From the Ashes

Richard Katz makes the case for Japan's revival

What factors in Japan make you believe that the country will eventually reform and revive? And what are the obstacles?

The positive side is that Japan does not have the feel of a failed state. There are so many Japanese people, particularly in their 40s and 50s, who are very smart, very ambitious, very talented and clearly capable of leading a new Japan. They are in business, they are in media, they are in academia and they are in bureaucracy, in many different institutions. But what they lack is a coherent institution to be the vehicle for reform. And they lack a very clear program for reform. Even reformers actually disagree among themselves as to what reform should look like. Should you focus on banking programs first, or budget deficit first? So it takes time to build up all of these things. I don't think the LDP (the Liberal Democratic Party) could be the vehicle for reform. You need a different political realignment.

You also have many people who lose their jobs in the process of reform. The social safety net in Japan is very weak. But the problem is what happens in the absence of reform. There are some people who think reform is destabilizing. But the failure to reform is even more destabilizing. Japan's social and political stability requires growth. When you don't have growth, companies can't pay their bills. Yes, initially, rapid reform would mean fast-rising unemployment. But eventually it will come down and not go as high. If you just delay reform, the unemployment rate goes up more slowly, but stays high for longer -- the real unemployment rate is not 5.5 percent, but 8.0 percent.

The failure to reform is even more
destabilizing than reform

The LDP has always been ruled by a coalition that includes just about everybody. And if there's growth, you can give everybody something. But if there is no growth, you cannot help one group without hurting another group. So the urban dwellers want cheap food imports from China, and farmers want to stop those cheap imports. And if you cut interest rates to zero to save the banks and their borrowers, life insurance companies go bankrupt, pension funds go bankrupt and elderly savers cannot get any income on their savings. So you cannot really have a very cohesive political society without growth. There are some countries, maybe like Switzerland, that can have low growth for many years and can still be stable, but not Japan. Japan's social systems, seniority wages, high debts, aging -- all of these require good growth to keep the system alive. So there is no stable alternative to reform. You have the people who know how to lead a new Japan. But I would say they lack the institutions, lack the clear program. It takes time to build. It will take them 10 more years, and Japan will succeed.

Japanese leaders have pledged to reform for more than a decade. Yet they have failed to deliver over and over again.

Mikhail Gorbachev was a very sincere reformer. But even with Gorbachev, the Communist Party in the Soviet Union could not be the vehicle for reform. So even Mr. Koizumi -- who I think is a very sincere reformer -- cannot make the LDP the vehicle for reform. Why? Because many parts of the LDP, like construction, farming, et cetera, would be hurt by reform. So the LDP tries to go both ways, talks about reform, but doesn't really do very much. That's why I think the LDP will eventually split. It cannot really survive because it's too unstable. Secondly, no society wants to go through very difficult reform if it can avoid it. And for many years, Japan's leaders, and also some very smart economists claimed falsely that Japan did not need reform. Japan could solve its problems by building bridges to nowhere or just by declaring an inflation target.

If you are a Japanese worker in construction or a farmer or a bank borrower, wouldn't you rather say, "Oh, let's not kill off the zombie companies! Let's just declare an inflation target! Solve the problem that way -- it's much nicer than reform."

People test easy paths before they accept or need more difficult ones. That's very natural in any country. But Japan is the only industrialized democracy that is still basically a one-party democracy. And it's very difficult for a one-party democracy to change. You need competition in politics to have change.

When I talk to many consumers, they say prices are still very high, while Japanese leaders and pundits are wondering why the country cannot break out of its deflationary spiral. What can you tell us from contradictions like this?

It's very, very interesting. Yes, prices are very high. This is one of the things that suppresses consumption. For example, Japanese households spend 23 percent of their budget on food. In America, households spend 10 percent on food. Food prices in Japan are too high because of a lack of cheap imports, because of the protection of farmers, because the food processing industry is so inefficient. So actually bringing down food prices, if you did it through more competition, would free up money to be spent on other items and really help consumer demand. So that's what they call a kind of "good deflation" -- prices come down due to more competition and more efficiency. But the majority of what Japan has is so-called "bad deflation," and what this means is that prices are coming down not because of good reform that improves purchasing power but rather because of weak demand. Now partly this really serves the unraveling of the old system. High prices are a kind of subsidy from Japan's consumers to inefficient companies and also from efficient companies to inefficient ones. Toyota, for example, pays high prices for steel and glass. But if demand is weak, then the prices cannot be kept high. The problem is not the fever. The problem is the flu. The fever is just a symptom. So in Japan's case, deflation is not a problem. Deflation is just a symptom of the problem of weak demand.

It's an illusion to say, "Oh, we will increase prices. That will restore demand." It's backward. If you restore demand, that will fight deflation. They should have coupled zero interest rates with a tax cut. Instead, the government raised taxes. Even this year, Mr. Koizumi says he's cutting taxes, but he is cutting taxes on companies that won't really spend the money. If a car company has 30 percent too much capacity, it's not going to use the tax cut to build a new factory. But while cutting taxes on companies, they are raising taxes on consumers -- higher health premiums, higher pension premiums, liquor taxes, tobacco taxes, all kinds of taxes.

Will foreign buyout funds play a role in Japan's recovery?

I think they will. I think the foreign role is very critical in Japan's recovery. I think what Japan needs is not gaiatsu (external pressure) but naigaiatsu, which is the combination of naiatsu (internal pressure) and gaiatsu. There is a difference between being a vulture fund and being what we call a "Florence Nightingale fund." Florence Nightingale funds are genuine rescue funds, or turnaround funds. They buy up companies to reorganize them and help them survive and recover.

Deflation is just a symptom of the problem:
weak demand

One more important thing is that foreigners can break the rules. And when they do, Japanese accept it. For example, if a Japanese manager had tried to do exactly what Carlos Ghosn was doing, the workers and managers in Nissan would not have accepted it. But because of Carlos Ghosn, they did accept it. But now that Carlos Ghosn can do it, then Japanese should be able to do it.

Are you worried that the US focus on North Korea will adversely affect Japan?

The US really needs to work with Japan, China and South Korea together to deal with the North Korea problem. It has to be firm but flexible. I think the Korean situation is very dangerous. Now if the Korean situation is resolved peacefully, that's fine. But if it becomes hostile, that changes everything.

If Japanese politics becomes dominated by security issues like North Korea, then it may be organized between who wants a strong stance and who wants a weak stance. People who agree on a strong stance may also be opposed to reform. Who are the Japanese reformers allying with? Other reformers who agree on economic reform or others who agree on security policy?

How big is the opportunity in China for Japanese companies? How can they take advantage of it?

I know a lot of people think of China as a threat. But I think of it as an opportunity in a couple of different ways. One is that countries that trade more and have more ratio of total trade -- export and import -- to GDP tend to grow faster because the competition from other countries forced them to become more competitive. Imports from China improve the efficiency of Japanese companies, which have to compete with Chinese companies. It will lower the costs of many items, which will help consumer demand. China is not only an export superpower but also an import superpower. The ratio of, for example, manufacturing imports to GDP, is actually much higher in China than in Japan. China runs trade deficits with many countries in Asia. So China's trade patterns have been very different from those of Japan. As China's economy grows, its exports grow and its imports will too. So China could become a very good market for Japanese companies. @