Tokyo Is Courting Disaster

A crisis in Japanese capitalism is unfolding. In the months ahead, the yen could weaken to 150 to the dollar from 133 and the Nikkei could plummet to 12,000, less than one third of its 1989 peak. Unless steps are taken soon to reverse course and reboot the Japanese economy, Asia's recovery will be jeopardized--and the U.S. and Europe could be hit with the biggest deflationary wave since the Depression.

A "sell Japan" mentality is already taking hold among the Japanese. Here are the facts: Profits, wages, and prices are falling fast. Industrial production dropped 3.3% in February from the month before, and the International Trade & Industry Ministry forecasts an additional 5% drop in March and April. These are huge declines, beyond what is seen in typical recessions. Auto, housing, and retail sales are all in sharp decline. A toxic combination of misguided government economic policy, political paralysis, and financial deregulation is setting the stage for massive capital flight.

The latest government pump-priming effort, like the dozen or so before it, is unlikely to work. Why? Only half of the $127 billion stimulus package is "pure water," or new money, and most of that will go to public works, not tax cuts. Construction companies receiving the largesse are likely to kick back campaign contributions. With elections looming, the Liberal Democratic Party wants to target spending in election districts to support its candidates. A massive tax cut that could restore consumer confidence is not to be.

The Nikkei appears to agree. Stocks failed to rally when the program was announced, and the index closed at 16,527. Banks and insurance companies were expecting the Nikkei to end its fiscal year in March at 18,000--last year's close. Now, they could be hit by stock valuation losses and forced to cut lending, exacerbating Japan's already severe credit crunch.

It's a dismal economic scenario--and it gets worse. Monetary policy has failed even though interest rates are down to 1% to 1.5%. Terrified of losing their jobs for the first time in their lives, people are curbing consumption and saving like mad. Trouble is, with rates so low, they can't get a decent rate of return. And the stock market is no alternative. Where are Japanese savers to go?

Enter the Big Bang. Financial deregulation begins on Apr. 1. By deregulating securities markets and cutting brokerage commissions, opening banking and insurance, and removing currency controls for retail accounts, Tokyo hopes to revitalize the economy. It may do so over time, but financial deregulation within a stagnant economy could first cause a tsunami of money out of Japan as citizens, seeking higher returns, invest abroad for the first time. "Sell Japan" could become the reality as people buy dollars and dump the Nikkei for the S&P.

Japan is stuck. Its old policies, once successful, are failing. In the past, devaluing the yen always boosted growth through exports. Today a weak yen is self-destructive. Some 40% of Japanese exports go to Asia, and the more Japan devalues, the more it hurts Asian growth and Japanese exports. Yen devaluation undermines competing Asian chips, cars and steel on world markets and raises prices on imports to Japan. A weak Asia means lower profits for Corporate Japan.

Massive tax cuts and a stronger yen could restore consumer buying power and confidence and lift Japan out of its seven-year stagnation. The economy was growing last year before Tokyo slammed it by raising VAT taxes 2%. But policymakers would have to shift mental gears. Japan is being run as a pension state, with policy directed at providing for retirement. Growth is not the goal, even though it is the best solution to the pension problem. A few corporations compete globally while the domestic economy stagnates. Investments made overseas in the glory years of the 1980s provide income. Japan is in decline. The economic dynamism that was the hallmark of postwar Japan is shifting to China.

This ominous script can be averted. But given the myopia of Tokyo's policymakers, it may take a crisis to save Japan.

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