Japan's Economy Is on the Mend, but a Cure Is Some Way Off

To truly recover, Japanese consumers need to get out and spend. So far, a crisis of confidence has prevented that from happening.
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Recalling the story about the man who cured himself of a supposedly fatal illness by spending a week in a hotel room watching

Marx Brothers

films, laughing himself silly, it would be wrong to ignore the importance of a patient's mood to his health.

Especially when that patient happens to be Japan, whose economy has fallen prey to an enormous crisis of confidence. This is what lies at the base of the liquidity trap, the death spiral into which Japan has fallen.

What Japan -- which has seen its gross domestic product shrink for five straight quarters -- desperately needs is for companies and people to get out and spend. But concerns about the authorities' ability to deal with banks' burgeoning debt have led to worries that the worst is yet to come. Under those conditions, the rational thing to do is not to spend, but to lay in cash for a long, cold winter.

"For the longest time, the Japanese public has been told there is no medicine for the cure," says Richard Koo, chief economist at

Nomura Research Institute

. "If you tell a lie a hundred times, people start to believe it. So a lot of people believed there is no cure for the disease. Fiscal policy is ineffective. Monetary policy is ineffective. Gosh, what can we do? That worsened the condition."

Recently, though, the mood has improved in Japan. The leading sentiment indicator, the

Bank of Japan's

quarterly

tankan

, showed slight improvement when it was released early this month. Reports released last week by the

Ministry of International Trade and Industry

and the

Economic Planning Agency

showed improving sentiment at small and midsize businesses, and consumer confidence at its highest level since September 1997. And let's not forget the resplendent

Nikkei

, which has added more than 20% this year. That suggests people may become a little freer with their money -- a good thing, if it happens.

The improved mood is not baseless, notes Toyoo Gyohten, a senior adviser to the

Bank of Tokyo-Mitsubishi

and formerly the

Ministry of Finance's

vice minister of finance for international affairs, Japan's highest ranked bureaucrat. (Showing admirable market timing, Gyohten left the post now held by

Eisuke Sakakibara

in 1989.)

"It's not only psychology," says Gyohten. "There are increasing areas where you see glimmers of hope in the real economy. The production index, inventory adjustments, housing starts -- they're all showing some signs of recovery."

Gyohten thinks the Japanese economy will begin to climb again sometime in the middle of the year. It's at that point that the real challenge comes: to sustain the recovery while putting through more restructuring. Japan continues to buckle under excess capacity, excess employment (despite the highest unemployment in a generation, many employed Japanese are underutilized) and excess debt. It's absolutely necessary for those excesses to be removed for Japan to really regain its footing, but removing those excesses will have deflationary consequences.

For that reason, Koo, who has lately been advising the Japanese government, thinks that another round of fiscal stimulus is necessary. "The private sector wants to repair their balance sheets," he says. "How do you repair your balance sheet? Well, you pay down your debt. Everybody's paying down debt -- no one is consuming, no one is investing. And while no one's consuming and no one's investing, the economy will continue to shrink, unless someone in the economy is doing that activity, and that's the role of fiscal policy when you have a balance sheet recession. That's what mankind has learned from the thirties -- from the wrong dictator, of course."

Though in the past Koo was something of a voice crying in the wilderness, lately he has been singing with the chorus -- or rather the chorus has been singing with him. Note the way Deputy Treasury Secretary

Larry Summers

, who formerly seemed to think fiscal stimulus offered only a temporary fix, has changed his tune. Moreover, it seems that he, too, is looking to see more stimulus. Speaking at the

Economic Strategy Institute

conference in Washington Tuesday, he said "it will continue to be essential that Japan implement stimulus measures until growth is restored, using all available tools to support strong domestic demand-led growth."

With the

Group of Seven

putting apparent pressure on Japan to launch a new round of stimulus, some have suggested Prime Minister

Keizo Obuchi

will announce another package when he meets with

President Clinton

this weekend. That would be in keeping with Japan's tradition of bringing a "souvenir" to meetings with the American president, and another round might give another boost to Obuchi's increasing popularity, allowing him to hold early elections while his foes are in disarray.

But Gyohten says that while it will eventually come, the time is not yet ripe for another package. The effects of the last round of stimulus are just hitting the economy now. Eventually, they will run out and the economy will flag under the deflationary effects of restructuring. The Japanese government does not have an unlimited supply of capital. To administer the medicine now, and risk not having enough when the chills come on again, could be tragic.