Now Japan Must Stay the Course

The Japanese economy seems to be out of intensive care these days. The stock market is up by more than 10% since the beginning of the year--the best performance among major markets and far better than the 9% decline in the Standard & Poor's 500-stock index in the U.S. The economy grew at a rapid rate in the first quarter, with profits expected to rise over the next year. And with confidence in U.S. companies battered by scandal after scandal, the Japanese system is starting to look better by comparison.

But the Japanese government should not view the parting clouds as a sign that it can slack off on financial and economic reforms. In fact, there's little evidence as yet that Japan's economic gains will be sustained. Take the stock market. The Nikkei may be up this year, but it's still down by 35% since the spring of 2000, when the worldwide stock market bubble popped. That's a bigger decline than the U.S. market, which is down by only 25% over the same stretch.

There's no sign, either, that Japanese productivity growth has picked up yet. During the 1990s, Japan experienced sluggish productivity gains, especially compared with the boom of the previous decades. That held down living standards and made it harder for companies to generate profits. And unfortunately, that pattern seems to persist. Over the past year, Japan's labor productivity in the all-important manufacturing industry declined at a rapid rate. Moreover, capital spending continued to decline in the first quarter.

In fact, to achieve solid growth going forward, Japan still needs to free up its labor markets and reform its financial sector. While unemployment is already at a record rate of 5.2%, the stalled growth in productivity suggests that companies, especially small and medium-size ones, still are holding onto too many workers. And the banking system is still caught in a crisis, with bad debt totaling almost 11% of loan portfolios. That's staggeringly high.

A rejuvenated Japanese economy would provide a big boost to the health of the global economic system. It would ease pressure on the U.S. to be the driving force behind world growth and lessen the threat that a weaker yen poses to other Asian economies.

It may turn out in the end that the Japanese recovery is for real. But many underlying problems remain, and there is no reason to stop reforming.

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