Introduction

Very high real interest rates and a trade deficit that exceeded $100 billion in 1984 have caused much concern over the ability of American firms to keep up with their foreign competitors. A great deal of the discussion of this topic has focused particularly on Japan, because Japan alone accounted for a large fraction of this enormous overall 1984 trade deficit through its success in exporting to the United States goods once supplied primarily by domestic producers.

Attempts to explain this favorable Japanese performance have taken many forms. Some have suggested that Japan may have imposed barriers to American firms’ attempts at establishing markets – through explicit policy actions, or by means of collusion among government, producers, distributors, and banks, or because of lack of faith in the quality of U.S.- produced goods. Others have argued that the U.S. trade imbalance is the inevitable result of our elevated real exchange rate, which makes American goods more expensive than those of our trading partners. This high real exchange rate is, in turn, attributed by many to the unprecedented peacetime fiscal deficits currently being experienced.

Although each of these potential explanations may be important, there is a third on which we focus in this chapter: the cost of capital.