Japan’s New Economic Challenge

If any country can shed light on the national repercussions of a financial meltdown, it is Japan. For a decade in the 1990s, Japanese government and economic leaders sought to work through the collapse of a "bubble economy" with seemingly much the same causes as the current U.S. financial meltdown. Japanese now look back at their "lost decade" not only as a crisis for their economy, but as a time that revealed deep fault lines in their entire social fabric. Japan’s image as a vibrant "economic superpower" poised to become a truly global force for change also disappeared during the national crisis of confidence that resulted from a decade of recession at home.

As the world economy seems destined for recession, Japan’s political system and diplomatic skill will be sorely tested. Expectations are high that Japan can bring its economic expertise as well as its cash to the table as global economic institutions are reconfigured to meet the scope of the challenge. Japan’s capacity to respond will largely depend on its domestic politics, and on whether it can garner support at home for this new agenda for global cooperation.

Japan’s "Lost Decade" and Today’s Global Meltdown

As the financial meltdown in the United States unfolded, many of the same gloom and doom hypotheses about Japan’s experiences found their way into the U.S. debate. Economists seem to agree that the causes of the current financial meltdown, and certainly the global scale of its impact, differ considerably from Japan’s experience. But the prospective agenda for policymakers seems to include some of the highlights: low growth, deflation, unemployment, and a debilitating amount of nonperforming debt. What Japan’s experience demonstrated with great clarity is that these problems must not be hidden, nor must indecision and inaction characterize the government response.

Japan is today much better positioned to cope with the crisis afoot. Financial sector reforms undertaken under Prime Minister Junichiro Koizumi have left Japan’s banks with better liquidity than U.S. or European banks. Furthermore, the trauma of the 1990s caused Japan’s banks to stay away from the complex debt securities produced by Wall Street, and thus they suffered less from the collapse of the U.S. subprime mortgage market than their U.S. or European counterparts. Japanese brokerage houses did find their profitability affected, but losses were not crippling. No Japanese bank was forced to close as a result of the global financial meltdown. In fact, the cash flow of banks was sufficient to allow some of them to compete successfully for the purchase of financial assets from troubled U.S. entities in 2008.

But the global economic fallout has begun to take its toll on Japan’s cash-rich banks as well as other sectors of Japanese industry. Japan’s automakers have already been hard-hit. The Nikkei stock market has lost more than 40 percent of its value over the past three months, a greater loss than the U.S. or European markets. Instability in global financial markets has ended the "yen carry" trade, or the practice of borrowing at low interest rates in yen and using the loan to buy assets elsewhere, and the return of yen to Japan has pushed its value to the highest in a decade against the dollar. With consumers around the globe buying less, and with the price of Japan’s goods now increasingly uncompetitive, exports will suffer.

Japan’s consumers are unlikely to rescue the failing economy, which officially slipped into recession in November 2008. Growth in Japan’s national economy of late has been attributed largely to the growth in trade and investment with China. July 2008 brought the largest economic contraction in seven years. The cabinet of Prime Minister Yasuo Fukuda moved to resuscitate domestic demand with a $105 billion stimulus package in August, and Prime Minister Taro Aso’s supplementary attempt in response to the global economic crisis adds another $51 billion to the mix.

The Impact on Japan’s Domestic Policy Agenda

Japan desperately needs to get its fiscal house in order as it seeks to cope with growing domestic demands for government spending on social infrastructure. The Japanese national debt is the highest of the advanced industrial economies. Longer demographic trends suggest the need for ever-greater fiscal outlays to provide for pensions and health care to meet the needs of the world’s most rapidly aging population. A major restructuring of Japan’s tax code to meet the soon-to-be exponentially increasing fiscal demands on the state for social welfare will come at precisely the time when Japanese households are likely to be reeling from the impact of the global economic downturn.

The political stalemate within Japan will not make management of the crisis easier. Ever since last summer, when the opposition Democratic Party of Japan (DPJ) gained control of the upper house of parliament, Japan has been preoccupied by the prospect of a historic transfer of power from the long-ruling Liberal Democratic Party (LDP) to the emerging DPJ. Procedurally, this electoral victory by the DPJ last year means little so long as the ruling Liberal Democratic Party and its coalition partner, the small New Komeito Party, hold a two-thirds majority in the lower house of representatives. But symbolically, this was an earth-shattering moment--it was the first time in the half-century of Japan’s postwar era that the opposition held power in one of Japan’s two houses of parliament.

The Japanese public has become increasingly critical of the ruling LDP, and pressure is on to dissolve the Diet. The LDP’s strategy of replacing prime ministers to squeeze greater enthusiasm out of an already tired electorate seems to be failing. Eventually, the public found fault with all three prime ministers in office this past year: with Shinzo Abe it was his scandal-prone cabinet; with Fukuda his seeming lack of vision; and with Aso the public has become cynical about his motives for delaying lower house elections that had been expected to take place this fall.

The recent fiscal stimulus package is broadly seen more as an electioneering gambit than as a serious effort to address the nation’s economic woes. At best, many see the key initiative--a 12,000 yen (about $120) tax rebate per person, with an additional 8,000 yen ($80) for those under eighteen and over sixty-five--as insufficient to stimulate consumer spending. Moreover, the Democratic Party of Japan has voiced serious concerns about the government’s plan, and few expect the supplementary budget (required to implement the stimulus package before the end of Japan’s fiscal year next March) can be easily passed in the divided legislature. The Democratic Party of Japan, feeling betrayed by the prime minister’s postponement of lower house elections, is not in the mood to have his ruling coalition get the credit for staving off recession.

Public confidence in the government has plummeted as successive prime ministers have appeared unable to make headway on critical domestic reforms: pension reform, tax reform, and an overhaul of Japan’s inadequate health care system. With so much at stake at home, public enthusiasm for a more activist Japanese role in global affairs has waned considerably.

What Lies Ahead for Japan

The global financial meltdown has revealed the changed domestic capacities, and emerging global challenges, for Japanese foreign policy. Expectations for Japan’s global engagement are higher abroad than at home. Japan, like all nations at the moment, will find the economic instruments that have facilitated its diplomatic achievements less available in coming years.

Yet in some ways the global economic crisis offers a strategic opportunity for Japan, an opportunity that the Aso cabinet seemed well aware of as it prepared for the G-20 Summit. Aso’s willingness to put significant resources at the disposal of the International Monetary Fund ($100 billion), and his priority on ensuring global liquidity--including the supply of U.S. dollars--made it clear Japan would not hesitate to provide leadership.

Japan’s ability to take advantage of the opportunity for reasserting its voice in the global economic crisis, and its longer-term ability to weather the economic downturn ahead, will also affect its two most important strategic relationships. Washington needs Tokyo to be a vigorous partner in this crisis, and to the extent that Japan can ease the diplomatic hostility toward the United States as it seeks to stabilize global economic institutions, it will offset other potential tensions in the relationship, such as military base realignments and negotiations with North Korea.

But it is China that perhaps motivates Japan’s thinking the most.  China’s growing influence in Asian diplomacy has been troubling, but even more so is the current need to turn to Beijing for help in stabilizing the global economy. China’s new centrality to world finance--a development underscored by President Hu Jintao’s prominent position next to President Bush in the G-20 photo op--has some in Tokyo worried. Japan’s future remains deeply tied to the United States, and to the U.S. commitment to the alliance with Tokyo. U.S. leaders must be sensitive to the need to keep Japan close--and visibly so--as they navigate these very difficult times ahead.