, however.

The US current account deficit swelled in the mid-1980s and then receded steadily until 1992, when it began to increase again. At the same time, as Table 1 shows, the Japanese current account balance followed the opposite pattern, rising sharply in the mid-1980s, dropping until 1991, then increasing again in 1991 and 1992. The trade balance shows more pronounced movements for both countries than the current account, because the United States has an increasing surplus and Japan an increasing deficit in private services that more than offset the net decline in US investment income associated with the increasing net debtor position. Unilateral transfers associated with the Gulf War also contributed to a temporary reduction of the US current account deficit.

Table 1Deficits and surpluses Trade and current account balances(annual averages, billion dollars)
1970–801981–831984–871988–901991–92
US current account0-17-133-106-33
US trade balance-12-44-135-117-85
Japan current account211645795
Japan trade balance8237278118
Bilateral US-Japan trade balance415454441
Sources: International Financial Statistics and Direction of Trade Statistics, IMF.

What are the causes of the US current account deficits and Japanese surpluses? Clearly, the explanation must be specific to the 1980s, because these sustained current account imbalances were not in evidence before then. It seems very difficult to argue that Japanese trading practices explain these current account patterns, since such an explanation would be valid only if Japan had, contrary to all available evidence, significantly increased its barriers to imports or subsidies to exports. If anything, Japan liberalized its trade policies in the 1980s, while the United States may have increased its protection.

There is near unanimity among economists that macroeconomic factors help explain variations in current account balances both in theory and in practice. First, declining national saving in the United States in the early 1980s, primarily due to public sector dissaving, caused an excess demand for goods in the United States, or equivalently, a shortfall in national saving relative to investment, thereby driving up real interest rates in the United States. Table 2 reviews the familiar evidence on saving, investment, and the current account for the United States and Japan. In both countries there have been declines in both private saving and investment rates since the 1960s. The current account balances in the 1980s are mainly the counterpart of divergent movements in government budget balances rather than private saving and investment.

Table 2Macroeconomic factors help explain variations in current account balances(percent of net national product)
United States
1960–731976–791984–90
Private saving10.210.17.4
Government budget-0.9-1.5-3.7
Private investment8.48.85.6
Current account0.6-0.1-2.9
Japan
1960–731976–791984–90
Private saving19.215.812.0
Government budget2.1-4.01.6
Private investment20.911.29.9
Current account0.60.93.5
Note: Numbers may not add up due to statistical discrepancies.Source: Barry P. Bosworth, Saving and Investment in a Global Economy, The Brookings Institution, Washington, DC, 1993.

Second, in an environment of increasing international capital mobility, these higher real interest rates allowed the United States to finance its current consumption by running up a large foreign debt, in addition to some crowding out of private investment. Third, other shocks in the early 1980s, such as tight US monetary policy and a portfolio shift toward dollar assets, may also have contributed to real exchange rate appreciation and current account deficits. To varying degrees, these shocks were partially reversed in the late 1980s, resulting in declining real interest rates in the United States, depreciation of the dollar, and reduced US current account deficits. Finally, more recently, in the early 1990s, recessions in Japan and Western Europe, combined with recovery in the United States, have resulted in a renewed worsening of the US current account deficit.

Medium-term macroeconomic shocks are transmitted to the current account primarily through the real exchange rate. The link between exchange rates and trade flows has been studied at length, and, after some controversy in the late 1980s, a near consensus has reemerged that trade flows respond in a predictable fashion to real exchange rate changes. Charts 1 and 2 indicate a strong correlation of US and Japanese net exports to exchange rates after allowing for a two-year lag. The controversies over the adequacy of the adjustment mechanism in the late 1980s seem to have arisen mainly from disregard of the normal long lags, and the failure to distinguish between nominal and real trade flows. In particular, the appreciation of the yen entailed a large increase in Japanese import volume, but the fall in Japanese import prices dampened the growth of nominal import values. It is important to recognize, however, that the exchange rate is not an independent instrument at the disposal of the authorities; it is an endogenous variable that adjusts to the types of shocks discussed above.

