It must be lonely at the International Monetary Fund. Fiscal disciplinarians are never the life of the party, but the fund’s tight-fisted solutions to economic crises have antagonized governments from Malaysia to Moscow, from Bangkok to Brazil.

Last week, the fund’s analysts darkened the mood in Tokyo. Their forecast of a 1.4 percent contraction in the economy in fiscal 1999 is a pointed contrast to the rosy predictions of the Japanese government, which anticipates growth of 0.5 percent this year. Not surprisingly, Prime Minister Keizo Obuchi, who has staked his political future on a recovery in 1999, called the forecast “harsh” and wondered aloud about the basis of their projections.

The prime minister might be forgiven for feeling a bit miffed. In recent weeks, the markets have given his policies a vote of confidence. The Dow Jones industrial average may have punched through the 10,000 mark, but among developed-country exchanges, the 225-issue Nikkei average has recorded the largest rise (in local currency) since Jan. 1. Rising share prices reflect renewed hopes that the economy has turned the corner. The passage of legislation to help bail out the troubled finance sector and the huge public-works spending in the new budget faith are both seen as signs of a new readiness to do what it takes to get the economy moving again.

Foreign money has fueled the rise in the Nikkei. After fleeing Japanese equities, fund managers have decided that it is time reweight their portfolios. That decision reflects renewed faith in Japan’s policies as well as concern over the durability of the U.S. boom. Taken together, they shift the equilibrium point for investment: Japan doesn’t look nearly as risky when compared to the potential losses triggered by a correction in the U.S.

Japan’s private sector has also won applause from foreign investors for its willingness to bite the bullet and accept the market’s bitter medicine. The fervor with which management has embraced “restructuring” symbolizes the newfound enthusiasm to return to profitability. Every day, another company announces layoffs and some new plan to trim corporate dead-weight. The Ministry of Labor’s latest quarterly survey of economic trends shows that 46 percent of responding manufacturing companies were engaged in restructuring. Kathy Matsui of Goldman Sachs counts 539 publicly traded companies that have announced plans to restructure.

Andrew Shipley, economist at Schroders, another investment bank, thinks the confidence in Japan’s private sector is overstated. He notes that the percentage of firms engaged in restructuring is in line with previous recessions. In the fourth quarter of fiscal 1993, for example, 50 percent of manufacturing firms were engaged in restructuring; in the first quarter of 1974, the number reached 74 percent.

Dig deeper and the numbers look less encouraging still. Rather than shedding unprofitable businesses and closing plants, most companies are cutting overtime hours, shuffling workers in-house or farming them out to subsidiaries, cutting holidays or part-time workers. Very few are actually cutting employment, encouraging early retirement or limiting recruitment.

In short, says Shipley, “there is nothing in the survey to suggest that firms are engaging in unprecedented efforts to boost profitability.”

Worse, Shipley is concerned that shedding labor will compound Japan’s woes. His logic is simple: As workers grow more fearful of losing their jobs, they will spend less. If demand collapses, the economy will lose another critical prop.

For most of us, that thinking is blindingly obvious. Curiously, it is not borne out by experience in the West. In the United States and Britain, for example, the restructuring of the ’80s was not accompanied by a fall in spending. In fact, Shipley points out that “households spent a rising share of their incomes as unemployment climbed.” That meant that firms could cut employee compensation without having to face a corresponding drop in sales.

If investors are banking on a similar phenomenon here, they need a reality check. Shipley argues that “there is a sense of fatalism entrenched in the household sector that was not shared by families in Western economies in the early 1980s.” There are several reasons for that: the novelty and shock of unemployment, the absence of a significant government welfare safety net and inflexible labor markets.

But the record is clear: Over the last 20 years, the Japanese spend less when unemployment rises. In February, the propensity to spend hit a record low 67.8 percent among Japanese workers’ households. This week, newly released sales figures for both supermarkets and department stores showed yearly declines. Supermarket sales plummeted 8 percent from last March, for the fourth straight month of decline. Department store sales fell 7.3 percent, their 11th consecutive fall. In both cases, the rate of decline from the previous month has accelerated.

The implications of this argument are important (in addition to the need for caution on the part of investors). First, the government needs to maintain an easy money policy. If consumers fear that prices will climb, they will be encouraged to spend today. If, as some fear, the Japanese economy is deflating — i.e., prices are actually falling — then there is even less incentive to spend and the risk of a further contraction of the economy will increase.

Second, and just as important, the government must restore flexibility to markets. Shedding surplus labor is a meaningless exercise if the newly unemployed don’t have somewhere else to go. New employment opportunities have to be created. That means the government has to quit playing lip-service to deregulation and act. Only then, will new businesses arise to absorb the growing army of the unemployed. Without it, the IMF’s dour predictions may even prove to be too rosy still.

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