HOW I WOULD SAVE JAPAN: CREATE SAMURAI INVESTORS

As evidenced by the ruling party’s defeat in the recent upper house elections, the reputation of Japan’s politicians and bureaucrats appears to be declining even faster than the nation’s economy. Indeed, for international investors the question has changed from “Can they finally get their act together?” to “Is their incredible bungling going to sink all our boats?”

As the Japanese appeared paralyzed this spring, unable to even pass legislation enacting their previously announced 17 trillion yen ($120 billion) stimulus package, the yen sank and Fed Chairman Alan Greenspan and Treasury Secretary Robert Rubin began contemplating post-Chinese devaluation scenarios — and did not like what they were seeing.

This led Mr. Rubin — who earlier had said publicly he would not intervene to support the yen — to intervene with the Bank of Japan to the tune of $6 billion to prop up the Japanese currency at a point when most of the world’s currency traders were short the yen. This led in turn to a 5% fall in the dollar vs. the yen in two days, and to screams of pain from any number of hedge fund currency jockeys. In short, good, clean fun was had by all.

What is not entirely clear is whether the event had any point, or whether it merely was the last totally honest member of the Clinton administration deciding to mislead the public just to be one of the boys. For as even Mr. Rubin admitted, currency intervention is a waste of time unless it reflects a change in underlying fundamentals — in this case, the Japanese government coming to grips with the ongoing economic crisis and taking corrective steps.

As for a change in Japanese policy, that seems as elusive as ever. The stimulus package is making its way slowly through the legislature, though no one is exactly sure any longer whether it will have the slightest positive effect. The decline in consumer confidence that is rapidly leading to a larger implosion of the Japanese economy is caused by a crisis of confidence at the household level, in large measure due to a rise in unemployment to new postwar highs.

The Japanese economy and bureaucracy need restructuring, not new construction as envisioned in the stimulus package. Japan, which has the slowest population growth in the developed world, already spends just under 9% of gross domestic product on public works — by far the highest percentage in the Western world. The United States, by comparison, allocates roughly 3.7% of GDP to such expenditures.

And what is Japan getting for its billions in public works spending? A particularly revealing example was described in a Wall Street Journal opinion piece shortly after the stimulus package was announced. It described the closure of the “special service” railroad between the city of Osaka and Kansai International Airport. In two years of operation, the railroad — which cost more than $100 million to build and subsequently incurred $61 million in operating losses — carried a total of 300 people , an average of one person every other day.

Any casual visitor to Japan will see examples of construction projects that seem utterly idiotic — bridges from nowhere to nowhere, train stations that the inter-city trains never seem to stop at, etc. My favorite example is an eight-lane highway on the northwest coast of Kyushu that carries no traffic at all — it’s not connected to the highway system — but does manage to pave over the oldest archaeological site in Japan, one that indicates the original settlers of Japan arrived on the islands from Korea. That was a historical legacy the Japanese could live without exploring.

The problem at this point is that Japan, by delaying so long in undertaking the necessary reform of its economic system, is now subject to two massive and completely separate problems. The dilemma for the government: Fixing either one at this point is likely to make the other considerably worse. Either choice is likely to be destabilizing for the rest of Asia, and perhaps for the United States as well.

The first problem, the “liquidity trap,” has been written about extensively in recent months. Put simply, the problem is that Japanese banks, in order to meet minimum capital requirements, are having to shrink their balance sheets as they recognize bad loans on their books. The only real way for a bank to shrink its balance sheet is to reduce the number of loans outstanding. As banks make fewer loans and call in existing loans, weaker borrowers are forced to the wall and the loans become bad, thus restarting the downward cycle. It was such a liquidity trap in the 1930s that gave us bread lines and Shirley Temple movies.

The second problem is more subtle, but well within the normal expectations of Economics 101. The governing Liberal Democratic Party has spent a great deal of time over the past several years bringing home to the citizenry that the demographic trends of an aging population mean the national balance sheet is extremely precarious. So precarious, that in 1997, when the economy was showing the first signs of economic recovery, the LDP put through a series of tax increases that effectively killed the recovery in its cradle.

The psychological effect of the tax increases has subsequently been magnified in the minds of most Japanese by a sharp increase in the rate of unemployment to a postwar high of 4.7% (about 8% if calculated the way the Commerce Department counts unemployment in the United States). This is partly due to the liquidity trap, as small and midsize employers, who lack significant clout with their lenders, go under.

The aspect of lifetime employment has always been wildly exaggerated in Western descriptions of Japan. For every salaryman with a virtual guarantee of a job for life there are 20 employees at subcontractors who could be — and are being — fired at will.

Rising job insecurity combined with long-term fears of unpaid or sharply reduced pensions as society ages has led the Japanese — already world-class savers — to establish new levels of austerity. Retail spending has fallen every month for more than a year. The psychology is so bad among individual Japanese that the one anticipated silver lining — increased bank deposits due to more saving — is not materializing.

Not only are the Japanese sending far more of their savings abroad than ever before, but distrust of the financial situation is so extreme that one of the fastest growing manufacturing sectors in the Japanese economy is the production of household safes.

Most of the advice Japan is receiving in this situation, from the likes of Mr. Rubin and Treasury Under Secretary Larry Summers, is to make the tax cuts in the last stimulus package permanent and to increase the pace of economic regulation. This is the economic equivalent of asking the Japanese to shoot themselves in the foot — something I can guarantee you the Japanese are perfectly capable of doing on their own.

