J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 26
Tuesday, April 29, 2003
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Viewpoint: Severe Acute Reform Repulsion Syndrome
The Bottom Line:
o Post Iraq War, the prognosis for the US economy remains
relatively brighter than Europe and most certainly Japan. In
Asia, the economic fallout from SARS (severe acute respiratory
syndrome) is spreading faster than the disease. This plus weak
economies in the G-7 have caused dollar bears to rethink their
o Fortunately, Japan seems (so far) to have been largely spared
from the ravages of SARS, which would be the last straw amidst
already crumbling expectations for better economic numbers and
what seems to have become a bottomless plunge in Japanese
o But while Asian economies and financial markets are suffering
from SARS, Japan's economy and financial markets are suffering
from SARRS (severe acute reform repulsion syndrome). PM
Koizumi's reformist movement seems to have essentially ground
to a halt since the end of 2002, as it is becoming boxed in on
all sides by SARRS, leading to much speculation about a
o Unfortunately, SARRS in Japan will be even more difficult to
cure than SARS will be in Asia, as the cure for SARRS involves
no less than dismantling the current policy-making "system" in
Japan and building a new one, a task that even "Koizumi the
lion-heart" is finding to be unassailable.
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Severe Acute Reform Repulsion Syndrome
Good news and bad news from the US
As 2003 began, the clouds of war were gathering over Iraq and the Dow
Jones industrial average closed the month of January at 8,053.81, or
3.5 percent lower than the close of 2002. It was not a good omen, for
street lore has it that "as goes January, so goes the year." But as we
mentioned in a previous Money Watch, onset of fighting in many wars
invariably marks the low point in the stock market, and the markets
historically rally after that.
As far as the US stock market is concerned, historical precedent
regarding war and stock markets has held true. After bottoming in
early March, the Dow Jones industrial average has rallied by
approximately the same amount that had been lost since the onset of
2003. The consensus on US economic growth, as reflected in the Blue
Chip Economic Indicators, had already trimmed expected US GDP growth
by early March to 2.6 percent in 2003 (versus 2.8 percent in January).
The US economy reportedly grew only 1.6 percent in the first quarter,
a much slower pace than economists were anticipating and well below
the 3.2-percent growth needed to boost the US labor market. Meanwhile,
unemployment has crept up from 4 percent in 2000 to the 6-percent
level. Consumer confidence has plunged from 140 in 2000 to around 60,
but consumer spending remains basically flat, trending between zero
and 1-percent growth. The good news, however, is that the US has
apparently avoided a double-dip recession, and the housing market has
remained surprisingly strong as it weathers the recession that began
in March 2001.
Relatively more bad news in Europe and Asia
The UK economy in the first quarter was still expanding but at its
slowest pace in a year, up just 0.2 percent, or half the rate of the
last quarter of 2002. UK consumer confidence is at an eight-year low.
The bottom line is that growth in the euro economies will continue to
lag behind that of the US in 2003 and 2004, according to IMF and OECD
estimates, and evidence of a recovery in European economies isn't
expected for several more months.
In Asia, the economic fallout from severe acute respiratory syndrome
(SARS) is spreading faster than the disease. The OECD is warning that
Asian travel, leisure and consumption will suffer major blows, and
economists are moving to reduce expected growth rates in the region.
The World Bank has trimmed its estimates of East Asia growth by 0.5
percentage point to 5 percent, while China's growth rates in 2003 are
being trimmed from 8 percent in 2002 to the low 7-percent range, even
though China's economy was racing along at nearly 10-percent growth
rates in the first quarter of 2003. Asia is particularly important to
the growth in global trade, as Asia (not including Japan) contributed
almost 45 percent of the growth in global trade volume in 2002 and is
expected to contribute over 30 percent in 2003.
The bottom line is that economic growth in the US (despite the US-led
implosion of tech, media and telecom stocks, the 9/11 disaster and the
Iraq War) is expected by the OECD and the IMF to remain well ahead of
that in the euro zone and among its Group of Seven peers.
