Hotel Okura Executive Luncheon Meeting
Getting Realistic About Japanese Reform
Dr. Kent E. Calder is Director of the Program on U.S.-Japan Relations at the Woodrow Wilson School of Public and International Affairs, Princeton University.
We hear a lot of prescriptive talk about the importance of Japanese reform, suggesting what ought to be done. But the subject of what is crucial from the market point of view, or feasible in terms of the Japanese domestic political process, is a smaller set of ideas. Certain parts of Japan's financial problem, particularly with astute international interaction, are quite tractable. But there are others where the incentives for resolution, certainly in Japanese politics, are very limited, and where we will have to wait for a much longer period before we see results. It is that kind of nuanced discussion that is really in order when we talk of "getting realistic" about Japan's debt problem.
There is no question of the massive scale of the crisis [LONG DASH] both the private-sector banking problem and the emerging public sector debt problem. It dwarfs, and is much more central to, the political economy of Japan than the analogy that is often given of the S&L crisis in the United States. Total banking losses as a percentage of GNP in Japan have been steadily rising; the cumulative total is about 14 percent of GNP already in Japan, while the total for the U.S. S&L crisis was something like five percent of GNP. The U.S. GNP was double the size, to be sure, but already the aggregate scale of the losses in Japan dwarfs that of the S&L crisis by a significant margin.
It is also important to remember that the bad debt problem in the Japanese economy is also much more central to the economy itself; it has a much more devastating effect on growth than in most analogous cases because it cripples the key
financial intermediary in the financial system, the banks. The best analogy is the Nordic banking crisis in the early 1990s, particularly in Sweden and Finland, but that was in a much smaller economy and it was also resolved much more quickly, particularly with a much more decisive response from the political system than we have seen so far from Japan.
There is no question that the impact on the Japanese economy, and through that on the world economy as a whole, has also been very substantial. Japanese growth over the last 11 years has averaged less than one percent. Growth is slowing down. The financial crisis alone is not responsible for this, but because the banks are such central financial intermediaries in the system, it is at the heart of the problem.
The problem of public finance is potentially even more serious. Gross public debt relative to GNP has been deteriorating steadily in recent years [LONG DASH] about 121 percent in 1999 and nearing 150 percent today. The prospects are that it will continue to deteriorate. Many calculations that have been made recently which add in such things as corporate liabilities and losses at government financial institutions suggest that the situation in public finance is worse than the net figures generally indicate.
The prospects for very large public pension liabilities pose another problem. It is well known that Japanese society is aging very rapidly. By 2020, over a quarter of the Japanese population will be over 65 years of age. This fact, in addition to the current problems of public finance in the absence of a very major restructuring, indicates that
the problem of public pension liabilities will also be very large.
Finally, one should note that budget rules such as Gramm-Rudman-Hollings in the U.S. or the Maastricht Guidelines in Europe, which reined in rising deficits over time, do not operate the same way yet in Japan, and this is another problem.
Barriers to resolution
There are important constraints on a resolution to what, on its face, is a rather troubling set of problems. One of them is Japan's position in the global economy. Japan is today, the largest creditor in the world by a substantial margin, with about 1.3 trillion dollars in gross portfolio assets. That was on December 19 of the year 2000, and that position has risen. Because of its massive creditor position, Japan is largely insulated from international pressure for reform.
The pressures that drove Korea, for example, in the four turbulent years since the financial crisis in 1997, toward major reforms which included nationalization of many of the banks, attempts to break up the chaebols, and much larger roles for foreign investment in the domestic political economy, are not operating in the same way in Japan because of its very different position in the political economy.
Another important factor is the political process. The Nordic banking crisis of the early 1990s led, in Sweden, to an emergency political coalition, restructuring of the ruling party arrangements, and a rapid response that included both nationalization of a number of the banks and aggressive efforts to wipe out bad loans. But here, too, there is significant contrast with the situation in Japan. First, the opposition clearly has less traction, for reasons that go right to the structure of the society itself, namely the absence of very distinct social groupings. The flipside, of course, is the strength of the ruling party. It has been very creative in crisis periods. The fiscal firepower of the ruling party, which has been able to devote those resources not spent on defense and other areas heavily toward public works, is an important factor. A strong degree of regulation in the economy has allowed for regulatory politics and given the ruling party, or in some cases the bureaucracy and the ruling party together, regulatory tools for reinforcing its dominance that have not been as applicable in other nations.
Some have argued that major reform in Japanese policy requires a new political system or a breakup of the 1955 system [LONG DASH] essentially one-party dominance by the ruling LDP with one rather symbiotic opposition party. There is, however, the possibility of a different dynamic of innovation; a more pluralistic process of interaction between the cabinet, the prime minister, and certain competitive groups within the ruling party itself. In 2002 we are going to see an interesting test of this possibility, focusing particularly on the area of tax policy.
There is no question that Prime Minister Koizumi has strong reformist instincts, and these are rooted partly in his political situation and partly in his personal instincts. It is fair to say, though, that the political system gives Prime Minister Koizumi incentives to reform in some areas but not in others. The area of fiscal policy, for example, which he has attacked with considerable vigor, is right at the heart of the areas where he has political incentives to try to create change.
But there are also political minefields where he does not have very strong incentives to reform. Non-performing loans offer a prime example of a no-win political situation. They create unemployment, they create bankruptcy, and they create regional distress that politicians have to deal with. Deflation and the whole issue of the price level also cut in very complex ways within the political system.
Is reform possible?
"It depends" is not a very satisfying answer, but that is the case. There are certain areas in which reform will proceed rather dynamically, but there are others, such as non-performing loans, that will prove much rougher going. Crisis-driven, or, as members of the Koizumi cabinet refer to it, reactive, reform, may finesse the political problem. Once an action forces an event from the market to which one has to respond, the situation can often be defined as a crisis. The crisis creates an opportunity to apply new resources, and facilitates dealing with the situation in a more creative way without the political fallout that would otherwise occur.
On the question of Koizumi and reform, the important point to be made is that the political system as a whole has put in place many tools for a more market-driven type of reform than was true in the 80s. These tools include mark-to-market accounting, consolidated accounting, improved disclosure in certain areas, the holding company structure, and a number of tax-related elements. Once the incentives for reform are in place, these tools will provide more momentum than would otherwise be possible. So where does that leave us off for the future? First, keep in mind that some changes have already been legislated, which will have positive effects. There are some significant improvements in the commercial code, for example, that are going to come into play. In other words, the market pressures and related fears of the future are going to be strong in 2002, which is a positive factor for reform. It will be a year of creative and productive debate on Japanese restructuring, and we can expect a series of major new proposals, centering on tax, that will appear from the spring after the budget process is completed. Through next fall, that will be the agenda, with implementation coming in 2003.
It will be a very interesting and dynamic policy debate, which will be given more force toward actual policy innovation because of the difficulties of Japan's situation. It is a race between that policy debate and the deepening financial crisis that Japan now faces.