For Japan, It's Every Which Way But Back

Op-ed in the Washington Post

October 20, 2002

Japan is about to surprise us. People have grown so accustomed over the past 10 years to seeing the world's second-largest economy mired in stagnation that many have almost stopped worrying about the risks posed by the giant's fragility. Japan's passive population, famously thrifty and rapidly aging, appears to accept the country's decline. Even frustrated U.S. officials have come to doubt whether change is possible. But the opposite is true: The Japanese economic condition is about to change radically, and probably for the worse. This would deal a body blow to an already weak global economy.

Japan may not be the next Argentina, but it cannot continue to be the slowly declining economic power of the past decade. This year, after a decade of fiscal erosion, spiraling private debt and price deflation, the country finds itself in a position of acute vulnerability to any external shock. The problem throughout the '90s was that each succeeding year of slow or negative growth reduced tax revenues but created an ongoing need for public works and social spending. After averaging less than 1.4 percent real growth a year since 1991, Japanese gross public debt is now more than 150 percent of a year's national income-twice that of the United States. Japanese government bonds carry a lower rating than Botswana's. The government has little room left in which to react to events.

Nor has the government been able to break what economists call "debt deflation ," a vicious self-reinforcing cycle, last seen during the Great Depression, where companies and individuals hit by falling prices and incomes are unable to service their outstanding debt obligations and so default or sell their assets. These defaults and fire sales drive prices down further and dry up bank credit, leading to another round of failures. Japan is well into its fourth year of declining prices, thanks largely to the perverse policies of the Bank of Japan, the country's central bank (no other country has suffered more than a calendar quarter of general price declines since World War II).

Partly as a result, in the past year Japan's corporate sector has been defaulting on loans faster than the banks can write them off. This erodes the banks' capital, which encourages them to avoid formal bankruptcy by rolling over what non-performing loans they can conceal while cutting back on new lending. The resulting credit crunch then fuels further drops in demand and prices. It also adds to the stock of Japanese bad debt, now estimated at more than $1 trillion.

Even a wealthy country runs out of funds at some point, and even timid older savers want to withdraw their money when it becomes obvious that their banks are bankrupt. In 1997, when economists first began to worry seriously about Japan, these limits were still far off. Debt deflation was merely a prospect of what might happen if the Japanese government did not take corrective action.

By this past April, however, I was able to forecast that Japan was more likely than not to fall into financial crisis by this fall because these problems had simply grown too large. Debt deflation had become a reality, and more and more savers and foreign investors had started withdrawing their money. The by-then heavily indebted Japanese government was no longer able to forestall bank runs by throwing money at the banks and the stock market without also inducing panic in the bond market. All it would take for the system to be overwhelmed was some unforeseen external shock.

That shock came in the form of the late-summer decline in the U.S. and global stock markets and its negative implications for U.S. import demand. The resulting drop in the Japanese stock market would have forced the banks to declare ruinous losses on their stock holdings in earnings reports at the end of September. On Sept. 19, the Bank of Japan revealed the depth of its concerns by announcing a plan to buy some stocks directly from private banks in hopes of provoking a government response. The bank, like the U.S. government, clearly believed that a controlled implosion of the Japanese banking system was preferable to an unplanned collapse.

On Sept. 30, Prime Minister Junichiro Koizumi reshuffled his cabinet. The discredited Hakuo Yanagisawa was replaced as minister for financial services by Heizo Takenaka, a noted economist and the only true reformer already appointed by Koizumi (as economics minister, which he remains). Takenaka assembled a commission of private-sector hard-liners on the banks and pledged to report by the end of October on the real state of the banking system and the steps needed to clean it up.

Japanese bank stocks and stocks of indebted businesses tanked, and the overall Nikkei stock average hit 19-year lows earlier this month. This was not surprising, since an honest report from Takenaka's team would call for the closure of many banks and the forced recapitalization of most of the rest of the Japanese banking system, hurting so-far protected shareholders. Some transitional contraction in the Japanese economy would be expected as capital was reallocated.