Japan has so far been largely spared from the global outbreak of SARS
that is ravaging the Asian economies. Yet the Japanese stock market
has failed to respond like the US stock market to the good news that
the Iraq War was short. Indeed, there is a growing sense of
resignation/helplessness about the never-ending plunge in Japanese
stock prices, as investors pounce on any negative development (such as
the Sony "shock" of bad fourth-quarter results and a glum outlook) to
sell Japanese stocks ever lower, led by an implosion in market
capitalization values of Japan's major banking groups.
Every weekend, the "talking heads" on the popular talk shows berate
the state of Japan's economy and debate what they, or the particular
"expert" guest they have invited on the show, believe is a credible
prognosis for fixing Japan and its imploding stock market. In
addition, the favorite speculation in Tokyo these days is who will
replace Junichiro Koizumi as prime minister, now in his second year of
But while the hot air from all these talk shows and in the Diet
probably has resulted in raising the average temperature in Tokyo by 1
degree or so, it has had absolutely no impact on the problems. While
some accuse the Koizumi administration of being "all talk and no
action," these same people are quick to resist and criticize any
serious attempts to tackle the mountain of issues of the Japan malaise
that need to be simultaneously addressed.
Everyone (politicians, the business lobbies, the major banks, the
bureaucrats and the voting public) will generally agree that Japan is
in need of serious reforms. But when it comes to actually implementing
reforms, there are 60,000 excuses for every reform. In other words,
while Asian economies and financial markets are suffering from SARS,
Japan's economy and financial markets are suffering from SARRS (severe
acute reform repulsion syndrome). Koizumi's reformist movement seems
to have essentially ground to a halt since the end of 2002, as it is
boxed in on all sides by SARRS.
There is no one particular reason for the continued, massive
destruction of shareholder value on Japan's stock market. Therefore,
to blame all of the stock market's problems (as a reflection of the
Japanese economy's structural problems) on the Koizumi administration
is less than fair. Nor is it fair to blame it all on the Bank of Japan
or on the banks themselves. A more honest appraisal would be that,
while there is a realization among all of the protagonists that these
problems will not solve themselves, and Japan is running out of time
to address them, no one's heart is really in it.
Is Koizumi's structural reform regime a 1980s-type solution to a
1930s-type problem? We may never know, because SARRS has already set
in. Recognizing the existence of a problem is usually an essential
first step to a solution, but SARRS takes over whenever substantial
structural improvements to the economy are attempted. This political
"gridlock" is as much responsible for the toxic shock that is behind
continued new lows in the Nikkei index and in Japanese government bond
yields as is any explanation based on market "fundamentals."
There are those who suggest that Koizumi and the current circumstances
resemble the Osachi Hamaguchi Cabinet (prime minister from 1929-1930
who was shot by an ultra-nationalist in 1930 and died in 1931). Others
suggest the current Koizumi Cabinet takes after the Fumimaro Konoe
Cabinet in 1937. If Japan were in the same phase as the US Great
Depression in the 1930s, the current problems in Japan would
supposedly be resolved by a depression itself. To prevent this
(assuming it is preventable), the government must take extremely bold
measures, but what exactly should these "bold" measures be? Japan may
have been here before, but, in the words of George Santayana, "those
who cannot remember the past are doomed to repeat it." Moreover, those
who remember the 1920s and what transpired then are no longer around.
The view that the current Japanese economy resembles the economy in
the Showa recession of the 1920s is not new. While economists and
policy makers have recognized the limited applicability of postwar
policies and countermeasures to completely different economic
conditions, there has been a severe lack of policy analysis of the
major deflationary phases in history and their possible applicability
to Japan's malaise -- not just by the government, but by all
Completely new framework for economic theory?
The last major deflationary wave (the Showa Depression in Japan and
the Great Depression in the US) and the failure of government policy
to successfully prevent the resulting depression brought forth an
evolution of new economic philosophies and theories to explain and
ostensibly "fix" these failings. Reacting to the severity of the
worldwide depression, John Maynard Keynes in 1936 broke from the
classical tradition with the publication of the "General Theory of
Employment, Interest and Money." The classical view assumed that in a
recession, wages and prices would decline to restore full employment.
