Will a Rudderless Japan Drift into Crisis?

Japan Needs a Captain

The upper house election in Japan last Sunday dealt a huge blow to the ruling Democratic Party of Japan (DPJ), leaving the country with a "twisted" parliament and no clear path forward. In contrast to the previous decades of nearly uninterrupted single-party rule, the new, messier political environment is a positive sign for Japanese democracy.

But this difficult transition to a new mode of governing comes at a time when strong leadership is needed to address a possible sovereign debt crisis that could hit within five years. Ironically, the DPJ's defeat last Sunday was partly the result of Prime Minister Naoto Kan's flip-flopping over a consumption tax that was meant to help stave off any problems emanating from its exceptionally large debt-to-GDP ratio (near 200 percent). Most voters support the tax but the prime minister buckled under criticism on the issue, fostering the impression that he is simply an opportunist. The party's loss may have made prospects for reform "an uphill battle."

I had the chance to talk with people from media, politics, government, business, and academia in Japan during the week leading up to election day. Consistent with the polls, many of the people I spoke with were undecided about which party to support, and the murky election result may delay financial reforms. Rating agencies Standard & Poor's and Fitch have warned of possible credit rating downgrades due to Japan's expected political gridlock, which may hinder the country's ability to reign in its sovereign debt.

Hatoyama's Parting Gift

Yet there is good news. While the lower house election last August was a rejection of the long-ruling Liberal Democratic Party (LDP), last week's upper house election was about real issues while also serving as a referendum on the DPJ's 10 months in power. A political monopoly has been replaced by a period of what Japan expert Gerald Curtis calls political "creative destruction." One DPJ staffer told me that the current, more pluralistic public debate over policy issues was the legacy of former Prime Minister Yukio Hatoyama.

Whether or not by design, the two administrations of Kan and Hatoyama have put on the table thorny issues, including the logistical details and strategic importance of the U.S.-Japan alliance and the previously unpopular idea of a consumption tax, which led to the downfall of the Ryutaro Hashimoto administration more than ten years ago. I was told the DPJ expression for this expanded public square is "the new public."

Meanwhile, the new smaller parties actually stand for something other than an unbridled thirst for power. In particular, Your Party, analogous perhaps to American libertarians, seeks an inflation target and to shrink the government thus unleashing Japan's entrepreneurial spirit and creating jobs. Your Party did quite well, gaining ten seats. It appeals to a common frustration in Japan with government in general and is populated with stars from Tully's Coffee Japan, JP Morgan Chase, and the Ministry of Economy, Trade and Industry (METI).

The outcome is a real multi-party system. But contrary to hollow calls for a revolution last fall, this is the new reality: the slow democratic politics of compromise.

Drifting into Troubled Waters?

Nevertheless, the slowness of Japan's new politics could launch the country adrift into a debt crisis. Although 95 percent of Japanese government bonds are held by domestic investors, several factors could create risks. First, with Japan's low savings ratio and low economic growth, if its aging population starts to draw on its savings, the government may be forced to rely on foreign funders who will demand higher interest rates. Second, a deteriorating Japanese current account, due to a stronger yen or weaker global demand for Japanese products, would also reduce a source of debt funding. Reuters has quoted one analyst as predicting a current account deficit by 2016. Finally, it isn't clear whether a consumption tax would generate enough revenue or whether the tax would only dampen an already stagnant economy.

But whatever happens, five to ten years seems to be the critical time horizon. The next lower house election will take place in 2013 and by 2015 Japan is expected to shift toward external funding of its debt and will therefore face higher interest rates.

"Three to four years from now I expect a sovereign debt crisis to hit Japan and long-term interest rates to surge," former Bank of Japan board member Teizo Taya said in a May interview with Reuters. Taya also believes that the five percent foreign holdings of Japanese debt would be sufficient to trigger a crisis if there were a sell off.

One government official echoed these views when I visited Tokyo last week, saying the current account was the figure to watch. But interestingly he said that while some had hoped the election of the DPJ would have provided the "shock" to the Japanese system to bring about economic reform, the DPJ's failures over money scandals, mishandling the U.S. alliance, and the consumption tax have killed that hope. Instead, he and his colleagues are looking to a debt crisis to provide the necessary shock for economic reform. Changes could occur in Japan's tax structure (reducing corporate taxes and increasing consumption taxes over time) as well as in its industrial policy to spur growth. Can't change occur without the need for a crisis?