Openness of Japanese market

Contrary to popular views, the trade balance is a macroeconomic phenomenon and has little to do with degrees of protection. In equilibrium, low imports also imply low exports, given the saving-investment balance. If Japan were to import more, it would eventually also export more. Trade barriers only affect the trade balance if they have significant fiscal implications that alter national saving and investment, which seems unlikely in the Japanese case since overt barriers are low. Similarly, deregulation in Japan would contribute to reduction of Japanese trade surpluses if it resulted in a decline in domestic saving or an increase in domestic investment. Even if it has little effect on the trade balance, the level of protection in Japan may still matter to Japan’s trading partners for other reasons, both political and economic. The perception that the Japanese market is closed may adversely affect the willingness of other countries to pursue liberal trade policies. Japanese barriers could also cause other countries’ terms of trade to deteriorate, although the magnitude of this effect is unclear.

Overt Japanese protection in the form of tariffs and quotas is perhaps lower than protection in most other industrial countries, except in agriculture.

The importance of invisible barriers to the Japanese market is more controversial. There are numerous anecdotes and case studies reporting substantial intangible barriers to the Japanese market, but it is difficult to assess their significance systematically. Japan has an unusually low volume of manufactured imports and intra-industry trade, and the level of inward foreign direct investment in Japan is much smaller than in other industrial countries. A number of studies have attempted to determine if Japan’s level and pattern of trade are abnormal, after controlling for country characteristics such as size, location, and natural resource endowment. These studies have arrived at conflicting conclusions, with most finding that Japan’s imports of manufactures are unusually small and others finding both that Japan’s total trade is normal and that Japanese trading patterns are consistent with Japan’s factor endowments.

Another approach to the issue of invisible barriers is to examine differences in prices of similar goods in Japan and elsewhere, since these might indicate implicit protection. The evidence is again ambiguous. Moreover, the macroeconomic evidence on the impact of exchange rate changes poses a challenge to those who argue that Japanese trade is not responsive to market forces at the microeconomic level.

Sectoral balances

As noted above, sectoral trade balances are affected by both microeconomic and macro-economic factors. The classical Ricardian model of trade provides a simple framework with which to analyze these effects. The basic idea is that relative unit labor cost—the centerpiece of the Ricardian model—is influenced both by sector specific variables (productivity and wages) and by the real exchange rate. For example, the automobile sector in the United States could be under pressure from Japanese imports because of some combination of (1) higher Japanese productivity in autos, (2) US auto workers’ wages are above the US average wage, (3) overall US wages are out of line with productivity, and (4) the dollar is overvalued.

An IMF study (see reference) analyzed the time series and cross-sectional behavior of relative unit labor costs, and correlated these costs with sectoral trade balances. Table 3 reports US and Japanese relative unit labor costs, expressed as a ratio of average unit labor costs for the seven largest industrial countries (G-7). Both productivity and exchange rate variations affect the results. Japanese overall productivity grew rapidly relative to other countries in recent decades, but had an unusually high dispersion across sectors. For many sectors, in the late 1980s, Japan’s productivity remained well below that of the United States and the G-7 average, but in a few manufacturing sectors, Japan had the highest productivity of the G-7 countries. US productivity in agriculture and aggregate manufacturing remain well above those of other G-7 countries.

