Alarmism Paralyzes Japan
By Richard Katz
The Oriental Economist
February 27, 2002Only a few years back, Forbes was exhorting its readers to buy Japanese stocks before it was too late. At the time, the Nikkei stock index was 22000. Today, it's 10000. Now the magazine is warning of a global depression caused by a crash in Tokyo.
Today's alarmism is just as unfounded as yesterday's optimism. Japan is not Argentina. Yes, it is in the throes of yet another financial crisis. But there's a world of difference between a financial crisis that must be handled and a meltdown that cannot be handled.
Japan will not slowly sink into the Pacific. On the contrary, Japan will eventually reform. And when it does, it will win the world's admiration. Its per capita GDP will grow faster than in the U.S. Its information technology revolution will prove even more revolutionary -- precisely because all the inefficiencies eliminated by IT are greater in Japan. As Japan's inefficient industries reform, sustained GDP growth of 3%, or more, is within reach.
The bad news is that it will take 10 more years to reach this promised land, and the journey will be very bumpy. This year's financial crisis is one of those bumps, as was the grass-roots revolt that made Junichiro Koizumi prime minister last year.
So deep-seated are Japan's dysfunctions that, even if it did everything right today, it would take another five years to get back to truly vibrant growth. And Japan will not do everything right today. The government's latest anti-deflation package, which is expected to be announced this evening, is mostly just a new label on old measures. Opposition to reform remains deep-seated, with a myriad of vested interests and millions of jobs at stake.
Japan's dilemma is that the obstacles to growth are woven into the very fabric of its political economy. Years of corporate collusion and protective regulations have eroded productivity growth. Even at full capacity, an unreformed Japan cannot grow faster than 1.25% to 1.5% a year. And yet, despite enormous budget deficits and zero interest rates, Japan cannot even attain full capacity. Endemic excess capacity suppresses investment while falling wages and other factors suppress consumer income.
Paradoxically, the very obstacles to growth serve as pillars of the political system. Collusion, regulations, high prices and bank loans to insolvent firms all serve as covert social safety nets in a nation where only half the workforce is covered by unemployment insurance. The electorate is divided between those who would benefit from reform and those who would be hurt by it.
Nonetheless, Japan will eventually undertake the necessary changes. While reform is destabilizing, failure to reform is even more destabilizing in the long run. Japan's political stability rests on economic growth. Take away growth and unbridgeable conflicts of interests arise. Each action to plug the leaky dike just causes the leak to break out elsewhere.
The zero interest rates used to keep borrowers and banks afloat have decimated the life insurers and pension funds, not to mention the interest income -- and thus the spending -- of millions of retirees. Meanwhile, firms are trimming staff and wages. Two million jobs have disappeared and, 2000 aside, real wages have been falling since 1997. Reduced wages mean reduced spending. Forced to cut my costs, I end up cutting your sales. Profits slump even more than wages.
All of this stagnation and bad debt shows up as an intractable banking crisis. But such a crisis is still a long way from a financial meltdown. Alarmist headlines predict a depositor run beginning around April 1, when deposit insurance will be lowered to "only" 10 million yen ($75,000) per person. Yet, 90% of Japanese households have total savings less than this amount. And those who have more can simply divide their accounts between two banks.
More fundamentally, there is a huge difference between Japan and South Korea or Argentina -- two countries that have suffered genuine economic implosions in recent years. Those countries both ran big trade deficits. When the foreigners pulled their money out, the oil and spare parts stopped coming in. Factories shut down. None of that will happen in Japan because it is a net creditor.
Tokyo can suppress crisis by throwing a lot of money at the problem -- and that is what Mr. Koizumi has decided to do. Today's anti-deflation package is not expected to include any specific measures. The only issues are when, how and how much money the government eventually puts forward. Tokyo might inject this directly into the banks with a facade of conditionality, as in 1999. The government's Resolution and Collection Corporation might buy up the bad debt at some favorable rate without foreclosing on the debtors.
What Mr. Koizumi won't do is "bite the bullet" on all the nonperforming borrowers that stand behind the nonperforming loans. He signaled this when his aides pressed the banks to give more than $2.3 billion in debt forgiveness to Daiei -- a retailing empire with $17 billion in debt and 100,000 employees.
The fact that even a committed reformer like Mr. Koizumi would repeat the errors of his predecessors shows the depth of Japan's dilemma. It also shows the strength of the resistance within his own Liberal Democratic Party to any crackdown on the bad debtors.
But that is only part of the story. Mr. Koizumi cannot fix Japan's budget deficit and its banking problems at the same time. Curing the banking ills will cost a lot: for a capital injection, this time with strict conditions; for unemployment compensation for three to four million newly unemployed; and for a big consumer tax cut to overcome the contractionary effect of so many bankruptcies and layoffs.
Forced to choose, Mr. Koizumi has prioritized the budget, partly due to the mounting public debt. But it is also an attempt to tackle the "iron quadrangle" of public corporations, construction firms, politicians and bureaucrats -- whom he rightly sees as a corrupt and parasitic cancer on the economy. Mr. Koizumi believes little else in the way of reform can be done until this political machine is destroyed, and budget cuts cut off their allowance.
It's an understandable priority, but the wrong one. If public works are the problem, it would be better to cut taxes. By tightening the deficit in the midst of a recession, he is making the economic situation worse and making it harder to solve other problems. Tokyo cannot keep the insolvent borrowers afloat while maintaining economic growth, because the bad borrowers create such excess capacity and deflationary pressures that healthier companies are unable to grow.
Mr. Koizumi hopes to limit the budgetary cost by restricting action to a bailout, rather than foreclosures on the borrowers. He also dreads the political and social impact of mass unemployment, not seeming to realize that "muddling through" is already destroying jobs -- with more losses to come.
The final factor is exaggerated fears that pulling on a few threads of Japan's tightly woven political economy could unravel the entire tapestry. Officials warned Mr. Koizumi that Daiei's failure could bring down the banking system. But that is difficult to imagine, as Daiei's debts at the big banks amounted to only 0.8% of their total loans. If the banks don't have the capital and reserves to cover this, government money will be needed, but whence the calamity? That is why unfounded alarmism is so dangerous, since it paralyzes the hand of reform.
Japan is a great nation mired in obsolete institutions. In the end, it will act -- once the pain of inaction surpasses the pain of action. Until then, the danger is not a cataclysm but relentless corrosion, not a meltdown but fear of a meltdown.
Mr. Katz is senior editor of The Oriental Economist Report.