Koizumi is blowing it: Japan's new prime minister squanders a chance to repair his country's economy.

The ascension of Junichiro Koizumi as prime minister has given Japan its best chance for genuine reform in years. This makes it doubly tragic that he is in great danger of flubbing the opportunity.

The problem is not Koizumi's sincerity. Like Mikhail Gorbachev, Koizumi is a product of the old regime, yet he genuinely understands how much Japan needs to change. But, like his Soviet counterpart, Koizumi faces two very large obstacles: his own political party and a tragically self-defeating economic strategy.

Like the Soviet Communist Party, Japan's ruling Liberal-Democratic Party (LDP) is incapable of being the vehicle of reform no matter who stands at its head. The LDP's social base is badly divided between those who would benefit from reform and those who would be hurt by it. Indeed, Koizumi came to power via a revolt by the LDP's grassroots urban machine against the more rural-oriented party leadership.

Ultimately, the process that put Koizumi in power may end up proving more important than anything he does. No longer can anyone claim that the Japanese voter is satisfied with muddling through. But the party barons have no intention of letting Koizumi succeed. Given his immense popularity, their daggers remain sheathed as they wait for recession to erode his support. For reform to succeed, the LDP will have to split again (see "LDP R.I.P" in the May/ June 2000 issue of The International Economy). The fight between Koizumi and the party bureaucrats could be the trigger for this split.

The LDP's civil war helps explain why Koizumi has chosen such a counterproductive economic strategy. Like Gorbachev before him, Koizumi is committing the tragic error of doing the right things in the wrong order. Koizumi is prioritizing budget cuts instead of eliminating the bad bank debt.

With Japan falling back into recession, this is the worst time for fiscal austerity. Yet, the small (2-3 trillion yen) supplementary budget now being considered is not enough to keep total government spending from falling from last fiscal year by an amount equal to at least 0.5 percent of GDP. Additional cuts of another 0.8 percent of GDP are planned for next year. This fiscal tourniquet would repeat 1997's horrendous blunder, when Tokyo raised taxes and sent the economy plunging. Once again, it associates reform with recession.

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 government spending as a substitute for reform and that this failed because fiscal stimulus alone cannot cure what ails Japan.

However, much of the motivation is political. The Koizumi camp believes few reforms can be implemented without first decimating the political power of reform's opponents, who are centered around the LDP's largest faction, the one led by former Prime Minister Ryutaro Hashimoto. Reducing public works, farm subsidies, and quasi-state enterprises all serve to cut the funding of vested interests and their LDP protectors. Much of what passes for fiscal reform is, in fact, an attack on the power structure of the old regime. While Koizumi's strategy is understandable, it is neither good economics nor good politics. If public works are a problem, switch to tax cuts. But why deepen the recession and give the LDP reactionaries more ammunition?

To make matters worse, Koizumi's actions on banking fall short of the bold campaign rhetoric that originally led to his election. He is sticking with his predecessor's plan for a limited write-off of bad debt: only 12,700 billion yen (US$100 billion) over the next two or three years. This is a small fraction of a problem now grown to 95,000 billion yen (US$766 billion)--almost 20 percent of GDP.

The dilemma for Koizumi is that he cannot cut the budget and solve the bad loan 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 the failed effort of 1999. Unemployment compensation expenses will soar as foreclosures eliminate at least three million jobs. Finally, there must be a tax cut for individuals--not companies--to offset the depressive effects of rising unemployment as well as the fact that years of near-zero interest rates have cut deeply into household interest income.

Forced to pick his priorities, Koizumi has chosen the budget. That is the wrong choice. The private economy cannot achieve self-sustaining recovery while it remains tied down by bad debt and bad debtors. Other reforms will be much harder to achieve without the foundation of private growth.

Nor can the budget deficit itself be cured without reviving private growth. Two-thirds of the growth in the deficit from 2 percent of GDP in 1990 to almost 8 percent of GDP in 2000 resulted from a drop in tax revenue; only one-third came from increased spending. The deficit is a symptom, not the underlying malady. Without a revival of the tax base, deficits will continue to expand.

