JPRI Critique, Vol. XIII, No. 2 (October 2006)
Will "Bretton Woods II" Be Caught in a Japanese-Chinese Crossfire?
By Marshall Auerback

"Bretton Woods II" -- a continuation by other means of the dollar-centered international order that prevailed in the postwar decades - seems contrary to all economic logic.   The world's savviest observers - former Federal Reserve Chairman Paul Volcker, leading investor Warren Buffett, Japanese Finance Ministry specialist Eisuke Sakakibara, and former Bundesbank President Hans Tietmeyer among others - have all pronounced the trend lines of the U.S. financial deficits to be unsustainable. No realistic scenario can be imagined under which those trends will be reversed through political action, leaving only a dollar crash to do the job. Yet the dollar crash has stubbornly refused to occur.

The reality is that the players who have the most relevant say in this matter, the central bankers of East Asia, notably Japan and China, still have a vested interest in the continuation of a dollar-dominated financial system. But are the motives of Japan and China - two of the three key players in this new global framework - identical?   Do these countries share the same long term interests?   Related to this issue is the question: can the United States and Japan, two of today's rich and established powers, adjust to the reemergence of China as a modern superpower? Or is China's ascendancy to be marked by yet further tensions, which could easily undermine the current Bretton Woods II system, and thereby finally bring to the fore the long awaited dollar crash (and all that follows)?   

In strictly economic terms, both Beijing and Tokyo would appear to have a coincidence of interests in continuing to support the monetary status quo embodied by Bretton Woods II.   As the world's largest holders of dollars, these two countries stand to lose the most in any general dollar crash (other than perhaps the U.S. itself). Both find themselves in the position of a market player who has cornered so much of what is being traded that he cannot liquidate his position without destroying its value--and in the meantime, has to pony up more and more to support it.

But economic calculations illuminate only part of a picture.   There is a political dimension to this monetary framework, and it is here that conflicting objectives threaten to undermine the core stability at the heart of Bretton Woods II.  

The Japanese view their alliance with the U.S. as the best means of forestalling Beijing's dominance of Asia and beyond.   And they have become less averse to flexing their nationalistic muscles alongside Washington to reflect this fact.   In this regard, Bretton Woods II dovetails nicely with Japan's political objectives, because an economically stable U.S. better helps Tokyo to retain its pre-eminent position in Asia.

By contrast, t he Chinese know that the radical neo-con intellectuals who assumed positions of influence in the Bush White House had identified China as a new "strategic competitor" and were spoiling for a fight, until their attention was diverted by Osama bin Laden. While Japan hastened to prove itself the perfect 'ally' in the Bush war on terror, Beijing has increasingly come to regard the U.S. as an American patsy that can never be trusted.  

One therefore has the sense that Beijing views the current monetary system as a holding pattern of convenience until they can get their own economic house completely in order, rather than a stable, long term monetary framework. China essentially hopes that, if and when the dollar-centric global financial regime unravels, it will have an economy sufficiently developed to permit the yuan to takes its place among the world's major currencies without the need for external backing that the country's dollar reserves currently provide. That will allow it to deal with the collapse of American purchasing power when the U.S. is finally forced to live within its means.  And if, in the course of this economic reckoning, the implosion from imperial overstretch (and a hollowed out manufacturing sector to boot) also helps to take down Japan a notch or two, so much the better, because China has long (and unpleasant) historic memories of Japan's domination of Asia some 60 years ago.  

The feelings of mutual suspicion between Beijing and Tokyo are likely to grow. Japan's new, nationalistic prime minister, Shinzo Abe, is a political "blue-blood" whose grandfather, former Prime Minister Nobusuke Kishi, was once charged as a war criminal following World War II (after serving as Munitions Minister in the Tojo Cabinet). Abe struck a chord among voters by taking a hard line on North Korea.   He has also consistently argued that he would strike at missile sites before Kim Jong-Il could fire off any weapons against Japan (a claim that will be scrutinized more seriously in light of Pyongyang's recent actions).

But more significant has been his ambiguous posture vis-à-vis China.   During the past decade, notably under incumbent Prime Minister Junichiro Koizumi, China has largely experienced tense relations with Japan as a result of a number of issues. These issues include, but are not limited to, Chinese opposition to a Japanese permanent seat on the U.N. Security Council (which Abe has already enunciated as one of the main foreign policy goals of his administration), former Taiwanese President Lee Teng Hui's visit to Japan at the end of 2004, conflicts over the Diaoyu or Senkaku islands, and the Chunxiao gas field northeast of Taiwan (which according to a 1999 Japanese survey holds 200 billion cubic meters of gas), the overt naming of China as a long term strategic threat to Tokyo in 2004, and Japanese Prime Minister Koizumi's annual visits to the Yasukuni Shrine that honours war-dead including 14 Class A war criminals.  

