Japan Must Confront Its Culture of Lies
By David Roche
President of Independent Strategy, a London-based investment consultancy.
Wall St. Journal
June 29, 2001

After a decade of public spending programs and huge budget deficits designed to boost the economy, the figures show Japan heading back into recession. If ever there was a time for reform, President Bush should tell Prime Minister Junichiro Koizumi this weekend, this is it. By reform, I mean cleaning up the banks and government finances, and liberalizing markets, particularly for labor. And the lodestar by which to judge whether reform is really happening is Japan's attitude to its own history in and around World War II.

The reason is not just moral, but practical. Nations like Japan that don't face their own past squarely usually have political and corporate systems that focus on maintaining stability and the status quo, and are quite prepared to lie to themselves to achieve this. Japan's failure to address its war guilt is part and parcel of a culture of denial in facing corporate failure, an insolvent financial system, bankrupt state finances, and endemic political corruption. In a sense, reform in Japan is all about changing this culture and facing truth.

For Japan to clean up its historical act is also important from a broader Asian perspective. Japan is the only country in Asia that can provide economic leadership and an anchor of democratic political stability. But until Japan becomes the locus of economic dynamism, the source of cheap capital, and the anchor for an Asian single currency, I doubt that Asia will realize its potential. Instead, Asia will slowly become dominated by China.

The single greatest economic truth to be learned from the euro is a historical one A single currency is the ultimate construct that binds disparate nations together prosperously and peacefully. But it can only happen if each nation has come to terms with its own history. If Germany was still claiming it did nothing wrong in the Nazi period, you can be pretty sure the single market and the single currency would never have happened. Europe would be the poorer for it. A real reformist government in Japan should get this overdue job done for its own and Asia's sake.

Currently, there is much hope that the new prime minister will deliver the goods. But as yet Mr. Koizumi has no mandate from the people to go for reform. What he has is a mongrel mandate from his party, the Liberal Democrats, based on the hope he can stave off disaster in the upper house election on July 29, and a sense that things cannot go on as before. That isn't the same thing as saying that the LDP or the Japanese people have opted for a proper reform program. If Mr. Koizumi is to do that, he has to go to the people in a general election to get a full mandate.

There's the rub. The Japanese voter is an even bigger stumbling block to reform than the manipulations of the politicians. Japan is a very comfortable country that works. The trains run on time. The health service is excellent. Plumbers are proud to be plumbers. In contrast to the U.S., Japan's corruption pyramid is inverted, with most crime at the top and little at street level, where most live their predictable, secure and wealthy daily lives.

There is little awareness of the pain that reform will cause. In a recent survey, 50% of respondents put a new fiscal stimulus package at the top of their priority list, and 46% put structural reform there. When it comes to switching political and social systems (which switching economic models always entails) in a democratic society, the either-or principle applies. This says that "either you, the voters, accept the pain of reform or the pain of not doing so will be greater." Japan lacks the either and the or. Its citizens believe there will be no pain from reform, only gain. When they realize the truth, the backlash against the reformers could be considerable.

Look at the economic pain. I reckon the cost of cleaning up the banking system's bad debts could add another 20 percentage points of gross domestic product to government debt, already at 130% of GDP -- the highest in the  Organization for Economic Cooperation and Development and even higher than Italy's in the bad old days. That would take interest costs to over 30% of government spending. And that's not the end of it. Over the years, the Japanese government has raided the Post Office savings accounts and public pension funds to finance political handouts, financial bailouts, equity-market support operations and fiscal-stimulus projects. Over the past 10 years, over 80% of the increase in household savings was lent to the government in one form or another by the financial system. These public assets are now probably worth just 30% to 40% of their face value. So the government owes Japanese citizens another hidden 30% of GDP. And when you add in around 130% of GDP in the net present value of unfunded pension liabilities, Japan's public-sector debt heads towards 300% of GDP.

Eventually, the government will have to come clean. But the impact of proper reform will be higher government debt costs, as the terrible state of public finances becomes clear. To keep public support for reform and avoid a deflationary cave-in of the economy, the government would have to protect household wealth. It would have to guarantee household deposits and print money like crazy. That means a weak yen. In a nutshell, a weaker yen seems to be a safe bet over time. If there is no reform, the yen will sink as capital exits Japan.

If there is reform, a weaker yen will be needed to offset deflation. The big winner from reform would be equities. If reform were to bring the level of return on equity in Japan to that of the U.S., the Nikkei's price/earnings ratio would be just seven. That's a steal. Money would flood in from abroad to buy Japanese equities based on such giddy hopes.

But don't hold your breath. Mr. Koizumi is not going to rush into breaking down the culture and attitudes of decades. More likely, he will start the wave unfurling, but not bring it crashing down. In Japan, even a wave is a break with ritual. It's just that the change can be drawn out like an eternal tea ceremony.