TEN YEARS TO RECOVERY
A half-century ago, Japan picked itself up from the ashes of war and, within a few years, stunned the world with its economic achievements. In all likelihood, it will do the same again. True, some analysts see muddling through and stagnation as Japan's future. Others even fear the financial system is headed for outright meltdown. But the most likely outcome is that Japan will reform and revive. And if it does so, bringing its host of inefficient sectors up to world benchmarks, it can achieve sustained growth of three percent a year, perhaps more.
Japan has already frittered away one decade, skeptics retort. Why should the next one be any different? Because no society puts itself through wrenching transformation until it has exhausted all other alternatives. And for years many of the best and brightest economists claimed that such alternatives existed: just spend more or print more money. As recently as the brief upturn of 1999-2000, many claimed these nostrums were already working; Japan's politicians and people preferred these consoling illusions. Only now have events persuaded the Japanese people that without reform the situation can only get worse. This new awareness was the force behind Prime Minister Junichiro Koizumi's election in 2001. The first step in solving a problem is admitting you have one.
Japan does not have the feel of a failed state. On the contrary, this is still the same nation that created the economic miracle of the 1950s and 1960s. The problem is that the institutions and practices forged to create that miracle still rule Japan -- and those obsolete institutions have turned into a political and economic straitjacket. Nonetheless, Japan abounds with bright, ambitious businesspeople, academics, and even bureaucrats who yearn to break out of those bindings. They are capable of leading the new Japan. What they lack is a clear economic program, critical mass, and an institution around which to coalesce. The good news is that with time, those too will come. The bad news is that it will probably take ten more years to reach this promised land. And the road from here to there will be very bumpy.
Why ten years? Japan's dysfunctions are so deep-seated that even if it did everything right today, it would take five years to achieve truly vibrant growth. But Japan will not do everything right today. Opposition to reform is equally deep-seated. A myriad of special interests and millions of jobs are at stake.
Japan's dilemma is that the obstacles to growth are woven into the very fabric of the nation's political economy. Decades of corporate collusion and protective regulations have steadily eaten away at productivity, limiting potential economic growth to around one percent a year, even at full capacity. Worse yet, Japan cannot even come close to full capacity despite enormous budget deficits and zero interest rates, because high prices suppress real household income and therefore consumer purchasing power.
Until the 1990s, "peaceful coexistence" between growth and Japan's structural flaws was possible. That is no longer the case. Japan's average annual growth since the spring of 1997 has been a negligible 0.3 percent. Manufacturing output is 10 percent below its 1991 peak. In a dramatic reversal, Japan's share of both global output and exports is shrinking for the first time in a century.
The catch is that the obstacles to growth are also pillars of the political system. Collusion, regulation, and bank loans to the uncreditworthy all serve as covert social safety nets in a country where only half the work force is covered by unemployment insurance. These practices shore up moribund firms and industries, sustaining millions of unnecessary jobs. High prices allow covert income redistribution from Japan's efficient sectors to the inefficient ones: for example, Toyota pays high prices for glass, electricity, and steel, and then passes on the cost to consumers. Furthermore, much of the support base of the ruling Liberal Democratic Party (LDP) -- as well as that of the opposition parties -- relies on such practices. Each party's base is divided between those who would benefit from reform and those who would be hurt by it. The same is true of many of the corporate-financial conglomerates known as keiretsu. The very things that make structural reform economically necessary also make it politically difficult.
Japan's economic crisis is thus a crisis of governance in both government and business. Revival will therefore require a fundamental overhaul of institutions. But even reformers disagree among themselves as to what constitutes reform. Defining the programs, reaching the intellectual consensus, and forming the necessary institutional coalition will take several more years.
REFORM OR ELSE
Still, there is little doubt that reform will eventually succeed, not least because Japan has no feasible alternative. Although reform destabilizes, in the long run the failure to reform is even more destabilizing. Undoubtedly, most of Japan's senior elite and much of the public would prefer to muddle through if only they could. But muddling through is not sustainable, as both the younger elite and the public are coming to recognize.
