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America's new rescuer: Japan

Posted: Monday, February 09, 2009

Here's a disillusioning thought: Solving the financial crisis may be beyond the capacity of government finances. The likely $3 trillion price tag, give or take, of both saving the banks and stimulating the economy is causing interest rates to inch up. U.S. Treasury long-term rates have already risen from 2.1 percent just before Christmas to nearly 3 percent.

This is happening because the rest of the world, which is also in trouble, is following in our fiscal footsteps. Financial markets envision a coming global credit Armageddon. And a scenario of rising interest rates, with rates really jumping once our economy starts to recover, could kill any chance that the recovery is sustainable.

The Obama team needs to do some quick, creative, global thinking. To escape a potential credit straitjacket, they should go where the money is. Today, the money is in Japan, still the world's largest source of excess savings.

It's true that we can rely on the hope of financing this new debt through tax increases. But because of the sheer size of the debt we're undertaking - by comparison, our gross domestic product is only $14 trillion - taxes as a percentage of GDP would have to roughly double, jumping from today's 20 percent to potentially more than 40 percent of GDP. And don't forget about the coming entitlement nightmare and the likelihood that more bailouts will be necessary.

Washington can do nothing here. Financial markets will conclude that the Federal Reserve will eventually monetize, or devalue, the debt by letting inflation soar. Such an expectation of future inflation will produce, in the near term, further increases in market interest rates - again, smothering recovery.

Even though the United States needs to become less dependent on foreign capital, for now at least we still need a banker - and one in sync with our long-term economic and security goals. Our choice: China or Japan.

During his confirmation hearings, Treasury Secretary Timothy Geithner fixated on China. But Beijing is sitting on its own social and political bubble, which is about to burst. When that happens, China will be tempted to draw massive amounts of its global savings back home if only to buy off the angry mobs in the streets. Japan is a more logical focus.

Unlike China, Japan is a mature, predictable, structurally stable economy. Geithner knows its financial system well. Tokyo is sitting on a mountain of savings in the form of official reserves, private savings and public pensions, and it is potentially open to a win-win deal on the issue of currencies and the purchase of our debt.

Consider the situation: Tokyo has lost control over its soaring currency. The yen has risen nearly 30 percent against the dollar in just the past 18 months, despite the dollar strengthening against most other world currencies. This dramatic surge (the result of once-aggressive Japanese buyers of foreign bonds bringing their savings back home as the world slashes interest rates to Japanlike levels) is killing Japan's global competitiveness. Locked in its own currency straitjacket, the export-dependent Japanese economy is in freefall. The collapse of Japanese exports to China hasn't helped matters. To put it simply, Japan is as desperate for currency relief as we are for credit relief.

So here's the deal: Tokyo agrees to ample enough additional purchases of U.S. debt and other financial assets to bring sustained downward pressure on U.S. long-term interest rates. This influx of capital would give the United States some breathing room to recover economically and eventually get our financial house in order. In return, Washington agrees to a weaker yen against the dollar. Achieving such a currency adjustment may seem farfetched, but the yen-dollar exchange rate historically has been heavily influenced by the market's perception of the U.S. and Japanese governments' comfort level for the currency relationship.

A new "G-2" deal would have its complications. For starters, Washington and Tokyo would have to cobble together a joint venture to protect American car companies from currency risk of their own.

A case can be made, however, that a joint international effort is really the only means of achieving advances such as a "next generation" environmentally friendly propulsion system. Japanese strategists would also need to be convinced that America has a long-term plan for financial reform.

It may turn out that even Japan's savings are not enough to finance our ballooning debt. But an attempt at a "G-2" deal is better than financial suffocation. Moreover, if such an alliance is a no-go, the Obama team quickly needs an alternative plan. No matter how much we hate it, America needs a banker. Timothy Geithner and Larry Summers are smart, and smart guys don't allow their boss to dive off the financial high board without knowing the depth of the credit waters below.

• David M. Smick is a global financial strategist and the author, most recently, of "The World Is Curved: Hidden Dangers to the Global Economy."



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