Japan needs a Thatcher revolution, not another minor fiscal boost

ON an economy in a bind
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The Independent Online
HARDLY a day goes by without some new call for Japan to reflate its economy, calls which are politely listened to - and then effectively ignored. Later this week Japan will go through the motions of making some further fiscal stimulus.

On Friday it is expected to announce an increase in the previously planned deficit for the 1998 fiscal year. But while the headline deficit will rise, in fact it will leave the overall fiscal stance pretty much as before, much to the ire of most other governments.

This clash over how Japan should dig itself out of what threatens this year to be another recession has become the most serious source of dissent within the Group of Seven. There have often in the past been tensions within the G7.

For example, during the 1980s European governments were critical of the US refusal to attack its twin deficits, the current account deficit and the fiscal one. The US, for its part, has long been critical of the Japanese refusal to attack its long-standing current account surplus.

But this disagreement over policy reveals a deep divide not just in policy prescription, but a conceptual divide over how the Japanese economy works. Both sides agree that Japan is in a bind; but they completely disagree on the appropriate tightness or otherwise of fiscal policy in this situation.

The bind is well-described in a new paper by the London investment advisers Smithers & Co, long-term Japanese specialists. It points out that the core of the problem is the combination of an ageing population and an excess of debt.

The former will restrict long-term growth while the latter will put a severe break on short-term growth. Japan needs to deregulate, but before deregulation can be successful, debt must be reduced. Cutting debt requires not only some write-offs of debts that can never be repaid, but in the longer-term, a shift to stock-market finance. But confidence in the stock market cannot be restored until it is clear that it has found a natural level and is not depending on the tacit support of the government.

The scale of the ageing problem is shown in the left-hand graph, which charts the rise in the proportion of the population over the age of 65. In contrast to the UK, which has a breathing space until about 2010, the proportion of over-65s rises relentlessly, year in, year out, for a generation. Germany, also shown, as much the same problem. In the view of Smithers, long-term growth in Japan is unlikely to exceed 1.5 per cent a year.

This is catastrophic for a bank-financed economy. The Japanese economic miracle was financed by cheap bank loans. Savers were denied a proper return on their money but this did not matter too much because rapid growth ensured that living standards were rising rapidly.

Meanwhile, rapid growth also enabled banks to write off their inevitable crop of bad debts. Now the situation is reversed. An ageing population needs a decent return on savings to pay for its retirement, while slow growth means that banks which are caught by bad debts cannot clear these by increasing their lending to other booming sectors.

The problem is further compounded by the fiscal position. Japan already has the highest running deficit of any G7 country, and faces an even greater crisis in the prospective deficit in its public pensions.

These are currently in surplus, but as shown in the right-hand graph, will plunge into deficit in about 15 years' time. (Again, Germany has a similar problem, while the UK escapes, though largely because our public pensions, being pegged to prices rather than wages, will be relatively low - maybe unacceptably low.)

The position of the Japanese Ministry of Finance is that it really should be tightening fiscal policy as soon as possible, for the longer it leaves the inevitable adjustment the more difficult it will be.

It has also been pressing the banks to make an honest disclosure of their bad debt position. A couple of weeks ago the banks did produce a new assessment of their bad debts. The MoF believes this disclosed the worst case outlook, though the markets remain sceptical.

So what will happen? One crunch comes next month, when there will be a tidying-up of bank accounts prior to the end of the financial year. The authorities have given an absolute, categorical statement of support of the banks: whatever happens, depositors, large or small, will not suffer.

However, it is possible that there will be some bank rescues: it is even possible that Japan may end up nationalising some of its banks, or at least owning equity stakes in them.

Smithers does not dwell on this. Its view is more that there will be a deepening of the recession, an inadequate fiscal stimulus, and continued disappointment.

It is particularly concerned that the economy will be compressed by a tightening of bank credit, which is desirable in the longer term (because it will enable banks to generate more profit and accordingly clear bad debts) but damaging to the economy in the short.

My own view is that the Japanese authorities are right in their reluctance to widen the fiscal deficit still further because any such widening is unlikely to provide the stimulus it is supposed to do.

So they cut taxes; the response by Japanese consumers will be to save the additional money, not spend it. Instead, what is needed is a combination of banking reconstruction and other structural reforms.

Rebuilding the banks' balance sheets has to be done in a way which is politically acceptable to the Japanese electorate, which is understandably loath to see taxpayers' money used to bail out bad lending decisions. So the right policy will be for the state to require some form of equity participation in return of any support.

Once the banks' balance sheets are secure confidence will gradually be rebuilt. There is something close to a consensus now in Japan of what needs to be done as far as the banks are concerned.

That is a start. The next stage will be building a consensus on the vast array of other structural reforms - things such as land use regulations, planning controls, educational reforms and so on - that Japan needs to make.

I think Western critics of Japan often miss the point when they focus on the fiscal position. The key problems are structural and attitudinal, rather than purely financial: how to change a whole mindset which was in the past very successful, but is no longer appropriate and is now dragging the country down.

What Japan needs is something much more like a Thatcher revolution, not yet another minor fiscal boost.

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