Watching the Japan follies

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If I had hair, I’d be pulling it out. That’s because I’ve been watching the latest, frustrating round of political hari-kari taking place in Tokyo. With Japan’s economic recovery stalling and national debt mounting, the last thing the country needs is a fruitless political squabble, but that’s exactly what the Japanese public is getting. The leading lights of the ruling Democratic Party of Japan (DPJ) are tussling for power amongst themselves. The battle shows just how detached Japanese politics have become from the true problems of the nation and how devoid of real solutions the country’s politicians actually are.

The pointless saga was tipped off by DPJ kingpin Ichiro Ozawa, who is challenging current Prime Minister Naoto Kan for the presidency of the party. Ozawa, who resigned from the party’s top post in 2009 amid a political fundraising scandal (though he has not been indicted for any crime), is wildly unpopular in Japan. Recent polls show that about two-thirds of the general public favor Kan, while Ozawa’s support languishes under 20%. But that means little in the vacuum-sealed world of Japanese politics. Kan and Ozawa are running neck and neck within the party, and it is possible that Ozawa could pull off a victory in the September 14 election. If Ozawa becomes DPJ president, Kan would almost certainly be forced to hand him the prime ministerial post after only three months in office.

There is no good outcome here for Japan. At best, the Ozawa-Kan contest could very well cause Japanese voters to lose the last remaining shreds of faith they might still have in the DPJ’s ability to run the country. At worst, Japan might be getting another dead-on-arrival prime minister, the third since the DPJ took office only a year ago.

Ozawa’s challenge is already inflicting some damage. In debates with Kan, Ozawa has been talking up the need for more spending on social welfare programs, which was an important element of the DPJ’s policy platform upon taking control of the government last year. But his comments have sent nervous ripples through Japan’s sovereign bond market. Since late August, yields on Japanese government bonds have been quickly rising, likely a sign that investors fear an Ozawa victory would lead to a further decay in the government’s already shaky financial position. Ozawa says he would pay for his policies by eliminating vaguely defined “waste” within the budget, but those promises fall far short of an actual fiscal plan. (Kan has been more rational on this issue, recently announcing a plan to balance the budget over the next decade.)

Japan can’t afford Ozawa’s populism. With government debt equivalent to nearly twice the size of the entire economy, there have been rising concerns about the state of Japan’s national finances. In fact, the International Monetary Fund warned last week that Japan was one of four countries (with Greece, Italy and Portugal the others) with the least available fiscal flexibility in the industrialized world – in other words, it is among the closest to having an unsustainable level of debt that could call into question the country’s solvency.

The one major issue Ozawa and Kan agree on is, unfortunately, the wrong one – the yen. Both have vowed to take action to stem the yen’s rise against the dollar. The yen is hovering near its strongest level in 15 years. But the insistence on maintaining a weak yen just shows how Japan’s political leaders are unwilling to think out of the box to confront the nation’s woes.

Here’s why: The conventional wisdom in Japan is that the country needs a weak yen to help its exporters compete in international markets. But this dependence on exports is an outgrowth of outdated thinking on Japan’s economy. There is really no reason Japan should be so reliant on exports. Unlike a small, open economy like Taiwan or Singapore, exports don’t account for that much of the economy – in fact, less than 20% of GDP. The problem is that the domestic economy doesn’t contribute enough to growth. In the April-June quarter of 2010, domestic demand actually contracted, while it was external demand that produced positive GDP growth.

A strong yen would work towards changing that unfortunate situation. It would force Japanese companies to become more efficient and potentially spur greater consumer spending. Here’s Jim Walker, a very smart economist at research firm Asianomics in Hong Kong, on the subject:

Japan is best served by a steadily rising yen in trade-weighted terms. This produces a downward bias on the cost of imports, thus increasing Japanese real domestic disposable incomes. It also encourages export-oriented industries to become more productive and save on Japan’s scarcest resource – labor.

In other words, a strong yen is good for Japan. But you’ll never hear that from Ozawa or Kan. For them, and the rest of Japan’s political-corporate establishment, a weak yen in a policy crutch, which allows them to dodge making hard decisions on economic reform. This key issue – how to restructure the domestic economy to produce better growth and jobs – is simply not on the table of Japanese politics. Naomi Fink, Japan strategist at Bank of Tokyo Mitsubishi UFJ, made this point in The Wall Street Journal:

Japan’s long postwar addiction to export-led growth has given rise to political apathy and ineffective policy making. This is one reason politicians remain so obsessed with the yen-dollar exchange rate—any drag on exports would force them to make tough choices about domestic reform. Now, however, a strong yen is being felt in a new way. Exports and overseas earnings are no longer enough to blunt the force of competition from imports on many Japanese companies… Just as Japan’s smartest companies have invested offshore to increase the output of their overseas facilities, they might first measure and then improve the productivity of their distribution, marketing and support processes onshore…Policy makers also should resist the temptation to try to slow this process either through attempts to intervene in the exchange rate or to raise barriers to foreign competitors. The longer corporate Japan delays this transition, the harder it will be.

So in the end, what we’re seeing in Japan today is yet more evidence that the country’s political leadership doesn’t get it. Until they’re willing to make tough policy changes, the economy will remain adrift, or potentially worse. And I’ll keep losing hair.