Everything that makes Japan's political economy stable depends on a certain minimum level of nominal and real growth. Take away that growth, and unbridgeable strains and conflicts of interest arise. The relief given to one interest group inevitably hurts another. Although some say that the "vested interests" will stop reform, these vested interests are no more unified than Karl Marx's capitalist class. Every passing day ushers in new conflicts: farmers versus urbanites, companies versus employees, banks versus insurance companies, young versus retirees, exporters versus domestic sectors, efficient versus inefficient.
Without growth, instabilities in one area inevitably spill over to the next. When sales stagnate, Japan's characteristic high corporate debt levels become unsustainable -- hence the country's intractable banking crisis. "Lifetime employment" and seniority wages -- boons during a boom -- turn into unbearable burdens when sales turn south. Compelled to cut labor costs, firms have slowly used attrition to eliminate 2.6 million jobs since 1997. They have replaced full-timers, who get large bonuses, pension plans, and other benefits, with part-timers who do not. Hence, with some brief interruptions, real wages per worker have been falling since 1997. Falling wages translate into anemic consumer spending, which means that profits decline even more than wages.
To keep money-losing borrowers and their banks afloat, Japan's central bank has kept overnight interest rates close to zero since 1995 and has driven the yield on ten-year government bonds down to around one percent. But those low yields make it impossible for life insurers and pension funds to pay old annuities with guaranteed returns of six percent. By late 2001, a half-dozen big insurers had gone bankrupt, and more than a hundred pension funds had closed. Meanwhile, low interest rates have reduced the net interest income of retirees and other savers by an amount equal to five percent of their total disposable income. No wonder consumer spending is so flat.
This blow to consumer income should have been offset by permanent tax cuts. Instead, in the name of supporting these retirees, the government imposed a consumption tax in 1989 and then raised it in 1997. The first time, the action cost the LDP its majority in the upper house of the Diet, a majority it has never regained. The second hike triggered the recession of 1997-98 and another big defeat in the 1998 upper house election.
Without better growth, the strains of aging can only get worse. Today there are five workers for every retiree. In 25 years there will be only two. Meanwhile, city dwellers rush to buy the newly available cheap imports of food and clothing from developing Asia. That preference hurts farmers and inefficient manufacturers, who then demand protection. How can the LDP appease the farmers, an indispensable base, without alienating city dwellers? Or vice versa?
The foundations of Japan's postwar political setup are buckling under these conflicts. The LDP's dominance has always rested on its ability to redistribute the fruits of growth to each of its narrow constituencies. That system has made Japan the only industrialized democracy that remains a one-party state. Except for two one-year interregnums, the LDP and its precursor parties have ruled Japan from 1945 to the present. The one-party system is, in turn, pivotal for the bureaucracy's excessive power. But in the absence of growth, the basis for single-party dominance has eroded.
Just as the Soviet Communist Party could not be the vehicle of reform, even with Mikhail Gorbachev at its head, neither can the LDP. If the party genuinely tried to reform itself and Japan, as Koizumi has partly attempted, it would tear itself apart. Yet failure to revive growth is already slowly rending the LDP. Paralyzed by this dilemma, the party wavers and waFFLes, pushing mild reforms one day, pulling back the next. There is growing disdain for the LDP among both the elites and the public.
The LDP has already split once, in 1993, causing it to temporarily lose power. Since then, it has been able to rule only through unstable coalitions with ever-changing sets of partners. It will sooner or later split again, perhaps as a consequence of Koizumi's rise. In all likelihood, the LDP's death throes will continue for several more years, primarily because there is not yet a group of opposition parties capable of displacing it in an election. The largest opposition party, Minshuto, is also paralyzed by conflicts of interest among its base constituencies. But LDP rule will collapse one day -- just like that of the Soviet Communist Party or the Italian Christian Democrats.
JAPAN IS NOT ARGENTINA
There are those who foresee neither reform nor muddling through, but meltdown. In early 2002, a new joke started making the rounds in Tokyo: What is the difference between Japan and Argentina? Answer: two years. Many forecasters warned of bank runs in the spring of 2002 when the government lifted full guarantees on all time deposits at the banks. It never happened.
