黑色星期一之后

The stock market crash of 1987 was an event of historical significance for the world economy. The crashes of 1893, 1907, and 1929 were comparable, but the 1929 plunge is the most widely known and in many ways the most relevant. In drawing the comparison, however, care must be taken not to confuse the crash itself with its aftermath.

In the crash of October 1929, prices on the New York Stock Exchange fell by about 36 per cent, as measured by the Dow Jones industrial average; this figure is almost identical with the loss that occurred in October 1987. After the fall, stocks recovered nearly 50 per cent of their losses and then declined by another 80 per cent in the long-drawn-out bear market from 1930 to 1932. It is that bear market, associated with the Great Depression, that preys on the public imagination. Precisely because it is so well remembered, history is not likely to repeat itself. The U.S. government’s immediate reaction to the 1987 crash already has borne out this contention. After 1929 the monetary authorities made a momentous mistake by supplying too little liquidity, thus failing to counter a drop in the money supply. The danger now is that the pressures of avoiding a recession, especially strong in a presidential election year, will lead the authorities to supply too much liquidity and thereby further undermine the dollar’s value.

Technically, the crash of 1987 bears an uncanny resemblance to the crash of 1929. The principal difference is that in 1929 the first selling climax was followed in a few days by a second one that carried the market to a lower low. In 1987 the second climax was avoided; and even if the market were to reach new lows in the future, the pattern would be different.

The crash of 1987 came just as unexpectedly as the crash of 1929. The worldwide stock boom was seen generally as unsound and unsustainable, but few people correctly predicted the sudden turn of events. I was as badly caught as the next person. I was convinced that the crash would start in Japan. That turned out to be an expensive mistake.

The most compelling similarity between the crash of 1929 and the crash of 1987—one not sufficiently appreciated by policymakers and the public—is that both incidents revealed a historic ongoing transfer of financial and economic power in the world economy. In 1929 the United States was superseding Great Britain as the world’s predominant economic force. In 1987 the power was flowing from the United States to the Asian economic superpower, Japan.

The crash of 1987 will be remembered as a signal event in that process as well as a harbinger of change in the international financial order because it offered dramatic evidence of the growing inadequacy of a global financial system based on an unstable and depreciating reserve currency, the U.S. dollar.

In retrospect, it is easy to reconstruct the sequence of events that led to the crash. The stock boom was fed by a growing supply of dollars; a reduction in liquidity then established the preconditions for a crash. In this respect, too, 1987 resembles 1929: It will be recalled that the 1929 crash was preceded by a rise in interest rates on short-term borrowing for stock transactions.

Exactly how the reduction in liquidity came about in 1987 is a thornier question. A definitive answer will have to await a great deal of research. But it is clear that the crucial role was played by international efforts to shore up the exchange value of the dollar—specifically through the Louvre Accord, which was initialed in February 1987 by finance ministers of the leading industrial countries called the Group of Seven—Britain, Canada, France, Italy, Japan, the United States, and West Germany. In the months following the Louvre Accord, the dollar was defended by sterilized intervention in financial markets—that is, domestic interest rates were left unaffected. When the Group of Seven’s central banks found that they had to purchase more dollars than they had an appetite for, they changed tactics. After then Japanese Prime Minister Yasuhiro Nakasone’s April 1987 visit to Washington, they allowed interest-rate differentials between the United States and other countries to widen until the private sector abroad became willing to hold dollars. In effect the banks privatized the intervention.

What is still unclear is whether it was the sterilized or the unsterilized intervention that actually caused the drop in liquidity. Sterilized intervention transferred large amounts of dollars to the coffers of central banks abroad, and the Federal Reserve Board may have inadvertently failed to inject equivalent amounts into the U.S. domestic money market. Alternatively, it may be that the monetary authorities in Japan and West Germany were afraid of the inflationary implications of unsterilized intervention, and their attempt to rein in their domestic money supplies led to the world wide rise in interest rates.

