The second session of the economic conference held at the London Business School turned to the changes that Japan needs to implement to lift the world’s second-largest economy out of recession.

Keikichi Honda, chairman of Sun Microsystems K.K., boiled down the basic task facing Prime Minister Junichiro Koizumi’s administration as transforming the nation’s traditional vertical economic model into a horizontal version — but he accepted that the task is far from an easy one.

“Since its inception 10 months ago, Koizumi’s government has stubbornly adhered to the belief that there will be no growth unless there is reform, and that has been supported by the citizens of Japan,” Honda said.

“For the first time, we see a reform program that has political support across the board. Therefore his popularity is important and whether he can live up to his promises is very important.”

Honda identified five central pillars of Koizumi’s reform plan as vitalizing the economy, including regulatory reforms; changes to the securities market; reinforcing the unemployment safety net; supporting startup firms, innovations and firms restructuring; and promoting stimulus measures.

“Corporate Japan has been successful until recently, but the trail that we took was in a unique environment,” he said. “Japan Inc. was made possible by a certain environment that when it was successful seemed to justify the system. That was the trap that we faced.”

The institutional fatigue that has set in now, he said, means that change is urgently needed.

Honda described competition policy that has seen 23 banks forced to regroup into four massive groups as a “mess,” while the banking system, “patchwork” taxation that makes golf club memberships tax-deductible, the myth of land capitalization and the looming threat of a lack of labor must all be addressed.

“The changes to the bankruptcy, corporate reorganization and civil rehabilitation laws being debated in current session of the Diet are very important, as is the overhaul of the taxation system, which will be discussed in the next two or three years,” he said.

Turning to the apparent lack of a sense of crisis in Japan about the country’s perilous economic situation, Honda said this is attributable to a number of factors, including an almost “religious belief” that Japan will cope in the same way as it rode out World War II’s deprivations and the oil shocks.

He went on to cite a younger generation that simply does not see the crisis that threatens to engulf them, a leaning toward frugality reflected in the high national savings ratio and housewives actually welcoming deflation because while the bread-winner’s pay check is smaller, they are still saving money as shops cut prices.

“In conclusion, following this path (of reform) is nothing but following a route to normality; what is difficult is going from a vertical economy to a horizontal one,” he said.

Gerard Lyons, chief economist and head of global research at Standard Chartered Bank, began his presentation with the upbeat message that “not everything in Japan is as bad as it seems.” But he then tempered that statement by outlining just how bad the economic situation may get if the problems are not addressed.

He identified the interrelated, core problems as the lack of a sense of urgency in Japan, an outdated fiscal policy and the problem of bad debts, underlying structural needs and the urgent need for banking sector problems to be resolved.

“Another big problem,” he said, “is that Japan spends too much time listening to U.S. economists.” Japan followed Washington’s lead and reveled in the bubble economy before heeding the call to relax fiscal policy, which resulted in a huge national debt. Now the U.S. is telling Tokyo to again follow its policy — but would that be the right move for Japan?

Japan’s real problems began in 1997, Lyons said, when employment was still steady despite the burst of the bubble economy; fiscal policy concerns only arose when the consumption tax was raised and it became clear that the weak yen policy was not working.

Lyons also identified the twin problems bedeviling the financial sector as being both demand and supply side, and suggested that solutions are needed to counteract them over both the short and long terms. He added that within the financial sector, the key to any recovery is the banking industry, which made excessive loans to the construction, retail and real estate industries back in the bubble years.

“Japanese banks need to develop greater risk-management skills and need to become more dynamic,” he said, adding that authorities have defined their goal as having a market like those in Britain or the U.S. — but to achieve the aim of being fair, free and global they must first rid themselves of their bad loans.

“What they need to do is address this head on,” he said. “The banks must write off their bad loans. The longer the economy remains weak, unemployment problems will continue and the stock market and land problems will continue.”

He identified four areas that need to be addressed to head off the crisis: openness and transparency; nonperforming loans that must be sold off immediately and by auction; acceptance by Japan that it needs to be dominated by foreigners (which he termed the “Wimbledon effect”); recapitalization of the banking sector, either in the form of nationalization or the injection of new funds.

Lyons ended on a downbeat note, calling for Koizumi to be judged on what he achieves rather than what he promises, and questioning whether Japan has the willpower to lift itself out of its economic quagmire.

“Japan needs a coherent approach; since the early 1900s, it has had four problems: debt, deflation, deindustrialization and deregulation,” he said. “It still has those four problems and I am more pessimistic than ever before that there will be a fourth ‘D.’ Financial disaster is inevitable without action.”

When the session was thrown open to the floor, Ronald Dore presented an alternative to Lyons’ reasoning for the failure of monetary policy being wholly a result of banks being burdened with bad loans and being unwilling to extend loans, pointing out that it is just as much a question of a lack of borrowers.

“Small and medium-size industries do not want to take out loans from banks because they are already heavily indebted and they prefer to pay down their debts rather then taking on new ones,” he said.

“This is a deflationary situation in which consumer and household spending is contracting, in which there is deflation and pressure on revenues all the time,” he said.

“It seems to me that deflation is absolutely the key,” he added, “I have always been convinced that wiping out the nonperforming loans by auctioning off everything . . . seems to me to be by no means the way of curing the Japanese economy of its present ills — which are demand deficiencies.

“When the economy is declining, wiping out NPLs will have side effects,” he added.

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