Why Is America Undercutting Japan?

Originally published at Project-Syndicate | Jul 21st, 2023

At a time when the United States is asking its allies to help it counter China, its wasteful, inefficient industrial policies are making it harder for them to comply. Rather than undercutting its “friends” with subsidies and protectionist trade barriers, America should be focusing on pro-growth innovation and labor-market policies.

TOKYO – Until 2017, America’s trade policies were reasonably well aligned with its strategic objectives. The United States was the world’s largest economy, with unrivaled military power, and its alliances with European countries and others bolstered security and underwrote prosperity for all. It also provided global leadership through bodies like the World Trade Organization, ensuring a common rule-of-law framework to support economic growth and cross-border exchange around the world.

Then came Donald Trump, who ushered in an era of US protectionism, unnecessarily alienating many friends and allies. His successor, Joe Biden, has attempted to repair some of the damage, but he has not reversed many key elements of Trump’s trade policies.

This is well illustrated by US policy toward Japan, a crucial American ally in Asia. Japan has long depended on the US for its security – an arrangement that dates to its defeat in World War II. Since Abe Shinzō’s premiership, Japan has been building up its military and security capacities, and demonstrating a greater willingness to defend its allies and strategic interests in the region – including with respect to Taiwan – but it still relies on the US security umbrella. Japan is also heavily dependent on trade, and it is a key country in both Asia and the global economy. What happens in Japan thus has implications for everyone. And now that China is flexing its muscles, Japan has become as important geopolitically as it is economically.

Japan was a relatively poor country prior to WWII, and it emerged from the war even poorer, having suffered great devastation. But by the end of the 1950s, post-war reconstruction and sound economic policies inaugurated a 30-year period of phenomenal growth. By the 1980s, Japan had become an economic powerhouse, leading other countries to introduce protectionist measures against it – such as the “voluntary export restraints” on Japanese vehicles advocated by US President Ronald Reagan’s administration.

The Japanese economy nonetheless sustained its strong growth. But its three-decade-long expansion had inflated a financial bubble that eventually burst in 1990, inaugurating two “lost decades” of stagnant output and deflation, with the 2008-09 global financial crisis delivering another blow. Over the following decade, the Japanese economy’s growth rate rose only a little before declining again with the onset of the COVID-19 pandemic.

But the tide may be turning. Over the past two years, Japan has largely offset the negative impact of an aging population and a shrinking labor force by allowing more immigration than ever before. It has worked off the hangover from the asset bubble, and deflationary expectations have weakened.

But it is too early to celebrate the defeat of stagnation and deflation, not least because US policies continue to damage Japan’s economic prospects. In the mid-2010s, the Japanese had enthusiastically supported the Trans-Pacific Partnership that US President Barack Obama negotiated with 11 other Pacific Rim countries. The TPP would have created the world’s largest free-trade area even though it excluded China. But Trump withdrew the US from the TPP during his first days in office, ceding the field to America’s great rival. While Abe successfully led an effort to create a free-trade area comprising the remaining countries, the absence of US participation has prevented that successor agreement from becoming a major catalyst of economic growth.

Worse, the Biden administration has not only kept most of Trump’s protectionist measures in place; it has also rolled out industrial policies such as the Inflation Reduction Act (IRA) and the CHIPS and Science Act, both of which directly threaten the Japanese economy (and many other US “friends”).

Auto exports are a mainstay of the Japanese economy, and some Japanese firms have been among the leaders in the shift to electric vehicles and batteries. But the IRA will now subsidize US purchases of US-made EVs to the tune of $7,500 per vehicle, openly discriminating against Japanese (and other) foreign producers. Likewise, the CHIPS Act subsidizes construction of semiconductor “fabs” in the US, undercutting Japan in another key sector. And on top of it all, the US is demanding that Japan not export to China products containing American-made components deemed sensitive to national security.

In response to these policies, Japanese companies are already directing new investments to the US, implying that they are investing less at home. Worse, the Biden administration has hinted at introducing measures like those favoring US-made EVs and semiconductors across a broad range of other industries, which would create even greater incentives for Japanese firms to relocate operations or investments.

As a general matter, subsidizing individual companies and industries harms the economy even if other countries do not retaliate, because it distorts market competition. But America’s “friends” are retaliating, and in some cases outspending, Americans in subsidizing their producers. The net effect is that taxpayers in all subsidizing countries are forced to pay for policies that cancel each other out, while more efficient producers lose markets to less efficient ones.

At a time when the US is asking its allies to increase their defense spending to meet the challenge posed by China, such waste is pure folly. Pro-growth policies by America and its allies – such as strengthening research and innovation and the quality and skills of the labor force – would do far more to achieve these countries’ geopolitical and economic goals.

Anne O. Krueger: A former World Bank chief economist and former first deputy managing director of the International Monetary Fund, is Senior Research Professor of International Economics at the Johns Hopkins University School of Advanced International Studies and Senior Fellow at the Center for International Development at Stanford University.

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