The year Japan went west
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Fly in over the vast Tokyo plain or look out from any of the city's tall buildings and you can see more economic activity being physically created than you could from any other point on the globe. You are not just looking at the homes, offices and factories of 30 million people - the largest collection of human beings in one place in the world. You are also looking at the largest single unit of the global economy, which produces between 3 and 4 per cent of the world's economic output. In all our homes there will almost certainly be something that has been made, designed or marketed in the Tokyo region: a camera, a TV set, a roll of film.

If however, you were to look across Tokyo last week, as I did, you would be looking at something else. You would be looking at the world's biggest recession. Japan's boom has gone horribly wrong.

In absolute terms, nowhere else is so much economic activity being lost so fast. We had the latest figures last Friday. In the April/June quarter the Japanese economy contracted at an annual rate of more than 3 per cent. It is now down three quarters in a row, for the first time since the Second World War, and there is absolutely no recovery in sight. Other countries - Thailand, Indonesia, Russia - may be heading down even faster, but they are tiny by comparison. Japan's economy is second only to that of the US. What happens there matters to all of us.

Yet the astonishing thing to the visitor is that you catch very little hint of the recession in the streets of Tokyo. With the exception of the civil servants, almost everyone I spoke to is extremely gloomy not just about the economy but, more generally, about Japan's place in the world. However, the physical fabric seems as glitzy as ever. The streets are crowded, the shops are full of people, everyone seems as busy as they did in the bubble years of the late Eighties. The surface looks the same; the real difference is inside - inside people's heads and inside the often- concealed balance sheets of the companies and banks.

The easiest way to understand this is to think of two British houses side by side. One is owned outright by someone in a secure job. The other is owned by someone who mortgaged to the limit at the peak of the boom and may now be made redundant. Assume house prices have fallen by half. The two houses look identical, but while the person in the first house may be disappointed by the loss of its value, the person in the second will be in despair. Much of Tokyo - businesses, banks and people - is in the position of owner number two. Debt crushes the spirit, but, until the lender forecloses, it is invisible.

So you see the physical fabric of the bubble years - in particular the glittering office blocks, the symbols of the success of Japanese corporations. What you don't see is the debt that paid for them. No one has a really accurate picture of the scale of indebtedness of many, maybe most, Japanese companies and banks for two reasons. One is that the published accounts are basically full of lies: assets put in at their cost rather than what they are worth now. The other is that, because Japanese companies own large chunks of each other's shares, any fall in the price of those shares is liable to pull another company down.

In the absence of decent data, the rumour mills grind away. Among companies there are those that are sound and those that will probably need to be rescued or simply go bust.

If the company situation is worrying, the plight of the banks is worse. Among banks there are those that are rumoured to be going bust any day now. Indeed it is actually possible that the whole banking system is bust, in the sense that the loans that will never be repaid are larger than the entire capital and reserves of the system.

It is quite hard to imagine that a business with a giant headquarters, thousands of workers, lines of black limos running squads of executives hither and thither, can actually be worth nothing. Sadly, for many Japanese banks this is true. They have taken in lots of money from depositors and then they have lost it.

This malaise and, in particular, this conflict between appearance and reality are reflected in day-to-day life. So while the stores are full of people, they aren't buying anything much, just walking around because there is not much else to do. There are, of course, pockets of activity. There is a boom in employment agencies for temporary workers. Lots of people have been laid off and are trying to get back into the job market. And anyone in the discount business has been doing well. In a recession everyone is hunting for a bargain. But the odd discount store is not going to save Japan's economy. What is?

Step back and ask what has gone wrong. The core of the problem is that a system that worked very well for 35 years is no longer working. The system has been the closely controlled economy, with giant companies closely linked with giant banks pumping resources into exports. The governing bureaucracy - and in particular the two most powerful ministries, the Ministry of Trade and Industry (Miti) and the Ministry of Finance ( the MoF) - has choreographed this economic triumph. People's savings were pumped into industrial investment, and, while they received a pretty dreadful return, industry boomed on the back of cheap funding. While Japan was catching up with other developed countries this worked wonderfully well. Any mistakes were quickly overcome by the rapid growth. When, by the Eighties, Japan had caught up, instead of trying to switch from growth to profitability, the country behaved like the classic nouveau riche, throwing money at ludicrous investments.

