Feb 21st 2008 @The Economist

Japan's pain
Why Japan keeps failing

How the politicians are to blame for the failure of Japan's recovery

TEN years ago Japan was on the point of financial and economic meltdown, with a political establishment utterly incapable of facing up to the crisis. Those Japanese who cared coined a not altogether pleasing English phrase: "Japan passing", implying not only that the world's second biggest economy was being passed by in a fast-changing world, but also that Japan could no longer even be taken seriously. A headline in The Economist at the time tried to sum up the situation more pithily: "Japan's amazing ability to disappoint" .

Until recently, that dreadful time could be regarded as an awful nightmare from which the country had woken up, for Japan seemed to be starting to live up to expectations. A razzle-dazzle prime minister, Junichiro Koizumi, came to office in 2001, appearing to bring profound change both to the political establishment and to its ability to deal with economic problems which had festered since Japan's asset bubble burst in 1990.

Mr Koizumi forced banks and companies to clear up piles of bad loans. Companies, thus unburdened, started to make money once more, and from early 2002 the economy began to grow again. Mr Koizumi appeared to have weakened the special interests?farmers, the construction ministry, senior bureaucrats?to which his ruling Liberal Democratic Party (LDP) had long been in thrall and which had supported its near-unbroken rule over the past half-century. In effect, Mr Koizumi declared war on the old-style LDP.

Voters loved it. Under Mr Koizumi's banner of market-minded reform, they delivered a stunning general-election victory to the LDPand its coalition partner, New Komeito, in September 2005. When Mr Koizumi retired a year later, there was a widespread belief that Japan was set fair for economic modernisation.

Yet once more there is talk of "Japan passing". The stockmarket has fallen alarmingly since last summer, and has been in open rout for much of 2008 (see chart). Measured by the Nikkei 225 share index, Japanese shares are 27% below last year's July high: deep bear-market territory. Share prices are now back to their levels of September 2005?not even half where they stood 20 years ago. In January foreign investors pulled record amounts out of the Japanese stockmarket. Ask any money manager: Japan still has an amazing ability to disappoint.

The latest doubts concern the robustness of Japan's four-year recovery, during which the economy has grown at a remarkably steady 2% or so a year. Though the most recent GDP estimate, for the last quarter of 2007, suggests above-average growth, many economists point out that the series is notoriously volatile, business investment has probably been exaggerated, and the quarterly growth figure will therefore very likely be revised downwards. Economists at Goldman Sachs said in late January that the economy was already in recession; others who are not so sure claim it is a close-run thing.

Meanwhile, political chaos has reigned since last summer. It has unseated one prime minister, Shinzo Abe, who succeeded Mr Koizumi but resigned under nervous and physical strain in September 2007. And it has ensured only the vaguest grip on power for his successor, Yasuo Fukuda. The chaos was set in train when the opposition Democratic Party of Japan (DPJ), led by Ichiro Ozawa, became the dominant party in the upper house of the Diet (parliament) last July after elections for half the chamber's seats. It has now brought the impetus for growth-boosting reforms, or indeed for any joined-up policymaking at all, to a halt.

So now the LDP's Diet-affairs chairman, Tadamori Oshima, responsible for pushing through Mr Fukuda's agenda, such as it is, despairs that "investors and political establishments around the world take one look at Japan today and conclude that we politicians are incapable of deciding on anything, not even whether to put one foot in front of the other." With foreign investors selling out, says Mr Oshima, Japan is fast becoming as irrelevant as it was a decade ago. He asks this British correspondent to prescribe a decent shinguru moruto?single malt?for his depression.

Despair is spreading among the political class responsible for the mess. If the opposition deplored the "absence of a framework to sustain economic growth", you might take it with a pinch of salt. But the admission comes from none other than the economy minister, Hiroko Ota, who for good measure says that Japan can no longer be considered a "top-tier" economy. Although she identifies the problem correctly, she has disappointingly little to say about how to solve it.

Demographics darken Japan's prospects further. Its population is greying faster than that of any other big economy, so the old will become an increasing burden on workers. Today, one-fifth of Japanese are over 65; by 2015 the proportion will grow to one in four, or about 30m. Now, with Japan's birth rate well below replacement, at 1.32, and with little immigration to speak of, the population of 127m has already started to shrink and will fall each year by about 0.6% over the next half-century. It is predicted to drop below 100m by mid-century. Already, rural regions are emptying, and the shutters are closing on the centres of more and more small towns. Without robust economic growth, Japan faces pain, especially since the government has racked up high levels of national debt in an attempt to spend its way out of its post-bubble slump.

