Will Japan’s earthquake shake up its economic policy?

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Though Japan is still struggling to resolve its nuclear crisis and tally the losses to human life and property caused by the giant earthquake and tsunami that devastated its northeast coast, scholars are already philosophizing on how the disaster could change Japanese politics and society over the long term. In an interesting essay for The Wall Street Journal, Michael Auslin, director of Japan studies at the American Enterprise Institute, argues that the quake may prove to be a significant turning point in Japanese modern history. “How the government responds,” Auslin says, “will determine the next decades of Japan’s history.”

A bungled earthquake response will not endanger Japan’s democratic constitutional order per se. But within that democratic framework, mounting public anger at officials can do a lot of harm. The greatest danger is that the Japanese, seeing the ineptitude of their government in their hour of greatest need, will simply lose faith in the political system. This cynicism could be corrosive…Alternately, it could result in massive political activism and demands for sweeping change in political parties…The great Tohoku earthquake has changed Japan in ways no one can yet envision.

This got my thinking about the future of the Japanese economy and economic reform. Will this horrifying catastrophe, and the need to rebuild, alter politics and create the political will to finally tackle the long-standing woes of the Japanese economy?

The more we learn about the destruction inflicted by the quake, the more severe the economic consequences appear to be, at least in the short term. Noting that the disruption to production in Japan could last longer than originally anticipated, BofA Merrill Lynch downgraded is 2011 GDP growth forecast to 0.9% from 1.5%.Yet, like many economists, the Merrill guys believe the hit will be temporary. The economy, they argue, will come to see a positive boost from post-quake reconstruction, and they upgraded their 2012 growth projection to 2.8% from 2.0%.

That’s promising, but it is not a solution to Japan’s economic problems. Any bump from the rebuilding effort will likely be temporary as well; then I expect Japan will sink back into the malaise it has suffered through for 20 years. Unless, of course, Japan’s political leaders do something about it.

I’ve argued before that the reason behind Japan’s Lost Decades is an unwillingness to change an economic model that has become mismatched with the realities of Japan’s position in the global economy. Just as in the 1970s, policymakers remain devoted to exports driven, if possible, by a cheap yen, while doing little to tap growth in the domestic economy. That may have worked when Japan was a developing nation, but now, with costs high and competition from China and rest of Asia intensifying, Japan needs to find more varied sources of growth. But entrepreneurship remains stifled by bureaucratic red tape; consumers are prodded to save, not spend, in part by an uncertain social safety net; fear of opening the local market keeps the country at arm’s length from a high-growth Asia. Instead of undertaking the reforms necessary, Japan has chosen to pump up fiscal policy to keep the economy puttering on while ignoring hard decisions. The result is the highest government debt to GDP ratio in the developed world, at 200%, and rising concerns about a looming fiscal crisis.

There is little doubt in my mind that Japan will experience political convulsions from the quake and its aftermath, as Auslin suggests. Prime Minister Naoto Kan was already likely on his way out before the quake; if he knocked the response to the catastrophe out of the ballpark, he might have strengthened his administration. But there have been enough fumbles, especially in regard to the nuclear fiasco, that I can’t imagine he’s saved his job. That likely means a new PM (who would be the third since the Democratic Party of Japan took office in 2009), or perhaps a fresh general election. My guess is that the new leadership, whoever it might be, will face even louder demands for change from a voting public sick and tired of political inaction.

But will that lead finally to economic reform? If the quake ushers in a fresh political lineup with new, bold thinking on the future of Japan, then maybe. But I’m more inclined to think just the opposite will prove true. Whoever ends up running Japan might be incentivized to maintain the country’s economic model just how it is.

Why is that? The country’s leaders, desperate to stimulate growth through this time of crisis, are more likely to favor old methods than try new, potentially risky, policies. Japanese policymakers like to create growth through a cheap yen and fiscal spending, and there is no indication that will change. Facing the need to rebuild infrastructure, the government will be able to boost growth with the budget, allowing the continued postponement of tough choices on reform. And the reconstruction effort will be another excuse to push off any serious action on the country’s feeble finances, even as state debt will continue to mount. Even more, will the country’s politicians be willing to implement policies that could dramatically alter the lives of a public already traumatized by the quake? For example, the government must confront the fierce opposition of farmers to free-trade policies in order to integrate more with Asia and liberalize the economy. Is that a politically dangerous battle the government will want to take on after farmers got hit by the tsunami?

This is, admittedly, wild speculation, and perhaps my view is overly cynical. My fear, though, is that Japan will use the current crisis as yet another reason to delay reform rather than embrace it.