Abe has angered China , but pleased many Japanese, by defending his nation's stance on its wartime record and the way it commemorates its war dead.   If anything   Abe is a more committed nationalist and right-winger than his predecessor, and he too has been a habitual worshipper at Yasukuni. But, after refusing to do so just prior to his election, he has now embraced a 1995 apology that expresses heartfelt regret for Japanese rapaciousness during the Second World War in his October 8 meeting in Beijing.

"The course Japan has taken over the 60 years since the end of World War II is based on a deep apology for the great suffering and pain caused in the past by Japan on the peoples of Asian nations and the scars that have remained," he said, echoing the words of the statement made on the 50th anniversary of Japan's surrender by Tomiichi Murayama, then the prime minister. "This is a feeling that I also feel, and a feeling I will always have in the future."

Does this signal a change in policy on the part of Abe?   Certainly, his Chinese hosts appeared relieved at having the opportunity to remove this impasse in Sino-Japanese relations, which was causing anxiety to Japanese investors, fearful of consumer boycotts and unrest in their Chinese factories. For its part, the Chinese Government, nervous about mass displays of popular sentiment, appeared to be rattled by the anti-Japanese riots in Shanghai in April of last year.

In a joint statement issued by the two countries (the first in seven years), Abe and Chinese President Hu Jintao resolved to do all they could to prevent their mutual neighbor, North Korea, from carrying out its ambitions to become a nuclear power. Abe said: "We have a common foundation, understanding and perception that we can never tolerate this."    The limits of this tolerance and the question as to whether Beijing will match Abe's robustness are likely to be tested in light of Pyongyang's declaration that it successfully tested a nuclear device at the same time as the Sino-Japanese summit.

But even if one assumes agreement on North Korea, Abe's longer term objectives still appear likely to bring the nation into conflict with Beijing in spite of the apparently harmonious tone of the summit.   It was noteworthy, for example, that neither the contentious issue of the visits to Yasukuni Shrine nor the Japanese constitutional question was raised directly.   Abe has not said whether he will visit Yasukuni, but he did say he would deal with the issue "appropriately" - a phrase also employed by Koizumi, who nevertheless made an annual pilgrimage.   So this issue could arise again as a potential irritant in relations between Beijing and Tokyo.

More significantly, Abe has already stated publicly that his main priority is to change Japan's constitution, written by the Americans after 1945, to allow its armed forces to act in collective self-defense alongside the U.S.    In his first act after being installed as prime minister, he appointed a cabinet packed with social conservatives and foreign-policy hawks. Abe's embrace of nationalism alarms Japan's principal wartime victims, China and the two Koreas, but it is winning quiet applause from the United States, which foresees an enduring change in Japanese military policy.    According to Richard Halloran, an authority on the U.S.-Japanese alliance, Japan is on the brink of sweeping changes in its security policy to rebalance its forces away from the vanished Soviet threat and towards the perceived Chinese one. The top American officer in Japan, Lieutenant-General Bruce Wright, told Halloran that "a monumental change" has taken place in Japanese attitudes. Tokyo has established a joint command center with the Americans, which captured data when North Korea fired missiles into the Sea of Japan in July 2006. The Japanese have upgraded their air defense technology and updated their navy.

Throughout the post-war period, Washington has continued to exercise immense indirect power in Japan from the creation of its "Peace Constitution" onward.   But during the 1970s and 1980s, one had the sense that the country embraced American strategic defence objectives with great reluctance, and only under extreme pressure from successive American governments (so-called " gaiatsu" ).  

Under Koizumi, this changed dramatically:   Japan became one of the most outspoken supporters of the Bush administration's global agenda, even to the point of enthusiastically committing troops to Iraq. In early December, 2004, Koizumi extended by a year the deployment of 550 ground troops in Iraq, the biggest and most controversial dispatch since the Second World War. His government also persisted in pushing for a revision to the 57-year-old pacifist constitution that would enable more effective participation in such missions as a way of strengthening the U.S.-Japan alliance.

No post-war Japanese leader, not even the noted nationalist Prime Minister Yasuhiro Nakasone, went as far as Koizumi. His government's stance was in marked contrast to Tokyo's reticence to commit anything beyond substantial sums of cash during Gulf War I, payments that were made under duress following some very open arm-twisting by then Secretary of State, James Baker.

