Posted on 30-10-2002

Japanese Wall Shades Global Economy
By Akio Mikuni and R. Taggart Murphy*

It is an old routine that goes back half a century: a sudden show of
resolve in Tokyo to do whatever it takes to fix whatever problem worries
the United States — complete with "reformist" ministers and bold policy
pronouncements. In time, both the policy and the minister are forgotten,
and Japan returns to business and politics as usual.

In this case, Heizo Takenaka, Japan's economics minister and chief
financial regulator, was set last week to announce a bold plan to
restructure Japan's banking system, which has more than $400 billion in bad
debt. With the support and approval of the United States, Mr. Takenaka
acknowledged that the banks will be unable to recover on their own, and
that fixing them will result in the failure of scores of companies. But at
home Mr. Takenaka's reform proposals received withering criticism even from
members of his own party, and his support from Prime Minister Junichiro
Koizumi may not last. Moreover, it is not entirely clear that the Bush
administration realizes the consequences of Mr. Takenaka's solution.

None of this is to say that Mr. Takenaka is not sincere, or that Japan's
financial system doesn't face a huge crisis. He is, and it does. But the
problem has been widely misunderstood. "Bad loans" only mean something in
an environment where a borrower's ability to generate cash flow to service
debt is the criterion of whether a loan is good or bad. That was not always
true in Japan. Most loans were secured by land and rolled over perpetually.
The criterion for loans in Japan was not corporate profitability but
bureaucrats' ability to drive up real estate prices.

Japanese finance has, to Western eyes, been an "Alice in Wonderland" affair
now for 50 years. Banks once lent far more money than they had in deposits.
Then, in the 1980's, Japanese government officials directed banks to lend
well in excess of real economic requirements. Much of that lending fueled a
surge in land prices that saw the theoretical value of Tokyo's Imperial
Palace grounds exceed that of the whole of California.

Bizarre as it may appear to outsiders, Japanese banking nonetheless was
driven by two rational objectives: the goal was to finance an industrial
plant that would secure Japan's economic autonomy and ensure its political
stability. It worked. Four decades after war had left Japan in ruins, the
country boasted the world's most formidable industrial machine. And a
constant flow of subsidies to politically powerful groups — farmers, small
shopkeepers, half a million construction companies — has bought 50 years of
political peace.

In recent decades, however, the system has changed. Credit now goes
increasingly to protect politically well-connected companies from failing
rather than to the kinds of firms that built the fabled Japanese economic
miracle. These credit policies, combined with falling land prices, brought
economic growth in Japan to a halt a decade ago. One of the results of this
collapse is more than $400 billion in unrecoverable loans. But recovering
those loans is not simply a matter of closing certain banks, recapitalizing
others and allowing some big companies to fail.

For starters, any questioning of the banks' integrity could lead to
economic disaster domestically. If the banks are seen as corrupt,
individual depositors could pull their money out of them. Japan's household
savings overwhelmingly take the form of bank deposits that carry either
explicit or implied government guarantees. The Japanese government, already
heavily in debt itself, can ill afford to honor these guarantees during a
wave of failures brought on by a run on the banks. Closing the banks could
also cause a political crisis. The flow of cash — from household to bank to
well-connected borrower employing retired bureaucrats and voters for the
ruling Liberal Democratic Party — fuels the very engine of the Japanese
political economy. Turning off this flow is tantamount to revolution.

The notion that Mr. Takenaka is going to do that, even with the full
support of Prime Minister Koizumi and the off-stage applause of the United
States Treasury Department, is preposterous. Indeed, last week members of
his own party and even a fellow cabinet minister criticized Mr. Takenaka
openly.

Any Japanese reform, political or economic, must eventually face this
reality: Japan has no central government able to override the
quasi-sovereign fiefdoms that constitute the Japanese political order.
Those fiefdoms — the more powerful ministries together with their protégés
and the various factions of the L.D.P. that provide political protection
for them — can and will sabotage any policy initiative that threatens their
autonomy.

This lack of any institutional mechanism for overriding the claims of
special interests helps explain the policy trap in which Japan now finds
itself. During the decades when the economy grew rapidly, this
institutional failing did not matter so much. But just as the Japanese
military leadership in World War II never allowed for the possibility of
retreat and didn't know how to conduct one, Japan's current economic
leadership has no accepted means of distributing the pain that would
inevitably accompany Mr. Takenaka's reforms. That is why, like all other
such initiatives of the past decade, they will be allowed to proceed only
when they have been gutted.

An upheaval in Japanese finance, bringing with it a complete restructuring,
is not impossible. But such a restructuring would produce shocks that would
reverberate around the world.

Japan as a nation holds nearly $3 trillion in dollar-denominated assets,
many of them ultimately supported by the very deposits that would be
withdrawn in a wholesale reorganization of Japanese banking. Those dollars
have played an indispensable role in permitting the United States to swell
its trade deficits far beyond the levels of most nations. That so many
foreigners are willing to keep their earnings from trade inside the United
States banking system — what "holding dollars" literally means — helps the
United States tolerate its deficits. But this situation is precisely what
restructuring in Japan threatens. If banks were forced to call in loans to
pay off depositors, and if those loans financed their customers' dollar
holdings, Japanese companies would be forced to sell their dollars for yen.
Real money and purchasing power would then leave the United States as the
conversion weakened the dollar, forcing a rise in interest rates and import
prices and further raising the risk of recession.

That is what usually happens to countries that run excessive trade deficits
— foreigners lose confidence in these countries' currencies, interest rates
rise, the economy goes into recession and, as people can't afford to buy so
many imports, the trade deficit begins to close. The United States has
escaped this fate largely because of the very problems with Japanese
finance that Mr. Takenaka promises to attack. Washington ought to be
careful what it wishes for.

* Akio Mikuni and R. Taggart Murphy are the authors of "Japan's Policy
Trap: Dollars, Deflation and the Crisis of Japanese Finance.''