CIAO DATE: 8/01

The Bush Administration's Japan Problem

David Asher

On The Issues

March 2001

American Enterprise Institute for Public Policy Research

Putting its moribund economy back on a path toward growth, will require Japan, America's largest trade partner and principal East Asian ally, to undergo draconian reforms in public and private finance. Such an effort will depend on U.S. support and cooperation, most importantly in tolerating a weaker yen and in more aggressive direct investment in Japan.

Securing peace in the Middle East, promoting free trade with Latin America, and repairing damaged ties with our European allies are all key foreign policy priorities for the new administration. Nonetheless, the biggest overseas challenge for the Bush White House in its first year in office could be helping the economic Titanic of the Far East—Japan—steer clear of the icebergs it is approaching.

Despite a few pockets of strength, such as the export and information-technology sectors, Japan's economy remains in a state of slow but steady decline. For fiscal year 2000, nominal GDP is on track to fall by nearly 0.5 percent—the third consecutive year of contraction—and could sink by another 2 percent in the coming fiscal year (which starts in April). In the midst of this protracted drop-off in domestic economic activity, the only reason real GDP growth has been positive is that prices have been falling even faster than output. That is hardly something to boast of.

Meanwhile, as the economy stagnates, Japanese consumer confidence is tumbling, the Nikkei stock average has sunk to a sixteen-year low, and corporate bankruptcy liabilities are topping 4.3 percent of GDP—a level far higher than the United States experienced during the Great Depression. As a result, Japan's major banks, which have relied on unrealized equity gains to meet capital adequacy standards, face running out of capital as those gains evaporate and their bad loan losses surge. Another banking crisis seems increasingly possible in the coming months.

 

Japan's Grim Public-Sector Finances

Making matters much worse, a public-sector financial catastrophe has been taking shape over the past decade. Egged on by Keynesians in the Clinton administration, the Japanese used massive fiscal stimulus packages to try to numb the pain of structural adjustment following the collapse of the financial bubble at the beginning of the 1990s. The result of this fiscal recklessness is that the level of Japanese gross government debt is now nearly 140 percent of GDP and at the current trajectory will surpass 200 percent in 2005. Measured on a cash-flow basis, Japan's public financial situation is even more deleterious. Currently, nearly 65 percent of tax revenue retained by the central government is needed to service debt, while long-term debt exceeds revenue by more than fifteen times. With those ratios, if the Japanese government were a company, it would have a subpar junk bond rating at best.

Japan has entered a zone in which all other countries that have experienced similar national balance-sheet deterioration eventually have encountered a debt-funding crisis. Of course, if a Japanese debt crisis were to erupt, the implications for global financial stability would be significant. Japan's national debt is now nearly 18 percent of global GDP, and its broad money supply (M3) represents a significant portion of global transactional liquidity. With a current-account deficit well over $400 billion, America would be particularly vulnerable to a surge in Japanese interest rates or a disruption of capital flows from Japan.

 

Given this dark backdrop, it is heartening that both Treasury Secretary Paul O'Neill and White House economic adviser Lawrence Lindsey have recently called for a new U.S. policy that, unlike its predecessor, supports rather than retards fiscal and structural reform in Japan.

In a speech at the American Enterprise Institute in December (available online at www.aei.org/past_event/conf001201b.htm ), Lindsey castigated the Clinton Treasury Department for its "harsh" and "confusing" badgering of the Japanese to pump up their economy without regard to the impact on its debt or its structural reform needs. "The U.S. Treasury has been fond of telling Japan that the path to economic growth is in ever expanding fiscal deficits," he noted. "At the same time the U.S. Treasury has been claiming here at home that our economic growth has been caused by ever contracting fiscal deficits." The unfortunate legacy of the Clinton administration's fiscal hectoring and Japan bashing, Lindsey pointed out, is that America has been set up as "a scapegoat for the pain which is sure to be associated with [the] reform" of Japan's public finances in the coming years.

The pain that the Japanese will have to endure to get out of their debt trap will be remarkable indeed. Merely to stabilize Japan's national debt between now and 2005 would require that the government of Japan boost revenue or cut expenditure by an amount equivalent to 11 percent of GDP—about ¥55 trillion. That is larger than the total amount of Japanese central government tax revenue and more than two-thirds of expenditure. This apparently would be the largest fiscal shift ever attempted by an advanced industrialized economy.

Effecting fiscal adjustment in Japan on such a large scale will be next to impossible without getting the Japanese economy growing again. Yet creating the grounds for endogenous growth requires a radical downsizing in corporate balance sheets to boost capital productivity. In the past decade, Japanese companies have invested on average over one-third more than those in the United States to yield only half the corporate return on assets (ROA). Morgan Stanley economist Robert Feldman estimates that merely bringing the average Japanese ROA back in line with the 1980s average would require companies to scrap unproductive assets and cut excess liabilities by a colossal 70 percent of GDP. Even then the average ROA realized by Japanese corporations would still be less than two-thirds that of their American competitors.

Simultaneously, with business operating costs some one-third higher and consumer purchasing power some one-third lower than the G7 average, Japan needs to radically deregulate its economy to improve price efficiency and boost domestic demand. In Secretary O'Neill's words, "If Japan's price structure for everything was open to the world economy, they would then do the things that are necessary to compete on a world basis and it would force them to clean up some of the things that don't add value to their economy."

An obvious problem, however, with serious market deregulation and balance sheet restructuring is that they would be immensely deflationary—especially if the government fiscal safety net were simultaneously withdrawn. And as the Japanese have learned the hard way, debt and deflation together make a poisonous
economic cocktail.

 

An Exchange Rate Solution?

Perhaps the only viable offset for the deflationary drag that regulatory and financial reform will produce inside Japan is a downward adjustment in the value of the yen-dollar exchange rate. Although many on Capitol Hill will find it hard to stomach a possible surge in imports, as the "global consumer of last resort" the United States will have to accept part of the burden of supporting the economy of its largest trading partner and central ally in the Pacific while the Japanese undertake unavoidable reform. Still, the U.S. government should explicitly tie its willingness to tolerate a weaker Japanese currency to the Japanese government's making credible commitments to fiscal, financial, and structural reform. A "blank check" policy certainly is not warranted.

A coordinated solution to Japan's problems could be turned to America's considerable advantage. As Secretary O'Neill also pointed out recently, a boom in Japanese direct investment in the United States in the 1980s helped America get its economic house in order. Now the tables have finally turned. A more realistically valued yen would dramatically improve the risk-return margins for foreign investors yearning to buy into "Japan dis-incorporated" on the cheap. A rush of dollars and euros would flow into Japan to take advantage of the opportunities that creative destruction and market clearing in the world's second largest, but hitherto most "cost protected," economy would bring. To bolster that process, the White House could launch an economic integration initiative designed to further harmonize competition and regulatory policies. Such an initiative would be a step toward free trade not just between the United States and Japan but inside Japan itself.

No matter what exact policy tack it takes, in the coming four years the Bush administration will have to be as attuned to balance sheets as to the balance of power in the planning and conduct of its diplomatic relations with Japan. Incoming deputy secretary of state Richard Armitage has expressed the noble goal of strengthening the U.S.-Japan security alliance in order to make Japan the "England of the Far East." Unless Japan addresses its myriad domestic financial and regulatory problems, however, it could run into a mid-1970s British-style fiscal crisis that would force it to dramatically scale back, rather than expand, its international and bilateral security alliance commitments. Getting Japan to emulate the reform policies of Margaret Thatcher thus must be an equally important part of any U.S. plan to make Japan the England of the Far East.

Japan's debt trap has become a problem not only for Japan but for America as well. Getting out of this trap is a policy challenge that must be met primarily by the government and people of Japan but that cannot be ignored by the government and people of the United States. It is time for the Japanese to prepare to meet this challenge and for Americans to stand ready to help.

 

David Asher is the associate director of Asian studies and director of the Japan Policy Project at AEI.