All this alarmism is not only wrong, it is dangerous. Fear of meltdown paralyzes the hand of reform. A classic example came a year ago when Koizumi himself instructed banks to bail out the huge Daiei supermarket chain -- a retailing empire with $17 billion in debt and 100,000 employees. Daiei was given $3.2 billion in debt forgiveness. Koizumi urged bailout partly because officials convinced him that Daiei's failure would doom the entire banking system. Yet Daiei's debt to the big banks amounted to just 0.8 percent of their total loans. How could its failure have caused a collapse?
There is a huge difference between Japan and countries that suffered genuine implosions, such as South Korea and Argentina. These latter countries all ran big trade deficits. When the foreigners pulled their money out, the oil and spare parts stopped coming in. Factories shut down. None of that will happen in Japan because it is a net creditor. Tokyo has the capacity to suppress crisis by throwing a lot of money at the problem. And that is exactly what Tokyo has done: always enough to stave off disaster, but never enough to solve the underlying malady. The real danger ahead is not cataclysm but relentless corrosion -- not meltdown, but the paralyzing fear of meltdown.
TURBULENT REFORM PROCESS
As with Gorbachev, the rise of Koizumi represents the inevitable attempt of the current system to reform itself. Koizumi may yet succeed, but he cannot do so as head of the LDP. His only hope is to split the party, a course he has consistently rejected. Koizumi came to power when the LDP's grassroots urban machine, terrified of getting smashed in the 2001 elections for the upper house of the Diet, rebelled against the party leadership and made Koizumi LDP president. In the ensuing elections, Koizumi saved the party from humiliating defeat yet shored up the very factions in the Diet that oppose his reforms. Still, the immense popular enthusiasm that greeted his arrival means no one can any longer assert with confidence that the Japanese people are satisfied with muddling through.
Some see Koizumi's rise, recent financial reforms, and announcements of corporate restructuring as milestones in an incremental process. But reform will not happen this way. Rather, the coming decade will see a tumultuous battle between the forces of reform and resistance, complete with institutional upheaval. If the current institutions were capable of incremental reform, Japan would never have gotten into such trouble in the first place. Many banks and firms will not survive the process. Although many bureaucrats are joining the reform coalition, the bureaucracy as a whole will see much of its power shift to the Diet. Like the Christian Democrats, the LDP itself may disappear once it loses power and access to the public trough for any length of time.
ANOTHER DAY OLDER, DEEPER IN DEBT
The first step in reviving Japan is to cure the problem of nonperforming bank loans (npls). The government says that npls now total $430 billion, or 10 percent of GDP, but private analysts believe the real number is closer to 20 percent. Resolving these loans is a prerequisite for restoring growth for one simple reason: behind every bad loan stands a nonperforming borrower, or a "zombie." The majority are in sectors suffering from immense excess capacity and inefficiency. This excess capacity drags down new investment and growth. Moreover, just to survive, the bad debtors slash prices, forcing healthier companies to match them. This adds to downward pressure on wages and consumer spending. Keeping bad debtors alive turns marginal companies into losers and good companies into marginal ones. New bad debt keeps rising more quickly than old debt can be written off.
The lesson from other nations is clear. In the entire postwar period, only three other rich nations have suffered half-decades of zero growth or worse: Switzerland, Sweden, and Finland -- all in the early 1990s, when they, like Japan and the United States, suffered banking crises. None of these countries recovered until they tackled their banking woes.
With his September 2002 cabinet reshuFFLe, which made economist Heizo Takenaka the minister in charge of handling npls as well as fiscal policy, Koizumi opened up one of those rare windows of opportunity for reform. Takenaka understands that the bad debt problem must be solved for Japan to grow, and that nonperforming borrowers are the core issue.
