AUGUST 9, 1999 VOL. 154 NO. 5

Going Nowhere Fast
A Japanese economic recovery? Don't bet on it, whatever the yen tells you
By DAVID ROCHE

Japan is a jellyfish. You think it's moving when the sea swells, but then the waves settle back and you find that the jellyfish, floating just below the surface, has barely budged.

I visited Japan recently and found the bureaucrats from the Ministry of Finance working as hard as ever to ensure that the Japanese economy hardly budges. But they cannot hold the line forever. The exponential growth in Japan's indebtedness, along with the death of dynamism in the economy, are fatal flaws. Paradoxically, the yen is getting stronger. In part, that's because the U.S. dollar--and the U.S. economy--are running into problems. But it also reflects the markets' belief that Japan's economic recovery has finally arrived. Indeed, first-quarter GDP figures showed 7.6% growth on an annualized basis.

The markets, alas, are looking at the jellyfish. If you strip out the impact of public works spending, there is no sustainable growth. Every tantalizing quiver is the result of Japan's huge, desperate fiscal stimulus programs, which have totaled nearly $1 trillion in the 1990s, including a hefty $4 billion in the most recent package set loose by Prime Minister Keizo Obuchi.

Public sector pump priming may produce one more miraculous growth figure for the second quarter. After that, the abysmal realities--rising unemployment, the erosion of household wealth--will put Japan back on the zero-growth path. By the end of the third quarter of this year, a massive new fiscal stimulus program will undoubtedly be unveiled. Why? Because a general election is on the horizon.

A crucial issue that will decide the fate of the economy is how the Japanese use their savings. The government can fund its huge budget deficit, currently 10% of GDP, as long as Japan's surplus savings remain at home and do not get spent abroad buying foreign assets. As of today, those savings do indeed stay home, not least because of the bureaucrats' scare-mongering campaign about the parlous state of the U.S. economy and its dreadful asset-price bubble. The Japanese public knows all about asset bubbles. Japan's financial institutions have nowhere to go but to buy government debt. They can borrow money from the Bank of Japan at a bargain 1.5% interest rate and get returns from government bonds at 1.75%, a quarter-point spread that carries virtually no risk. And foreign investors are pouring cash into Japanese stocks in the hope that the economy is recovering and corporations are restructuring. All of that keeps the yen strong, which is just a symptom of the underlying disease. The bureaucrats believe Japan needs low interest rates, because the economy is so lousy, and a stable currency. Furthermore, the government needs buckets of cash to fund its deficit, and Japan's fragile banks need that quarter-point interest-rate spread to help them recapitalize.

All well and good. It's a tidy system designed to help everyone sleep well at night. The problem is that this spreading of benefits among hobbled banks and profligate government breeds a static economy and, worse, a very undynamic society. Japan needs higher returns on capital to cover the cost of its rapidly approaching demographic dotage; to push corporations toward the rational use of capital and labor; and to boost productivity and produce real growth. But as Thomas Aquinas did when faced with a beautiful woman, Japan's bureaucrats pray that God will grant them the necessary self-control--only not right now, thanks. Indeed, they hope that those marvelous pressures of "globalization" will somehow move Japanese companies to restructure without driving up interest rates--and without huge capital outflows looking for higher returns abroad, which would topple the whole pyramid.

This is where the bureaucrats are in outer space. Undoubtedly, there is some restructuring going on in Japanese industry. But serious restructuring, of the sort that would double today's paltry 2% return on company assets, would require massive layoffs and sales of unprofitable subsidiaries. That's a fat hope in a country committed to a peculiar form of capitalist socialism--a system designed to save the mediocre rather than reward the talented.

In the U.S., an eccentric genius can become an entrepreneur and then a billionaire, changing society along the way. Japan has no shortage of creative talent, perhaps more than its neighbors in Asia. Yet the creative geniuses in Japan will likely end up dyeing their hair yellow, wearing rings in their noses and crying into their Kirins on the fringes of society--or, more sadly, moving abroad. Japan's culture has to start changing, particularly in the boardroom. If people are rewarded, promoted and paid to be creative, they will create. But most of the wizards who have made Japan's best products never made the management committee or, truth be told, earned a decent living. All this may change in 10 years--but not in 10 months. Until then, investors rushing into Japanese stocks in the hope of gains from restructuring will end up being disappointed. They're hynotized by the undulations of the jellyfish, which floats but never goes very far.

David Roche is President and Chief Global Strategist of Independent Strategy