I favor the latter explanation, although I cannot rule out the possibility that the former also contributed to the liquidity squeeze. The West Germans harbor a strong anti-inflationary bias. The Japanese are more pragmatic; they did, in fact, allow their interest rates to fall after Nakasone’s return to Tokyo. But when the Japanese found that an easy money policy was merely reinforcing the unhealthy speculation in financial assets, including land, they had second thoughts. The government tried to slow the growth of the Japanese domestic money supply and bank lending, but speculation already was out of control. Even after the Bank of Japan started to tighten its monetary grip, bond market prices continued to soar. As a consequence, the yield on the bellwether Coupon #89 bond issue fell to a historic low: 2.6 per cent in May before the bond market crashed.

The September 1987 collapse of the Japanese bond market was the first in a sequence of events that will enter the annals of history as the crash of 1987. Investors speculated heavily in September bond futures, but they could not liquidate their positions. Hedging against these losses led to a collapse of prices for December futures. The yield on the Coupon #89 issue climbed above 6 per cent before the bond market bottomed out. It appeared at first that the collapse would carry into the stock market, which was even more overvalued than the bond market. But, in fact, speculative money moved from bonds to stocks in a vain attempt to recoup the losses. As a result, the Japanese stock market reached minor new highs in October.

The consequences for the rest of the world were more grievous. The government bond market in the United States had grown dependent on Japanese buying. When the Japanese began to sell U.S. government bonds, even in relatively small quantities, the bond market suffered a sinking spell that went beyond any change justified by economic fundamentals. Undoubtedly the U.S. economy was stronger than had been expected, but the strength came in industrial production rather than in consumer demand. Commodity prices were rising, encouraging inventory accumulation and raising inflationary expectations. The fear of inflation was more a rationalization for the decline in bonds than its root cause. Nevertheless, it served to reinforce the bond market’s fall.

The weakness in bonds widened the disparity between bond and stock prices that had been developing since the end of 1986. Such a disparity can persist indefinitely, as it did in the 1960s, but as it widens it creates the preconditions for an eventual reversal. The actual timing of the reversal depends on a confluence of other events. This time political considerations played a major role: Reagan had lost his political luster, and the 1988 elections were approaching. When downward pressure on the dollar was renewed, the stock market’s internal instabilities converted a decline into a rout.

The first crack came when a widely followed Wall Street guru, the technical market analyst Robert Prechter, issued a bearish signal before the October 6 market opening. The market responded with a resounding fall of 90 points. This signaled underlying weakness in the market, but similar incidents had occurred in 1986 without catastrophic results. The situation deteriorated further this time when the dollar also started to weaken. On Tuesday, October 13, Alan Greenspan, chairman of the Federal Reserve Board, announced that the trade balance was showing an “extraordinary” structural improvement. So the figures published on Wednesday, October 14, which showed an improvement in the trade deficit only half as much as expected, proved all the more disappointing. The dollar experienced severe selling pressure.

Pursuing unsterilized intervention would have required an increase in interest rates—one that would need to be all the larger because of the earlier increases in Japan and West Germany. U.S. authorities were not willing to undertake such a tightening; and by Thursday, October 15, as the stock market continued to decline, Treasury Secretary James Baker was reported to be pressing Bonn to lower West German interest rates or else face a further fall in the dollar. The stock market decline continued to accelerate amid reports that the House Ways and Means Committee was planning to limit the tax deductibility of risky “junk” bonds issued in leveraged buyouts of companies. Although the provision was abandoned the next day, October 16, stocks that had been bid up in the expectation of takeovers or leveraged buy-outs declined sufficiently to force the liquidation of margin accounts by professional arbitrage traders.

Then came the sensational lead article in the Sunday, October 18, issue of the New York Times. Treasury Department officials reportedly were advocating openly a lower dollar and blaming the West Germans in advance for the stock market collapse that these remarks helped precipitate. Some selling pressure on “Black Monday,” October 19, was inevitable because of the instabilities accumulating in the stock market; but the Times article had a dramatic effect, exacerbating the built-in instabilities. The result w7as the largest single-day decline in history: The Dow Jones industrial average dropped 508 points, or 22.6 per cent of its value.