The reason that solving the debt problem is a prerequisite for private sector recovery is this: Behind the bad debts stand the bad debtors, the majority in sectors suffering from immense excess capacity and inefficiency. This excess capacity is an anchor on new investment and growth. Moreover, just to survive, the bad debtors are slashing prices, forcing healthier companies to match them. This adds to deflationary pressure on wages and consumer spending. Keeping bad debtors alive turns good companies into marginal ones and marginal companies into deadbeats.

The result is that new bad debt keeps rising faster than old debt is written off. In the fiscal year that ended March 2001, official non-performing loans (NPLs) rose to yet another record high, 43.4 trillion yen (US$350 billion), almost 9 percent of GDP. And that's hardly the whole problem; 60 percent of firms going bankrupt last year were not on the NPL list.

Like his predecessors, Koizumi is pressuring the Bank of Japan to pull his chestnuts out of the fire--or, more precisely, pull a rabbit out of its hat. The BOJ's August 14 announcement of further ease was, in part, a response to this pressure.

The Koizumi team suffers the illusion that printing still more money will somehow overcome the depressive forces of excess capacity, bad debt and fiscal retrenchment. However, if monetary stimulus by itself had the power to revive private growth, then five years of near-zero interest rates should have done so already. The reality is that structural depressants have drained monetary stimulus of much of its usual punch. As economists at the International Monetary Fund rightly put it, "Policy measures to strengthen banks are a prerequisite to restoring the effectiveness of the monetary transmission mechanism." (1)

The chimera of a monetary magic bullet rests on the following chain of logic: 1) the BOJ can create inflation simply by declaring a target and printing lots of money; and 2) inflation will cause businesses and consumers to spend more. Both links in the chain fail. All the evidence shows that the BOJ's ability to create inflation depends on the state of the real economy. In normal periods like 1977-90, when the economy was operating around full capacity, hiking money supply growth clearly led to higher inflation down the road. By contrast, in the 1990's, when the economy was operating far below capacity, the link between money and inflation broke down.

Even big increases in money supply growth failed to affect the inflation rate. Instead, the ups and downs of inflation were far more dependent on the ups and downs of real GDP growth. The inflation faction has cause and effect backwards: It argues that inflation will promote growth, but it can't get the inflation unless it gets growth first. Ironically, the latter point is something that Paul Krugman himself used to stress before he changed his mind. (2)

But, suppose the BOJ could create inflation at will. This might depress consumer spending rather than elevate it. Inflation and negative real interest rates erode the real value of savings; they have a "negative wealth effect." To preserve their wealth, households have to save even more. Careful studies of Japanese savings behavior document this. Nor are companies already saddled with excess equipment likely to incur more debt to buy still more unneeded machinery just because the BOJ targets inflation.

Japan faces a long and difficult period of structural reform, of which debt clean-up is only the first step. Fiscal and monetary measures are indispensable to ease the dislocation during this transition. Stimulus and reform must be partners, not alternatives.

Instead, Japan has been trapped in a false choice. The traditional LDP approach was to spend and print money to avoid reform--neither pain nor gain. In reaction, Koizumi wants to remove fiscal stimulus while still avoiding the surgery needed to cut out bad debt and "bad borrowers." He offers pain without the gain.

In choosing Koizumi, Japan's voters showed they are willing to accept temporary hardship as the price of finally tackling Japan's structural woes. But they will not long tolerate a needless recession. If Koizumi persists on his current course, he will hand the LDP's anti-reform apparatchiks the weapon that they want to straitjacket or oust him.

(1) Post-Bubble Blues: How Japan Responded to the Asset Price Collapse, pg. 144.

(2) "What's Wrong With Japan," at http://web. mit. edu/krugman/www/nikkei.html.

Richard Katz is Senior Editor of The Oriental Economist Report and Author of Japan, The System That Soured (M.E. Sharpe, Inc., July 1998).