Table 3Much of Japan’s trade is consistent with relative unit labor costs(sectoral relative unit labor costs and intra-G-7 trade balances)
United States
Relative unit labor costs 1Trade balance 2
19701980198519891972198219871991
Manufacturing1.321.001.200.93-3.4-6.0-13.0-6.7
Agriculture0.620.510.610.562.73.92.37.2
Manufacturing sectors
Machinery1.371.031.210.92-3.3-8.4-22.4-13.0
Textiles1.470.961.180.93-5.4-2.3-7.8-1.9
Nonmetallic minerals1.340.971.220.93-2.3-4.8-7.6-4.0
Paper1.220.951.111.02-3.7-4.0-5.2-2.7
Basic metals1.241.121.431.14-10.9-22.1-20.2-9.9
Chemicals1.240.981.250.960.5-0.6-4.2-1.7
Food1.471.061.230.96-0.10.10.43.8
Japan
Relative unit labor costs 1Trade balance 2
19701980198519891972198219871991
Manufacturing0.660.850.871.116.48.910.96.3
Agriculture1.481.691.702.05-4.9-16.5-11.9-15.4
Manufacturing sectors
Machinery0.840.870.851.0413.224.728.318.0
Textiles0.851.221.392.2310.9-4.2-4.2-17.0
Nonmetallic minerals0.591.100.981.294.43.42.30.5
Paper0.610.840.800.98-6.4-11.6-7.8-6.9
Basic metals0.460.470.630.829.48.53.5-0.7
Chemicals0.610.670.600.86-0.8-6.0-1.8-2.6
Food0.460.710.881.24-1.9-8.0-6.5-8.6
Source: Organization for Economic Cooperation and Development.

The effects of exchange rate movements are evident for all categories of US trade. For example, US total manufacturing unit labor costs are high in 1970 and 1985, periods when the dollar was relatively strong, but in 1980 and 1989 the opposite is true. By 1989, US manufacturing unit labor cost was below the G-7 average.

Japan’s comparative advantage in manufactures is reflected in relative unit labor cost below 1.0 until the late 1980s, when the strong yen overwhelms the continuing underlying competitiveness of Japanese manufactures. The dispersion in manufacturing productivity for Japan is reflected in its unit labor costs.

Intra-G-7 trade balance data for the same sectors and countries is also shown in Table 3. The trade balances have been scaled by sectoral value added, and shown with a two-year lag with respect to the years for which unit labor cost data are shown, to allow for the typical lag uncovered at the aggregate level. The US comparative advantage and Japanese disadvantage in agriculture manifested themselves in structural US surpluses and Japanese deficits. Similarly, the low Japanese unit labor cost in manufacturing (until the late 1980s) and the generally high US counterpart (with the exceptions of sharp dollar depreciations in the late 1970s and the late 1980s) are consistent with Japanese structural surpluses and US deficits in manufacturing. At a more disaggregated level, many of the results also make sense, although there are some anomalies, which may be due to factors not considered here, such as raw materials and product quality.

Statistical analysis confirms that Japanese sectoral trade balances are at least as responsive to relative unit labor costs as those of other G-7 countries. The finding that much of Japan’s trade is consistent with relative unit labor costs complements other research using factor-endowments-based approaches to comparative advantage. That is, technological differences and factor endowments are both important in explaining Japan’s comparative advantage.

Adam Smith was right

In the United States and Europe, it is widely believed that Japanese trade surpluses are harmful to Japan’s trading partners. From a macroeconomic perspective, there is nothing surprising about Japan’s surpluses. Declining US national saving rates relative to Japan naturally entailed capital outflows from Japan and capital inflows into the United States, which had their counter-parts in Japanese current account surpluses and US deficits. The fact that macroeconomic factors have determined the current account imbalances raises the important question of whether macroeconomic policies have been appropriate, a topic which is beyond the scope of this article.

At the sectoral level, Japan’s intra G-7 trade balances are explained relatively well by sectoral relative unit labor costs, although there are some anomalies for all countries. This does not mean that protection is nonexistent in Japan, but it does suggest that the extent to which trade patterns are determined by comparative advantage is greater for Japan than for most other major industrial countries. Consequently, the results reported here provide no support for the view that Japan’s sectoral trade balances must be “managed” because Japanese trade is not responsive to normal market forces. If France is substituted for the United States, and England with Japan, Adam Smith’s critique of mercantilism is as relevant today as it was in 1776.

This article is based on two longer papers by the author: “Comparative Advantage, Exchange Rates, and G-7 Sectoral Trade Balances,” IMF Staff Papers, June 1994 and “The United States-Japan Trade Balance: A Review,” IMF Paper on Policy Assessment and Analysis (PPAA/94/8).

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