Economic issues should be the central focus of the May 3 meeting between Japanese Prime Minister Keizo Obuchi and President Bill Clinton, but the Kosovo conflict and other global security issues may displace them. Global security and prosperity would benefit from Japan’s economic revival. The country slipped into a recession in 1997, which deepened in 1998, accompanied by the worsening of a massive bad debt problem in the banking sector. Obuchi will argue that his government’s economic stimulus packages and banking reforms have stemmed the economic decline and that recovery will proceed through 1999. The Clinton administration must privately challenge this characterization. Publicly, the administration should press for further banking restructuring and an opening of Japanese markets that will provide a better basis for economic recovery beneficial to both U.S. firms and Japanese society.
POLICY BRIEF #49
Prime Minister Keizo Obuchi of Japan will visit Washington D.C. on May 3 for a bilateral summit meeting with President Bill Clinton. Economic issues should be at the forefront of this meeting, but are in danger of being shunted aside. Japan’s economy has not turned the corner to recovery, and progress on market access issues has slowed to a crawl. Public and private signals from Clinton are essential to stemming the downturn. Failure to raise or press macroeconomic and trade issues will only worsen the situation.
Japan, one of the world’s most affluent countries, is the second-largest economy and largest international net creditor. Continued recession negatively influences world trade because it reduces exports to Japan. Financial turmoil and possible collapse could have an impact on global financial markets if Japanese investors have to withdraw their funds to pay debts at home. The affluent Japanese buy the sophisticated, high-tech goods and services U.S. firms produce, so improved market access matters greatly.
Economic problems and concerns also are paramount to the broader agenda of bilateral relations. The United States needs a healthy, confident Japan to face the security threats of the world. A financially weakened Japan may balk at the cost of international involvement. Participation in developing theater missile defense (TMD), for example, will be very expensive. A self-absorbed, shrinking Japan is unlikely to be a helpful partner on global issues. In the early 1990s, when the United States experienced a recession, the Japanese government worried about America turning inward. But now the Japanese are becoming increasingly absorbed in their domestic worries.
The Japanese economy should be of central importance to the bilateral summit agenda, and must not be shuffled into the background by the conflict in the Balkans or other global security issues. The president must express concern that the Japanese economy continues to deteriorate. No burning trade issues require strong tactics, but the president should publicly mention an array of market access issues to move the negotiating process forward.
Japan’s Shrinking Economy: A Backdrop
During the Clinton administration’s first term, bilateral relations were quite contentious as the United States pursued an ambitious negotiating agenda under the 1993 bilateral Framework Agreement. Once the bitter negotiations over access to Japanese automobile and auto-parts markets concluded in 1995, however, the visibility of the trade relationship faded. Though rather tense discussions of insurance, semiconductors, civil aviation, harbor services, and color film continued, the dickering proceeded with less visibility and quieter rhetoric. When the administration lost a landmark World Trade Organization (WTO) case on access to Japan’s consumer market for color film, for example, Clinton could have publicly declared his dismay, but instead took the loss philosophically.
Debate over structural issues, dubbed the Enhanced Initiative on Deregulation, highlighted Clinton’s second term. Rather than focusing on access by individual products or firms to Japanese markets, negotiations centered on broad problems (such as standards or regulations) affecting many products. In its first year, this process yielded agreements in several areas, including standards for a variety of building materials. This bilateral discussion continues, but progress has been very slow.
Meanwhile, macroeconomic and financial issues evolved to become the dominant focus of the bilateral relationship in 1997 and 1998. Japan has experienced economic stagnation during the 1990s. The enormous amount of bad debt in the banking sector–caused by the speculative rise of real estate and stock prices in the late 1980s and their subsequent collapse–complicated problems. Just as the economy appeared to be recovering, a disastrous decision to raise taxes in April 1997 threw the country into a serious recession. The recession exacerbated the bad debt problem, and that fall, a mid-size bank (Hokkaido Takushoku Bank) and the fourth largest securities firm (Yamaichi Securities) filed for bankruptcy.
Japan entered 1998 with a deepening recession and no macroeconomic policy to arrest the decline. Indeed, in the first quarter of the year, the national Diet passed a contractionary budget. The government also offered only a single initiative to the failing banks: recapitalization funds (through government purchase of preferred shares and subordinated bonds) with no strings attached. Economic policymaking in Japan entered its nadir. Set against a serious financial crisis in other parts of Asia and emerging problems in Brazil and Russia, the Japanese recession and muddled policymaking heightened global economic insecurity.
The Clinton administration and the broader policy community reacted to these policymaking blunders with strong and bluntly expressed criticism and pressure. Administration officials, principally Treasury Secretary Robert Rubin and his deputy, Lawrence Summers, strongly urged the Japanese government to pursue fiscal expansion (preferably through tax cuts), and to develop credible policies to cope with the festering bad debt problem and the banking sector’s attendant financial weakness. During his high-profile June 1998 visit to Tokyo, Summers pressed the Japanese government to establish a process for reducing bad debt in the banking system.
