- The Washington Times - Friday, April 5, 2002

April 1 is the beginning of a new fiscal year in Japan and, despite recent government-engineered gains in the Nikkei, the economic picture is even grimmer than before. Notwithstanding creative efforts at life support, the Japanese economic system cannot survive indefinitely in its current incarnation.

At a certain point, when the underlying forces build up sufficient tension, something will crack in Japan's financial system. This "earthquake" will extend from the economy into the political and social spheres. When this will happen is not clear. What will trigger the shake-up is clearer: substantial and visible defaults on a debt structure that is already unsustainable.

Japan does not exist in a vacuum. Most of Asia has followed the Japanese development model, with a lag time of anywhere from five to 20 years. Japan's state-centric model began breaking down in 1990. By 1997, the rest of Asia was in difficult straits as well.

Therefore, the issue is not merely the fact that Asia's largest economy is in terrific trouble, but that the rest of Asia will be depressed by Japan's failures. There may be exceptions, but the Japanese disease in general will transform itself into the Asian disease.

Japan is in its longest recession of the post-World War II period. An unsightly mix of 17 months of recession and deflation has gouged everything from manufacturing orders (down 22 percent for 2001) and company earnings (down 72 percent in 2001), to factory use (at record lows) and capital spending (down 12 percent in the last quarter alone).

Japan's only year of gross domestic product growth above 1.6 percent occurred in 1996, when most of the reconstruction after the Kobe earthquake was completed. Standard & Poor's recently reported that not a single Japanese firm it had contacted expressed optimism for the next business year.

In an attempt to protect their positions, large individual and institutional Japanese investors are abandoning traditional mechanisms such as stocks and piling their cash into government-guaranteed bonds. That has pushed bond yields to a pathetic zero percent, although that is still a better return on investment than a stock market that until recently has slouched at an unstable 18-year low.

The country's deflationary spiral will continue to have profound and accelerating effects on consumer spending. Discount chains like Wal-Mart which on March 14 announced plans to acquire Japanese retailer Seiyu in its first venture into the Japanese market should do well.

This is, of course, only the tip of the iceberg. Changing patterns will extend themselves throughout the system, altering the shape of the Japanese economy and society.

A domestic-led recovery is not an option, as the traditional stimulus measures have long since been exhausted. On the fiscal side, excessive and wasteful deficit spending saddled Japan with 666 trillion yen in debt ($5 trillion) the largest sovereign debt in human history.

Monetary policy is also incapable of serving as an engine. The Bank of Japan has increased the amount of money it is pumping into the system, but the money base is rising at 10 times the rate of the money supply, indicating that banks would rather hoard cash than risk losing it on new loans. Business propositions are so poor that bank lending has declined in each of the past five years, although interest rates essentially have been at zero percent since early 1999.

The Japanese have so delayed implementing a meaningful solution to their problems that the amount of medicine now needed to make a difference likely would kill the patient. For example, forcing severely weakened banks to close would push equally weakened companies out of business, with the resulting effects on unemployment.

The Japanese economy is upending, with government-backed bonds becoming the center of gravity of the entire asset, debt and investment market. So long as the government itself doesn't default, Japan may avoid a catastrophic collapse. But with the major credit-rating agencies threatening to knock Japan's sovereign rating down to equal or below that of Barbados and Greece, and the new "austerity" budget still calling for a 37 percent deficit, the outlook is not hopeful.

The remaining options are limited and ineffective. Policy now revolves around heavy government intervention and the constant manipulation of statistics to give the illusion of progress.

The one bright spot is that 95 percent of Japanese government bonds are held domestically. A $300 billion default on those foreign holdings is bad no matter how you slice it, but a $6 trillion default would be truly catastrophic.

The unavoidability of Japan's collapse is as much cultural as macroeconomic. There is a culture of consensus and a social contract of obligation. Consensus makes new initiatives difficult. Obligation makes the severe austerity needed to revive the system impossible.

Therefore, the interesting thing about Japan is not how it will solve its economic problems, but rather what the social, political and cultural consequences of economic failure will look like.

In Japan's culture, failure is largely inconceivable, and denial is a way of life. During World War II, it took two atomic attacks to convince the Japanese government that failure was imminent.