The bureaucrats' blunders

Even though companies are far sounder than they were a decade ago, with fewer debts and more focused operations, Japan's productivity is still pitifully low. A lack of investment is not the problem. Rather, low interest rates, an export boom and a business environment in which managers are scarcely accountable to shareholders may have generated too much of the stuff. Indeed, as Andrew Smithers of Smithers & Co points out, high investment and slow growth mean that Japan's return on new investment is around half the level in America. At least companies, notably Japan's exporters, have been making record profits. But now the impact on exports of higher oil prices, coupled with a sharp rise in the yen since last summer?a consequence largely of financial-market volatility?throws that profitability into question. That is even before considering what harm an American-led slowdown might do.

Were Japan's recovery broad-based, an export slowdown would matter less, because domestic consumption would take up the slack. Yet despite repeated predictions from economists, household spending has failed to follow a rise in business investment and exports.

The reason again lies with companies. Even where they have been making record profits, companies have hoarded their cash rather than pay more out in the form of higher wages, which have stagnated even as employment has increased. Now that a stronger yen and dearer oil are eating into profit margins, the situation may not improve soon. As a result, Mr Smithers notes, even after drawing down savings this decade, households still consume a smaller proportion of GDP than in any other rich country. It raises a question: was the path that Mr Koizumi chose to get Japan out of the economic swamp misguided, at least in part? By emphasising low interest rates (good for indebted companies but bad for savers) and low wages (ditto) to help companies out of their mess, Japan's economy has depended too much on exports and is now worryingly vulnerable to external shocks.

Politicians complain about firms' tendency to hoard cash, and urge firms to pay workers more. Yet the incompetence and unpredictability of politicians help explain the companies' caution. A year ago, for instance, in a well-intentioned attempt to crack down on predatory lending, the government all but destroyed the consumer-finance industry.

A more serious episode still started last summer, when a system for vetting new buildings was introduced in reaction to the faking of earthquake-proofing data?itself a reaction to hasty new regulation brought in a few years back. The housing ministry was unable to get new software for the new system running in time. New-building approvals ground to a halt, and new construction fell by 40%.

Slowly, matters are righting themselves?new construction in December was just one-fifth below levels a year earlier. But the extraordinary effect of a single bureaucratic bungle has been to knock 0.6 percentage points off Japan's growth. The building-standards fiasco was one reason for the reduction in the government's growth forecast for the fiscal year to the end of March, from 2.1% to 1.3%.

These costly blunders were committed even before July's elections divided the Diet; with the current political chaos, the risks of things going wrong is still higher. The incompetence of politicians and bureaucrats does not just lead to expensive short-term disasters; it also threatens Japan's long-term growth prospects.

Japan needs a mass of economic reforms?a more open climate to foreign investment, for instance, lower tariffs on imported food, fewer subsidies for farmers, freer trade, better tax treatment of foreign companies, the abolition of a welter of business subsidies, a more flexible labour market, greater fiscal rectitude (national debt is currently around 180% of GDP), more accountability by pension funds and insurance companies, further privatisation of services and much more. Takatoshi Ito of Tokyo University, who sits on the Council on Economic and Fiscal Policy, the government's advisory body that drove structural reform during the Koizumi years, has calculated the economic benefit of pursuing the reforms the CEFP advocates, and the costs of abandoning them. Pursue reform, he argues, and Japan should be able to grow at a respectable 2% a year. Abandon it, and growth will crawl along at 1-1.4%.

And crawl it will, if Mr Ito is right, because Japan has abandoned reform. Blame a political establishment of underwhelming talent and vision, and an almighty constitutional mess.

First in line for blame is Mr Abe. Though he came to office as a self-styled reformer, nothing he has ever said or done suggests an interest in improving the economy. Once in office, he seems to have calculated that Japan would chug happily along, leaving him to pursue pet nationalist themes such as inculcating patriotism in schools. A tin ear for other issues left him oblivious to a growing chorus of dismay at decaying country towns, sluggish wage growth and a growing scandal of bureaucratic incompetence and corruption in the state pension system. On top of that, Mr Abe's government, though short-lived, was dogged by a seemingly endless series of financial scandals. The LDP's upper-house defeat was the punishment. Amazingly, Mr Abe appears to think he deserves another shot at high office?at 53, he is young by the standards of Japanese politicians.