Since spring 1998, Japan has redrafted its macroeconomic and banking policies, driven by both domestic factors and American pressure. The government established two stimulus packages of proposed tax cuts and spending increases in late April and November that reversed the contractionary character of the fiscal year 1998 budget. Meanwhile, monetary policy–the other major macroeconomic policy tool–has remained expansive, with interest rates close to zero (except for a short-lived upward blip early this year). Furthermore, in October, the Diet passed laws providing for nationalization of insolvent banks and recapitalization of financially weak banks (with restructuring strings attached). The government has nationalized the Long-Term Credit Bank of Japan and the Nippon Credit Bank. Once stripped of bad loans, these institutions will be sold to the private sector, just as the Resolution Trust Corporation (RTC) unloaded the surviving savings and loans in the United States in the 1990s. Banks asked for and received ¥7.5 trillion (roughly $60 billion) in recapitalization from the Japanese government in March in exchange for issuing corporate restructuring plans.
Despite the policy changes, the economy continued to contract throughout 1998. Growth declined to -2.8 percent for the calendar year, and a roughly similar contraction is anticipated for the fiscal year that ended March 31, 1999. Quarterly GDP statistics have shown a shrinking economy for five quarters. Nevertheless, since the beginning of the year, the Japanese government began broadcasting a modestly optimistic view, arguing that the economy was bottoming out and would return to growth in 1999. The government has officially forecast 0.5 percent growth for fiscal year 1999 (April 1999 to March 2000).
More Trouble To Come
Despite the gloomy picture of the Japanese economy, the prime minister will argue in Washington that recovery is about to begin. The Japanese government points to a deceleration in the decline of some economic indicators, and to occasional monthly upticks in others, such as household spending, as proof of improved conditions. Part of the government’s motivation for window-dressing stems from a belief that psychology is the problem–if people believed the economy was getting better, they would spend more. Part of the motivation also is political. The ruling Liberal Democratic Party (LDP) would like people to believe the economy is recovering before it faces the next election for the lower house of Parliament (which must be held by fall 2000, but could be called earlier if the LDP chooses). However, an upbeat view of the economic situation and of bilateral economic relations would be misleading.
The Japanese economy may not be stabilized. True, the two stimulus packages are now providing some oomph. But much of the government’s increased spending goes to public works projects of dubious economic value and props up a very inefficient and corrupt construction industry. Such stimulus may not kick the economy into a self-generating recovery. More importantly, additional fiscal stimulus now has pushed the government deficit to a high level. The consolidated government deficit will probably reach 7 percent of GDP this year, up from 4 percent in 1996, and outstanding debt will exceed 100 percent of GDP. While the debt and deficit level won’t lead to imminent disaster, prudence may make the government reluctant to widen the deficit, and U.S. Treasury officials may concur. Japan may lack usable macroeconomic policy tools to keep the economy from sliding by this fall.
Significant evidence supports the view that the economy has failed to recover. Most private sector forecasts for fiscal year 1999 are gloomy (averaging around -0.5 percent, with The World Bank recently announcing a -0.9 percent forecast). Corporations report significant amounts of surplus labor–workers they would eliminate if they did not feel bound by implicit lifetime employment practices. Should commitment to maintaining surplus employment weaken in the face of further deterioration of corporate profits, unemployment could easily jump, causing a slowdown in consumer spending. Unemployment already is at 4.6 percent, up a full percentage point during the past year, and at its highest level in the post World War II period. Economists have forecast possible double-digit levels of unemployment within a year. Worried about possible joblessness, households have cut back on major purchases. Both housing starts and automobile purchases are continuing to fall each month. Corporations are operating with considerable excess capacity, suggesting that plant and equipment investment will continue to remain flat. Companies also are maintaining high inventory levels, suggesting that production must fall further before the levels decline enough to spark a production recovery. And with banks preoccupied with improving their balance sheets, total bank lending continues to shrink at about a 4 percent annual rate.
While bad bank debt is better controlled than it was a year ago, the situation is still serious and could deteriorate. The two most notorious examples of insolvent banks have been nationalized, but the clean-up process remains opaque, with allegations of continued lending for political purposes to borrowers of questionable credit-worthiness. Most private sector analysts believe other insolvent banks exist, but the government has moved against only one other small bank. This timid approach contrasts with the RTC’s vigor in the United States, and is not an encouraging sign. Meanwhile, the recapitalization of weak banks has been decidedly modest relative to the level most economists think will be necessary to repair balance sheets. More important, restructuring plans announced as the quid pro quo for recapitalization funds have focused on downsizing rather than on changing management behavior. Banks got into serious financial trouble by making imprudent, unethical, and illegal loans. Closing branches or withdrawing from international lending will not address the structural problems in management decision-making that led to these mistakes. Despite restructuring efforts, banks will face additional non-performing loans if the overall economy continues to decline.