Unfortunately, the initial measures released in October were a big disappointment. The banks and LDP barons successfully stonewalled Takenaka as Koizumi stood apart from the fray. One prominent LDP leader even castigated Takenaka as "nothing better than an agent for foreign vultures," i.e., foreign investors who supposedly plot to buy bankrupt Japanese banks and firms on the cheap. Still, Koizumi barely intervened. Unless the widespread negative reaction compels a reversal, yet another chance will have been squandered. Why is it so hard for even a reformist government to address the problem?
One obstacle is Koizumi's insistence on fiscal austerity. Japan cannot cut the budget and solve the npl problem at the same time. Dealing with bad debt will cost lots of money. The banks need a new capital injection, this time with more stringent conditions than in the failed effort of 1999. Unemployment compensation expenses, as well as spending on job placement and retraining, will soar as foreclosures eliminate at least three to four million jobs, not even counting multiplier effects. Finally, there must be a tax cut for consumers -- not companies -- to offset the depressive effects of rising bankruptcies and unemployment. Forced to pick his priorities, Koizumi has chosen budget cuts. That is the wrong choice, especially at a time when the economy is already so weak.
Why is Koizumi reprising known errors? Some of the motivation is economic: the sincere belief that a bloated state sector is Japan's chief economic defect. Moreover, Koizumi correctly recognizes that his predecessors abused public works as a substitute for reform.
However, much of the motivation is political. Koizumi believes few reforms can be implemented without first decimating the political power of the iron quadrangle of LDP politicians, public enterprises, bureaucrats, and construction firms who parasitize the economy. Much of what passes for fiscal reform is in fact an attack on the funding base of the old regime. But if public works are a problem, Koizumi could simply cut them while cutting consumer taxes even more. That way, he would not hand the antireform forces so much political ammunition. In any case, Koizumi appears to have missed what the credit rating agencies have always made clear: if the deficit is temporarily expanded for purposes that expand the tax base down the line, as solving the bad loan problem would do, it would in fact boost credit ratings.
If fiscal policy were the only impediment, however, it could be surmounted. Koizumi is already retreating a bit on that front. The far more serious obstacle is fear of bankruptcy, joblessness, and social dislocation in a nation where one's current job is one's primary safety net and labor markets are too rigid to deal with the newly unemployed. Bank loans to the uncreditworthy have made those redundant jobs possible. Even reformers fear that pulling on a few threads may unravel the entire tapestry. As long as the only choices offered are further delay or an uncushioned "hard landing," Japan will choose delay and bailouts every time. But the longer they wait, the higher the ultimate job losses.
How can policymakers and investors distinguish between more false promises and real action? They will know Tokyo is serious when it moves on beefing up unemployment compensation, launching a huge tax cut aimed at consumers and housing, and preparing the institutions needed to buy up and sell off the assets of nonperforming borrowers. So far, there is little or no progress on these vital fronts. Worse yet, there is sometimes action in the wrong direction -- for example, cuts in unemployment benefits. Eventually, though, Japan will have to bite the bullet. The issue will keep coming to the fore until it is tackled.
A TALE OF TWO ECONOMIES
Although fixing the npl problem is the indispensable first step, it is nonetheless only a first step. If nothing else were done, Japan would be back in the soup in a few years. Japan faces two obstacles to growth: a supply-side problem and a demand-side problem. The former is by far the much larger of the two.
From 1975 through 1990, Japan grew at 4 percent a year; economists estimated at the time that its long-term potential growth rate was 3.7 percent a year. Potential growth is a supply-side issue, a function of how fast labor and capital are growing and how fast society improves its efficiency in using its labor and capital. Had Japan kept growing at 3.7 percent, its GDP today would be 30 percent greater than it actually is. Yet GDP is operating "only" at 6 percent below its full capacity. So at best, fiscal and monetary demand stimulus could only address the 6 percent problem. What about the other 24 percent? Why is it that full-capacity potential growth has tumbled to only a bit more than 1 percent and is on track to descend to 0.5 percent potential growth by 2010?
