Helping Koizumi out of the box

While the eyes of the world's press and political leaders are firmly fixed on the war on terror and the explosive situation in the Middle East, an economic time bomb of potentially nuclear proportions is now set for detonation in Japan unless bold preventive action is taken soon. During his recent Asian tour, U.S. President George W. Bush praised Japanese Prime Minister Junichiro Koizumi as the leader whose new policies would prevent the explosion. But Mr. Koizumi, already under fire for lack of accomplishment, promptly undermined his (and the U.S. president's) credibility even further by unveiling a hopelessly inadequate economic reform plan that fails to alter the steady march of Japan's economy toward a meltdown that could take much of the global economy with it. Even if Mr. Koizumi really wants to pursue the necessary reforms, it is clear that the old guard of Japan's ruling Liberal Democratic Party will not allow him to do so.

It is time for the U.S. to start thinking outside the box on Japan policy. For starters, the Bush administration ought publicly to make clear its loss of confidence in the LDP leadership while suggesting to Mr. Koizumi that he might best lead by resigning and precipitating a political realignment.

Such a stance would mean changing the traditional U.S. policy of subordinating economic concerns to a priority on cooperation with the long dominant LDP to assure Japan's support for U.S. security policies. This approach is now badly outdated because economic and security interests have merged. Accounting for nearly 70% of total Asian GDP, Japan is by far the biggest buyer and investor in the region, and a meltdown of its economy would greatly complicate the task of dealing with North Korea and the terrorist threat in the Philippines, and might stimulate the disintegration of Indonesia and other parts of Southeast Asia. Beyond that, the meltdown would disrupt global financial markets and potentially damage the U.S. economy in ways that could undermine the conduct of the war on terrorism. But a meltdown is precisely the situation which Japan and the world are moving towards at an accelerating pace.

A decade of stagnation and deflation has left Japan's financial sector saddled with $1 trillion to $2.4 trillion of bad debts that are growing more rapidly than they can be written off. A bailout requiring enormous public funding is inevitable at some point. At the same time, massive deficit spending that is meant to provide a stimulus to the economy (and pork for the LDP) has sent the national debt soaring to a developed country high of nearly 140% of GDP without having the intended effect of stimulating economic growth. With deflation, the debt to GDP ratio rises automatically. Thus, if current conditions continue, the debt ratio could double in less than a decade. Long before then, however, it will become unsustainable.

So far, the deficits have been financed through the sale of Japanese government bonds yielding only about 1.5%. If, like Argentina, Japan had to sell its bonds abroad, the economy would have collapsed long ago because foreign investors would demand much higher returns for such risky assets. But because of its high savings rate and trade surplus, Japan has been able to finance all the debt internally.

However, there is a limit even to what Japanese savers can provide. Total annual Japanese savings are currently about $1.1 trillion, of which about $800 billion are used to cover corporate and household investment needs, leaving a maximum of $300 billion available to finance government bond issues. With annual new JGB issues running at about $230 billion, the Japanese government is approaching the point at which it will not be able to sell all its bonds in Japan and will be forced either to cut spending dramatically or to print massive amounts of new yen. In either case, the economy will go into a severe crisis.

Of course, these calculations are subject to many variables, and no one can predict the exact timing, but there is probably a window of one to three years before extreme scenarios become inevitable. Exactly what would happen is also unpredictable, but if Japan attempted to deal with a crisis by cutting expenditure, the result could be a 1930s-style depression that would have severe ripple effects globally. Alternatively, running the printing presses and printing money could easily lead to a surge of inflation that would wipe out Japanese savers and cause a devaluation of the yen that would destabilize the rest of Asia while cutting off the critical flow of capital that helps finance America's huge trade deficit. Without this capital, U.S. interest rates would soar, taking the economy back into recession.

All this can be avoided if bold action is taken in the next few years to truly reform the system. But such action will not be taken as long as the LDP old guard is in control because reform means destroying the vested interests that constitute the core of the party's support.

In this situation the Bush administration's options are quite limited. But the U.S. does play a peculiar and subtly powerful role in Japanese politics: One lingering effect of the post-World War II military occupation and the long years of Japanese security and economic dependence on the U.S. is that the LDP's power rests to a significant extent upon the perception that the party has a special relationship with Washington.

Thus, by cutting the old ties and letting its doubts about the course the old guard has set be known, the administration could help create a new political reality that is the necessary prerequisite to economic reform. This, of course, implies abandoning the current administration's stance of not publicly criticizing Japanese policy, but such a step could only enhance U.S. credibility and influence with the Japanese man in the street who knows the LDP plans are phony and has been wondering why the U.S. doesn't catch on.

As for Mr. Koizumi, since it is now clear that he cannot carry out reform from within the LDP, if he truly wants reform the only alternative is to seek a political realignment by resigning from the party, dissolving the Japanese parliament and precipitating new elections that would focus on the need for political as well as economic restructuring. Because such a move dovetails neatly with Washington's needs, the Bush administration should encourage Mr. Koizumi to consider it seriously. But regardless of what Mr. Koizumi does, it is essential that the U.S. government not delay reform by acting as if he and the LDP are the only realistic choices. They are not.

Of course, success is not guaranteed. But the risk of a new U.S. policy on Japan is less than the risk of doing nothing.