From the ashes: Richard Katz makes the case for Japan's revival.

JAPAN WEARS A CLOAK of gloom these days. The headlines dutifully report the latest corporate bankruptcy, the surge in crime, more suicides, growing unemployment, dropping wages ... who could possibly be betting on Japan making a comeback? Richard Katz, for one. Katz, author of Japanese Phoenix: The Long Road to Economic Revival, published late last year, predicts that the nation is well on the road to revival and sustained economic growth of 3 percent or more. But Katz is no cheerleader--his previous book, published in 1998, was entitled Japan: The System That Soured--The Rise and Fall of the Japan Economic Miracle. Katz is also editor-in-chief of the Oriental Economist Report, a monthly newsletter on Japan, and special correspondent for Weekly Toyo Keizai, a leading business magazine. Reporter Takehiko Kambayashi caught up with Katz to find out what was behind the optimistic title of his new book.

What factors in Japan make you believe that the country will eventually reform and revive? And what are the obstacles?

The positive side is that Japan does not have the feel of a failed state. There are so many Japanese people, particularly in their 40s and 50s, who are very smart, very ambitious, very talented and clearly capable of leading a new Japan. They are in business, they are in media, they are in academia and they are in bureaucracy, in many different institutions. But what they lack is a coherent institution to be the vehicle for reform. And they lack a very clear program for reform. Even reformers actually disagree among themselves as to what reform should look like. Should you focus on banking programs first, or budget deficit first? So it takes time to build up all of these things. I don't think the LDP (the Liberal Democratic Party) could be the vehicle for reform. You need a different political realignment.

You also have many people who lose their jobs in the process of reform. The social safety net in Japan is very weak. But the problem is what happens in the absence of reform. There are some people who think reform is destabilizing. But the failure to reform is even more destabilizing. Japan's social and political stability requires growth. When you don't have growth, companies can't pay their bills. Yes, initially, rapid reform would mean fast-rising unemployment. But eventually it will come down and not go as high. If you just delay reform, the unemployment rate goes up more slowly, but stays high for longer--the real unemployment rate is not 5.5 percent, but 8.0 percent.

The LDP has always been ruled by a coalition that includes just about everybody. And if there's growth, you can give everybody something. But if there is no growth, you cannot help one group without hurting another group. So the urban dwellers want cheap food imports from China, and farmers want to stop those cheap imports. And if you cut interest rates to zero to save the banks and their borrowers, life insurance companies go bankrupt, pension funds go bankrupt and elderly savers cannot get any income on their savings. So you cannot really have a very cohesive political society without growth. There are some countries, maybe like Switzerland, that can have low growth for many years and can still be stable, but not Japan. Japan's social systems, seniority wages, high debts, aging all of these require good growth to keep the system alive. So there is no stable alternative to reform. You have the people who know how to lead a new Japan. But I would say they lack the institutions, lack the clear program. It takes time to build. It will take them 10 more years, and Japan will succeed.

Japanese leaders have pledged to reform for more than a decade. Yet they have failed to deliver over and over again.

Mikhail Gorbachev was a very sincere reformer. But even with Gorbachev, the Communist Party in the Soviet Union could not be the vehicle for reform. So even Mr. Koizumi--who I think is a very sincere reformer--cannot make the LDP the vehicle for reform. Why? Because many parts of the LDP, like construction, farming, et cetera, would be hurt by reform. So the LDP tries to go both ways, talks about reform, but doesn't really do very much. That's why I think the LDP will eventually split. It cannot really survive because it's too unstable. Secondly, no society wants to go through very difficult reform if it can avoid it. And for many years, Japan's leaders, and also some very smart economists claimed falsely that Japan did not need reform. Japan could solve its problems by building bridges to nowhere or just by declaring an inflation target.

If you are a Japanese worker in construction of a farmer or a bank borrower, wouldn't you rather say, "Oh, let's not kill off the zombie companies! Let's just declare an inflation target! Solve the problem that way--it's much nicer than reform."

People test easy paths before they accept of need more difficult ones. That's very natural in any country. But Japan is the only industrialized democracy that is still basically a one-party democracy. And it's very difficult for a one-party democracy to change. You need competition in politics to have change.

When I talk to many consumers, they say prices are still very high, while Japanese leaders and pundits are wondering why the country cannot break out of its deflationary spiral. What can you tell us from contradictions like this?

It's very, very interesting. Yes, prices are very high. This is one of the things that suppresses consumption. For example, Japanese households spend 23 percent of their budget on food. In America, households spend 10 percent on food. Food prices in Japan are too high because of a lack of cheap imports, because of the protection of farmers, because the food processing industry is so inefficient. So actually bringing down food prices, if you did it through more competition, would free up money to be spent on other items and really help consumer demand. So that's what they call a kind of "good deflation"--prices come down due to more competition and more efficiency. But the majority of what Japan has is so-called "bad deflation," and what this means is that prices are coming down not because of good reform that improves purchasing power but rather because of weak demand. Now partly this really serves the unraveling of the old system. High prices are a kind of subsidy flora Japan's consumers to inefficient companies and also from efficient companies to inefficient ones. Toyota, for example, pays high prices for steel and glass. But if demand is weak, then the prices cannot be kept high. The problem is not the fever. The problem is the flu. The fever is just a symptom. So in Japan's case, deflation is not a problem. Deflation is just a symptom of the problem of weak demand.