But today Japan is a different place.   No longer does Tokyo resist American pressure to advance a more assertive, nationalistic posture; much of the country now embraces a renewed nationalism, driven by a fear of loss of influence in the Asia/Pacific region (particularly due to the rise of China), and mounting frustrations of paying compensation in the form of hundreds of millions of dollars in loans and grants to South Korea. North Korea's nuclear weapons program has also contributed to an incremental remilitarization of Japan:   military budgets have been expanded and the government has progressively undercut its pacifist constitution by legitimizing and legalizing the sending of military forces abroad, as well as announcing a commitment to join the American missile defence ("Star Wars") program.

In many respects, Tokyo has become Washington's most valuable partner in the war on terror in that it helps to underwrite financially the latter's increasingly assertive interventionist global foreign policy.   It is hard to envisage a chronic debtor country like the U.S. mounting successive wars with little financial strain in the absence of Japanese support.   Indeed, as Chalmers Johnson has noted, part of Japan's debt is a product of its efforts to help prop up America's global imperial stance. For example, in the period since the end of the Cold War, Japan has subsidized America's military bases in Japan to the staggering tune of approximately $70 billion. Refusing to pay for its profligate consumption patterns and military expenditures through taxes on its own citizens, the United States is financing these outlays by going into debt to Japan, China, Taiwan, South Korea, Hong Kong, and OPEC. This situation has become increasingly unstable as the U.S. requires capital imports of at least $2 billion per day to pay for its governmental expenditures. Any decision by East Asian central banks to move significant parts of their foreign exchange reserves out of the dollar and into the euro or other currencies in order to protect themselves from dollar depreciation would produce the mother of all financial crises.   The Bank of Japan has largely acted as dollar sub-underwriter of last resort to forestall this eventuality.   Arguably, if Britain qualifies as America's "51 st state", Japan is the 52 nd .   

The contemporary Japanese-American political setup thus resembles a flourishing vine (Japan) that has grown to great heights around a pole (the United States), but would likely tumble should the pole around which it twists ever itself fail. But, as R. Taggart Murphy has noted, this image requires qualification, for not only does the pole support the vine, but the vine has, for the past 35 years, become an increasingly important prop for the pole:

"The U.S. needs Japan today to a far greater degree than it requires the United Kingdom. Japan's companies manufacture a range of both high value-added components and finished products on which American technological and military supremacy totally depends. Japan's continued central role in financing the U.S. trade and government deficits and propping up a dollar-centered international order is . . . the key explanation for Washington's ability to project and sustain a vast global military establishment without crushing domestic tax burdens. Since the mid-70s, at every crisis point when it has looked as if upheavals in the foreign-exchange market might force the U.S. to live within its means, it has been the Japanese elite that has acted to support the dollar, the Bretton Woods II regime and, by extension, the continuation of American hegemony." (R. Taggart Murphy, New Left Review, July-August 2006)

Clearly, Japan's policy makers have identified their country's own economic survival with the continuous build-up of (Japan-owned) dollars in the American banking system.   This is consistent with Japan's own historic traditions; for fifty years after the 1895 Sino-Japanese War, Murphy notes, much of what Japan did abroad was premised on attempts to forestall the rise of an independent Chinese power, while buttressing its own. Japan's long postwar acquiescence to the status of an American protectorate is, in part, a matter of following the path of least resistance toward this continuing objective. But it is also due to the belief, held by much of Tokyo's political elite, that the alternative to American protection is incorporation into a new Chinese Empire as a tributary state.

One could argue that China has similar interests in supporting the current financial stability implied by Bretton Woods II, but only until Beijing is economically strong enough to disentangle itself from dollar hegemony.   It clearly does not share Tokyo's strategic aspirations in East Asia, but seeks to replace it as the political and economic locus of the region.   It is prepared to remain a repository of huge U.S. dollar holdings in part because China needs to create millions of new jobs each year to forestall politically dangerous unemployment; Chinese leaders are acutely aware that large numbers of idle young men form a most reliable recipe for political disorder.  China's present strategy is to keep the engines of growth humming with exports on the one hand and a constant flow of foreign investment on the other. If rapid growth goes on long enough, China presumably hopes that the percentage of the country's total assets tied up in the state-run enterprises will be small enough to be manageable in any slowdown.

As such, there is a natural tension built into Bretton Woods II.   Japan is clearly discomfited by the rise of China and is doing as much as possible to forestall it. In this regard, it is broadly supported by the United States in spite of the latter's often expressed desire to turn Beijing into a "responsible stakeholder" in the global economy.   Beijing has replaced Tokyo as Washington's leading "unfair trade" bogeyman, presumably because although Japan's bilateral surpluses with the U.S. remain significant, Tokyo can offer something in the way of a strategic quid pro quo -- clearly not the case with China.

