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KWR Viewpoints:

Japan: Give Prime Minister Koizumi a Break

By Uwe Bott, G.E. Capital (the views expressed here are solely his own and not necessarily those of GE Capital)

Every time I visited Japan over the last ten years things seemed to have gotten a little bit worse with diminishing hopes of a turnaround. Whichever way one looked at Japanese fundamentals, they caused grave concern. Throughout the 1990s and into this millennium, Japan suffered from low growth to no growth. Fiscal stimulus packages kept the economy from falling into the abyss. At the same time, these packages increased output volatility, a factor that had a negative impact on the underlying structure of the economy. Moreover, they were focused almost entirely on public works programs in a failed Keynesian approach to Japan’s fundamental problems.

Japan’s economic dilemma can be summed up as follows: The successful industrial policy of the post World War II period created an industrial complex in Japan made up of conglomerates, who prioritized volume growth and market share. Profitability was only of secondary interest. The long-term perspective of these conglomerates was much envied in the U.S. and Europe during the 1980s and it was broadly assumed around the world that Japanese companies would be propelled to be leaders in every major industry in the 21st century.

This did not come about for two key reasons. First of all, there was a drive towards global integration of markets, especially during the 1990s. This process entailed that the incumbents in key industries had to restructure to maintain their competitiveness in the future. Such restructuring required a flexible labor market that did not exist in Japan. Second, technological progress took a quantum leap in the 1990s. During the 1950s to 1980s, Japan had been masterful in adapting technology developed mainly in the U.S. to its industrial processes, hence producing superior goods in the electronics and automobile sectors in particular. However, Japan failed to adjust its educational system to prepare for the technological challenges of the mid- to late 1990s. As a result, the country was left with an outdated industrial structure, diminishing competitiveness and the economy missed the shift from the post-industrial age to the information age.

All of this occurred against the background of a bubble economy that burst in the early 1990s, and a permanently impaired financial sector due to its weak capital structure as well as its poorly performing assets. Consumer confidence never recovered and external demand was weak. Concerns about a rapidly aging population added to the medium-term pessimistic outlook. Fiscal and monetary policy completely failed to address the growing crisis. As a matter of fact, they made matters worse. Expansionary fiscal policy led to record public sector debt by any measure, and monetary policy set in motion a deflationary process that seemed unstoppable and that was likely to snuff out any recovery of domestic demand.

Government officials seemed completely unfazed by all of this. The Finance Ministry defended its ineffective prime pumping and discounted the danger of rising debt. Government officials also regarded concerns about the financial system as exaggerated. Finally, the Central Bank defended its monetary policy, suggesting that aggressive injection of new money would foster inflation. By the same token, the Bank of Japan officials insisted that commercial banks would not lend anyway because of their balance sheet problems even though the two concerns were mutually exclusive. There was an existential struggle between the Finance Ministry and the Bank of Japan, with the latter insisting that a further loosening of monetary policy would occur only if the government restructured the economy. Yet, the political system was too stale to force dramatic change. Many foreign observers had come to similar conclusions as I did regarding Japan’s predicament as well as to the most promising tools that could lead to a recovery.

Then, something truly extraordinary happened in April of this year. The Liberal Democratic Party (LDP) feared for its survival during July elections to the upper house of parliament. It removed the highly unpopular Prime Minister Yoshiro Mori and to the surprise of analysts at home and abroad replaced him with a political maverick, the John McCain of the LDP, Junichiro Koizumi. Had it been left to the party elders this revolutionary change would not have taken place, but Mr. Koizumi enjoyed such broad-based grassroots support that it simply overwhelmed the establishment. Mr. Koizumi said all the right things — so far as foreign analysts were concerned. He planned to rein in government borrowing, stop gold-plating the Japanese infrastructure, concentrate on restoring health to the financial system and introduce reforms that would return the Japanese corporate sector to competitiveness. He was very open about the immediate consequences of his reforms: more unemployment, a culture shock to the system and a slow recovery. Most foreign analysts immediately embraced this new leader with a boyish look and long hair. They continued to be concerned about his political pull to execute his ambitious plans, but they were nevertheless thrilled with the prospect of a new and rejuvenated Japanese economy.

Unfortunately, this foreign support proved to be fickle. Soon after Mr. Koizumi took over it became more and more apparent that the U.S. economy was in a greater slump than had been thought. At the same time, Europe started to slow down as well. All of a sudden, we were faced with a global economic slowdown last experienced in the early 1980s. This changed everything in the minds of many analysts and observers. All of a sudden talking and writing heads in the Western press began to turn against Mr. Koizumi. His policies would lead Japan into a sharp recession and they would only make things worse. Some of his critics were the same people that were outspoken proponents of structural change in Japan until April.

This self-serving, opportunistic criticism of Mr. Koizumi’s reform proposals (and as of now they are just that) is unfair and unhelpful. Mr. Koizumi was right and continues to be right in recommending fundamental, structural changes in Japan. I would add that his reforms should be accompanied by using public funds to introduce a basic unemployment insurance program that would help those, who loose their jobs in the process so that they can make it through this difficult period (there is practically no support for the unemployed at present). And yes, the Bank of Japan has to do its part through an aggressive loosening of monetary policy. Japan’s problems must be addressed on the supply side and on the demand side. But the country’s problems have not changed because the world economic outlook has deteriorated. Mr. Koizumi has enough challenges at home to convince the old hands in the LDP to go along with his reforms. It is a difficult political balancing act to sell austerity to his people, yet the Japanese seem ready and willing to sacrifice.

We have learned a lot about the importance of soft factors, such as "confidence" in successfully managing an economy and international markets over the last ten years. All too often perception becomes reality. Yet, we have learned too little about how to create fertile perception. In Japan’s case all hinges on that. The Japanese people have to believe that they now have competent and forceful leadership in place, and that dramatic and painful structural changes will be beneficial in the long run. They must understand that Japan is a wealthy country in terms of its people and its financial assets and that a more efficient reallocation of both will make them successful again. Foreign analysts and observers can help in forming this perception. They can further add to the new beginning by making complementary proposals to Mr. Koizumi’s reform plans. At the end, a sustainable Japanese recovery will be a blessing to all.