Analysts generally regard the stock market as the passive reflection of investors’ expectations. But in fact, it is an active force in shaping them. Investors’ expectations are presumed to be rational, but it is impossible to be rational in the face of genuine uncertainty. The greater the uncertainty, the more investors are likely to take their cue from the stock market. In turn, the more their investment decisions chase market trends, the more volatile the market becomes. The reliance on market trends has been carried to its logical conclusion in portfolio insurance programs. Portfolio insurance and other trend-reinforcing devices such as stock and index options in theory allow individual participants to limit their risk at the cost of aggravating the instability of the system. In practice, when too many people use such devices, the system breaks down. On October 19, such a breakdown occurred. The market became disorganized and panic set in. The liquidation of margin accounts—whose collateral depends on the market value of the stocks held—further depressed prices.

The plunge in New York had repercussions abroad, and the collapse of other markets reverberated back to New York. London’s stock exchange turned out to be more vulnerable than New York’s, and the normally staid Swiss market was shaken even more. Hit worst of all was the Hong Kong market. There, a group of speculators in the futures market persuaded the colony’s government to suspend stock trading for the rest of the week in a bid to settle futures contracts at artificial, pre-crash prices. The ploy failed, the speculators were wiped out, and the futures market had to be rescued by government intervention. While the Hong Kong market was suspended, selling from Hong Kong radiated to other markets in Asia, Australia, and Britain. The selling pressure persisted for the better part of 2 weeks after Black Monday. Although other stock markets hit new lows, the New York market did not exceed the lows set in the initial selling climax.

Only Japan’s stock market escaped collapse. A 1-day panic followed Black Monday, when prices on Tuesday, October 20, fell the legal limit of approximately 15 per cent in the absence of many transactions. Japanese stocks traded at large discounts in London the next morning— Tuesday in Europe. But by the time the Japanese market reopened on Wednesday, October 21, the Ministry of Finance had made a few telephone calls, the sell orders had miraculously disappeared, and large financial institutions were aggressively buying stocks. As a result, the market recouped a large part of the previous day’s losses. Prices sagged further after the panic; and at the time of the gigantic November 10–12 Nippon Telephone and Telegraph stock issue, which involved raising about $37 billion from the public, it looked as if the market might unravel. But the authorities intervened again, this time permitting the four largest brokers to buy and sell shares for their own accounts—in effect giving them a license to manipulate the market upward for the benefit of themselves, their clients, and the government.

The two outstanding features of the crash of 1987, then, were the absence of a second selling climax in New York and the relative stability of Tokyo’s market. These two features deserve further exploration because they provide some insight into the future.

A TRANSFER OF POWER

The historical significance of the 1929 crash derives from its role as the precipitator of the Great Depression. It occurred during a period when economic and financial power was moving from Europe to the United States. The shift in power produced great instability in exchange rates, and the result was that the dollar replaced the British pound as the international reserve currency. Still, in itself, the crash of 1929 played no clearly defined part in the pound’s demise as the world’s leading currency.

By contrast, the 1987 crash marked a significant step in the transfer of economic and financial power from the United States to Japan. Japan has been producing more than it consumes, and the United States has been consuming more than it produces. Japan has been accumulating assets abroad, while the United States has been amassing huge debts. The process of transfer received a great push when Ronald Reagan took office with a program of cutting taxes and boosting military expenditures, and it has been gaining momentum since then. Both governments have been loath to acknowledge it: Reagan wanted to make Americans feel good about being American and pursued the illusion of military superiority at the cost of undermining the country’s leading position in the world economy; Japanese leaders wanted their country to keep growing in America’s shadow as long as possible.

The crash of 1987 revealed Japan’s strength and made the transfer of economic and financial power clearly visible. It was the collapse of the Japanese bond market that depressed the U.S. bond market and set up the American stock market for a fall. But Japan was able to avert a collapse of its own stock market. To top it all off, U.S. monetary authorities forestalled a second selling climax only by abandoning the dollar. Herein lies the significance of the two key features I have singled out. Japan in effect has emerged as the world’s banker—taking deposits from, making loans to, and investing in other countries. The dollar is no longer suited to serve as the international reserve currency; but whether a new international currency system can be established without another Great Depression remains a compelling, open question.

