Japan Faces Tough Choices to Turn Economy Around

Japan’s next prime minister--whoever he turns out to be--will inherit a legacy of cynicism and skepticism and the mistrust of international financial markets, frustrated foreign governments and an angry Japanese public.

What can the new Japanese government do in its first 100 days in office to address the domestic and international crisis of confidence that brought down Prime Minister Ryutaro Hashimoto on Monday and that threatens to keep bearish financial markets and disgruntled voters at the throat of his successor?

Japanese and Western economic and political experts interviewed Tuesday on both sides of the Pacific offered specific prescriptions to restore global confidence in the competence of the Japanese government and to get the world’s faltering No. 2 economy moving again.

Their ideas range from slashing taxes to creating incentives to build housing to get Japanese out of “rabbit hutch” apartments and into larger homes that would require spending saved-up yen to furnish; from dealing with bad loans to deregulating electricity and providing tax incentives to spur creation of small to medium-sized businesses.

Some of these proposals have already been endorsed by the Hashimoto government but could be reshaped, improved, watered down or delayed by opposition parties, flush with victory over the ruling Liberal Democratic Party, or LDP, in Sunday’s elections for the upper house of parliament.

Several sources expressed the hope--unrealistic at the moment--that a government of national unity, not an LDP-led one, will be formed.

What was striking was the consensus among Japanese and American experts about how serious Japan must be about making changes.

Loopholes in Bank Restructuring Plan

Here’s a private-sector agenda to jump-start Japan:

* Bank restructuring. The experts urge Japanese lawmakers to beef up this bill and pass it without delay.

At the urging of the United States, which fears Japan’s mountain of bad debt could bury the rest of Asia and ultimately damage the American economy, the Hashimoto government on July 2 approved a “total plan” for state-backed “bridge banks” that would take over bankrupt financial institutions but keep credit flowing to worthy borrowers.

While everyone wants the bill, modeled on the 1980s U.S. savings and loan bailout, the devil is in the details. Western and Japanese financial analysts agree the current plan leaves lethal loopholes. And the opposition Democratic Party of Japan, which scored big in Sunday’s elections, has expressed concerns that the bill could force taxpayers to bail out banks that deserve to die of mismanagement.

“It’s a shell game,” said Richard Katz, author of “Japan: The System That Soured,” a new book on the rise and fall of the Japanese economic miracle. “Instead of having a ‘convoy system’ to protect the banks, we’re now going to have a convoy to protect the borrowers.”

Hideaki Akimoto, chief researcher at Daiwa Research Institute, says the bill must be revised to include a definition of what constitutes bankruptcy, ensure that bankrupt institutions are killed off and not bailed out, and punish bad managers and stockholders.

Restoring public confidence is a theme that runs through the responses. “The government must be very frank with the people, identify banks that will fail and at the same time stress the strengths of Japan’s economy,” said Mike Mochizuki of the Brookings Institution in Washington.

And the bill must be passed quickly and at any cost, said Kazuaki Harada, director general of Sanwa Research Institute. “If it doesn’t go through, a global recession could start from Tokyo,” Harada warned.

* Personal income and corporate taxes. Analysts say these must be slashed. Like the “bridge bank” idea, everyone favors this, with the possible exception of the Ministry of Finance, and the LDP has belatedly promised permanent tax cuts.

The tax cuts must be large and meaningful, “sufficient to increase economic growth,” said economist Adam Posen of the Washington-based Institute for International Economics. Posen, author of the forthcoming book “Restoring Japan’s Economic Growth,” calls for a tax cut amounting to roughly $160 billion to bring Japan back from recession to growth of 3% or more per year.

Japan’s corporate taxes, among the world’s highest, should be cut from 46% to 40% and income tax on top earners from 65% to 45%, effective in fiscal 1999, said Harumi Ichiki of Sumitomo Life Research Institute.

U.S. investment managers agree on the size of the tax cut. Grayson Bryan, chairman of the Asia Society California Center, recommends that tax breaks be used to encourage entrepreneurs.

* Public spending. This is another area in need of increases, experts say. To do this effectively, the Japanese must scrap the budget law, which restricts spending to stimulate the economy, and increase public works outlays at least 2% over 1998, Ichiki said.

Others say the government should spend more--not, say, on concrete to pave riverbeds but on more nursing care for live-at-home elderly citizens, more day care and proper unemployment insurance to compensate for the now-inadequate benefits available for victims of corporate restructuring.

U.S. experts, seeing Japan’s economy as sinking deeper toward depression, recommend drastic action. “They should flood the system with money, set a target rate of inflation to reverse the current deflation,” said Lee Thomas III, of Pacific Investment Management Co. in Newport Beach.

