Koizumi needs a shift from his sacred reforms

Susumu Saito Director of Trilateral Institute Inc. The Asahi Shimbun Tokyo

Andrew Mellon, a former U.S. treasury secretary, left his mark in history with the following, often-cited, piece of advice to President Herbert Hoover in 1930: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate ... it (panic) will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

The result of Mellon's advice was the Great Depression of the 1930s. A stream of advice given to Prime Minister Junichiro Koizumi by his own advisers and American "friends" ultimately amounts to what Mellon said to Hoover.

The Japanese economy has private capital stocks and labor force that can generate at least 700 trillion yen of gross domestic product. This vast economic engine, however, has been forced to operate at around 500 trillion yen of GDP, or about one-third less of capacity, for the past decade. The approximately 200-trillion-yen gap between potential and actual GDP is called the deflationary gap.

What the central government has pushed for since the autumn of 1996 amounts to slashing the "extra" physical and human production capacity that can generate at least 200 trillion yen more of GDP.

The result must be obvious to sensible economists when the nation's economy can supply 700 trillion yen of GDP without additional private investment, but macroeconomic policy-monetary and fiscal-is geared to aggregate demand of only 500 trillion yen of GDP. Prices fall and bankruptcies and unemployment increase until the "rottenness" is purged from the system. Given the size of the deflationary gap, this process of "purification" does not stop until the whole economy sees the bottom of the deep abyss.

Accordingly, the physical assets that correspond to this deflationary gap weigh down upon financial institutions as bad assets or nonperforming loans. No financial system will stand if more than 30 percent of its total asset should be accounted for as nonperforming. It is no wonder that financial crises occurred in Japan in 1997 and 1998 after the government started forcing banks to write off bad loans.

Thereafter came the plan of replacing Japanese banks' bad loans with government debts, in the name of financial restructuring in the autumn of 1998. This plan has allowed Japanese banks to accelerate the write-off of more and more bad loans. In plain language, more companies are forced to go bankrupt and more people are thrown out of work.

This method of "reviving" the Japanese economy, a key element of Koizumi's "economic reform," has only aggravated overall business conditions further, as I have repeatedly warned in this column since last spring.

The replacement of private debt with public debt does not reduce the total debt of the economy as a whole. The resulting sharp deterioration of business conditions has worked to reduce government tax revenues, while budget deficits and total public debt have ballooned for the central and local governments.

The rapid deterioration in public finances has cornered the Finance Ministry to push Koizumi to raise taxes for health insurance and so forth and to slash fiscal spending under the banner of "economic reform." Such fiscal policy tactics, however, will only dampen business conditions further.

Koizumi, his advisers and many opinion leaders continue to shout the same slogan that the delay in the write-off of bad loans by Japanese banks is the root cause of deflation. Even the U.S. government has renewed the same call. But it is simply a mistaken idea. Even if all the remaining bad loans are wiped out all at once with a further injection of more than 100 trillion yen into the Japanese banking system, the only result will be a sharp contraction of the Japanese economy, with mass unemployment and paralyzed public finances.

After nearly 10 months with Koizumi in office, about two- thirds of the Japanese people appear to have begun to suspect what will really come after the "economic reforms" that had been supposed to bring about a bright economic future, according to various recent opinion polls. They rightly demand that measures to restart the Japanese economy should take priority over everything else in economic policy.

Despite the apparent failure in economic policy, however, Koizumi's newly suggested anti-deflationary measures will still act mostly as the brake pedal and only partly as the gas pedal of the Japanese economy, since they stress cleaning up bad loans as soon as possible.

Japan needs a Copernican turn in economic policy: An increase in aggregate demand, brought about by mobilizing all extraordinary measures until aggregate demand approaches the GDP's potential of about 700 trillion yen. Even the idea of the Japanese government unconditionally distributing a certain amount of credit to all the Japanese people every year until the deflationary gap disappears, as has been suggested by some economists, may not be absurd at all.

Besides bills issued by the Bank of Japan, the central government is legally entitled to issue paper and coin currency. In the electronic age, the government does not actually have to print banknotes and mint coins. It can electronically remit credit to the bank accounts of all the Japanese people. It would then be up to each individual recipient to decide how to use that credit.

The market can therefore be left to decide how the credit is used-a much more efficient means of distributing credit than ordinary fiscal policy. In any case, Japan's political system has been shown to be incapable of efficiently allocating economic resources through ordinary fiscal policy.

The benefit of this idea is that credit created in this way does not have to be counted as debt, either of the government or the Bank of Japan.

Bad bank loans are not the cause, but the result of a deflationary gap that has been left to widen for a long time. Koizumi's policy of fiscal austerity has only widened the deflationary gap and will widen it further: It is a path to the economic abyss. The closing of the deflationary gap through an increase in aggregate demand, on the other hand, would simply evaporate the current problems of bad bank loans, financial and industrial crises, bankruptcies, record-high unemployment and, ultimately, deflation.

It appears to be extremely difficult for the current Japanese government to undergo a Copernican transformation in economic policy. A 180-degree turn in economic policy may require a new government.

The current political situation can be compared to that in the final 13 months of the Pacific War from December 1941 to August 1945. In July 1944, the island of Saipan fell to U.S. forces. The outcome of the war was all-too apparent, and it was clear the war had to be brought to an end.

It was a matter of time before the American long-range B-29 bombers flying out of Saipan and Tenian began to lay waste to Japan's industrial areas and cities. The supply of raw materials for Japanese industry had been already choked off by the American submarine blockade. The destruction of physical industrial capacity in the Japanese home islands would make it logistically impossible for Japan to continue fighting at all.

Nobusuke Kishi, state minister in charge of logistics in the Cabinet of Hideki Tojo and a postwar prime minister who worked to revise the Japan-U.S. Security Treaty in 1960, proposed an immediate end to the war. Infuriated, Tojo demanded his resignation, but Kishi refused, resulting in the toppling of the Tojo Cabinet in July 1944.

Two successive military Cabinets, however, continued the war for 13 more months, resulting in more than 90 percent of the 1.9 million deaths among Japanese combatants in the 45-month-long Pacific War-in addition to those killed in the simultaneous wars with China and the Soviet Union. Military leaders could not face up to the realities of the war, and only continued to demand that all of Japan's 100 million people give their lives in a decisive battle on the homeland. Those leaders could simply not take responsibility for the outcome of the war, resulting in the deaths of many Japanese under the name of the sacred war.

The current crop of Japanese political leaders are forcing unnecessary sacrifices on the Japanese people once again, under the name of sacred economic reforms. Japanese opinion leaders with a conscience should speak up. It is never too late for anybody to admit a mistake. The sooner the better, before misguided economic policy unnecessarily piles up more and more casualties.