The crash of 1987 confronted the U.S. government with the question whether its ultimate priority was to avoid a recession or to preserve the value of the dollar. The response was unequivocal. In the days immediately following Black Monday, the dollar was cut loose from its moorings; and in an interview published in the Wall Street Journal on November 5, Baker made the news official.

The dollar moved obediently lower, and a second selling climax in the stock market never took place. The mistake of 1929 was avoided, but only at the peril of committing a different kind of mistake. The decision to cut the dollar loose is painfully reminiscent of the competitive currency devaluations of the 1930s: Temporary relief may be bought at the cost of greater damage later.

Prospects appear good that a U.S. recession can be avoided, at least for the time being. Consumer spending already was declining prior to October 19, and the crash is bound to breed more caution in consumers. But industrial production has been benefiting from the lower dollar and industrial employment has remained strong. The 2-year, $76 billion reduction in the federal budget deficit negotiated in November 1987 by the White House and congressional Democrats is too small to have much impact. If American corporations slash capital expenditures, foreign corporations expanding in the United States may take up the slack. It is unlikely, therefore, that the downturn in consumption will develop into much more than a flat first quarter or first half in 1988. Both Bonn and Tokyo are likely to stimulate their economies. The net result would be a continuation of the slow growth that has prevailed in the world economy since 1983. It may surprise many just how little direct effect the stock market is going to have on the real economy.

The trouble with this scenario is that it leaves unresolved the imbalances that spurred the crash of 1987. Neither America’s budget nor its trade deficit is likely to disappear. The aftermath of the crash may bring some respite; but eventually the dollar is bound to come under pressure again—either because the U.S. economy will be strong and the trade deficit will persist, or because it will be weak and lower interest rates will be needed to stimulate it.

Britain found itself in a similar situation prior to the discovery of North Sea oil in 1969. The result was stagflation—high inflation coupled with low production and high unemployment—and a sequence of stop-go fiscal and monetary policies that alternated between economic expansion and contraction. Now the same things are in store for the United States. The principal difference is that the United States has the world’s largest economy and its currency still serves as the international medium of exchange. As long as the dollar remains unstable, international financial markets will remain accident-prone. Although the Louvre Accord created the preconditions for a crash, the actual fall in the dollar triggered it.

If the dollar continues to depreciate, owners of financial assets will take refuge elsewhere. Once the movement gathers momentum, not even a rise in interest rates can arrest it because the dollar’s rate of depreciation will outpace the interest-rate differential with foreign currencies in its favor. Eventually, rising interest rates will bring on a more severe recession than the one the Reagan administration has sought to avoid.

It has happened before. In the last 2 years of the Carter administration, speculative capital continued to move to West Germany and Switzerland even when a penalty was charged for it to be accepted there. The specter of a free-falling dollar is more real now than it has been at any time since President Jimmy Carter was forced to sell bonds denominated in hard currencies in 1979.

Ever since the crash, stock markets worldwide have weakened whenever the dollar has weakened, and vice versa. The clear message is that any further decline in the dollar will be counterproductive. The administration seems to have received the message. A budget compromise of sorts was attained 1 month after the stock market crash. Unfortunately, this compromise does not leave the administration much leverage with Tokyo and Bonn; the budget cut was described as “a miserable pittance” by the ranking minority member of the Senate Committee on Finance, Robert Packwood (R.-Oregon). Moreover, the crash of 1987 demonstrated that the administration is more concerned with avoiding a recession than with stabilizing the dollar. The burden of supporting the dollar will fall primarily on U.S. trading partners.

The best way for Japan to protect its export markets is to transfer production to the dollar zone; the process already had started prior to the crash. Many Japanese concerns, led by the automakers, are establishing manufacturing subsidiaries in the United States and Mexico. The process will be accelerated by the crash and the falling dollar, both of which have made assets denominated in dollars cheaper to acquire and the American market less profitable to supply from abroad. The eventual solution of the U.S. trade deficit will be import substitution—by Japanese factories in America. It echoes the solution to Europe’s seemingly incurable “dollar gap” after World War II, when many U.S. corporations became multinational and the United States consolidated its hegemony over the world economy. Similarly, the birth of Japanese multinational corporations will coincide with Japan’s ascent as the world’s banker and economic leader.