The root problem is that there is not one Japan but two. Japan suffers from a unique "dual economy" -- a dysfunctional hybrid of super-efficient exporting industries and super-inefficient domestic sectors. Almost all of the exporting sectors owe their initial success to the promotion and protection provided by Japan's industrial policy during the 1950s and 1960s. But exporters could not rely on these aids forever. Facing the pressure of stiff competition overseas, producers of cars, electronics, and machinery developed some of the best technology and highest productivity in the world. Unfortunately, these efficient exporters and the efficient parts of the service sector total no more than 20 percent of the entire economy.
Meanwhile, most Japanese live and work in another Japan that is shielded from both imports and domestic competition. As Japan matured in the 1970s, catch-up economics became obsolescent. But in reaction to the oil crises of 1973 and 1979, Japan shifted from promoting future winners to protecting losers. Cheaper Korean steel was blocked, not by formal barriers but by cozy deals among steelmakers and their customers. Regulations aimed at protecting the inefficient were used to limit competition in sectors spanning half of GDP. Naturally, these permanent crutches atrophied the economy's muscles. In food processing, for example, Japan's productivity is at one-third of U.S. levels and falling further behind. Yet more people work in food processing than in automobile and steel manufacturing combined. Retail and wholesale trade, construction, finance, farming, materials industries, and most of the service sector trail almost as badly in productivity.
The dual economy was sustainable only so long as efficient exporters earned enough to prop up weak domestic sectors by paying high input prices. By the late 1980s, however, exporters unable to bear the burden fled offshore. Japan is on the verge of making more cars and electronics outside its borders than at home. As the efficient sectors fled, the productivity of the entire economy started being dragged down to the level of the stagnant ones.
Because the process was so gradual, no alarm bells went off. Besides, an extraordinarily high level of investment offset and thus hid the problem. By 1990, price-adjusted corporate investment hit an unprecedented 19 percent of GDP. But much of this investment had little lasting value. Instead, it left the twin pyramids of excess capacity and bad debt. Automakers can make 14 to 15 million vehicles a year, but not since 1993 have they sold even 11 million units, domestic sales and exports combined. Retailers kept expanding floor space at a six percent annual clip even after same-store sales started falling three percent a year. Eventually those misguided investments, combined with unending loans to the dark side of the dual economy, created Japan's bad debt problem. Once the 1980s bubble popped, such excess investment could no longer be sustained; investment today is ten percent below the 1991 peak. As a result, the consequences of inefficiency can no longer be offset, and growth has ground to a virtual halt.
The same structural defects are also at the heart of Japan's chronic deficiency of demand. Corporate collusion and misguided regulations not only sap productivity but also produce notoriously high consumer prices. Those high prices, in turn, suppress real household income and consumer demand. Once high prices are considered, total private-sector household income (primarily wages, interest, and dividends) is actually a smaller share of national income today than it was in 1980. Consumption as a share of GDP is lower than in other advanced economies -- not because households save too much but because they earn too little. It is excess saving by business, not households, that explains Japan's chronically weak demand. Japan never made the shift to consumer-led demand that other maturing countries did. The consequence is a kind of economic anorexia: Japan's inability to consume all that it produces. But if achieved, fiercer competition will not only improve supply-side efficiency but will also increase real purchasing power by lowering monopolistic prices.
If these structural defects have been around for so long, how did Japan manage to grow four percent a year during 1975-90?
It did so by stimulating demand through huge trade surpluses, mammoth budget deficits, and, during the late 1980s, cheap interest rates that temporarily fed private investment as a kind of disguised public works.
Today, Japan is like a patient that has abused antibiotics so much that they no longer pack their punch. Tokyo is applying more fiscal and monetary stimulus than ever yet getting less benefit than ever. The stimulus has surely prevented depression, but it cannot revive self-sustaining private growth. Why would auto or steel companies or retailers facing the burden of 30 percent excess equipment go even deeper into debt to build even more useless capacity just because interest rates are low or because the Bank of Japan promises inflation? Japan's intractable deflation is not the cause of weak demand and the debt crisis, but a symptom. Monetary measures alone cannot cure it.
