What Lever Could Get Japan Rolling?

Japan's economy is falling further into a deflationary spiral. On Jan. 24, the government predicted that the economy would expand by 0.6% in real terms and contract by -0.2% in nominal terms in 2003. The same day, interest rates fell below zero for the first time in Japanes history. The overnight call rate on $123 million of funds traded between three foreign banks was -0.01%. Says Takatoshi Ito, professor at the Research Center for Advanced Science & Technology at the University of Tokyo: "Things are getting worse by the day."

While prices are falling, unemployment is rising. It's now 5.5%, an enormous level by Japanese standards. More and more companies are going bankrupt. And despite vigorous efforts by Japanese regulators to encourage banks to deal with their bad loans -- properly classifying them and then setting aside adequate provisions to cover them, for example -- little progress is being made. "The banks' problems are adding to the deflationary pressure," says Malcolm Williamson, president and chief executive officer of Visa Intl. "I've never known a country come out of a recession with a bankrupt banking system."

UNRESPONSIVE PATIENT. Japan's problems are a prime topic at this year's World Economic Forum in Davos, Switzerland. Once an engine that drove the world economy, the country is now a drag. "What's worse is the fact that the economy isn't responding to the policy initiatives made so far," says Junichi Ujiie, president and chief executive officer of Nomura Holdings, one of Japan's largest investment bank. "We need more radical action."

Ujiie argues that the government "must implement both supply- and demand-side measures" to tackle the crisis. On the supply side, he says, labor markets should be deregulated and the banks forced to take real action -- by cutting staff and costs -- to solve their problems. On the demand side, government should overhaul the tax system to encourage people to spend and companies to invest. "A key problem is that the amount Japanese people save is greater than business' willingness to invest," says Paul

Krugman, professor of economics at Princeton University.

That's just a start, says Masayuki M. Matsushita, vice-chairman of Matsushita Electric Industrial. Japan's basic problem, he argues, is that "we're not international enough." He wants the country to open up more to foreign workers, ideas, and companies in order to stimulate change.

INFLATION TARGETS? The Japanese government is talking about pumping more money into the economy in an attempt to stimulate demand and growth. But the University of Tokyo's Ito observes that the Bank of Japan -- the central bank -- has been doing that for years to no avail. Consumers have continued to save rather than spend. "What Japan needs in the short term," says Ito, "is for the BoJ and government to take aggressive action together to put an end to deflation."

Ito's solution: The central bank should adopt inflation targets in order to encourage price increases. And to stimulate growth, the government should launch a conservative spending plan as well as tax reforms. "It should temporarily nationalize the weakest banks, restructure them, and tackle the nonperforming loans," Ito says.

Although such measures would weaken the yen, investors would recognize them as credible attempts to restructure the economy, Ito argues. "They would become more confident and begin investing more heavily in Japan." In the medium term, he says, more Japanese companies should shift production to China, while keeping design and development in Japan. At the same time, the labor force should be increased by encouraging more women and retired people to work and allowing more immigration.

Yet, many business leaders at Davos wonder if even a plan as comprehensive as Ito's would be enough to pull Japan out of its deflationary spiral before 2005. Krugman says the country could be stuck in this mode for at least a decade. Just one more headache for a world economy reeling from war worries, higher oil prices, and sluggish growth. By David Fairlamb at the World Economic Forum in Davos

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