[OPE-L:7870] NYTimes.com Article: Would Reform Ruin Japan?

From: Rakesh Bhandari (rakeshb@stanford.edu)
Date: Tue Oct 29 2002 - 17:28:18 EST

About three years ago in discussion with Fred, I mentioned Susan 
Strange's warning of the consequences of a Japanese repatriation of 
capital from the US. There was an article in Business Week sometime 
in the last year which downplayed the threat. The threat is 
considered seriously at the end of this analysis. If I remember 
correctly, Strange drew heavily from Taggart Murphy, co author of 
this piece.

Would Reform Ruin Japan?

October 29, 2002

It is an old routine that goes back half a century: a
sudden show of resolve in Tokyo to do whatever it takes to
fix whatever problem worries the United States - complete
with "reformist" ministers and bold policy pronouncements.
In time, both the policy and the minister are forgotten,
and Japan returns to business and politics as usual.

In this case, Heizo Takenaka, Japan's economics minister
and chief financial regulator, was set last week to
announce a bold plan to restructure Japan's banking system,
which has more than $400 billion in bad debt. With the
support and approval of the United States, Mr. Takenaka
acknowledged that the banks will be unable to recover on
their own, and that fixing them will result in the failure
of scores of companies. But at home Mr. Takenaka's reform
proposals received withering criticism even from members of
his own party, and his support from Prime Minister
Junichiro Koizumi may not last. Moreover, it is not
entirely clear that the Bush administration realizes the
consequences of Mr. Takenaka's solution.

None of this is to say that Mr. Takenaka is not sincere, or
that Japan's financial system doesn't face a huge crisis.
He is, and it does. But the problem has been widely
misunderstood. "Bad loans" only mean something in an
environment where a borrower's ability to generate cash
flow to service debt is the criterion of whether a loan is
good or bad. That was not always true in Japan. Most loans
were secured by land and rolled over perpetually. The
criterion for loans in Japan was not corporate
profitability but bureaucrats' ability to drive up real
estate prices.

Japanese finance has, to Western eyes, been an "Alice in
Wonderland" affair now for 50 years. Banks once lent far
more money than they had in deposits. Then, in the 1980's,
Japanese government officials directed banks to lend well
in excess of real economic requirements. Much of that
lending fueled a surge in land prices that saw the
theoretical value of Tokyo's Imperial Palace grounds exceed
that of the whole of California.

Bizarre as it may appear to outsiders, Japanese banking
nonetheless was driven by two rational objectives: the goal
was to finance an industrial plant that would secure
Japan's economic autonomy and ensure its political
stability. It worked. Four decades after war had left Japan
in ruins, the country boasted the world's most formidable
industrial machine. And a constant flow of subsidies to
politically powerful groups - farmers, small shopkeepers,
half a million construction companies - has bought 50 years
of political peace.

In recent decades, however, the system has changed. Credit
now goes increasingly to protect politically well-connected
companies from failing rather than to the kinds of firms
that built the fabled Japanese economic miracle. These
credit policies, combined with falling land prices, brought
economic growth in Japan to a halt a decade ago.

One of the results of this collapse is more than $400
billion in unrecoverable loans. But recovering those loans
is not simply a matter of closing certain banks,
recapitalizing others and allowing some big companies to

For starters, any questioning of the banks' integrity could
lead to economic disaster domestically. If the banks are
seen as corrupt, individual depositors could pull their
money out of them. Japan's household savings overwhelmingly
take the form of bank deposits that carry either explicit
or implied government guarantees. The Japanese government,
already heavily in debt itself, can ill afford to honor
these guarantees during a wave of failures brought on by a
run on the banks.

Closing the banks could also cause a political crisis. The
flow of cash - from household to bank to well-connected
borrower employing retired bureaucrats and voters for the
ruling Liberal Democratic Party - fuels the very engine of
the Japanese political economy. Turning off this flow is
tantamount to revolution.

The notion that Mr. Takenaka is going to do that, even with
the full support of Prime Minister Koizumi and the
off-stage applause of the United States Treasury
Department, is preposterous. Indeed, last week members of
his own party and even a fellow cabinet minister criticized
Mr. Takenaka openly.

Any Japanese reform, political or economic, must eventually
face this reality: Japan has no central government able to
override the quasi-sovereign fiefdoms that constitute the
Japanese political order. Those fiefdoms - the more
powerful ministries together with their protÈgÈs and the
various factions of the L.D.P. that provide political
protection for them - can and will sabotage any policy
initiative that threatens their autonomy.

This lack of any institutional mechanism for overriding the
claims of special interests helps explain the policy trap
in which Japan now finds itself. During the decades when
the economy grew rapidly, this institutional failing did
not matter so much. But just as the Japanese military
leadership in World War II never allowed for the
possibility of retreat and didn't know how to conduct one,
Japan's current economic leadership has no accepted means
of distributing the pain that would inevitably accompany
Mr. Takenaka's reforms. That is why, like all other such
initiatives of the past decade, they will be allowed to
proceed only when they have been gutted.

An upheaval in Japanese finance, bringing with it a
complete restructuring, is not impossible. But such a
restructuring would produce shocks that would reverberate
around the world.

Japan as a nation holds nearly $3 trillion in
dollar-denominated assets, many of them ultimately
supported by the very deposits that would be withdrawn in a
wholesale reorganization of Japanese banking. Those dollars
have played an indispensable role in permitting the United
States to swell its trade deficits far beyond the levels of
most nations.

That so many foreigners are willing to keep their earnings
from trade inside the United States banking system - what
"holding dollars" literally means - helps the United States
tolerate its deficits. But this situation is precisely what
restructuring in Japan threatens. If banks were forced to
call in loans to pay off depositors, and if those loans
financed their customers' dollar holdings, Japanese
companies would be forced to sell their dollars for yen.
Real money and purchasing power would then leave the United
States as the conversion weakened the dollar, forcing a
rise in interest rates and import prices and further
raising the risk of recession.

That is what usually happens to countries that run
excessive trade deficits - foreigners lose confidence in
these countries' currencies, interest rates rise, the
economy goes into recession and, as people can't afford to
buy so many imports, the trade deficit begins to close. The
United States has escaped this fate largely because of the
very problems with Japanese finance that Mr. Takenaka
promises to attack. Washington ought to be careful what it
wishes for.

Akio Mikuni and R. Taggart Murphy are the authors of
"Japan's Policy Trap: Dollars, Deflation and the Crisis of
Japanese Finance.''


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