The twin ministries still glower at each other across an eight-lane boulevard - Trade and Industry in a white tower, Finance in a squat grey block. But their reputation, particularly that of the MoF, has been shattered. The bureaucrats, who form a thoughtful, cultured, hard-working elite, are seen to have failed.

Why, I asked the man at Miti, did they not see this catastrophe coming? The nub of his answer was that they thought they had got through the recession and that they had a great 25-year plan for the next generation of growth industries. Main problem: they did not know the scale of the banking system's bad debts because the MoF didn't tell them. When the banks started to collapse and the East Asian downturn struck, Japanese consumers took fright and the vicious spiral began.

And across the road at the MoF? I was there last Friday, the day it was revealed that Japan was now in the longest downturn since the Second World War and share prices had their largest fall this year. The MoF man mentioned that there were some economic figures out, but he hadn't seen them yet. Instead he was delighted that the yen seemed to be climbing against the dollar.

It is odd. Just as you cannot see much sign of recession in the streets, so you find a refusal among officials to accept quite how serious things have become. I don't think it is explained by the traditional Japanese cultural distinction between what is said and what is really meant. The business people I met had absolutely no hesitation in saying how alarmed they were about the economy, how they detested the bureaucrats and politicians and how they felt that Japan was approaching a revolution akin to that which swept through Britain under Margaret Thatcher.

In fact three people suggested to me that the coming revolution would be comparable with the Meiji revolution 130 years ago or with the creation of the present democratic system after the Second World War.

Too dramatic? Impossible to judge. What accounts for this cataclysmic view of the country is the fact that most Japanese can only remember success, so what is happening is entirely new. I had dinner with Masatoshi Ito, the founder of the Ito-Yokado group, one of Japan's two largest retailers. He is a lively septuagenarian who built up the group more or less from scratch after the war.

"Surely," I asked, "there must be some bright spots, some places where demand is all right?"

He shook his head. "Maybe when the bank rescues have been completed, but, at the moment, no."

If the bureaucrats attract much of the opprobrium for the collapse, the politicians catch the rest. "I've given up on politicians" and "I do not have a high regard for our politics" were two of the more measured comments from business leaders. They were principally referring to the Liberal Democrats, who have been in charge virtually non-stop since the mid-Fifties.

If there is a focus for hope it lies in the Democratic Party of Japan, which has now become the principal opposition party. The Democrats are led by Naoto Kan, a telegenic 51-year-old. Some people see him and, just as importantly, the people round him, as the great hope for Japan. He looks the part, has been dubbed "Japan's Tony Blair" and is of a completely different generation from the gerontocracy of the LDP.

I went to a party meeting at which the words for "reform" and "bold" kept sprouting, but I do not really think anyone at the stage knows how strong the the zeal is to take the very tough decisions that will have to be taken - like, for starters, do you make bank depositors suffer as well as bank shareholders? If not, then the present "muddle through and hope that something turns up" strategy will continue.

Muddling through has strong attractions. If only, somehow, they could go on patching things up, concealing problems, hiding bad debts, hoping that exports will save them... It is very difficult for any country to accept that a formula that has worked very well before is no longer working. The obvious parallel is Britain in the 1970s. An elite had managed to win a war, construct the first comprehensive welfare state and maintain a leading position in scientific and technical advances. When the strains showed, its instinct was to patch. Only the humiliation of the IMF conditions in 1976 forced change.

The first question for Japan is: will the situation be so bad that patching becomes impossible? If there were a banking crash that led to three years of deep recession and a surge in social tensions, change might be forced on the country.

The second question is: what will be the mechanism for change? Can the system change itself from within? The last two great changes were forced on Japan from abroad by the US. However, not only is there no appetite for such action in America, but Japan would not accept such pressure even if there was. So Japan is on its own.

Whatever happens - and my instinct is that there will be a great change of some sort, but not for another four or five years - there is a lot to play for. Japan's recession has a long way to run.