At a certain point, it becomes inappropriate to speak of Japan's problems as primarily economic. They cannot be solved in economic terms alone, as neither the origins nor the consequences are economic. Japan's problems are rooted in its political and social system, both designed to harmonize diverging interests.

The United States could have implemented severe austerities in the 1970s and 1980s, accepting that they would fall unequally and cause severe social dislocation as some industries vanished and others were invented. Japan's political and social system could not readily contain these dramatic changes. It was easier to endure long-term malaise than to withstand short-term restructuring.

With domestic policy-making ossified, external determinants have become key.

Any number of events, such as a spike in oil prices, a short-term military conflict, a crash in the automotive market or a sudden credit downgrade, could disrupt the local perception that Tokyo is still creditworthy and trigger a credit run and default.

The key to evolving Japanese foreign private investment strategies is productivity. Japanese labor productivity dipped in absolute terms in 2001 and is now only 69 percent of that of the United States.

Outward Japanese investment flows are beginning to follow a two-tiered pattern. The Japanese will build capacity in Asia to take advantage of lower cost production to manufacture actual goods. But in the United States, they will simply provide capital for American consumption, whether in the form of stock purchases or outright loans to American firms.

So while overall Japanese holdings in the United States likely will increase, Japanese whole ownership of entire asset sets, such as Sony or Mitsubishi factories, should decrease, with the reverse occurring in Asia.

This will produce sharply different results in the United States and in the rest of Asia when the Japanese default occurs. Japanese investments, particularly wholly owned ones, tend to be heavily leveraged and vulnerable to credit crunches. When Tokyo defaults and the income on those trillions of government bonds on which the Japanese economy now depends ceases, it will affect every Japanese investment across the globe.

Domestically, it means the collapse of the mutual funds that are the preferred investment tool of the average Japanese (the funds themselves are heavily involved in the government bond market), which will wipe out a large portion of personal savings.

In the United States, the steady flow of Japanese capital will dry up.

Until the default occurs, Japan will remain exactly where it is in a depression.

That is not to say that Japan is incapable of transformation. Quite the contrary, it is difficult to imagine any country that has undergone more profound change over the past two centuries. When one considers that Japan was an entirely preindustrial society when Adm. Matthew Perry arrived in 1853, and an industrial power a half-century later, the scope of Japanese transformative capability is stunning.

Considering that Japan was transformed from a militarist warrior state to a pacific liberal democracy literally overnight makes it obvious that when properly motivated, Japan is capable of amazing cultural adaptiveness.

Japan is an earthquake society. Like the Soviet Union before it, it does not transform continually and glacially, as the United States does. Rather, it builds up stresses until the system finally breaks apart in social upheaval. As with the Soviet Union, what appeared permanent and unchanging suddenly will be transformed.

But, unlike the Soviet Union, Japan has core strength. Whereas the Soviet Union was a regime, Japan is a culture of stable relationships. When a regime loses legitimacy, all is lost. A culture, however, cannot be destroyed easily. Japan's culture is the only one to have undergone an industrial revolution without a concurrent social revolution. In Japan, feudalism was never overthrown. It simply adapted to industrialization.

Thus, the regime is as malleable as the economic system. What are permanent are the core feudal relationships and principles that bind the country together. Japan can be radically transformed within the context of its core relationships.

Thus, the insolubility of Japan's economic problems creates increasing tension within Japanese society. At some point, quite unexpectedly, there will be an upheaval. But this upheaval likely will not leave Japan helpless, as is the case with Russia.

The upheaval will be framed in a uniquely Japanese format and will create what will appear to be a new Japan, suddenly giving itself the tools to redefine its economy. Japan has no way out with its current regime and outlook.

Therefore, Japan must create a new regime with a different outlook that behaves in a different way, while retaining its core social values. This is something that Japan has done many times before; it is something Japan will do again, and it is something the current crisis will require.

It is therefore time to stop thinking about the shape and depth of the Japanese economic crisis and start looking over the hill to the impending Japanese political and social crisis and resolution that the economic downfall eventually will necessitate.

Peter Zeihan is an analyst at Stratfor in Austin, Texas, a provider of global intelligence to private companies and subscribers. Its Web site is Stratfor.com.

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