Large-scale Japanese investments already give Japan considerable political leverage in the United States. Thirty-three states have established trade-promotion offices in Japan. But they are not likely to make much headway if those states’ congressional representatives are vocal supporters of protectionist measures. In spite of all the posturing, protectionism may no longer be a viable policy option. Indeed, when the Japanese have built their factories in a few years’ time, they may become the most ardent protectionists—to keep out competition from South Korea and Taiwan.

A NATIONAL IDENTITY CRISIS

Many times in the course of history, economic, financial, and eventually, political and military leadership has passed from one country to another. The latest instance came in the period between the two world wars, when the United States supplanted Britain. But knowledge that such shifts have taken place in the past does not make the prospect of Japan’s emergence as the world’s dominant financial power any less disturbing, not only from the point of view of America but also from that of the entire West.

For the loss of pre-eminence is bound to engender a crisis in America’s sense of national identity. Having just expended enormous sums—even though borrowed from abroad—in the pursuit of military superiority, the American people are ill-prepared to cope with the loss of U.S. economic superiority. Moreover, the sense of national identity in America is much less firmly rooted than it is in, say, Britain, which has faced a similar transition. The popular reaction in the United States may therefore be stronger and more troubling. A crisis of self-confidence might develop that could have profound consequences for American political behavior, both internally and internationally.

Over the long run, the implications for Western civilization are equally profound even if less obvious. The international trading system is an open system; its members are sovereign states that have to treat each other equally. In the short run, this will not change if Japan takes over leadership. On the contrary, the Japanese can be expected to step more gingerly than the Americans have on occasion.

But there is a more subtle, longer-range problem. The United States and Britain are part of the same culture; Japan is not. The Japanese have shown tremendous capacity to learn and grow, but their society remains fundamentally different from the West’s. The Japanese tend to think in terms of the subordination of the individual to the collectivity. Contrast this with American notions of equality and individualism, and the difference between the two cultures is brought into focus.

A similarity in political institutions sometimes disguises deep social differences. Japan, like the United States and Britain, is a democratic country. But below the institutional surface operate social attitudes that raise troubling questions about a world with Japan as number one. Both the United States and Britain are open societies. Internally, people enjoy a large degree of freedom; externally, the borders have been open to varying degrees to the movement of people, ideas, goods, and capital.

Japan, to a large extent, remains a closed society. The features it does have of an open society, such as a democratic form of government, were imposed by an occupying power after a lost war. For outsiders, rights to sell goods and to become citizens are carefully circumscribed. The plight of Japan’s Korean minority, which is denied full citizenship despite having lived in the country for decades, suggests an attitude toward outsiders that is not reassuring.

Japan also has a very strong sense of national mission and social cohesion. Japanese want to be part of a group that strives to be number one, whether it is their company or their country; and they are willing to make considerable sacrifices for that goal. They cannot be faulted for holding such values; indeed, it is more appropriate to criticize Americans for their unwillingness to suffer any personal inconvenience for the common good.

But the United States in particular and the rest of the world in general are confronted with the question whether they will allow themselves to be dominated by a society with such a strong sense of national identity. The issue troubles not only those in the West but also the Japanese themselves. A strong school of thought in Japan wants the country to open up to become more acceptable to the world. But an equally strong commitment to traditional values persists, as does an almost pathological fear, especially among the older generation, that Japan may lose its drive before it becomes number one. Internal Japanese tensions and contradictions will work to undermine social cohesion and hierarchical values. Much depends on how fast the transition to leadership occurs. If the United States proves itself to be more viable than it has been of late, the value system of an open society also will seem more attractive to the Japanese.

The closed character of Japanese society manifests itself in many areas. Formally a democracy, Japan has been ruled by the Liberal Democratic party since 1955; prime ministerial successions are negotiated behind closed doors. Formally the domestic market is open, but foreign companies usually find it impossible to penetrate without retaining a domestic ally. Nowhere is the difference between Western openness and the closed character of the Japanese more dramatic than in financial markets.

