Japan: The World's No. 2 Economy Teeters on the Brink

Japan's economic situation is ever closer to spiraling out of control. Recent grim data show that the economy is in free fall. Prices and wages are declining, creating a self-reinforcing contraction in employment and output, as dysfunctional policymakers squabble over what to do about it all.

Japan is almost certainly in its worst recession in at least 20 years. Real gross domestic product began falling in the second quarter, and lacking any engine of growth, economists expect it to shrink through mid-2002. October data were dismal. Industrial production dropped to a 13-year low, as exports fell and businesses cut their capital spending. Retail sales sank for the seventh month in a row, and housing starts declined, despite the Bank of Japan's zero-interest-rate policy. Unemployment rose to a record 5.4%, and confidence is plummeting.

Now, the financial risks are rising. Standard & Poor's lowered Japan's credit rating to AA, and it could drop further. Along with Italy, that's the lowest rating among Group of Seven industrial nations. S&P cited lack of progress on reform, debilitating government debt equal to 130% of GDP, and a budget deficit greater than 6% of GDP. Any fiscal-policy efforts to stimulate the economy will add to the debt problem and run counter to reform efforts.

The big worry, however, is deflation, which threatens to destabilize the financial system. Consumer prices in October fell 0.8% from a year ago, and they have been falling for two years. Any speedup in that rate of decline will make debt burdens, both public and private, increasingly onerous, since deflation lifts the real cost of paying back a loan. Banks are already saddled with more than $1 trillion in bad loans, by some estimates, and many large banks may have exposures to the recently bankrupt Enron Corp.

The hope is that the government will take over the bad loans with funding from the BOJ. Banks have increased their loan-loss reserves recently with the apparent help of the BOJ, but progress is too slow to remove the growing threat of a serious financial crisis.

By James C. Cooper & Kathleen Madigan

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