Japanese Phoenix-The Long Road to Economic Revival

Fifty years ago, Japan arose from the ashes of war to achieve an incredible period of economic growth. Japan will arise again. And its economic growth will eventually outstrip America's.

The information technology revolution in Japan will be greater than the US's. But it will take Japan a decade of bumpiness for it to get there. This decade will not be a period of slow, incremental reform, as some argue. Rather, it will be a period of clashes-between the reformers and the resistance. Ultimately, Japan's is a problem of governance. So many of the political and economic institutions will not survive the process. The Liberal Democratic Party will split and it may even disappear. There will be new personalities, new parties, and new political alignments.

Why will it take ten years? The problems are so deep that Japan needs at least five years of doing the right thing for the real economy to recover. Before that, however, Japan has to do what is right; and that won't happen for another five years from now.

Japan will not slowly turn into an Argentina. Why? First of all, from the many conversations I have had with people in Japanese media, academia, and business, it is clear to me that the Japanese people understand the country's problems. The problem is that you have a great nation trapped in its institutions. Competition in business and politics is needed.

Second, failure to reform would be destabilizing. Japan needs nominal and real growth; otherwise things fall apart. Without economic growth, you cannot help one group without hurting another. If you help urban dwellers by allowing cheap imports, you hurt the farmers. You cannot satisfy all groups as you could during times of growth. There are many discouraged workers and people that have not entered the workforce (such as young people and mothers who choose not to work). So the unemployment rate is actually around 8.5% and it will keep rising. Japan is losing its security and only half the people in the workforce are covered by unemployment compensation. Japan cannot muddle through.

To recover, Japan needs to develop the right institutions. But what does reform really amount to? The reformers do not agree. It is budget reform? Is it tax reform? Here is my opinion about what structural reform is.

When looking at the hundreds of areas that constitute structural reform, you can test the legitimacy of each area with a test. Does the proposal solve the two obstacles to recovery?

The first obstacle is a supply problem, namely productivity and efficiency. Productivity is so bad, even if Japan's industries were operating at full capacity, the country would only be able to grow at one or one and a half percent per year. The second obstacle is chronically weak demand. Japan has a form of economic anorexia: it cannot consume what it produces. The cash is not circulating from the corporations to the households. Tokyo Style, for example, hordes cash that it does not know how to use.

Though it is important, the Big Bang, or financial reform, has not been able to do its job. The financial system is supposed to allocate capital to the right parts of the economy. Instead we have seen growth in financial socialism. Political criteria, and not profitability, decide whether or not loans are made. This has offset the Big Bang.

When you talk about corporate reform, competition and shareholder power make companies do the right thing. But Japan is full of cozy oligopolies. The Japan Fair Trade Commission is just not doing its job and is, in fact, going backward. Most mergers and acquisitions are cases of weak companies getting together to form bigger oligopolies that can control and will raise prices. Sometimes bigger is better, but this is true less so these days. In fact, internal competition within industries is key.

Also the rate of company births and deaths is important. In Japan, the mammals are growing up, but the dinosaurs are protected. The death of firms is important for releasing capital and labor. But lousy firms are not being destroyed. Among the OECD countries, Japan has the lowest rate of births and deaths of companies. Therefore, labor mobility is low.

So what is being done to address antitrust? The JFTC now looks at companies' market share in the world, not just in Japan. This is fine for companies with international exposure. But, as many companies only operate in the domestic market, this is the wrong criterion to use. The international market is not the place to look.

When people talk about labor reform, they talk about cutting wages. No. This is the wrong way to go. Labor reform means labor mobility, downsizing, and the like. Industries can actually grow as a result of downsizing and declines in prices. Trapping workers in a company hurts demand and efficiency.

Globalization in the form of financial integration is happening, however. The foreign share of the stock market is getting bigger. Banks and capital markets will start fighting. But who will run the capital markets? If the old banks take over, I will fear for the capital markets. We need new institutions-some foreign-in the capital markets.

A lot of tax reform is going in the wrong direction. The housing tax credit is good. But giving tax cuts to corporations and rich individuals while raising the taxes of the middle class hurts demand. You are lowering the taxes of the savers. Maybe Great Britain and the US tried this strategy in the past, but Japan's problems are different. Japan is a high saving nation. A tax cut on capital gains is a recipe for more Tokyo Styles. It encourages companies to leave their money inside the company instead of paying out dividends to shareholders. What should happen is a tax break for dividends.