Making tax cuts permanent will not increase the sense of economic well-being of a population that is worried about being laid off and not having an income to tax in the first place. Even worse, a thorough restructuring and opening of the Japanese economy will, long before it provides improvements in economic efficiency and new types of jobs, sharply increase the unemployment rate and government budget deficits, thus exacerbating the lack of confidence that is the root of the current crisis. It could well turn a contained, if deep, recession into a full-fledged depression. In this case, the Japanese are right to reject the advice they’re receiving — not that they themselves have a clue of what alternative might be tried.

One intriguing suggestion has come from Massachusetts Institute of Technology economist Paul Krugman. To him, the only way out of the liquidity trap that Japan faces is through engineered inflation — basically having the Bank of Japan turn on the monetary taps and not stopping or slowing until the economy recovers. The central bank would state from the beginning that the goal was not a mere pickup in economic activity, but rather a sharp reflotation of asset prices in the midst of a general reflation.

a short, sharp shock

Most economists reacted to Mr. Krugman’s prescription of inflation to fix the Japanese dilemma the way vampires react to bulbs of garlic, and on the face of it, it seems like a genuinely strange concept. Isn’t a government-sponsored asset bubble what got them in trouble in the first place? But the more I think about it, the sounder it seems, though I wouldn’t advocate it myself.

The advantage is that it solves the bank bad-debt problem and liquidity squeeze in a single stroke, makes credit easier to obtain (which would ease the increase in unemployment as business spending rises) and helps reduce the high savings rate as people front load spending to insulate themselves from the impact of rising inflation.

My only concern about the Krugman approach relates to its very audacity. The situation would have to be much worse for such a nuclear alternative to be attempted, for the simple reason that if it did not succeed there would be no Plan B. If such a dramatic reflation failed, the Japanese economy would be a basket case for decades, and the result could well be a global depression whose end would be difficult to foresee.

But I do think that Mr. Krugman has his finger on the central issue, at least to a much greater extent than officials of the Clinton administration. The issue is how do you break the liquidity trap without aggravating the sense of economic unease among consumers? You could simply bail out the banks, but that would get you nowhere in the medium term. It would cancel the next source of serious job layoffs, but in itself would do nothing to stimulate borrowing or investment.

The key is to mobilize the greatest asset pool in the world — Japan’s private household savings. A way has to be found to move money from passbook savings (which pay a laughable 30 basis points return to savers) into the property and equity markets. This alone, if enough money were moved, would refloat much of the Japanese financial system.

his object all sublime

To me, the obvious solution is incentives, paid through the tax system. Rather than simply give income tax cuts as recommended by Westerners — which the Japanese would promptly save — I would tier the taxes paid on various forms of income. For example, if the proceeds from property rental were taxed at a minimal rate — say 5% — overnight the value of all property would rise significantly. The same impact could be achieved by eliminating taxation of stock dividends while increasing taxes on passbook savings interest.

It’s important to remember the magnitude implicit in some of these changes — the Tokyo stock exchange dividend yield is already higher than the government 10-year bond yield. If a change in tax laws did no more than force the two into yield parity, the Nikkei could easily rise significantly from current levels.

Such a reflation of Japanese equity and property prices would also go a long way toward solving the economic crisis in the rest of Asia. First, it would inevitably cause an increase in the value of the yen vs. the dollar, thus making it easier for other Asian countries to increase their exports to the West. It would also, in the medium term, restore Japan as a buyer and investor in Southeast Asia, radically shortening the period of recovery in Asia. Absent a revived Japan, the length of that recovery period figures to be somewhere between a decade and never.

Of course, like all solutions, the one outlined above comes with a problem, and one that is particularly unpleasant for those enjoying the current bull market. A precondition for a dramatic recovery in Japan and Asia is an equally dramatic change in the underlying conditions of the present prosperity, particularly in the United States.

And the reason is fairly simple. While the United States has had a tremendous spurt of non-inflationary growth since 1991, we have not significantly increased our savings rate. In fact, the percentage of debt held by foreigners — particularly the Japanese — has increased in recent years and appears to be accelerating once again. At the same time, our merchandise trade deficit is starting to look like the plot of a disaster film.

A sharp reversal in current Japanese policy towards reflating the economy will inevitably lead to a sale of overseas liquid assets, such as U.S. Treasurys, to finance the domestic expansion. This would not only lead to a sharp rise in interest rates as we Americans increasingly financed our accumulated national debt from our own meager pool of savings, but possibly to an increase in the dollar against all other currencies, with the possible exception of the yen. That would be almost as brutal a blow as rising interest rates. Despite all the “New Paradigm” nonsense, by some estimates 90% of the improvement in the United States’ competitive position over the past decade is solely due to a lower currency in the wake of a 1985 accord to reduce the value of the dollar vs. other major economies.

With the situation verging on critical, I’m taking a bullish stance on the Nikkei vs. the Standard & Poor’s 500 stock index. (From a bottom-up standpoint, though, I’d still be extremely cautious — current-year earnings are still set to decline 60% to 70% across the board.) People who bet on rapid, logical change in Japan aren’t getting any wiser or richer: Lately we’ve only been getting older — much older.

Mr. Tyson is chief investment officer and managing director of Mastholm Asset Management, an institutional money management firm in Bellevue, Wash. This article first appeared in Mastholm’s newsletter, View from the Mast.