The countries of the West have gone too far in allowing financial markets to function unhindered by government regulation. This has been a grievous mistake, as the crash of 1987 showed. Financial markets are inherently unstable; stability can be maintained only if it is made an objective of public policy. Moreover, instability is cumulative. The longer markets develop without regulation, the more unstable they become, until eventually they crash.

The Japanese attitude toward financial markets is totally different. The Japanese treat markets as a means to an end and manipulate them accordingly. The authorities and the institutional players are connected by a subtle system of mutual obligation. Recent events provide an insight into how the system operates. The first time the market verged on collapse after Black Monday, a few telephone calls from the Ministry of Finance were sufficient to rally the financial institutions. In the second instance, at the time of the issue of Nippon Telephone and Telegraph shares, financial institutions proved less responsive, perhaps because the finance ministry had used up its credits in the first round of telephone calls. It now had to rely on the big stockbrokers, whose survival was directly threatened. By giving them license to manipulate the market, the authorities avoided disaster.

Whether a plunge in Japanese stock prices can be avoided indefinitely is one of the most fascinating questions about the current financial situation. Japanese authorities have allowed a speculative bubble to grow in Tokyo real estate and in the stock market whose magnitude has few parallels in history. To illustrate, Nippon Telephone and Telegraph shares were sold to the public at 270 times earnings, while American Telephone and Telegraph shares were valued at 18 times earnings. If the Japanese market functioned like the exchanges in New York and London, it already would have collapsed. For at no time in the past has a bubble of this magnitude been deflated in an orderly manner. The authorities were unable to forestall a crash in the Japanese bond market, but they may be able to do so in the stock market. ‘The continuing strength of the yen works to their advantage. If they succeed, it will represent a first, the dawn of an era in which financial markets are manipulated for the public good.

The October turmoil moved the Japanese stock market back toward a closed system. Foreigners owned less than 5 per cent of Japanese stocks at the outset of the crisis, and they dumped much of their holdings during and after it. Interestingly, the selling was absorbed not so much by Japanese institutions as by the public, which was encouraged by the brokers to go heavily into debt. Japanese brokers did, in fact, speak of buying stocks during the crisis as a patriotic duty whose accomplishment would set Japan apart from the rest of the world. Margin debt is at an all-time high. The Japanese government faces the task of reducing this debt load without forcing the liquidation of margin accounts.

Why did the Japanese authorities allow the speculative bubble to develop in the first place? That is another fascinating question for which there is only conjecture. External pressures may have played a role: The United States was pushing for lower interest rates in Japan, and those lower rates encouraged speculative investments in land and bonds offering the prospect of larger rewards. But the Japanese would not have yielded if it had not suited them.

At first, inflating financial assets allowed the authorities to discharge their obligations toward the commercial banks at a time when the real economy was in deep trouble. Without the land and stock market boom, the commercial banks would have seen many of their loans to industrial companies turn sour amid a recession for domestic industries, and their earnings would have suffered. Land and stock market speculation allowed them to expand their loan portfolios against seemingly good collateral and also allowed the industrial companies to counteract their earnings shortfall with proceeds from zaitech—that is, financial manipulation.

The land boom also served to preserve a high domestic savings rate and a favorable trade balance in spite of the rising value of the yen. With the cost of housing rising faster than wages, Japanese workers had good reason to save an increasing share of their income. With the domestic economy in recession, the savings were available for investment abroad. That was an ideal recipe for amassing wealth and power in the world, even if the foreign investments depreciated in value. I suspect that at least a few of the Japanese power elite would be quite pleased to see investors lose some money; for it would stop the Japanese from going soft before Japan became great. How else can a democratic government’s willingness to sell shares to its electorate at obviously inflated prices be explained?

But soaring land and stock prices soon began to have adverse consequences. The high savings rate prompted additional foreign pressure to stimulate the domestic economy, and the government finally had to give in. Moreover, the gap between those who owned land and those who could not widened to such an extent as to threaten social cohesion. When the domestic economy began to recover, the need to allow banks to finance speculative transactions disappeared; it became appropriate to redirect their resources to the real economy. The government’s attempt to rein in bank lending and the money supply set off the chain of events leading to the Japanese bond market plunge and, in turn, to the crash of foreign stock markets.