"The Deadlocked Japanese Economy"

Underneath the sovereign debt risk is an economy that is in irons. Just as its political system faces drift, so does Japan's economy, according to a METI report released last month.

METI minister Masayuki Naoshima puts it this way last month when he unveiled his ministry's new industrial vision: "Some people say that the Japanese economy is recovering from the economic and financial crisis triggered by the Lehman Shock the year before last. However, in reality, many Japanese people probably find no improvement in the sense of stagnation they feel in their everyday lives. They even seem unable to see any new light for the future. I believe the reason for this lies in the uncertainty about 'what will drive Japan's revenue and employment in the future.'"

Naoshima goes on to underscore the economic conundrums Japan faces: People think that Japanese people save too much, thus dampening demand, but actually the household savings ratio is one of the lowest among major economies; on the flip side, domestic consumption is stagnant since wages haven't risen in the past decade; an export-led recovery may seem appealing but Japan's export ratio is low by international standards and stagnant wages in the past 20 years call into question the country's industrial structure; specializing in high tech products would also seem logical but Japan's global market share "has rapidly declined" and low levels of profitability suggest that the business model for Japanese industries that has "caused them to lag behind the world."

In response to these challenges, government officials told me last week that the broad strategy is to globalize Japan, making its social systems, ports, and infrastructure attractive to businesses that create value and jobs. Naoshima puts it like this: "If Japan wants to save itself from decline, Japan has no other choice but to aggressively push forward with globalization. However, if Japan pursues only globalization without taking action to stop the decline in its international competitiveness as a business location, Japan will lose both domestic jobs and added value."

A major element of this strategy will be to "globalize human resources." This means the country's education system must be modified in order to create a more worldly mentality among the next generation of leaders, thus slowing the inward-looking direction or "Galapagos syndrome" as I have called it. One of the most creative proposals I heard last week is to encourage university students to study abroad by offering a ten-year income tax break to those who take advantage of the program. As these more cosmopolitan leaders enter the job market, they must find companies with a more globalized governance structure, diverse board of directors, and global business strategy, one official told me.

Japan Needs More Mavericks

It's nearly a cliché to say that in Japan, the nail that sticks out gets hammered down. Harmony and conformity are prized in big organizations. But these qualities can also lead to stagnation. Entrepreneurship requires a bit of rebelliousness.

During my trip last week, I traveled to Numazu for a day to visit one of the most innovative breweries in Japan. Baird Brewing Company is a joint partnership company that was founded in 2000, and in recent years has received much acclaim for its high quality, creative beers. I had the great fortune to meet the company's founders Bryan and Sayuri Baird, a husband and wife team. Bryan graduated from Johns Hopkins SAIS in the early 1990s and came to Tokyo to enter the corporate world but had another calling. "I didn't know much about brewing at the time but I knew how to study," he said. Using passion and determination, he founded the company with some friends. For the first few years, his beers were dismissed as too challenging. His customers were initially afraid to try something new. For the same reasons, Bryan's competitors in Japan were brewing up pale, uninspired, safe lagers. Bryan stuck to his principles and kept making a great product that emphasized Japan's proud tradition of craftsmanship (monozukuri) until his customer base caught up with him.

"The Japanese people need to overcome their fears and be the nails that stick out," Bryan told me. Bryan is an entrepreneur who embodies what Japan needs—globalized human capital creating a business that adds value and jobs. Another notable maverick who has been globalizing Japan includes Rakuten CEO Hiroshi Mikitani who is making English the official language at Japan's biggest online retailer. Fast Retailing, Nissan Motor, and Toyota Motor also are moving in the direction of adopting English at the workplace.

In politics, LDP star Taro Kono recently published a book on how he is going to revive his party. The main message is: As a nail that has stuck out in the LDP, he knows how the party can revive the economy. Japanese culture is famous for its perseverance and the country's history proves it. The country needs some major changes in order to prosper. For it to create real change, Japan needs more mavericks. And to pilot away from the rough waters, it will need a bold leader; it needs a captain.

Photo by quatro.sinko

Interview with Kazumasa Iwata today

This morning I interviewed Kazumasa Iwata, head of the Japanese Cabinet Office's Economic and Social Research Institute and former deputy governor of the Bank of Japan. Check out Policy Innovations soon for the audio and iTunes for the podcast. He was between meetings with government authorities and financial institutions, so the interview was a brief 16-minutes but nevertheless very rich in insights.

