How Japan Can Restart Its Engine

Economic policy has taken a strange turn in Asia. Japan, long the the region's growth engine, is in a deflationary recession brought on by self-inflicted policy mistakes. Asians now blame Tokyo for making their financial crisis worse by weakening the yen and not absorbing their exports. China, once a pariah, is heralded as a self-sacrificing savior by refusing to play the competitive-devaluation game and keeping the yuan steady. Thailand looks great by implementing tough International Monetary Fund reforms quickly and is being rewarded with a stronger baht and new inflows of foreign capital. Indonesia may cut a deal with the IMF and still evade serious reforms. Korea is making some changes, yet still refuses a major overhaul of the chaebol. If this pattern continues, Asia's economic and political balance of power will be dramatically altered.

Japan, the world's second-largest economy, appears paralyzed. Profits, wages, and prices are all falling. Car sales are plummeting, and layoffs are rising. Consumer confidence must be restored, yet Prime Minister Ryutaro Hashimoto refuses to do what economists all over the world believe he must do--cut taxes. Japan's monetary policy has stopped working, and its fiscal policy is contractionary. The proposed budget will cut 1.2% out of next year's gross domestic product. With spring elections months away, the Liberal Democratic Party insists that government money to buoy growth go to construction companies. But a tax cut for individuals would be a much greater growth stimulus.

The yen could easily go to 150 under these conditions. In the past, a weaker yen boosted exports to the U.S. and Europe and stimulated Japan's growth. But with Asia taking 40% of Japan's exports, a weak yen is self-destructive. It competes with Korean and other Asian currencies, which makes Korean and other Asian exports to Japan more expensive and undermines their chips, consumer electronics, and cars in world markets. A weak Asia imports fewer Japanese goods, which is why corporate profits are suffering. To play a leading role in promoting Asian economies again, Japan must cut taxes and switch to a strong yen policy.

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