Second in line are the ancient crocodiles of the LDP. In a panic, they closed around Mr Fukuda, who at 71 is the face of experience over Mr Abe's callow youth. Under Mr Koizumi and Mr Abe, decision-making had devolved from the LDP corridors to the prime minister and even as far down as the cabinet. Under Mr Fukuda, power has flowed back to the factions and to the party gerontocrats?notably two former prime ministers, Yasuhiro Nakasone (89) and Yoshiro Mori (70) as well as Tsuneo Watanabe (81), publisher of Japan's biggest-circulation newspaper, the Yomiuri Shimbun. It was Mr Watanabe who arranged the farcical secret meetings late last year between Mr Ozawa, leader of the opposition DPJ, and Mr Fukuda about forming a "grand coalition"?though he has not since bothered to inform his newspaper's readers about that.

Taking back the car keys

In effect, a generational coup has taken place, with the keys to the political car taken back by the oldies. The result is that structural change is on hold. Negotiations to lower trade barriers with other countries have slowed. Tax reform to set the budget on an even keel has been put off. A senior reform-minded civil servant says that morale among modernising bureaucrats, those that favour privatisation and more competition, has sunk. None of them, he says, now dares propose growth-boosting reforms?as they used to under Mr Koizumi and even Mr Abe?for fear of incurring the disfavour of their political masters. Meanwhile, attacks on foreign investment are on the rise again among politicians and old-guard civil servants.

Mr Fukuda understands Japan's problems better than Mr Abe did. He spelt some of them out in his policy address to the Diet's new session last month: he underlined the need to overcome labour-market rigidities that discourage women and the elderly, and discriminate against Japan's army of workers who can find only temporary jobs. He bemoaned Japan's feeble standing as an international financial centre, thanks in part to hostility to foreign investment. He stressed the importance of putting the government's rickety finances to rights, and he has since championed the cause of consumers.

Yet both allies and opponents alike believe he has neither the gumption nor the authority forcefully to push for these goals. In particular, the government already looks like missing a long-agreed target to balance the budget, before interest payments, by 2011. In the government's latest budget, for the fiscal year beginning in April, the LDP's traditional clients, farmers and road-builders, are getting goodies denied them in recent years.

Third in line for blame comes the DPJ's Mr Ozawa. His party's ranks have plenty of young politicians favouring market-driven reforms. Deploring the one-party state that Japan has largely been under the LDP since the second world war, this bunch thinks Japan would be better served by competitive parties alternating in power. Perhaps Mr Ozawa does, too. After all, nearly two decades ago when he himself was a baron in the LDP, he first launched the debate about how Japan should modernise long before the political establishment was thinking about it. Ever since he stormed out of the LDP, he has vowed to bring it down.

Mr Ozawa's style, however, if occasionally brilliant, is also thin-skinned and autocratic: he does his deals in the shadows without consulting colleagues. These are hardly the right qualities for the leader of a party that makes such a great show of transparency and accountability.

Meanwhile, his mercurial character has only got more erratic. Since campaigning as the farmer's friend?admittedly a successful strategy in the upper-house elections, where rural votes carried a disproportionate weight?Mr Ozawa has come to sound like the old-style LDP bosses against whom he once turned. That unsettles the modernisers in his party, most of whom represent urban, more reform-minded constituencies.

And how else, apart from ascribing a growing erratic streak to Mr Ozawa, to explain the extraordinary about-face last November, when he switched from vowing to bring down Mr Fukuda and his government to cutting private deals with the prime minister? To the DPJ's modernisers, a grand coalition would spell doom to the party, which defines itself precisely by offering itself as an alternative to the LDP. Younger parliamentarians have become so dissatisfied with Mr Ozawa that Yukio Hatoyama, the DPJ's secretary-general, now says that he, and not Mr Ozawa, is answerable to the party caucus. It is a hint that Mr Ozawa, at least for the time being, has agreed to cede some authority.

Yet Mr Ozawa has a gun to the party's head. He knows that a split over his leadership might cause the DPJ to crumble. And should he choose to leave (he has flounced out of parties before), a handful of parliamentarians leaving with him would mean that the DPJ would almost certainly lose its upper-house majority.

Most of all, perhaps, blame two parties bursting with internal contradictions, a constitution that never envisaged opposing parties controlling the Diet's two chambers, and a culture that treats politics as a personal, sometimes family, business, not a means of offering voters choices about how their country should be run. An election would not solve these problems, but it might at least encourage parties to tell voters what they stand for.

Lastly, the voters must take some of the blame. Ten years ago, when The Economist lamented Japan's amazing ability to disappoint, one shrewd parliamentarian wrote in to challenge that. The headline, he said, should have read: "The Japanese people's amazing inability to be disappointed". A general election would at least give them the chance to start holding their politicians to a higher standard.