Apropos of Earth Day today and in response to my question about Tokyo's future role in Asia, he listed several environmental measures he saw desirable for Japan, including striving to build a low-carbon society, reducing emissions, replacing older, higher-emitting automobiles, and increasing research and development in clean energy technology--something that Japan has excelled in for decades (see a piece I co-wrote on Japan as an efficiency superpower here).

As for Japan's response to the financial crisis, he seemed worried about the employment situation and gave the impression that Japan's monetary policy and fiscal stimulus packages were meant to cork the loss of jobs but would not necessarily create new ones--as Japan appears to be creeping up to possibly a 6-8 percent unemployment rate.

What was the biggest issue Mr. Iwata saw for the US-Japan relationship for the long term? I was pleased that his answer was to fight protectionism. He sees a growing threat of trade protectionism through the use of WTO-legal measures. As I have advocated with Sherman Katz and Robert Fauver, Mr. Iwata even suggested that the US and Japan pursue a free trade agreement.

Directionless Japan?

The Bank of Japan could be leaderless within a week is the headline today in an article in the Times of London online:

The central bank of the world’s second largest economy could be “leaderless within a week” after an assault on the Japanese government by the opposition party.

The opposition Democratic Party of Japan (DPJ) today successfully blocked the government’s nomination of Toshiro Muto as the next Governor of the Bank of Japan. Analysts claim the gambit could force a general election.

The piece goes on to paint a very bleak picture for the Japanese economy:

With nobody selected to replace Toshihiko Fukui as governor when his term ends next Wednesday, the BoJ faces its worst crisis since gaining independence a decade ago. The turmoil also coincides with a Japanese stock market in tatters and the economy balanced on the edge of recession.

It reminds me of the lashing the Economist gave Japan a few weeks ago. On the cover of an issue that covered Japan’s economic and political problems, the magazine inserted an “i” in Japan to create “Japain.” Here is the essence of their argument:

A few years ago, people hoped that Japan, which is still a bigger economic power than China and has some marvellous companies, would help take up some of the slack in the world economy if America tired; that now looks unlikely. Productivity is disastrously low: the return on new investment is around half that in America. Consumption is still flagging, thanks in part to companies' failure to increase wages. Bureaucratic blunders have cost the economy dearly, and Japan needs a swathe of reforms to trade and competition without which the economy will continue to disappoint.

The leaderless central bank seems to be an apt symbol for Japan in general.

During my trip to Japan last week, I heard several stories from businesspeople about an overall lack of direction in the country.

One employee of a major Japanese manufacturing firm said that current economic growth is the result of hard work and innovations made five to ten years ago. The manufacturing sector operates on a five-year product cycle, so if we want to know what is in store for Japan’s future, we should look at what is happening now. In his view, hard work and the “samurai spirit” are long gone in Japan. The recent entrants into the labor force are lazy, he said. His forecast was therefore bleak for Japan’s manufacturing sector.

What’s more, he said that Japan as a society needs instructions on what the next goal is. He said that firms are great at reaching centrally-mandated goals. The problem is that no one has a sense of what is next for Japan.

His friend, a Japanese entrepreneur, told me that there are still few incentives to become an entrepreneur in Japanese society. As an entrepreneur, one can expect no favors from the government and lower earning power compared with salaried employees. Where is the productivity and innovation going to come from?

As many people know, Japanese bureaucrats briefly considered promoting nanotechnology and biotechnology as alternatives to manufacturing. Now that the consensus is that manufacturing is Japan’s strength, panic is setting in about Japan’s relative competitiveness in that sector.

I heard one story about a major manufacturing company hiring consultants to build a new business strategy from scratch. As the story went, the company asked the consultants, “What should we do next?”

Another businessman told me about some of the young entrepreneurs he has met. In his view, they have no ideas and are simply throwing away their careers because they launch businesses without a business plan or experience.

The same businessman went on to tell me that executives looking for new employment opportunities are only concerned about two things: the salary offered and the benefits available. In his experience, no one talks about finding rewarding work or making a difference. This mentality may be a hangover from the restructuring that took place over the previous decade. Moreover, during the Koizumi years, restructuring and the use of part time labor only provided a temporary fix.

Here is a fairly pessimistic assessment from economist Krassimir Petrov in the Market Oracle:

To summarize my expectations about the Japanese economy in 2008, the macroeconomy and the stock market should perform poorly, while the Yen has a strong potential to rise. The long-term strategic investor should stay out of the Japanese stock and bond markets.