It's an illusion to say, "Oh, we will increase prices. That will restore demand." It's backward. If you restore demand, that will fight deflation. They should have coupled zero interest rates with a tax cut. Instead, the government raised taxes. Even this year, Mr. Koizumi says he's cutting taxes, but he is cutting taxes on companies that won't really spend the money. If a car company has 30 percent too much capacity, it's not going to use the tax cut to build a new factory. But while cutting taxes on companies, they are raising taxes on consumers--higher health premiums, higher pension premiums, liquor taxes, tobacco taxes, all kinds of taxes.

Will foreign buyout funds play a role in Japan's recovery?

I think they will. I think the foreign role is very critical in Japan's recovery. I think what Japan needs is not gaiatsu (external pressure) but naigaiatsu, which is the combination of naiatsu (internal pressure) and gaiatsu. There is a difference between being a vulture fund and being what we call a "Florence Nightingale fund." Florence Nightingale funds are genuine rescue funds, or turnaround funds. They buy up companies to reorganize them and help them survive and recover.

One more important thing is that foreigners can break the rules. And when they do, Japanese accept it. For example, if a Japanese manager had tried to do exactly what Carlos Ghosn was doing, the workers and managers in Nissan would not have accepted it. But because of Carlos Ghosn, they did accept it. But now that Carlos Ghosn can do it, then Japanese should be able to do it.

Are you worried that the US focus on North Korea will adversely affect Japan?

The US real]y needs to work with Japan, China and South Korea together to deal with the North Korea problem. It has to be firm but flexible. I think the Korean situation is very dangerous. Now if the Korean situation is resolved peacefully, that's fine. But if it becomes hostile, that changes everything.

If Japanese politics becomes dominated by security issues like North Korea, then it may be organized between who wants a strong stance and who wants a weak stance. People who agree on a strong stance may also be opposed to reform. Who are the Japanese reformers allying with? Other reformers who agree on economic reform or others who agree on security policy?

How big is the opportunity in China for Japanese companies? How can they take advantage of it?

I know a lot of people think of China as a threat. But I think of it as an opportunity in a couple of different ways. One is that countries that trade more and have more ratio of total trade--export and import--to GDP tend to grow faster because the competition from other countries forced them to become more competitive. Imports from China improve the efficiency of Japanese companies, which have to compete with Chinese companies. It will lower the costs of many items, which will help consumer demand. China is not only an export superpower but also an import superpower. The ratio of, for example, manufacturing imports to GDP, is actually much higher in China than in Japan. China runs trade deficits with many countries in Asia. So China's trade patterns have been very different from those of Japan. As China's economy grows, its exports grow and its imports will too. So China could become a very good market for Japanese companies.

AN EXCERPT FROM RICHARD

Katz's Japanese Phoenix: The Long Road to Economic Revival.

A half century ago, Japan picked itself up flora the ashes of war and within a few short years stunned the world with its economic achievements. It will do so again. Japan will reform and revive. When it does, its economic achievements will once again earn the world's admiration. Once again its per capita GDP will grow faster than that of the United States. Its information technology revolution will prove even greater than America's--precisely because all the waste and inefficiencies eliminated by IT are greater in Japan. As Japan brings its inefficient industries up to world benchmarks, sustained growth of 3 percent, perhaps more, is within reach.

That's the good news.

The bad news is that it will take 10 more years to reach this promised land. And the road will be very bumpy. The renewed recession and banking troubles that began in 2001 are some of those bumps. So was the grassroots revolt that led to the ascension of reformist Prime Minister Junichiro Koizumi in 2001.

Why 10 years?

The Long and Bumpy Road to Revival

So deep-seated are Japan's dysfunctions that even if it did everything right today, it would take five years for this to show up in truly vibrant growth.

But Japan will not do everything right today. Opposition to reform is equally deep-seated. A myriad of vested interests and millions of jobs are at stake. Nor is Japan divided clearly between the parties of reform and resistance. Rather, each party and ministry and firm is divided between reformers and resisters.

Japan's dilemma is that the obstacles to growth are woven into the very fabric of its political economy. Years of corporate collusion and protective regulations have steadily eaten away at productivity growth, making it impossible for an unreformed Japan to grow faster than 1.25 to 1.5 percent a year, even at full capacity. High prices and negligible interest rates suppress real household income and thus purchasing power. It has become impossible for Japan to attain full capacity despite years of enormous budget deficits and zero interest rates.

