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After remaining in the doldrums for more than 10 years, the Japanese economy is now plagued by deflation. The Tokyo Stock Exchange’s benchmark Nikkei index has fallen to the 8,500 level, and the nation’s unemployment rate remains high. Last fall the government announced a policy package for expediting the disposal of banks’ bad loans and promoting industry revival, and bank bosses are getting serious about their restructuring efforts. Serious problems remain, however, in implementing the package.

The fiscal 2003 budget, approved by the Cabinet last month with the fiscal 2002 supplementary budget, calls for an issuance of state bonds far exceeding the cap of 30 trillion yen set by Prime Minister Junichiro Koizumi. Officials say the issue is necessary to make up for a serious revenue shortage stemming from deflation, implement a 1.8 trillion yen tax cut for stimulating business investment and consumer spending, and increase expenditures on selected business sectors that are likely to stimulate private demand.

Newly issued bonds will account for 44.6 percent of the fiscal 2003 budget. The outstanding balance of long-term debts held by the central government and local authorities, except those relating to postal administration, will total 686 trillion yen, 137 percent of the gross national product. The ratio is the highest among industrial countries. The government is clearly laggard in fighting deflation and implementing fiscal reform.

Japan has failed to take proper action to deal with the collapse of the economic bubble and suffers from more serious economic problems than do other industrial countries. But deflation is a global phenomenon caused by intensified competition and excessive supply as the market economy spread worldwide after the end of the Cold War. In particular, the U.S. economic downturn following the end of the information-technology boom has contributed to global deflation. The slow recovery of Japan, the world’s second-largest economy, is a serious problem for the world.

Until last fall, there was little perception in the business world — except in smaller businesses and industrial sectors facing difficulties under traditional management strategies — that an economic crisis was impending. This was true even though macroeconomic indicators were worsening. Automaking and other competitive manufacturing sectors were enjoying brisk sales at home and abroad. Japan had the world’s largest foreign credit and individual savings. Even though department stores suffered from slow sales, boutiques reported strong sales of brand-name goods and discount electronic stores did good business selling cell phones, digital cameras and other new products. Japanese remained active overseas tourists. Although personal income was recording slow growth, consumers were willing to spend money on quality products and services.

Unemployment was high, for Japan, but stood at less than 6 percent. Bank bosses saddled with huge bad loans continued to receive high salaries. Instead of implementing drastic reforms, they appeared to be pushing plans for banking mergers.

Few people were satisfied with the status quo, but few were enthusiastic for drastic reforms. Clearly, Japan was in a state of an unhealthy, temporary equilibrium. Even though it had the largest fiscal deficit among industrial countries, it continued to delay improving the primary balance. Nevertheless, the budget deficit remained manageable and did not cause an increase in the tax burden on the public.

The existence of huge bad loans showed that many companies that could have gone under continued to survive, helping secure employment for Japanese. Japan’s current-account surplus helped maintain the nation’s international prestige and caused its overseas assets to increase.

The unhealthy equilibrium will not continue indefinitely. The problem stems from the continued economic slump causing prolonged deflation, a fiscal deficit, a bad-loan mess and a current-account surplus.

Some pundits tolerate the low-growth economy, saying prices remain low and people’s livelihood is stable. However, lack of growth affects employment and threatens the social security system. The fund shortage in the public pension system is likely to force the government to raise premiums or to cut benefits.

Barring drastic changes in the system, the only alternative is to raise the consumption tax. Koizumi says the tax will not be raised while he is in office. Regardless of how long he stays in office, though, the government will be forced to raise the tax eventually.

Although foreign rating agencies have reduced their ratings on Japanese government debt, state bonds sell briskly. Financial institutions buy the bonds because they find no other reliable investments. Consumers buy them to save for a rainy day amid growing concerns about employment and social security. Corporate demand for funds is slow because of deflation, but once private demand for funds recovers, demand for state bonds will decrease sharply.

Japan’s current-account surplus stems from the fact that many exporting countries have higher economic growth rates than Japan. If the Japanese economy recovers, the surplus is likely to decrease. Japanese manufacturing and service industries are burdened with much higher costs than their rivals elsewhere in Asia, and therefore are relocating their production facilities to China.

The most serious problem in deflation is Japanese companies’ decreased competitiveness resulting from higher costs. The best way for Japan to achieve a healthy, long-term equilibrium is to promote a shakeout of companies, establish safety nets for the unemployed, and foster high-added-value and highly productive industries.

There is a strong demand in Japan for a decrease in the yen’s value, but there is also strong pressure in the United States for a cut in the dollar’s value. U.S. pressure for a rise in the yen’s value is unlikely to abate. While some Japanese are waiting for an upward revaluation of the Chinese yuan, Beijing is unlikely to take that drastic action, since it is burdened with many imbalances.

In fiscal 2003, Japan will have to end the unhealthy, temporary equilibrium and push real structural reform. Japan’s political leaders, business executives and top bureaucrats are extremely slow in taking action toward that end. The moment of truth in the nation’s economic revival is approaching this year.

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