The issue of oil is also a major bone-of-contention . Beijing and Tokyo both want to exploit the oil and gas resources in the East China Sea, which has already led to near-clashes. After Japan began drilling for gas in disputed waters in 2005, Chinese state media warned that conflict was "inevitable."   Five Chinese warships, some armed with missiles, then appeared at a drilling platform in the sea near where Japan had staked its claim. According to Japan, the Chinese ships targeted a Japanese reconnaissance aircraft hovering overhead before choosing not to shoot it down. Tokyo did not back off; it fortified its claims in the sea and threatened military force against future Chinese actions.   

During the Abe-Hu summit in Beijing, the leaders promised to step up talks in the disputed area, and to revive frozen discussions on defense, economics and culture, but t he competition over energy resources is now becoming an additional area of contention over and above existing trade disputes between Tokyo and Beijing.   Indeed, China's growing presence on the international energy stage could ultimately bring it into confrontation with both Japan, and the world's largest energy consumer, the United States, where a growing number of American soldiers and sailors are being committed to the protection of overseas oil fields, pipeline, refineries, and tanker routes.   Given the parlous state of America's national finances, it is clear why Tokyo, with its huge repository of savings, is being brought in effectively to help underwrite this policy.   With these 3 global behemoths engaged in an increasingly fraught competition over an increasingly scarce resource, it is clear that the global economy will pay a higher price for oil, not only in dollar terms, but also in blood for every additional gallon of oil we seek to consume.

But, in the medium term, it is Taiwan which potentially marks the most explosive touchstone in the delicate triangular relationship of the U.S., China, and Japan.   Abe, who has been a supporter of Taiwan in the past, has told both sets of Chinese leaders that Japan has not changed its position of recognizing the island as part of China.   But the fact of the matter is that the U.S. has long held regular high-level military talks with Taiwan over defense of the island, ordered a shift of Army personnel and supplies to the Asia-Pacific region, and worked strenuously to promote the remilitarization of Japan. In contrast to most of East Asia, Taiwan readily embraces this:   Taiwan, it should be remembered, was a Japanese colony from 1895 to 1945, and experienced rather benign governance, in contrast to its Korean counterpart. Today, as a result, many Taiwanese speak Japanese and have a favorable view of Japan. Taiwan is virtually the only place in East Asia where Japanese are fully welcomed and liked.

Consequently, with Washington's direct encouragement, Japan has recently injected itself into the single most delicate and dangerous issue of East Asian international relations -- the problem of Taiwan.   On February 19, 2005, in Washington, Japan for the first time joined the administration in identifying security in the Taiwan Strait as a "common strategic objective." Nothing could have been more provocative to officials in Beijing that the realization that Tokyo was about to abandon almost six decades of official pacifism by claiming a right to intervene in the Taiwan Strait.   Abe gave no indication that he was prepared to reverse this position, despite the positive atmospherics in his discussions with Beijing.

One must also not ignore Washington's role in potentially fomenting additional trouble in this area, even as the U.S. and China appear to be in the process of institutionalizing a new top-tier dialogue between Washington and Beijing.   The Bush administration risks undermining its effectiveness by indirectly encouraging ongoing tensions between China and Japan on Taiwan. It appears highly unlikely that Washington would welcome a full rapprochement between Japan and China, given that this might compromise America's own perceived security interests in the Asia/Pacific.

By the same token, there are no guarantees that China will continue to act with comparative restraint on the issue of Taiwan, if it continues to be provoked by Washington and Tokyo.   The Chinese themselves might not politely wait until their own system is sufficiently robust to cope with the resultant financial instability.   Markets are jittery everywhere; their fears almost endless. There are an unseasoned Federal Reserve chairman who has yet to confront his first real crisis, the ongoing war in Iraq, an impending confrontation with Iran, the resultant disruption to supplies of crude to the Western economies, and the implosion of the U.S. housing bubble; all on top of the ever-present threat of a Chinese banking crisis, and the galloping U.S. current account deficit, which now shows the danger of reaching the threshold of debt trap dynamics.   Any one of these eventualities, or yet something else, could trigger a panicked flight from the dollar that would overwhelm the ability and willingness of the official sector to contain the flood and preserve the current Bretton Woods II system.   At which point the game of scapegoating would likely come into being, thereby further exacerbating underlying tensions among Washington, Beijing, and Tokyo.   This is one three-legged stool which might not stand the test of time.

Marshall Auerback is a global financial strategist based in Denver, Colorado, and a frequent contributor to the Japan Policy Research Institute.

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