* Housing construction. Instead of shelling out billions on public works, as the $124-billion stimulus package approved this spring will do, introduce tax breaks and subsidies to encourage Japanese to build and buy better housing, said Karel van Wolferen, one of the West’s preeminent Japan-watchers and author of “The Enigma of Japanese Power.”

“It would keep the 500,000 construction companies busy without them destroying the Japanese countryside,” Van Wolferen said. “You would create a lot of new living space that has to be filled with stuff,” including new electronics, appliances, furniture and so on.

“The stimulus package is meaningless because it doesn’t trickle down,” he noted, but making mortgage interest tax-deductible and offering other homeownership incentives “would bring about the more developed consumer-driven economy that we’ve all been waiting for.”

Chalmers Johnson of the Japan Policy Research Institute in Cardiff, Calif., agrees with the emphasis on housing, saying: “Japan’s economy needs to be recast to one favoring domestic consumers from one that has always favored industry producing for exports.”

* Government payroll. Cut the number of state workers by 30% by 2003, up from the 10% reduction by attrition that is now envisaged, said Daiwa’s Akimoto. Slashing these salaries, which account for 75% of government spending, would keep the budget deficit to 3% of gross domestic product even after permanent tax cuts, he said.

This idea may thrill the markets, but it will probably be fought by the Democratic Party of Japan, which is backed by the public employees union, the nation’s largest.

* Public construction. Announce that the government will pay only internationally competitive prices for all public works projects, proposed Katz. This would save money by forcing competition in an industry infamous for price-fixing cartels and could lead to increased imports of South Korean steel and concrete, for example, a move that would help Japan’s wounded neighbor.

But expect howls of fury from a hard-hit sector that provides up to 12% of all Japanese jobs and has been a wellspring of legal and under-the-table political contributions for the LDP.

* Deregulate electricity. Japanese electric power is notoriously expensive and a contributor to the high costs that have driven many manufacturers offshore. Liberalizing retail sales of electricity and allowing tightly regulated utilities to buy and sell power to each other outside their designated territories would bring down prices, argued Junji Ota, economist at the Okasan Research Institute.

But deregulation would face opposition from the powerful utilities and their unions, Ota said.

* Consumption tax. Hashimoto carried the 1996 parliamentary elections by promising to raise this hated levy from 3% to 5% to close a yawning budget deficit. But it’s time now to chop it back to 3%, a Japanese businessman said, and scholar Johnson urged: “Abolish the tax altogether.”

The trouble is, the main foe of this tax has been the Japanese Communist Party--the last group the LDP wants to be seen as caving in to. For the government to say “the Ministry of Finance was wrong, the government was wrong, and in recognition of this past sin, the government is going to recant and reverse itself” would be a powerful and popular public relations gesture, the businessman said.

* Foreign investment. Steal a page from South Korean President Kim Dae Jung’s playbook and announce that Japan will welcome more direct foreign investment--and take concrete steps to encourage it, several analysts suggested.

The most recent data show Japan invests seven times more abroad than it receives in foreign investment--an improvement over the 15-to-1 ratio of the past. This would help reverse the capital outflow from Japan and thus strengthen the yen.

‘A Wonderful Chance for the Opposition’

Though the startling anti-LDP vote Sunday is seen here as a hopeful sign that Japanese voters are no longer willing to simply muddle through, skepticism still outweighs optimism that meaningful reforms can be implemented quickly.

“The problem is the LDP is constitutionally incapable of doing what is necessary, and the opposition, though its heart is in the right place, doesn’t know what to do,” Katz said. “Thorough reforms of the type Japan needs will take years.”

In fact, a prominent Japanese businessman calls for different leadership. “The LDP failed. It should not form the next government, the opposition [Democratic Party of Japan] should,” said Iwao Tomita, founder and chairman of Deloitte Touche Tohmatsu, a Tokyo-based accounting firm. He understands that his suggestion might be unrealistic as long as the LDP holds a majority in Japan’s lower house of parliament. But he looks ahead. “This is a wonderful chance for the opposition to organize,” he said.

Clearly, sentiment is growing among the Japanese that the economy must be fixed, no matter how painful. And that makes possible measures that would have been considered political anathema a week ago. “We need drastic surgery, not just aspirin for fever relief,” said Tokyo University economist Yukio Noguchi.

Efron reported from Tokyo and Flanigan, The Times’ senior economics editor, from Los Angeles. Chiaki Kitada and Makiko Inoue of The Times’ Tokyo Bureau contributed to this report.