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Japan's economy -- nao kan fix

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Japan’s new Prime Minister, Naoto Kan, has made an impressive start.  He seems confident and decisive, with a clear view of the challenges before him.  His Policy Speech to the Diet on 11 June has many interesting elements including: cleaning up government; fixing up the economy, public finances and social security; and building up foreign policy and national security policy.

Fixing up the economy, public finances and social security is where Kan is making his first moves.  The signs are good.  But is it still possible to save the economy without having a crisis?

As Kan says, the Japanese economy has remained stagnant for nearly twenty years since the bubble economy burst.  The Japanese people have lost their former self-confidence.  He wants to build a society whose people can hold hope for their future through the "Third Way", based on his “New Growth Strategy”.

The “First Way” refers infrastructure spending during the 1960s and 1970s.  Improvements in roads, seaports, airports and other facilities led to increased productivity and powered economic growth.  But by the 1980s and 1990s, when basic infrastructure was in place, continued infrastructure spending did not produce effective results.

For Kan, the first decade of the twenty-first century saw the arrival of the “Second Way”.  Economic policy was based on excessive market fundamentalism.  This policy pushed people out of work and aggravated deflation.  The social unease was typified by haken-mura, the impromptu tent city that sprung up in Hibiya Park [in central Tokyo] two years ago.

The “Third Way” will create new demand and employment, and new forms of growth.  The main problems are the stagnant economy, swelling fiscal deficit and loss of confidence in the social security system.  The government’s goals are "a strong economy", "robust public finances" and "a strong social security system".

How to create a "strong economy"?  His New Growth Strategy has "green innovation", "life innovation", "the Asian economy" and "tourism and the regions", as well as "science and technology" and "employment and human resources".  His "New Growth Strategy" incorporating concrete measures in these areas will be completed and announced later this month.  He hopes to achieve economic growth of 3 percent in nominal terms, or 2 percent in real terms, by fiscal 2020. Casting off deflation is his immediate priority.

How to create robust public finances?  Japan’s public finances are in dire straits due to the large number of expensive public works projects and tax cuts, chiefly in the 1990s, as well as the steep increase in social security costs as a result of our rapidly ageing society.  Japan’s public debt is the worst of any developed country, and not sustainable.  So Kan plans reforms to eradicate wasteful spending.  The New Growth Strategy should help build healthy public finances through increased tax revenues.  Also, a thorough reform of the taxation system is necessary.

How to building a strong social security system?  According to Kan, the economy, public finances and social security can exist in a mutually beneficial, "win-win" relationship.  He proposes to rebuild the social security system (pensions, medical, nursing, child care) to overcome the problems of a declining birth-rate and an ageing society.

Kan concludes that lack of political leadership was the main reason why reforms in Japan fell short in the past.  He is right.  But he already sews seeds of doubt … “Whether I am able to demonstrate such leadership depends on whether I indicate a clear vision for Japan to my fellow citizens and whether they place their trust in me and give me the go-ahead to carry out this vision”.  I would have preferred to hear “yes I kan”.

I would also have preferred to hear some of the following issues emphasized by the OECD in its “Going for Growth” exercise.  Japan needs a great wave of deregulation in the services sector to boost productivity and innovation.  Labour productivity in Japan is the lowest of the G7 countries and some one-third lower than in the US.  Foreign direct investment, which could be a source of dynamism and innovation, is virtually non-existent in Japan. 

Japan has the highest corporate income tax rate in the OECD area.  This is not only a big deterrent to investment.  But it also provides a big incentive to avoid and evade taxes, which many big companies do.  At the same time, the share of wage income subject to personal income tax in Japan is the lowest of the OECD group of countries.  One source of tax revenues for improving the budget is environmental taxes, which are very low. 

Protection of the agricultural sector is double the OECD average.  It has proved to be a massive failure and should be abolished tomorrow.  Japan’s labour market is basically a brand of economic apartheid with one group being overly protected and sleeping on the job, while fully one-third of workers have irregular contracts with no job security or training.  Balanced reform of the labour market is necessary.       

The question remains: is Japan's destiny that of a Greek tragedy?  Can Prime Minister Kan salvage the situation?  I don't think so.  Public debt will continue to pile up.  Interest payments on this debt will consume an ever growing share of the government budget, competing with health and pensions.  In a few years time, the current account will swing into deficit, as the population continues ageing.

And then one day, financial markets will say they have had enough.  Domestic holders of public debt will start to offload that debt, and invest overseas.  Capital flight is often the beginning of a financial crisis.  And since Japanese corporations now do so much business overseas, keeping money out of the country is as easy as pie.

There is an old joke that goes like this.  What's the difference between Japan and Greece?  18 months, is the answer!  It may take a bit longer, but the clock is ticking.


Policy Speech by Prime Minister Naoto Kan

at the 174th Session of the Diet, 11 June 2010


Economic Policy Reforms: Going for Growth 2010