Japan is reforming and backtracking at the same time. Today for every one step Japan takes forward, it takes two back. The resistance is winning. But if this were a boxing match, this would only be only round two. In the end, Japan must reform because otherwise it risks political instability.

Q: You say labor mobility has declined. This seems counterintuitive. Has labor mobility really declined?

There is job loss through attrition, but not real mobility. You also see the use of part-timers without benefits. People are stuck in firms. Rigidities in the labor market have actually increased. If you were able to change the laws so that companies were able to lay people off, you could solve a lot of problems. This is, however, a collective action problem. How can you lay people off, when other companies don't hire 40 year olds and age discrimination is still legal? You have to solve ten problems to solve one.

Q: Japan needs unemployment insurance, so that a job loss would not be so catastrophic to a person's life. What is the first measure to take? The labor law or what?

It is a dilemma. First, you need to deal with the unemployment compensation problem. Only half of the workforce is covered. And it is only based on base pay. Suppose you increase the deficit to solve the non-performing loans problem, which means foreclosing on bad borrowers. This means spending a lot of money. Rating companies would actually view this kind of move favorably. Not all deficits are created equal. Spending money for the unemployment system would also be a very good investment because it allows you to do the other things you need to do. In terms of labor laws, the government and corporations need to get together to reach an agreement, for example on lateral hiring. Unless labor is more flexible, you will be spending all your money on unemployment compensation.

Q: If you put your policies into effect, you could see a domino effect and a collapsing bond market, blasting the economy. Don't you think that the budget deficit presents a problem to your policy recommendations?

The reason Japan's budget deficit is so high is that demand is so weak. The issue is not anxiety; it is income. Consumer spending tracks consumer income. If the government cuts spending, you go deeper into recession. But if you keep spending on deficits that do not revive consumption, you run into the problems you mentioned. There is some breaking point. Imagine you are a doctor. If you come to a car accident and find a guy with broken bones, bleeding from the arteries, and not breathing. What do you do? Broken bones are last. Fix the breathing first or else he will be brain dead. Prime Minister Koizumi is a sincere doctor who is working very hard on the arteries (the budget deficit). Meanwhile, the brain cells are going dead one by one. Breathing is the non-performing loan problem. This is not being done. You don't bailout bankrupt corporations. You must solve the NPL problem first. Yes it will cost a lot of money. But from the standpoint of investors and rating agencies, investing the ten-year bond is safe if the government is investing in areas that will solve the problem. The cost of reform will only get bigger with delay.

Q: What do you mean Japan's problems are "not that bad?"

What I mean is that Japan is not Argentina, nor is it Poland or Indonesia. Japan's economy is dead in the water. Which is hard to do, by the way. BMW sales are up, but sales of cheaper cars are down. But people are not starving in the streets either. There won't be a 10% fall in GDP. These are not unsolvable problems. They could have been solved before, except there were problems of governance. But there is also fear of chaos and social dislocation. Bankruptcy is not chaos. But the fear is paralyzing.

Q: Do you have a device for recycling the NPLs?

There is an expression: don't bet on the horse, bet on the jockey. Non-performing borrowers are the problem. You have to distinguish between the companies that will be reorganized and those that will be liquidated. If you look at Shinsei Bank and Nissan Motors, I wonder how much of the bad borrowers are due to structural problems and how much is just bad management. The policy must be to foreclose on zombie borrowers because zombie companies create more zombies.

Q: Some say that Japan's demographic shift is the main problem.

Demographics will force reform. The labor force is shrinking. The only way to support Japan's aging population is for each worker to produce more. The alternative is to raise taxes. Can you get productivity growth to deal with the changes in demographics? I believe three percent growth per year is feasible. The advantage of backwardness is with reform, you can get a lot of productivity growth.

Q: Are there external pressures that could force political realignment in Japan?

The biggest external pressure is foreign direct investment. You have these chains of cartels. At the ends of the chains is finance (who gets the money) and retail (passing costs to consumers). Toys "R" Us forced other retailers to offer discounts. The growing anxiety of baby boomers will be a driver that may break up the LDP. That's the breaking point.

Q: Positive economic growth is forecasted for Japan. Might this lead to complacency? Who will lead Japan if Koizumi cannot?

It does not matter who is at the head of the LDP. The LDP cannot do the reform without tearing itself apart. I agree that growth might lead to complacency. People need to know what the reform package will be.