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How Japan’s economy fared in 2006 and its prospects for 2007

by Teruhiko Mano

There were two major developments in the Japanese economy in 2006.

The first was the Bank of Japan’s decision to terminate its quantitative easing policy in March and lift the benchmark short-term interest rate to 0.25 percent in July, ending the five-year, four-month reign of the “zero-interest-rate” policy installed in March 2001.

The central bank’s move also lifted its official discount rate from 0.1 percent to 0.4 percent.

The second major development was the achievement of Japan’s longest postwar expansion since the so-called “Izanagi” boom between 1965 and 1970 with the release of the monthly economic report for November.

The driving force behind the interest rate hike was of course the recovery of the Japanese economy. The economy this year must have been good since the expansion has continued for more than 4 1/2 years. However, widespread sentiment indicates the people at large don’t feel the economy has recovered.

What are the reasons for this gap between official assessment and public sentiment?

There are three. The first is the fact that Japan’s economy grew by double-digit rates during the Izanagi boom. The pace of the current expansion is extremely slow — around 2 percent a year.

The second factor is that the current expansion has created a huge gap between prosperous and less prosperous regions in the country, as well as between successful and less successful individuals. During the postwar reconstruction period, the benefits of growth were distributed more evenly among all regions and individuals.

The third factor is that price movements in Japan have just barely begun crossing from negative to positive territory. Unlike past expansionary phases, however, there is little inflationary pressure to boost corporate sales.

These are all the result of the radical changes that globalization has created in the economic environment around Japan. It’s not only raw materials and products that are being exposed to international competition, but wages and land as well. And economic expansions do not automatically trigger higher wages or land prices.

So what about 2007? Some economists say that a recession is imminent now the expansion is nearly five years long. But I project that Japan will achieve another year of growth at a pace of about 2.5 percent. Why?

The Japanese economy is currently being driven by capital investment and exports. Whether these two engines will keep running depends largely on the trend of the global economy.

U.S. economic policymakers are waiting to see if the Fed’s interest rate hikes will contain inflation there, while the Dec. 7 rate hike by the European Central Bank and accompanying speculation on an additional hike suggest that European economies are continuing to grow.

Economic expansion meanwhile remains strong in populous, emerging economic powers, such Brazil, Russia, India and China — the so-called BRICs. Therefore, it is unlikely that demand for Japanese products will see a rapid decline.

However, Japan needs another engine — higher consumer spending — if the economy is to grow by more than 3 percent a year. And there are high hurdles to achieving that.

Real income must rise in order for private consumption to expand. Japanese companies are still cautious about raising nominal wages, although some are beginning to talk of increasing base pay. After all, they can always find abundant supplies of inexpensive labor overseas. And wage hikes could make them less competitive.

Two things must happen if consumption is to expand despite the sluggish increase in wages.

One is that the yen’s real purchasing power must get stronger. To make that possible, further deregulation is necessary, including in agriculture. A stronger yen will be a negative factor for exports, but it will raise purchasing power and could juice up consumer spending.

The other thing is that productivity in the public sector must increase, because public-sector inefficiency is hampering improvement in Japan’s overall productivity. The recent series of bid-rigging scandals illustrates that much more can be done to make the public sector more efficient.

It is essential for Japan to make these two things happen and boost the public’s real purchasing power. Resistance to reform is likely to intensify as the nation braces for the Upper House election next year.

Prime Minister Shinzo Abe needs to confront and eliminate these forces in the new year as he carries on with his predecessor Junichiro Koizumi’s reform agenda.