The stock market boom prior to Black Monday diverted attention from the fundamental deterioration of America’s financial position. The frenetic activity in financial markets and the lure of quick rewards made it possible to pretend that Reagan administration policies were working. The crash of 1987 came as a rude awakening. Many of the profits slipped away in a day or two; and the frenetic activity will soon be succeeded by the stillness of a morgue. Prospects are now dismal. One way or another, Americans face a reduction in living standards. Much will depend on the policy route Washington chooses.

The most likely path is the one Britain followed earlier, which probably will produce similar results for the United States. But the damage to the world economy may prove much more severe because of the dollar’s importance. Some policymakers also feel a temptation to dabble in protectionism. Although this is an option whose political viability, as mentioned earlier, will diminish, it nevertheless could cause a lot of mischief before it is brought under control.

Finally, there is the possibility that Washington will reassert the leadership it so far has failed to exercise. Doing so would involve not only putting the American house in order but also bringing into existence a new international financial order that could accommodate America’s relative loss of financial power.

A smoothly functioning international economy cannot exist without a stable international currency. Monetary authorities in the United States and elsewhere began to recognize this fact with the September 1985 Plaza Agreement, in which the Western signatories pledged to push down the dollar’s value in an effort to correct external imbalances. They reaffirmed it with the Louvre Accord. Unfortunately, their actions were inadequate, and the Louvre Accord fell apart in the 1987 crash.

On January 4, 1988, the central banks embarked again on a course to support the dollar. They may achieve temporary success as they did after the Louvre Accord, particularly because the dollar clearly is undervalued now and the trade figures are likely to improve for several months. But the success will prove fleeting unless it is underpinned with a better balance between consumption and production in the United States. A lower budget deficit, a higher savings rate, and higher productivity all would help improve the balance.

A country with large budget and trade deficits cannot expect foreigners to accept an ever increasing flow of its currency. Holders of financial assets seek the best store of value. Allowing the currency to depreciate beyond some point becomes counterproductive because it encourages the holders of financial assets to seek refuge elsewhere. Nor does continued depreciation bring any significant near-term improvement in the trade balance because the adjustment process takes time, while a fall in the value of the currency makes an immediate negative impact on the trade balance (the “J-curve” effect). Moreover, the exchange-rate instability discourages exporters from making the investments necessary to expand their production capacity.

Barring a fundamental change in U.S. economic performance, there simply is no realistic exchange rate at which the dollar can continue fulfilling its role as the international reserve currency. Yet the international financial system cannot function without a stable currency as its foundation. This is the central lesson emerging from the crash of 1987.

An international currency system that is not based on the dollar is needed desperately. The yen is not yet ready to serve as the international reserve currency, partly because the Japanese financial markets are not sufficiently open and partly because the rest of the world is not ready to accept Japanese hegemony. If the West sees trouble in the way the Japanese are flexing their financial muscles, it should consider steps to develop a viable alternative for the international financial system.

The ideal solution would be a genuine international currency, issued and controlled by a genuine international bank. International lending for balance-of-payments purposes would then be designated in the international currency. The currency’s value would be tied to gold or to a basket of commodities, ensuring that debts would have to be repaid in full. Only when the dollar loses its privileged status will the United States cease flooding the world with dollars. The sooner the transition is made, the better the chances of arresting America’s economic decline.

Today the idea of an international currency and an international central bank has few supporters. Ironically, it is likely to receive a more enthusiastic response in Japan than in the United States. Many Japanese would like their society to become more open. The Japanese retain vivid memories of when they tried to go it alone in World War II. They would prefer to flourish within a worldwide trading and financial system rather than embark on the impossible task of creating their own. As newcomers they would willingly accept an arrangement that did not fully reflect their current clout.

But it is the United States that stands to gain the most from a reform of the international currency system. A new system would allow America to consolidate the global position that it otherwise is in danger of losing. The United States still is in a position to strike a favorable deal, especially in view of its military might. Most important, the United States could preserve an open international financial system, while Japan, as one of its leading members, would become a more open society in the process. The alternative is an experience similar to the 1930s: financial turmoil and beggar-thy-neighbor policies sliding toward worldwide depression and perhaps even war.