Heed the Nikkei. A revaluation of Japan Inc. is under way. Take government economic policy: The recent 2000- point drop, sending the stock index down 50% from its high, is a vote of no confidence in traditional policies, including protection of domestic markets; high-tax, high-pork budgets; and single-minded promotion of exports. Then take Corporate Japan. Even as it plunges, the Nikkei is rewarding internationally competitive industries, such as autos and electronics, with higher stock prices while severely punishing once protected, overvalued domestic industries, such as finance and insurance. The competitive forces of the open global economy are catching up to Japan's closed domestic economy. Only massive deregulation and a significant tax cut that redistributes buying power away from bureaucrats toward Japanese consumers can restart the nation's economic growth. State-directed mercantilism has gone as far as it can, and the Nikkei is moving Japan toward a more open--and ultimately more competitive--economy.

But only if policymakers allow the Nikkei to work. As the U.S. discovered in the 1980s, the process of becoming competitive can be extremely painful. Despite tremendous resistance, the job was essentially done in the U.S. by the beginning of the 1990s. Japan, however, is dragging its feet. Nearly six years into a growth recession, assets have yet to be assigned their proper market values. The Nikkei is down, but it may need to drop even further. Just 24 months ago, it plummeted, but before it could revamp the economy, fearful Finance Ministry bureaucrats, with help from the U.S. Treasury, propped it up with liquidity and a massive yen devaluation--to no avail.

The man most responsible for the Nikkei's current plunge is also most responsible for Japan's deregulation. Prime Minister Ryutaro Hashimoto rode a promise of deregulation into office and surprised everyone by actually trying to deliver on that promise. First, he announced a "Big Bang" deregulation of his nation's financial system. Then, he agreed to U.S. pressure to open Japan's insurance market. Without fixed prices and government protection, dozens of banks and insurance companies were then seen as overpriced by Japanese investors. Their shares plunged, as did those of companies in other protected industries that are candidates for deregulation.

But Hashimoto must depend on the support of zoku giin, or tribes of special interests within the party. They have stuffed his new budget with pork, ranging from new money-losing bullet trains to agricultural subsidies. To pay for this lard, as well as that left over from previous public-works programs, Hashimoto is pushing for a two-percentage-point increase in the consumption tax, to 5%. Consumers don't like it. They have already cut back their spending, sending the Nikkei down further.

Special interests will put tremendous pressure on Hashimoto to backtrack on his deregulation efforts. He should resist, because there is no alternative tool left for Japan. Pump-priming has failed. Low interest rates haven't worked. A weak yen isn't doing the trick. Only more competition can stimulate growth. Hashimoto should speed deregulation of retailing, transportation, telecommunications, construction, and electric power. He should also take advantage of growing public cynicism toward Japan's bureaucrats by reducing their authority. Above all, he should cut, not raise, taxes.

Japan now has a two-tier economy, one competitive, one not. Prime Minister Hashimoto must defeat the bureaucrats and special interests who are resisting change and integrate all of Japan into the global marketplace.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE