Bad News for the Economy

In the aftermath of the terrible attacks of September 11, most attention has been focused on the search for the missing and the nature of the response from the United States and its principal allies. But there is a growing awareness that the attacks have serious implications for the global economy, including Japan—all negative. These implications complicate the Japanese government’s efforts to revitalize the economy in a number of ways.

First, what had been a slowdown in the U.S. economy is certainly now a recession. Just the lost output due to the grounding of passenger and freight air traffic for several days might have been enough to push the United States into recession, and this will be compounded by a loss of hotel and restaurant business. These losses will continue as people cancel or postpone unessential trips over the next several months. Needless to say, a U.S. recession is bad news for the Japanese economy, since exports, which have often helped rescue the economy from recession in the past, will continue falling for the near-term future.

Second, the Tokyo stock market, like others around the globe, was hit with a wave of selling in the wake of the attack. While markets elsewhere are likely to recover somewhat after the initial shock wears off, Tokyo might not, because investors—individual and institutional—correctly recognize how bad the news is for Japan. As the market falls, so does the ability of the banking sector to finance the write-off of non-performing loans. Of course, the banks’ problems are already much worse than the Financial Services Agency or Prime Minister Junichiro Koizumi have ever been willing to admit. But the situation is now far more worrisome, and a full-scale financial crisis in Japan is a real possibility.

Third, the yen has risen against the dollar since the attack. This suggests that Japanese investors are removing funds from the United States, which has a double negative impact. The repatriation of funds from dollar-denominated assets means that investors are abandoning profitable investments (interest rates are higher in the United States than Japan) to bring money back to Japan where it will earn less—not a good development for the economy. Furthermore, the strong yen compounds the negative impact on exports.

Fourth, the U.S. government will be distracted from what is happening to the Japanese economy because the Bush administration will be totally focused on devising strategy for its war on terrorism. The initial meeting of the bilateral sub-cabinet economic group, scheduled for the weekend of September 15, was called off and may not be held before next year. The fall meeting of the IMF and World Bank, scheduled for late September in Washington, has also been canceled. At this point, it’s not even clear whether President George Bush will be visiting Japan in October on the way to the APEC meeting in Shanghai. Even if he does, the war against terrorism will dominate his agenda, and he will be in no mood to discuss Japanese domestic economic issues. Opportunities will then be lost for American and European leaders to express dismay at economic developments in Japan and to press for better responses. The policy process in Tokyo has long depended in part on gaiatsu, and a strong dose of it was needed this fall to prompt Koizumi into real action on his vague reform agenda. Now that very useful gaiatsu is not likely to be applied.

Finally, the Japanese government, too, will be distracted from dealing with increasingly urgent economic problems by the war against terrorism. The prime minister, his cabinet and the Diet will instead be focused on difficult questions of what Japan can or cannot do to fulfill its role as an ally of the United States. This is a war, no matter how ill-defined the enemy may seem, and the Bush administration is mobilizing an international coalition to pursue the terrorists and the governments that harbor them. Faced with demands for some form of participation, the Japanese government will have less energy to devote to domestic economic policy over the next several months.

For all these reasons, the economic picture for Japan has now darkened considerably. Many of us expected a mild recession this year, accompanied by some modest progress on the banks’ non-performing loan problem. Now the possibility is for a more serious recession, perhaps compounded by a financial crisis accompanied by bank failures.

It is natural for the Koizumi administration to be absorbed with devising a response to terrorism. But the last thing the United States needs at a time like this is an ally bogged down with economic problems. Japan’s ability to play a role in the world’s confrontation with terrorism will be seriously undermined if it is saddled with a recession, or worse, experiences a full-scale banking emergency due to inattention to economic policy. It is thus critical in this time of crisis that the Japanese government not lose sight of the importance of fixing the economy.