Keynes held that the opposite was true. Falling prices and wages, by
depressing people's incomes, would prevent a revival of spending. He
insisted that direct government intervention was necessary to increase
total spending. To varying degrees, most governments in the developed
world now pursue Keynesian policies. Japan, in particular, has pursued
classic Keynesian policies.
Keynes' arguments supposedly proved the modern rationale for the use
of government spending and taxing to stabilize the economy. Government
would spend and decrease taxes when private spending was insufficient
and threatened a recession; and it would reduce spending and increase
taxes when private spending was too great and threatened inflation.
But Keynesian government spending has not stabilized Japan's economy.
Instead, it has merely pushed Japan's government finances ever closer
to crises. Milton Friedman, one of the best-known "monetarist"
economists, became the darling of supply-side "laissez-faire"
proponents (such as the Reagan administration in the 1980s) because he
argued eloquently for non-interventionist policies by governments. In
the monetarists' view, attempting to manage demand in a Keynesian way
would simply destabilize the economy. Instead, monetary policy and
supply-side policies make markets work better and reduce unemployment.
The monetarist view of deflation
Banking-sector-generated deflation can occur because of the money
multiplier function of banking. A bank receives money on deposit,
holds part of it as a cash reserve and loans out the rest. This
effectively increases the supply of money since both the loaned cash
and the credited deposit at the bank function as money. A loan is also
a kind of deposit, as a bank credits itself with the money it has
loaned. A bad loan is one that cannot be paid off and at some point
must be written off as a loss by the bank. Correspondingly, the bank's
"deposit" is also lost, and the money supply thereby decreases by that
amount. When loans and credit get overextended, their abrupt collapse
decreases the money supply, thereby producing conspicuous deflation.
This was particularly severe in 1929.
Historically, such credit crises have healed themselves in a year or
two, as bad loans were written off and the extension of new loans
began again, thereby avoiding a depression. Herbert Hoover and
Franklin Roosevelt, however, both thought that high wages were the key
to healing the economy. They promoted high wages all through the
1930s. In a deflationary period, however, overvalued labor is
effectively priced out of the market. People with jobs, especially
union jobs, were very well paid in the 30s, but unemployment peaked at
28.3 percent in 1933 and was still up at 20 percent in 1939 -- it had
previously never been higher than 18.4 percent (in 1894).
In more recent history, the monetarist theory that inflation was
caused by money creation, rather than by an "overheated" economy, and
that economic growth is caused by capital investment in the free
market, rather than by high taxes and the demand-side effects of
government spending, was first tested in the "supply-side" economics
promoted by former president Ronald Reagan. Here, wholesale tax cuts
and the fiscal conservatism of the Volcker-Greenspan Federal Reserve
System were largely responsible for the economic prosperity of the 80s
and the 90s in the US. Similar policies had a similarly positive
effect on the UK under Margaret Thatcher, and while much more painful,
a similar result was seen following the collapse of communism in
Russia. These modern day examples are in effect a vindication of
common sense classical economics and monetarism and are in direct
contrast to the failed Keynesian policies in Japan.
Keynesian policies and the Japanese way
Ostensibly, the free market allows prices of everything from wages to
bad loans to property to gold to move toward market clearing levels.
Price fixing never works without an application of force (such as
government force) and produces either surpluses or shortages. Thus it
is not surprising that massive government intervention during the
Heisei Malaise has produced the "excess supply" that some economists
are claiming is Japan's "problem." But "supply-side" economics and
"laissez-faire" (i.e., small government) economic policies are
fundamentally at odds with the structure of Japan's postwar political
framework. To allow market forces free reign, the Keynesian proponents
proclaim, would be to stand aside and allow market forces to "ravage"
Japan and perhaps even push the economy into depression.