Pressures to maintain lending to politically favored businesses continue. With commercial banks often balking at supplying credit to medium and small businesses, government institutions are now relieving the credit crunch. But this credit distribution delays or prevents important economic restructuring. In order for economies to emerge from recession in a healthy fashion, governments must initiate a Darwinian process of weeding out inefficient companies. But Japan lacks sufficient vigor for this culling.
In the United States, trade frustrations mount. The Bush and Clinton administrations made modest progress in the 1990s in reducing access barriers. Some progress on deregulation, plus recent economic distress in Japan, also has opened the way for some foreign firms in some industries to make corporate acquisitions in Japan that would have been unthinkable just a few years ago. Their ability to buy Japanese firms may improve market access somewhat, but the reality is that a number of vexing trade issues remain on the table. When the automobile negotiations ended without actually invoking punitive retaliatory tariffs on American imports of luxury cars from Japan, the government concluded that the Clinton administration lacks commitment to its tough bargaining stance. Progress has slowed to a crawl on many issues of access to Japanese markets.
These trade issues influence the larger picture of Japanese economic performance. The economic malaise of the 1990s stems from macroeconomic factors–the rise and collapse of the speculative bubble in real-estate and stock-market prices–and bungled macroeconomic policies. But by 1999, it is clear that part of the solution must be structural. Productive resources in Japan are misallocated, and a healthy recovery depends on the contraction of inefficient or bloated sectors, such as construction, and expansion of innovative new industries, such as information technology. To carry out such a restructuring, the economy critically needs deregulation, changes in corporate governance, restructuring of financial markets, improved accounting, and increased competitive pressures from foreign firms to force greater efficiency. American pressure aids restructuring by leading to deregulation and improved market access for foreign firms. Slow progress in negotiations will stall the Japanese economic recovery.
The Summit: A Step Toward Recovery
The U.S. government needs to pursue realistic objectives and craft realistic rhetoric about Japan’s economic potential. Over the past year, the United States has continuously called for Japan to lead the Asian recovery by restoring its own growth and acquiring more imports from the rest of Asia. But Japan cannot now achieve these goals. Under the best of circumstances, Japan will not return to growth until 2000, and many believe the turning point will be even further in the future. The reality is that the rest of Asia may recover without any improvement in Japan or assistance from rising exports to the Japanese market. Yes, the United States wants Japan to return to healthy growth. But unrealistic calls for Japan to be the engine of Asian expansion can only serve to create unnecessary frustration in Washington from unfulfilled expectations.
The president should politely but firmly reject, in public, the prime minister’s expected optimistic economic forecast. The Japanese government will be eager to point to American endorsement of the prime minister’s message in its campaign to reverse the public conception of a worsening economy and also to boost the political fortunes of the LDP. But real evidence, not an upbeat message, is needed to reverse public opinion. The Japanese government is attempting create a silk purse out of a sow’s ear, and Clinton should not be party to the deception. In public, Clinton’s message should be restrained, but in private, the president should warn the prime minister that his government is once again out of touch with reality.
Clinton also should press for accelerating action on the bad debt problem. Japan has taken the right steps–nationalizing two banks and providing a shot of modest recapitalization to others–but they remain insufficient and somewhat flawed. The danger will be that the recovery stagnates or the economy slides back toward crisis. Clinton should help keep the process moving forward through friendly and firm admonishments. The president must applaud Japan’s positive actions, but he still can make the case for a more vigorous approach.
Deregulation and market access deserve a prominent role in the discussions, especially because the government now faces limits on fiscal stimulus because of the large deficit. Reviving economic growth should remain a key American policy goal, but this goal can and should be folded into our trade agenda. If trade issues are not given high visibility during the summit, the Japanese government and media will assume that the United States is satisfied with the past several years’ diminished pace of progress. The U.S. government commands limited tools for advancing its trade agenda with Japan. The WTO is not appropriate or helpful in all cases, and unilateral retaliatory action is problematical under WTO rules. Nevertheless, raising issues at the summit remains a means of signaling the intensity of American concern, and the president can make a strong case that the American trade agenda will help Japan, and not just boost American firms.
Obviously the president and prime minister should and will discuss a wide range of bilateral and global issues, including North Korea, Iraq, and Kosovo. But the meeting should focus on Japan’s economic woes and what needs to be done to address them. With the right policies, the Japanese economy will recover in another year or two; without policy changes, the danger of renewed financial crisis and sharper economic contraction remains. If the president does not press firmly on trade and related issues, the record of stalemate and inadequate progress will continue.