Japan will never solve its chronic deficiency of demand until it shifts a greater share of national income to the consumer. For years, Japan has been trapped in a false debate between structural reform and macroeconomic stimulus. The reality is that neither works without the other. On the one hand, structural reform is needed not just to boost efficiency but to make macroeconomic stimulus more potent; as the International Monetary Fund points out, fixing the banking system is a precondition for restoring the efficacy of monetary stimulus. On the other hand, the initial depressive effects of structural reform are so severe that it cannot be implemented without a macroeconomic safety net. The question is whether demand stimulus is used as anesthesia to support the surgery of radical reform or as a narcotic to dull the pain. The LDP conservatives argue for narcotics but no surgery. Seeking to cut off the narcotics, Koizumi is also being stingy with the anesthesia.
THE THREE PERCENT HURDLE
With reform, a growth rate of three percent is within reach. This is possible because so many sectors lag so far behind that bringing them up to world benchmarks would yield huge results. Cutting the U.S.-Japan productivity gap in food processing in half over ten years, for example, would yield more than six percent annual productivity growth in that sector alone. If all of Japan's backward industries took 20 years to reach U.S. benchmarks, that improvement would add 1.5 percent a year to GDP growth. The precedent is the recent U.S. productivity boom, in which most improvement came not in high-tech but in old-economy sectors such as retail sales and banking.
Reforms would also bring huge benefits on the demand side. Currently Japanese spend 23 percent of their household budgets for food, compared to about 10 percent for Americans. Suppose food prices could be lowered, due to reduced subsidies, cheaper imports, and more competition. Think of all the money liberated to buy other items.
The difference to ordinary people is immense. At three percent per capita growth -- the rate Japan enjoyed between 1975 and 1990 -- living standards would double every 23 years. Children would live twice as well as their parents. The aging could be supported without crushing taxes. In contrast, at the 0.5 percent rate seen in the past decade, it takes 140 years for living standards to double. Worse yet, when the average is so low, many people actually see their living standards decline.
Some Japanese leaders claim they are already undertaking rapid reform. They point to the financial "Big Bang" (the liberalization of financial services that kicked off several years ago), corporate mergers and restructuring announcements, accounting reforms, deregulation, and similar actions. Critics say all this helter-skelter motion signifies little. The way to judge reform is to ask whether it truly addresses both obstacles to growth: supply-side inefficiency and demand-side anorexia. In truth, although many big reforms have been undertaken, every step forward is matched by two steps back.
Take the Big Bang. It could have been very helpful if it had been allowed to do its work. Unfortunately, whatever benefits it might have brought in allocating capital more efficiently and giving household savers a better return have been more than offset by other developments. Zero interest rates and blatant political pressure are used to keep banks rolling over loans to those who cannot pay. "Financial socialism" -- that is, the share of deposits and loans mediated by government bodies such as the postal savings system -- has soared to 45 percent and 35 percent, respectively.
In the corporate world, the vast majority of the mergers and acquisitions have been used to combine weak firms in troubled industries into even more powerful oligopolies. Examples include banking, paper, steel, gasoline, and chemicals. Price control, not efficiency, is the name of their game. Although there has been some genuine restructuring, it is mostly in industries that were already efficient, such as autos and electronics. Japan is witnessing the most restructuring where it is least urgent and the least reform where it is most urgent.
There are exceptions, to be sure. The wholesale sector has slimmed down quite a bit, and the textile sector has enjoyed the benefits of downsizing and outsourcing. Rates for long-distance phone calls have fallen dramatically due to regulatory reforms allowing new entrants. But so far such good news remains rare.
Japan cannot gain greater competitiveness without more competition. And yet both the Ministry of Economy, Trade, and Industry and the Japan Fair Trade Commission are backsliding on competition policy. Both have encouraged these oligopoly-strengthening corporate mergers. The jftc has even loosened the criteria for judging monopolistic bargaining power. Officials say that economies of scale are the key to competitiveness. Although that claim was true back in the 1950s and 1960s, today's competitive pressure is the dividing line between the dark and bright sides of the dual economy.
