Tales from the dark side: Divining the causes of Japan's economic nightmare. (Culture & Reviews).

Dogs and Demons: Tales front the Dark Side of Japan, by Alex Kerr, New York: Hill & Wang, 432 pages, $27

IN THE ANCIENT Chinese philosophical text Han Feizi, the emperor asks a painter which subjects are the hardest and easiest to depict. "Dogs and horses are difficult," the artist says. "Demons and goblins are easy." In other words, the simple, everyday things are hard to get right; it's much easier to come up with big, eye-catching monstrosities. Alex Kerr, a long-time resident of Japan and author of the acclaimed Lost Japan (1996) believes that nation suffers from a severe case of "dogs and demons." Thanks to ossified and inefficient financial and political institutions, Japan has created all manner of monstrous projects and fiscal outcomes while failing to create the conditions necessary for economic growth. The result: The country that inspired all manner of economic envy and inspiration in Americans 15 years ago now inspires something else.

"In field after field," he writes in his new book on Japan, Dogs and Demons, "the bureaucracy dreams up lavish monuments rather than attend to long-term underlying problems." Kerr traces these problems to both political and cultural sources. The first, familiar to economists from the public choice school of analysis, is the tendency of bureaucracies to expand and defend their turf. Government agencies keep on spending money, building new projects, and finding new excuses to continue long after their original purpose has faded.

But culture plays a major role, too, Kerr argues. Japanese are taught from birth not to question authority, to fit in with the group. That leaves bureaucrats without much serious opposition, and explains why Japan has failed to address problems that are behind an economic malaise that has lasted more than a decade. Kerr is pessimistic that Japan can change before things get much, much worse, With the United States now facing its own serious economic problems, it is worth looking at Japan once again, this time as an example of what to avoid.

At the heart of Japan's economic problems--stagnant growth and a growing irrelevance in the world economy--is a banking system that no longer works. The government says that Japanese banks have some $400 billion in bad loans on their books. Adjusting for the size of the economies, that would make Japan's debt problem four times worse than the U.S. savings-and-loan crisis of a decade ago. However, many economists believe that Japan's bad debts are actually far higher, and may total more than $1 trillion. (It's difficult to get a grasp on just how large the debt problem is because banks use all sorts of accounting tricks to mask bad loans.) Most--if not all--of Japan's banks are technically insolvent. They can't lend enough money to keep the economy growing. Even if they could, there just aren't enough good borrowers out there to make a difference.

How did Japan reach such a state? "Japan's financial system rests on bureaucratic fiat," Kerr writes. The system was set up to pump cheap capital into the business sector. Banks rarely called in bad loans; companies were encouraged to borrow and expand continuously. "A company would borrow against assets such as land, and then reinvest the money in the stock market. The market would rise, and thus the company would have 'latent profits' against which to borrow more money, with which to buy more land. And on to the next round," according to Kerr.

Those cycles created huge real estate and stock market bubbles. But those tends couldn't be sustained forever. The bubbles burst in 1989, after the Bank of Japan raised interest rates, slashing liquidity growth and making it impossible for banks to keep pushing money out the door. The crash left banks with a mountain of bad loans. But they didn't call those loans in-that would have meant liquidating companies (and admitting that the "asset" of those loans was in fact worthless, bringing the bank's solvency officially in question). In fact, they often continued to make loans to those very same companies, piling up more bad debts.

Why? The government was reluctant to push through the sort of housecleaning that the United States went through in its S&L crisis. The muchreviled Resolution Trust Corporation stripped bad assets from the books of S&Ls and liquidated them. At the same time, it pumped money into the system to bail out depositors at the failed S&Ls. But Kerr says there are deeper forces at work in Japan. "Traditionalists hold the hallowed word Wa (peace, or harmony) as Japan's ultimate ideal, even going so far as to use Wa as an alternate name for Japan itself," he writes.

In a nation where harmony is the supreme value, no one is willing to strike a discordant note. Banks are reluctant to call in bad loans. The government is reluctant to force them to. It's better to paper over the system and ignore problems than it is to call attention to them and fix them. In effect, the search for Wa ends up rationalizing a lot of inefficiency and outright corruption. Kerr reveals that some police departments actually have manuals detailing how to cover up embarrassing events.)

If the government isn't addressing the nation's economic woes, what is it doing? Well, for one thing, it is paving over most of the nation. Japan devotes 9 percent of its gross domestic product to public works. By contrast the United States spends just I percent of GDP on public works.

"The colossal subsidies flowing to construction mean that the combined national budget devotes an astounding 40 percent of expenditures to public works (versus 8 to 10 percent in the United States and 4 to 6 percent in Britain and France)," Kerr writes. Construction accounts for 10 percent of all Japanese jobs, more than double the share in the United States or Western Europe. What keeps the system going? Graft. Some 1 to 3 percent of the budget of each public works project gets kicked back to the politicians who arrange it. Nor is that the end of the corruption.

