The National Interest: May I begin, please, by asking each of you your view of what has happened, or not happened, since this past September 11 that may be described as out of line with the early post-attack expectations of economic analysts?

Martin Feldstein: After September 11 of last year, you will recall that stock markets collapsed, and the reason was obvious: People were afraid. Consumers worried that the U.S. economy would go into a tailspin, and businessmen worried that such expectations would create a self-fulfilling prophecy. In fact, the economy did very well. It has since slowed down, but this is part of a normal cyclical pattern. I don't think we can attribute very much to September 11 insofar as broad economic effects are concerned, and I think this does run contrary to many expectations at the time.

Carla Hills: Anticipations of damage may have been excessive, but security concerns continue to be a drag on the market. Companies are spending for protection, an expense they had no idea would be needed before last September 11. The congestion at our borders, north and south, has had an adverse effect on some sectors, too. Many believe--indeed, the administration has said explicitly that it believes--that another strike is highly likely. This makes the market quite jittery, and this is not about to go away.

TNI: Let me ask this as an addendum: Had the war in Afghanistan not gone as swiftly and successfully as it did, do you think it would have made any difference? In other words, would a general lack of confidence in the conduct of the war against terrorism have translated psychologically into a greater lack of confidence in the economy?

MF: Good question, but it's very hard to say.

CH: It is, indeed, hard to say, but I think we need to keep in mind that the war on terrorism is not over with the campaign in Afghanistan. Clearly, large numbers of bright and thinking people are concerned about the road ahead. Their concerns enter into how the government plans its budget, and into the planning of both companies and individuals. It affects the countries that they will invest in and a host of other decisions. So, yes, there is a link between how people perceive the war on terrorism to be going and their economic decisions on a range of issues and levels. But as Marty suggests, tying down the details of the relationship is very difficult.

East Asian Prospects

TNI: Let's tour the world, shall we? Japan is still, I believe, the world's second-largest economy--unless one counts Europe's euro zone as a single economy (which I, as a Euroskeptic, do not--at least not yet). And the Japanese are having great difficulties getting out of their protracted recession. Why has it proven so difficult for them to shake their problems?

MF: The Japanese lack the political ability to tackle the restructuring that they need to undertake. They lack the political wherewithal to put funds into a restructured banking system--if indeed they could summon the courage to restructure it. And many large non-financial companies, especially in construction and retailing, also need to be foreclosed or restructured. At the same time, the Bank of Japan is trying unsuccessfully to provide stimulus to the system. It has driven interest rates down; indeed, short-term interest rates are down to virtually zero and the longer-term rate is just one percent. But the banks aren't lending because they are afraid to take the risk, as they see it, of lending additional money while the economy is at a standstill and many businesses are insolvent. In sum, then, the Japanese can't deal with their long-term restructuring problems, and they can't achieve the short-term cyclical turnaround that they need to stop prices from falling and to start creating more jobs.

CH: I don't disagree.

TNI: Let me press a little further on the particulars of the political aspects of this problem. Banks will be banks, and consumer psychology, as ever, remains something of a mystery, and that explains, as you suggest, some of Japan's problems--especially its shorter-term ones. But how much of the seeming structural paralysis has to do with the relationship between the ruling LDP (Liberal Democratic Party), the large industries and the ministries that deal with them, and the banks?

MF: Yes, ultimately, there are a lot of industries that are very well connected with the LDP--and the politicians, who benefit in many ways from these connections, are unwilling to force bankruptcies upon those industries. That, in turn, contributes a lot to the problems that the banks have, and it helps explain why stimulus policies emanating from the Bank of Japan do not have the impact they otherwise might. Moreover, if Japanese policymakers took the right kinds of fiscal actions, by reshaping the tax system, they could stimulate the economy. That would make it possible to deal with the long-term problems--so we should not separate sharply what we call short-term and long-term problems.

TNI: Let's move on to China. China has acceded to the WTO and now faces a series of adjustments, some easy and some that pose very difficult dilemmas for them. They have a schedule against which to make those adjustments. How are they doing in the early going, and what would you project would be their course?

CH: China has made enormous progress in recent months. They've enacted thousands of new laws and regulations, and published many of them. This may not seem to some like a major event, but this makes China as a WTO member very different from the China that existed before the WTO. They have a great deal more to do. As you say, the challenges before them are tremendous. Their banking system is carrying huge amounts of non-performing loans that have been made to state-owned enterprises. Some state-owned enterprises have been privatized but many are still getting loans that will never be repaid in order to make products that are neither wanted nor needed. That is because state-owned enterprises continue to provide employment to people who otherwise would be left out of China's continuing surge of economic growth. China needs to create about 30 million jobs to absorb the unemployment that will be caused by the restructuring that the government has promised. If that does not sound daunting enough, consider that about 10 million Chinese enter the workforce every year. So they have a huge challenge before them.

Moreover, the Chinese have not yet developed a safety net to provide pensions and protections for those who are laid off; that is another reason why it is so difficult and potentially so unsettling politically to privatize the state-owned enterprises rapidly. These enterprises have traditionally supplied what social safety net that does exist. But reforming too slowly has adverse implications, too--not least for a banking system that, as I just said, suffers from too many politically-directed loans to economically deficient enterprises.

China also faces an enormous problem with rural unemployment and poverty, which is truly grinding. The rural sector is not only growing at a much slower rate than the urban sector, it is actually declining. That is why China has an estimated floating population of about 150 million--people who have left farms in search of work in the cities--and it is why the urban-rural gap is growing rapidly. It is in the countryside then, not surprisingly, where we are seeing a rising tide of protests and uprisings against local authorities.

So China has an enormous challenge before it, but it has made tremendous progress, and it is clearly a different country than it was a decade ago. Changes on such a scale take time; we need to continue to work with China, in my view--patiently and for as long as necessary--because these changes, whatever their temporary side effects, are as positive for the United States as they are for China and East Asia.

TNI: Let's talk for a moment about the impact of these changes in China on the rest of Asia, especially Southeast Asia. As I understand it, the huge size of China's poor population suggests that China will maintain a competitive labor wage advantage for a long time. This worries countries such as Indonesia, Malaysia, Thailand and others; they fear that there is no bottom to China's capacity to be a production platform--to make things cheaper than everybody else--and, hence, to capture export markets more effectively than everybody else. Are these worries justified?

MF: There are really two issues here. First, not only is the size of China not a handicap--after all, China has been growing at about 6-8 percent a year for the past many years--but the potential of China as a market is a major factor. Foreign businesses value their positions in China not just because wages are low, but because the market is enormous.

Now, with respect to the fears of their neighbors, I also hear that a lot when I am in Asia. And it is true, the Chinese will end up making some things now being made in Thailand or Korea; but they're not going to make everything, and the Thais, Indonesians, Malaysians and others have their own relative advantage. They will remain major exporters.