Investors are looking for Japans new model of socio-economic development

By Dr. Michael Ivanovitch

Decades of economic stagnation and an increasing damage that is causing to the society seem to be met with a
resigned acquiescence of the Japanese political class. Governments growth strategies have relied on exports and
cheap money to reinforce overseas sales with a competitive exchange rate, despite clear evidence that this is a
losing game. It is also more than that: it is, in fact, an abdication of economic policy because an export-led growth
strategy is based on variables Japan cannot control since exports depend on external demand and on world prices.
The onus, therefore, is being shifted onto the Bank of Japan to print money and take the blame for problems caused
by the governments ineffective economic policies. That is still the case.

Indeed, the current economic recovery has been almost entirely driven by external demand, with 85 percent of
Japans GDP growth in the second quarter coming from net exports. Going a little farther back, all the growth since
the middle of the last decade an annual average of 0.3 percent -- has come from sales to Japans trading partners.
Obviously, a systematic stagnation of domestic demand, which accounts for 98 percent of GDP, is not a growth model
for the worlds third-largest economy.

This seemingly irretrievable loss of Japans ability to grow on the basis of its internal demand has taken a heavy toll
on the countrys social fabric. Rising unemployment and underemployment have created insecurity and serious
psycho-social problems, exacerbated by shrinking social welfare services and a rapidly aging population.

All these things are well known, but there was little debate about serious policy changes the country needs during the
recent leadership contest within the governing party. The measures proposed by the two candidates were designed
to provide cyclical support to the economy, with an appeal to the Bank of Japan to cooperate with an even looser
monetary policy. In the case of the prime minister, the proposed stimulus package of 920 billion yen came after his
statements about the need to raise consumption tax and to speed up the consolidation of public sector accounts.
Investors are left wondering what the actual policy is, and how determined is the government to support the economy,
promote job creation and arrest the countrys debilitating deflation.

The difficulty is that long years of reliance on exports, while neglecting the structural problems of domestic demand,
have left Japan with no effective policy options that use conventional tools of economic stimulation. For example, any
attempt to rev up domestic demand must start with household consumption, which represents 60 percent of GDP.
But a tax cut in an environment of job insecurity and uncertain growth prospects of the economy would be mostly
saved rather than spent. In addition, long-term interest rates would rise on fears of widening budget deficits. That, in
turn, would raise costs of consumer credit and depress household consumption. Another problem is that a sustained
growth of private consumption usually comes at a time of rising residential investment as people buy furniture,
housing appliances, consumer electronics, cars, etc. In Japan, however, that seems quite unlikely. Expensive real
estate, falling family formation and declining population growth have sent the housing sector in a free fall down at
an average annual rate of 11 percent over the last three years.

It thus seems that a stimulus to household consumption and to domestic demand in Japan has to work through a
broader policy to support family formation and rising birthrates. That would include child subsidies, creation of child
daycare centers, education allowances, grants to help young couples access to property, etc. These active family
policies have been successfully used in some European countries (France and Sweden, for example) to stop adverse
demographic trends and support domestic spending. Japan would have to do the same, but there is no sign of any
such systematic policy approach that would invigorate economic activity in fields ranging from residential construction
to education, medical and social welfare services. I have no doubt that, at some point, the government will move in
that direction because, as was the case in other advanced countries, the Japanese electorate will demand it.

Export reliance may also require revisions of trade policy and delicate political accommodations. Asia now takes 56
percent of Japans exports, with China accounting for nearly half of that. China (including Hong Kong) takes almost
as much of Japanese exports as Europe and US combined. Clearly, Japan has to greatly diversify its current trade
flows to avoid difficulties inherent in Asias rapidly shifting power structures.
How likely is it that Japan will implement policies to create a more stable and a better balanced economy? Prime
Minister Kans tearful address to his party is no doubt sincere and patriotic, but none of his policies announced so far
go beyond the ineffective short-run expedients. Investors understand that, and they will continue to focus on Japans
global companies. The yen will retain an upward bias due to large trade surpluses and currency operations of
countries diversifying their reserve holdings.