"The system works like this: the River Bureau of the Construction Ministry builds a dam, then hands its operation over to an agency called the Water Resources Public Corporation (WRPC), many of whose directors are retired officials of the River Bureau. The WRPC, in turn, with no open bidding, subcontracts the work to a company called Friends of the Rivers, a very profitable arrangement for the WRPC's directors, since they own 90 percent of the company's stock," Kerr writes.

The River Bureau has dammed or diverted all but three of the nation's 113 major rivers. The government has honeycombed mountains with thousands of miles of virtually unused highways. It has covered more than 6o percent of its coastline with cement. Government programs have caused almost half of Japan's woodlands to be cleared and replanted with a monoculture of cedar. The results of 50 years of a construction state, Kerr believes, are that "Japan has become arguably the world's ugliest country."

If the countryside has been laid waste, cities and towns are no more attractive. Cities small and large are dotted with ugly, unused cultural centers, concert hails, and museums. Japanese architects' political connections matter more than their skill. They no longer have to design buildings that either serve a function or please the eye of anyone other than the architect.

As a result, Japanese architecture is dominated by two schools: manga and massive. The latter is self-explanatory. Buildings impress by their sheer size. The manga style refers to Japan's comic books. Structures in this style are known for their curious shapes, odd materials, and garish colors. Lately, the two schools have begun to merge. While cities are rushing to build cultural centers no one will ever use, they are ignoring simple steps that could make Japanese cities more beautiful, such as burying power lines.

Wa, the culture of harmony, built the system, and is also the reason that the Japanese put up with the system. The first lesson Japanese school children learn, according to Kerr, is to move in unison. Literally. He writes that in Japanese kindergartens playtime is strictly regulated. The children do the same exercises, run in the same direction. Spontaneity is frowned upon.

The second lesson taught by Japanese schools is that it is a crime to be different. Kids routinely ostracize and haze those who are too bright or too dumb, too fat or too thin, too short or too tall. The hazings have even sometimes resulted in death. But it's all accepted, often encouraged, by authorities.

In terms of instruction, schools concentrate on rote memorization. This process produces literate, obedient people. But it doesn't produce a lot of creative, independent people, Kerr says. Japanese students "have not been taught analytical thinking, the ability to ask unusual or creative questions, a sense of brotherhood with the rest of mankind or curiosity about and love for the natural environment," he writes. These traits actually served Japan well, for a time. The nation set its mind on one goal--becoming an industrial powerhouse. The banking system funneled money to the great manufacturing concerns. The school system turned out millions of hard-working, obedient workers. But once this train was set in motion, it became impossible to stop or even to alter its course.

Institutions that should help correct Japan's problems don't seem to have much effect. Japan has a nominally free press, but the government and businesses restrict information by providing it only to members of tightly controlled press clubs. Reporters or media outlets that offend bureaucrats or top business officials run the risk of losing their access to any information.

Meanwhile, opposition politicians have little power to sway things. This is due partly to the fact that the Liberal Democratic Party has controlled the government for so long. Opposition parties just don't have much power to oppose change. Also aiding the seemingly unstoppable momentum of Japanese policies is the fact that elected politicians of any party have little influence over the bureaucrats. Politicians come and go, but the bureaucracies remain. And of course, Wa continues to be a strong cultural impediment toward speaking out or advocating big change.

Those are Lessons worth remembering as the United States lays in for a long "war on terror." All around us are calls for unity and bipartisanship and strengthening the hand of the Federal Bureau of Investigation, the Defense Department, the Central Intelligence Agency, and other government agencies. The Japanese system doesn't crush all individualists, of course. But those who survive the system often emigrate to other countries, where their open minds are more appreciated. Those individualists who stay find themselves marginalized.

"In spite of the pressure for conformity, there is a generation of adventurous young Japanese who are well aware of what will be needed to compete in the big wide world. The question is whether there will be enough of them to make a difference," Kerr writes.

Kerr's book went to press before Junichiro Koizumi became prime minister in April 2001. Koizumi promised sweeping reforms to jumpstart the economy. He took direct aim at the troubled banking system, promising to force banks to write off bad debt at last. It was the sort of plan that Western economists had long urged. Koizumi's popularity ratings were very high, and there was a great deal of hope that he could finally make the changes that Japan needs.

But Koizumi's popularity, it seems, was more predicated on his hairstyle, his clothes, and his general status as a maverick than on his specific proposals. He has had to battle members of his own party as well as the massive Japanese bureaucracy. Koizumi's reforms are stalled, perhaps already dead. Kerr is probably not surprised.

So what happens to Japan? It's still the world's second-largest economy. It still has a hard-working labor force. It could continue to muddle along for a long time. But the longer it goes without real economic growth, the less relevant Japan becomes and the less wealthy it becomes. In the 1930s, Argentina was one of the world's wealthiest nation. Decades of bad government policies reduced the country to Third World status. Perhaps a similar fate awaits a Japan already bedeviled by its demons.

Contributing Editor Charles Oliver writes for Investor's Business Daily.