Takenaka's appointment brings matters to a head. It simultaneously makes real financial reform more likely than at any time since Japan's bubble burst and all but ensures an overt financial crisis if reforms are not fully implemented. Either way, there is no going back to the slow decline of the past decade. Neither Japanese savers nor foreign investors will leave their money in the system knowing that the Bank of Japan and the country's financial services minister have confirmed that assets are at risk in the banks.

Entrenched interest groups-including the small banks most likely to be closed, indebted construction firms and the rural Diet members who pay for their safe seats by protecting the banks and channeling pork-barrel projects to those firms-will oppose Takenaka's effort. If they succeed in frustrating bank closures, reform in Japan is dead. In that case, there will be an abrupt sell-off of yen-denominated assets.

Even if Takenaka succeeds in pushing through a bank reform program, a crisis could still occur. Because closing banks and bankrupt companies creates short-term unemployment and lets deflation continue, bank reform alone is not enough. A supportive macroeconomic environment must be provided to cushion the transition. There should be a policy package of aggressive monetary expansion and targeted fiscal stimulus combined with the financial cleanup.

We should not be too optimistic about such a deal being made. The Bank of Japan has repeatedly insisted that financial reform must precede any truly expansionary policy on its part. Because of a shortsighted focus on the loss of revenues, the Ministry of Finance has resisted sensible temporary tax cuts or expansion of Japan's limited safety net. Politically, the Bank of Japan, the Ministry of Finance and the Financial Services Agency have been playing chicken with each other for the past four years, each wanting the other two agencies to take proactive steps-and thereby admit past mistakes-first. If the macroeconomic policymakers, however, wait to stimulate until after Takenaka delivers bank closures, it may be too late. Then we would see the same sell-off of Japanese assets as in the scenario of reform failure, just a few weeks or months later.

In either case, the Japanese government would try to prop up securities prices, but with the financial system already so weak, the public budget would be unable to support the added burden. Bond downgrades would follow, interest rates would rise and Japanese investment would collapse. Rising interest rates would wipe out banks that had eluded closure but held vast quantities of low-interest Japanese government bonds. Japanese savers fearing default would move their assets into cash or gold or out of the country, further starving the Japanese economy of funds.

The yen would fall drastically, below 150 to the dollar, feeding trade conflicts with the United States and East Asia, as well as Chinese opportunism in the region, with significant foreign policy implications. A Japanese crisis would also reinforce the globalization backlash occurring in Latin America. All the model emerging markets of the early '90s -- South Korea and Brazil, Thailand and Argentina-would say, with some justification, "We followed your models, we adhered to IMF reform programs when those models failed, and we end up hit hard once again because a wealthy country did not take the difficult steps we were forced to take. What is the point of playing by your rules?" Of course, Japan's contraction would also reduce already anemic world growth, putting more Americans and Europeans out of work.

On the other hand, if Takenaka does succeed in cleaning up the banks, and if the Bank of Japan and the Ministry of Finance do provide the needed macroeconomic support-and if the U.S. government puts sufficient pressure on the Japanese government to make all this happen, because it almost certainly will not in the absence of such pressure-then it is also the end of Japan as we have come to know it, but in a better way.

Within six months or less, Japanese stock and real-estate prices would hit bottom and begin to rise. If unemployment were allowed to rise as well, meaning that restructuring was taking place, the yen would not have to fall so far or for so long. Within a year to 18 months, the Japanese government could start reselling distressed assets and nationalized financial firms to the private sector, shoring up the public balance sheet and putting people back to work. All of the technological prowess, human capital and accumulated savings that had been squandered by 10 years of self-destructive policies would at last be gainfully reemployed. Japan will never grow again the way it did in the 1950s and '60s, but it could easily more than double its growth rate of the '90s for the foreseeable future.

It could go either way, and we will find out which it is going to be-crippling financial crisis or a fresh start-before the year's end. But one thing is already clear: Japan will not remain as it has been.