Japan's America Problem by Fareed Zakaria

August 3, 1998, U.S. Edition

Japan's America Problem
If Tokyo really wants to solve its financial crisis, it should stop following U.S. advice and start creating a little inflation.
By Fareed Zakaria

AMERICAN OFFICIALS SEEM FRUSTRATED AND ALMOST mystified by Japan's unwillingness to tackle its economic problems. They compare Japan's outgoing prime minister to Herbert Hoover, call his finance minister "the Minister for the Destruction of the World Economy" and seem to have little faith that the prime minister-presumptive, Keizo Obuchi, can restore vigor to its economy -- and hence to the whole of Asia. In fact, if Japan were actually to do what it would take to boost its growth rate, Washington would be outraged.

Japan is in its worst economic recession in 25 years. Output shrank by 5.3 percent in the first quarter; unemployment is rising and productivity is stagnant. Meanwhile, only Japanese growth can fuel a recovery in Southeast Asia, which relies on Japan to buy its goods and invest in its assets. A continuation of the slump in Tokyo will have much wider effects eventually; Japan's is still the world's second largest economy and its greatest source of surplus capital.

For Japan to grow, its corporations and consumers need to start buying and investing, spurring production. For its part, the Clinton administration has been urging Japan to reform its banking system and prime the economy with a mixture of government spending and tax cuts. But these measures won't lift Japan out of its recession.

It's true that Japan's banking system is over-regulated and massively inefficient, and currently conceals bad loans and losses that add up to at least $ 600 billion. Reforming this industry will require deregulation, transparency and, most important, allowing bad banks to fail. But the effect of these reforms in the short and medium term will be a stream of bankruptcies (of banks and the businesses to which they had loaned money), a decline in the stock and real-estate markets, more unemployment and a severe loss of consumer confidence. In other words genuine financial reform would probably turn Japan's recession into a depression.

The fiscal stimulus and tax cuts could both spur growth -- in theory. But the government has, since 1992, spent more than $ 500 billion with some, though not much, sustained effect. (Government spending in Japan, as in the United States, goes not to places where it will have strong multiplier effects economically but to places where politicians need votes. How much has West Virginia's extravagant highway system contributed to American productivity growth?) Tokyo cannot keep spending money; its budget deficit is already 7 percent of GDP and will only increase when, one of these days, it will have to pick up the tab for bank failures.

In this atmosphere of gloom, tax cuts are unlikely to unleash a wave of consumer spending. In the first place, the Japanese are born to save; their savings rate is twice America's. They also know that they are an aging society, with a pension system verging on bankruptcy. And they are scared out of their wits daily by the American government and media, who tell them that they are living in an economic basket case. Thus the tax cuts will probably exacerbate Japan's fundamental short-term problem -- which is a widening gap between savings and domestic investment.

Is there anything Tokyo can do to jump-start its economy? Actually there is, and it's simple and effective: bring on a little inflation. The noted economist Paul Krugman has pointed out that the only way to get Japanese companies and consumers to stop saving and start spending is to convince them that things will be cheaper today than tomorrow. The Bank of Japan could simply announce that it is targeting a 2 percent rate of inflation (rather than the current one, which is below zero), creating a rush of spending. Such a move would also ease the financial crisis, since asset prices would rise and debts would be easier to pay off, making the inevitable bank bailout cheaper.

There's one small problem with this solution -- it means that the yen will fall further in value. This would actually help speed up Japan's recovery since its exports will become cheaper on world markets. But politically it's a problem. A falling yen could well lead to another round of currency devaluations in Southeast Asia and beyond. Most important, China, which may soon have to devalue its currency anyway, could take this as an opportunity to do so and blame the Japanese for having created instability and panic around the world. Tokyo is petrified of being considered irresponsible by its neighbors and by the United States. And Washington, fearing further instability in Asia, and particularly in China, has consistently suggested that Japan take every measure it can to boost its economy -- other than spurring inflation.

Thus a sensible Japanese economic policy appears to be pitted against a sensible foreign policy. But Washington should recognize that Japan is 75 percent of Asia's economy. If it doesn't grow, none of Asia will. A policy of inflation in Japan has its costs. Were Japan to inflate, while there might be a short panic after the yen drops, Japan and the United States could shore up other regional currencies -- thus demonstrating its good intentions to the world in general and China (and the United States) in particular. Sometimes tough economic policy can also be the right foreign policy.