What they really mean is that such free market forces threaten the
very system upon which the postwar political framework is based. Since
1955, the Liberal Democratic Party (LDP) maintained power
uninterruptedly for nearly four decades and was able to promote a
highly stable policy-making process. LDP leaders functioned as
brokers, joining the expertise of the elite civil service with the
demands of important interest groups in what came to be known as "the
iron triangle." From the 1960s, the LDP's policy-making power
increased, while that of the bureaucracy has declined. The system was
successful in that it provided most groups in society with adequate
representation and a share of prosperity. Japan's bureaucracy has
evolved from the samurai warrior class in the Edo period (1600-1867)
to the clerical and administrative functions of a new elite civil
service that came into being following the Meiji Restoration in 1868.
Although the US occupation dismantled both the military and zaibatsu
establishments, it did little to change the power of the bureaucracy.
There was considerable continuity -- in institutions, operating style,
and personnel -- between the civil service before and after the
Despite an increasingly unpredictable domestic and international
environment, and in contrast to the image projected by the "take
charge" Koizumi administration, policy making in Japan largely
conforms to well-established postwar patterns. Getting anything done
requires close collaboration of the ruling party, the elite
bureaucracy and important interest groups. Steps taken to institute
more formal policy development take place in deliberation councils
(shingikai) and other committees. Thus the shingikai often represented
a fairly advanced stage in policy formulation in which differences can
be thrashed out and the resulting decisions couched in language
acceptable to all. Committee members work closely with their official
counterparts, advancing the requests of their constituents, and are
one of the most effective means through which interest groups can
state their case to the bureaucracy through the channel of the ruling
party. The result is a system that makes perfect shills for
interest-group politics, where the only real interest is in getting
money out of the government. For this to work, taxes and spending must
be as high as possible. And that is why died-in-the-wool Keynesian
economics has been so enduring in Japan and is also why the opposition
to monetarist, "laissez faire" economic policies runs so deep. Thus
the Koizumi administration's efforts to circumvent this system, as
with previous serious attempts at reform in Japan, are eventually
doomed to failure as long as they are dependent on the existing
A top-down solution to Japan's malaise rests not in ousting Koizumi's
administration, but with the system itself. Judging from Shintaro
Ishihara's carefully ambiguous comments, he has not given up hope of
leading his country, and there are many within the LDP and the general
public that would like to see Ishihara as prime minister.
Realistically speaking, it's a long shot. While a general election
would not be required, Ishihara would first have to again win a seat
in the Diet, ostensibly through a by-election that could not be held
until after the LDP presidential election in September.
If Ishihara were to attempt to become prime minister by being elected
as president of the LDP, he would be put in exactly the same
circumstances as Koizumi and therefore would also be set up to fail.
If, as some suggest, he is waiting for Koizumi to be totally
discredited, preferably by a financial crisis, he would arrive too
late to prevent exactly what the LDP, the government, the Bank of
Japan and the general public would like so very much to avoid.
Moreover, while Koizumi's approval ratings are down dramatically to
around 45 percent, previous LDP presidents and prime ministers would
have sold their mothers-in-law for such numbers. Based on this
remaining popularity (which is a combination of support from
"reformist" LDP members and independents), he could attempt to remain
prime minister despite losing the presidency of the LDP. Indeed, he
has repeatedly threatened to destroy the LDP if it throws him out.
Those seeking to get rid of him would then have to pass a
no-confidence motion to set the wheels in motion to oust him as prime
minister if he refused to leave voluntarily.
An internal breakup (with Koizumi as a catalyst) of the LDP could form
the basis of a major restructuring of the policy-making "system" in
Japan that has remained largely unchanged in the postwar era. Just as
a financial crisis could form the focal point for Japan's recovery,
the breakup of the LDP and reorganization of Japan's political parties
along "reform" and "anti-reform" lines could form a similar historical
-- Darrel Whitten
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"What You Should Read After Irrational Exuberance"
A weekly strategic analysis of Japan's economy and
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Written by Darrel Whitten firstname.lastname@example.org
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