TOKYO: China has now officially supplanted Japan as the world's second largest economy. The question for Japan is whether or not the country will continue to tumble down the list of the world's great economies, or whether its politicians will return to a path of reform that can revive growth. That the ruling Democratic Party of Japan now seems trapped in a power struggle between Prime Minister Naoto Kan and party power broker Ichiro Ozawa suggests that serious economic reform is not at the top of the DPJ agenda. In the 1980's, Japan's annual GDP growth averaged 4.5％; since the early 1990's, the economy has been virtually stagnant, averaging barely 1% annual growth. In the 1990's, Japan's government, grossly misjudging the sources of the economy's difficulties, vastly increased government expenditures on public works, but ignored supply-side adjustments. This policy created new vested interests, and thus a new political environment, as construction companies and other beneficiaries of government contracts began donating heavily to the ruling Liberal Democratic Party. This kept the LDP's coffers brimming, but posed the risk of a serious financial crisis in the late 1990's. It was in these circumstances that Prime Minister Junichiro Koizumi took office in April 2001. Under Koizumi's leadership, insolvent banks were made whole again. At the start of Koizumi's government, 8.4% of bank loans in Japan were non-performing. By the end of his tenure, the rate was down to 1.5%, restoring the country's potential for growth. Indeed, this was one reason why Japan was so little affected by the “Lehman Shock” that incited the global financial crisis. But macroeconomic reform came to a screeching halt after Koizumi stepped down in 2006. A series of short-term prime ministers began a pattern of huge government outlays. Not surprisingly, the economy deteriorated. Frustrated by the long-ruling LDP's poor political and economic management, voters opted last year for change at the top. But the pattern of economic mismanagement, far from being reversed, has only become worse. Huge spending increases were directed at farmers and households. As a result, the share of tax revenue to total spending this fiscal year slipped below 50%, something unseen in Japan's entire post-war history. Despite the parlous fiscal position, for now the market for Japanese government bonds (JGBs) remains stable. But this is because government bonds are purchased mostly by domestic organizations and households. In another words, the government's negative saving is financed by the private sector's positive savings. But that private-sector safety net of savings is fraying. Japanese households hold savings of about ¥1.1 trillion in net monetary assets. In about three years, however, the amount of JGBs will exceed the total assets of Japanese households. Government debt will no longer be backed up by taxpayers' assets. Confidence in the JGB market will likely decline. Moreover, as Japan's society ages, the household savings rate will decrease dramatically. This will make it difficult, if not impossible, for the domestic private sector to finance the budget deficit indefinitely. And new demands for fiscal expenditures are expected to grow as the country ages. In about five years, all baby boomers will be over 65, but pressure on government expenditures for pensions and health care is expected to start sooner, around 2013. Japan's new government, led by Prime Minister Naoto Kan, started discussing a consumption-tax hike to offset the growth in spending. But a consumption-tax hike is no panacea, particularly given the government's lack of a growth strategy. Although a tax increase will undoubtedly be needed, it is the wrong priority at the moment — and could prove counter-productive if it causes the economy to decline dramatically. Indeed, Koizumi's government demonstrated the best way to tackle fiscal consolidation. Koizumi decided that a primary budget balance should be restored in 10 years. And he came close to being successful, as the primary deficit of ¥28 trillion in 2002 was reduced to just ¥6 trillion in 2007. Had this effort been continued for two more years, a primary surplus could have been realized. Without a strategy for growth, which includes efforts to reduce government expenditures and a policy to stop deflation, Japan's economy will remain in the doldrums. But Kan still seems unwilling to focus on growth. Instead, like so many other leaders before him, he proclaims his desire to find a “third way.” But, as history has shown, no third way exists. Kan continues to believe that a large government, with growing social-welfare expenditures, is the way to get the economy moving. This should not be surprising. He used to be involved in civic movements and groups — like environmental organizations – that take little heed of the need for economic growth. Increasing the tax burden seems almost a natural part of such a mindset, as does ignorance of the need for increased economic competition. Without that, and a renewed focus on growth, Japan will continue to climb down the global ladder of success. Indeed, any Japanese who thinks that complacency is an option should look to Argentina. A hundred years ago, Argentina was arguably the world's second wealthiest economy. Now, thanks to bad policies, and even worse politicians, it ranks among the world's also-rans. Heizo Takenaka was Minister of Economics, Minister of Financial Reform, and Minister of Internal Affairs and Communications under Prime Minister Junichiro Koizumi; he is currently Director of the Global Security Research Institute at Keio University, Tokyo. Copyright: Project Syndicate (www.project-syndicate.org).