Japan Is Not Argentina

In January 2002 a new joke started making the rounds of Tokyo: What is the difference between Japan and Argentina? Answer: two years. The same month, John Makin, a well-connected economist at the American Enterprise Institute, in an essay entitled "Japan in Depression," predicted an imminent "failure of the banking system ... [and a] full-scale 'run' on the banks." Forbes magazine, whose cover only a few years earlier had exhorted its readers to buy Japanese stocks "before it's too late," now warned that "Japan's economic crisis ... might drag the world into Depression." In May 2002, Adam Posen of the Institute for International Economics raised the alarm that, "the Japanese economy is likely to tumble into crisis sometime before the Diet's supplemental budget process begins in September 2002." This follows Posen's failed March 2001 forecast that financial breakdown, complete with capital flight and possible bank runs, were "almost inevitable in Japan this year [2001]." Many forecasters warned, despite all the evidence to the contrary, that bank runs would ensue 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's dangerous. Fear of meltdown paralyzes the hand of reform. Even reformers fear that pulling on a few threads risks causing the entire tapestry to unravel. Daiei was bailed out in part because officials and newspapers warned that its failure could cause the entire banking system to collapse. Yet its debt to the big banks amounted to just 0.8 percent of their total loans.

More fundamentally, there is a huge difference between Japan, on the one hand, and countries such as South Korea and Argentina, which suffered genuine implosion. These countries all tan big trade deficits. When the foreigners pulled their money out, the oil and spare parts stopped coming in. Factories shut down. People were thrown on the street. 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 just enough to stave off disaster, but never enough to solve the underlying malady.

In the end, Japan will act--once the pain of inaction surpasses the pain of action. Until then, the real danger in Japan is not cataclysm but relentless corrosion. Not meltdown, but the paralyzing fear of meltdown.

Conservative Revolutionaries

There are those who say Japan will never reform because it will never accept an "American model" unsuited to Japanese values. This identification of reform with "Americanization" is fanned by the opponents of reform. Yet it reflects some real fears in the population.

But this fear is not insurmountable because it is not soundly based. So many of the institutions and practices that are normally regarded as the embodiment of ancient Japanese culture and values are, in fact, political constructs of rather recent vintage. From "lifetime employment' to bank-centered finance to the cartels run by industry associations, many of Japan's institutions are products of the fight against the Depression, then mobilization for war, and finally post World War II mobilization for revival. Time and again new wine was put in bottles with very old labels to give them authenticity. Reform does not mean becoming more "American." It means becoming a different kind of Japan, one that, in certain ways, resembles an earlier Japan.

Perhaps reformers need to learn the same trick as the resistance: to link needed changes to preservation of what is valuable in traditional values. Japan's communitarian values are admirable. The only problem is the way that these values are implemented. Japan can provide for all its citizens and still have growth. Security can be achieved with a social safety net and fluid labor markets rather than the preservation of unproductive jobs. Egalitarianism can be pursued with redistributive taxes rather than distorted prices.

Yes, Japan's people have been acculturated to be more risk-averse than Americans. And for three decades Japan sacrificed efficiency in the name of security. But the result is that they have ended up with neither. Today efficiency is not the alternative to security but its indispensable prerequisite.

Often, very revolutionary changes occur for very conservative motivations. Japan will reform not because people want changes--though some, such as young, educated women, do--but because people want to hold on to what they now feel entitled to. Consider a baby boomer born in 1945 of so. Having seen real hunger as a child, and now grown accustomed to affluence, he or she finds it being snatched away. Baby boomers who never expected to be the main support for their parents now must do so because of the pension crisis. They never expected their grown children would be jobless and living at home--not after the time and money invested in "cram schools" to get them into the best colleges. But with youth unemployment at 10 percent, that is the case for millions of families. Those seeking rather modest ends will find that far-reaching change is required to achieve them. Were Japan's political-economic system capable of incremental adaptation and reform, this would not be so. Since it isn't, thorough political-economic overhaul is needed just to regain what used to be the status quo.

Skeptics retort: Japan has already fritted away a whole decade. Why should the future be any different? But no society puts itself through wrenching transformation until it has exhausted all other alternatives. And for years many of "the best and brightest" macroeconomists claimed that such alternatives existed: just spend and/or print enough money.

Finally, events have persuaded the majority of the Japanese people and elite that without reform the situation can only get worse. But there is not yet consensus among reformers on the content of reform. The task now is to reach consensus and to create the institutional vehicles to bring it about.

* TAKEHIKO KAMBAYASHI (From The Ashes, page 43) is a Tokyo-based freelance writer whose work has appeared in The Washington Times and The Christian Science Monitor. He studied journalism at the University of Mississippi and authored Mississippi: Contradictions of Life in America (published in Japanese) about his experiences in the deep south of the US, where he was fascinated to discover many similarities to his native Japan. He has held many jobs (butcher, truck driver, English teacher, sommelier and a waiter serving Japan's Prime Ministers and the Imperial family, to name a few) and continues to write about the nexus of business and cultures.