In Japan. Double-Dip Downturn Looms

Ask Japanese why their economy plunged in 2008 and most will blame the "Lehman shock."

A year from now, the "Dubai shock" may crop up in discussions about why Japan is shrinking anew. Dubai's debt crisis accelerated an export-killing yen surge and showed that the world economy remains sick without an easy cure.

The collapse of Lehman Brothers Holdings Inc. and Dubai World's bust bookend Japan's recent experience quite neatly. If Lehman's fall pulled the rug out from under Japan, Dubai's coincided with a day of reckoning many in Tokyo have yet to discern.

Japan was the first major economy to go into freefall in 2008, a dynamic that accelerated after Lehman's collapse that September. It also was perhaps the first to climb out of recession, growing for the last two quarters on an annualized basis. Now, the odds favor it being the first double-dip economy. Far from being a cyclical phenomenon, this one may be secular.

You're free to read optimism into Japan's latest stimulus package. Sure, 7.2 trillion yen ($81 billion) of fresh spending helps. And waiving the 15 percent tax for overseas investors on interest from corporate bonds is a step in the right direction that will attract more global demand.

The trouble is, the longer-term consequences of short- termism are catching up with Japan. And the economy is simply out of obvious options to restore growth in the long run.

Zero-Rate AddictionFor a decade and a half, Japan lived from fiscal hit to monetary high. It worked well while the effects lasted. Now Japan is shackled with the largest public debt among industrialized nations and a corporate sector that's addicted to zero interest rates. As much of the world mulls an exit strategy from massive stimulus, Japan is going the other way.

Look at how Japan has decoupled from different regions. On the one hand, it isn't hobbled by the financial-system problems undermining the U.S. and Europe—and should be recovering. On the other, Japan can't latch on to the benefits of solid growth in China and the rest of East Asia.

A mature economy with an aging population that lives and dies by exports has no choice but to go backward in this global environment. A weak return on capital and a strong yen is prompting manufacturers to cut costs. That means lower salaries, less employment and, in turn, more deflation.

How did Japan get here? Look no further than Japan Airlines Corp. (JSLSY), which is becoming even more of a zombie company as we speak, and Japan Post Holdings Co.

Japanese MicrocosmDebt-laden JAL, which may be getting a public loan guarantee of as much as 700 billion yen, lives from bailout to bailout. Japan Post was supposed to have been privatized, getting the nation's largest pool of savings away from politicians' pet projects. Cronyism is getting a new lease on life as the government pulls it back into the public sector.

Neither JAL nor the postal system has incentives to become more competitive or profitable. They are a microcosm of what ails the entire economy. By standing by to pump fresh money into the economy year after year, the government deadened the forces of "creative destruction" championed by Joseph Schumpeter.

Welcome to the zombie economy. Constant handouts to the private sector breed complacency. We tend to focus on the public debt, which is almost 200 percent of gross domestic product. An equally big problem is how unproductive Japan is amid the rise of China, India and South Korea.

All those Bank of Japan rescues, fiscal packages, loan guarantees and bailouts keep labor concentrated in inefficient areas and starve more productive and lucrative ones of talent. The efforts staved off unemployment, yet led to entrenched stagnation.

No 'Black Swan'The return of Japanese deflation is being treated like a "Black Swan," or a highly unexpected event with great impact. Anyone who didn't see deflation coming back wasn't looking in the right places. It also had as much to do with Japan's rigidities as chaos in markets.

Japan had two decades to reduce costs and overcapacity, and it didn't. It relied on stimulus and a weak yen—two things on which officials in Tokyo can no longer rely. Japan used to get by on strong global demand for its high-end cars and gadgets and advantageous exchange rates. Not anymore.

The nation has a major competitor in the name of Ben Bernanke. The U.S. Federal Reserve chairman hasn't only co-opted the BOJ's zero-rate policies, but seen to it that the "carry trade" that used to hold down the yen shifted to the dollar. Even more than recent quality problems and recalls, the strong yen is hammering Toyota Motor Corp. (TM).

The global crisis caused a shift away from top-end products to cheaper Asian goods. The risk is that corporate Japan decides this is a typical cycle. It's not, and there's no hunkering down until demand returns. It's time for a rethink of the nation's entire industrial system.

The process won't take months, but years. The sooner we get on with it, the less susceptible the second-biggest economy will be to the Lehmans and Dubais of the world.

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