The sine qua non for successful reform is increasing globalization. If competing imports and foreign firms could reach critical mass on Japanese soil, then domestic anticompetitive practices would become unsustainable. Here the record is mixed. There has been a remarkable sea change on the foreign direct investment front. Renault's takeover and rehabilitation of Nissan is only the most publicized example. Foreign firms now manage 20 percent of privately managed pension funds and have achieved a 15 percent market share in life insurance, mainly through buyouts of Japanese firms. On the other hand, there has been little increase in competing imports. Virtually all of the growth in imports of manufactured goods has come from Japan's own overseas affiliates -- for example, Matsushita TVs made in Malaysia rather than Samsung TVs made in South Korea. Such captive imports neither challenge monopoly pricing nor compel corporate restructuring.
Some alleged reforms offer no reform at all. Koizumi's proposed tax "reform" would cut taxes on firms while raising them on households. Starting this spring, Tokyo will take another $20 billion a year in health and social security premiums out of the pockets of workers and their employers. This adds up to an effective permanent tax hike of 0.5 percent of GDP. Tokyo is planning to partially offset this by a temporary tax cut, but that is designed mostly to benefit companies, not consumers. At the same time, Tokyo is reducing the minimum threshold for paying income taxes. All these moves take money away from those most likely to spend and transfer it to those most likely to save. And then the politicians wonder why demand is so low and scapegoat the Bank of Japan. Tokyo claims it is moving in line with international norms. But Japan's problems are different -- the United States saves too little whereas Japan saves too much. Different problems require different solutions.
There are certainly plenty of possible tax reforms that could provide real help. Take real estate taxes. Today, there is no tax penalty for leaving property idle. The tax on holding property is infinitesimal, as low as 0.4 percent of the real market value. On the other hand, if a developer takes a risk and makes a profit, all the assorted taxes can take away the lion's share of the gain, sometimes as much as 80 percent. Reversing these perverse incentives could revive the real estate market, helping to solve the banking crisis. The one positive note in this area is a government proposal to reduce inheritance and gift taxes when the recipient uses the money to buy a home.
At present, the tax system gives incentives for interest income and capital gains at the expense of dividends. This is a mistake on both demand and efficiency grounds. One of the big reasons for excess and misguided investment is that moribund firms -- which often own each other's shares and therefore face little real investor power -- hoard cash. If they were impelled to pay dividends, the cash would flow to households, which could then either spend it or invest it in a better firm. This step would increase both investor power and consumer demand.
Given the limited nature of progress so far, what grounds are there for optimism over the long haul? One must look at the current phase as just the 2nd round of a 15-round battle. The forces of reform are still embryonic, but time is on their side. The task of the last decade was for Japan to realize that it needed to reform. That has now been accomplished. The task of the coming decade is to actually implement that reform. Eventually, once the pain of inaction surpasses the pain of action, Japan will act. If nothing is as powerful as an idea whose time has come, then the battle for reform has finally begun.
THE UNITED STATES IS NOT JAPAN
Is America retracing Japan's path of bubble and bust? It is extremely unlikely. The differences between the two countries are far more telling than the similarities. Indeed, it is very hard and unusual for rich countries to get into as much trouble as Japan has. Despite the weak nature of the current recovery, the United States will most likely grow at least three percent a year in the coming decade. In contrast, Japan's malaise was caused not by the 1980s bubble alone but by deeper problems of the dual economy and economic anorexia. For its part, the bubble was caused by three interrelated factors: outlandish stock and property prices, excessive bank lending tied to these asset prices, and excessive investment in physical capacity. With the exception of technology stock prices, the U.S. economy shares none of these features.
In Japan, the ratio of a stock's price to annual company earnings (the p/e ratio) for the 1,500 biggest companies soared from a reasonable average of 20 in the early 1980s to an unsustainable peak of 70 during the bubble. In the United States, bubble prices were primarily limited to technology stocks, where p/e ratios reached 47 in early 2000. The rest of the main companies listed on the Standard & Poors 500 Index peaked at a p/e ratio of 23.