Japan's Distraction by Regional Economic Integration

It is very human to put off unpleasant tasks by pursuing less pressing matters, while daydreaming of far-off goals. Very human, but so doing is not usually an indicator either of progress on the tasks at hand or of meaningful commitment to the dream. The Japanese government's distraction into attempts at regional trade and monetary integration should be seen in this light. It is a sign of various bureaucratic elements' frustration with progress on domestic economic stagnation, and the decline in Japan's world role that has resulted. It offers few direct benefits to the Japanese economy, and has no meaningful medium-term implications for Japanese government behavior.

At least as importantly, the same interest groups currently blocking progress at home will also succeed in blocking any meaningful economic integration of Japan with Northeast Asia, unless they are defeated politically on the domestic front. If the latter occurs, the transformation of the Japanese economy, while ultimately beneficial, will be so absorbing that Japan is unlikely to bear the adjustment costs of integration on the terms that will be on offer. Moreover, such a transformation will radically increase Japan's financial ties to the United States and to Western Europe, while making Japan suddenly more threatening to China, both of which will also impede regional integration.

Japanese motivations and goals for regional economic integration: It is necessary to disaggregate the actors and their motivations in the Japanese context. Even the government bureaucracy is hardly unified. The Ministry of Foreign Affairs has obvious tactical and public-relations interests in presenting overall government policy as being more-or-less generally committed to integration, but this should not be taken at face value. There are actually several different strands within the political scene:

• The Ministry of Foreign Affairs has been casting about for some program to offer now that Japanese economic decline, US unilateralism, and the Asian financial crisis have combined to undermine Japanese soft power in the multilateral sphere. It also, like all diplomatic services, values "better relations" as an end unto itself. So MOFA wants to get whatever deals it can to make Japan look like it is leading some initiative and burying the past.
• The Ministry of Economy, Trade and Industry has been a minor player at best in domestic economic debates for several years, and has a diminished role in the WTO context. It also has a number of people genuinely committed to economic reform in Japan. METI's hope is to get bilateral trade and regional trade agreements that will induce restructuring and opening in declining Japanese sectors.
• The Ministry of Finance has long harbored ambitions for the use of the yen as a world currency, but recognizes that these are now completely unrealistic given Japan's fiscal situation. It desires to, at a minimum, stabilize capital flows in and out of Japan by some means. It also shares the (legitimate) general sense that there is an under-representation of Asian voices at the IMF and the World Bank, and the (unjustified) sense that had Japan been more involved the Asian crisis would have gone better. MOF's plan is to push for Asian monetary integration in order to stave off exchange rate conflicts with neighboring markets and to have a bargaining chip with the United States and European Union for voice at the IMF.
• The Prime Minister and the Diet would like to score some points abroad so as to distract the Japanese public from the problems at home. The Prime Minister in particular wants to be seen as building good relations with Korea and China, but also to satisfy his desire for a more assertive Japanese foreign policy. Economic integration is an occasional issue for them, but only as passing opportunities arise (much like the United States with regards to trade policy).
• Export-oriented businesses in Japan are primarily concerned with their ability to move investment and production abroad, both for efficiency's sake and to gain market access. Unfortunately, they are politically rather weak, which is why they have been exploited to pay for the rest of the Japanese economy. Their main concern therefore is simply to avoid disruptions in economic relations, particularly with China. Trade agreements could in theory help their bottom line, but would require major liberalizations, and would mostly result in the exporting of production back to Japan (a la Mexico to the United States post-NAFTA).
• Import-competing and non-traded businesses in Japan are also the primary interest groups blocking domestic reform. These include agriculture, construction, retail, food, and numerous services. Unfortunately, they are politically extremely powerful, and their main concern is the same on the foreign as well as the domestic front: protectionism. These undermine any support for trade agreements, at least agreements that can be WTO-consistent, and weaken support in the Diet for such initiatives.

There are also two competing ideological factors at work in Japanese approaches to regional economic integration. The first is the desire for historical rapprochement with Japan's neighbors in Asia on the postwar Franco-German model. This is a genuine conviction on the part of some of the populace, a handful of legislators, and the bulk of senior officials in MOFA. The other factor is a new nationalism in Japan, usually designated as desire for greater "assertiveness" in foreign affairs. This includes some resentment of Japan's continued military dependence on the United States, and desire for a stronger Asian role in world affairs (if not Japanese dominance of that role). The current Prime Minister, many younger legislators, Japan's Self Defense Forces, some bureaucrats in all agencies, and a variety of voters share this view.

In the short-term, Asian economic integration serves both ideologies. It requires Asian neighbors to put the past relationship with Japan behind them in significant ways, it reorients Japanese policy initiatives towards Asia and away from (pleasing) the United States, and it puts Japan in the position of being big brother in the region. Were integration to become more than just an initiative or long-term goal, and require not only sharing of decision-making with other Asian economies but also influence of outside forces on Japanese domestic structures, this cozy coexistence of ideologies would likely cease.

The economic potential for Japan from integration: Rhetorical appeals to the economic benefits of the European model of integration are misleading for a host of reasons: France and Germany never presented each other after 1945 with the security threat that Japan and China (and indirectly divided Korea) do; all Western European countries were and are much more open and integrated with their neighbors than Japan at the start of integration; collaboration with German occupation was the rule on the continent, and the Nazis never treated the dominant ethnic groups in occupied Europe particularly badly; the relative wealth and productivity gap between the major nations in Europe was never that wide from 1950 onwards; the economies in the region out to catch-up were extremely small in population relative to the core economies; and there was a clear long-term deal to be made between German macroeconomic stability and French political acceptance of Germany, whereas Japan cannot offer either macroeconomic stability or acceptance to China (or vice versa).

Of course, it can be argued that, on purely economic terms, EU integration has been something of a disappointment, and in particular EMU has been a net loss so far-European integration is a political project. Nonetheless, as a benchmark it should be made clear what the economic aspects of such integration entail, and similarly so for Japan. There are three major lines of regional economic integration in play in East Asia:

• Bilateral and regional free trade agreements. These tend to attract the most attention for several reasons: they most obviously involve government-to-government negotiations at a high level; they are most clearly in contrast to an established multilateral alternative; they are the newest to Japan, which has previously abjured such pursuits; and they most directly affect stakeholders in Japan. Currently, Japan has concluded a pseudo-FTA with Singapore, and is in negotiations with Korea, the Philippines, and Mexico.
• Monetary cooperation from Chiang Mai onwards. The currency swap agreements concluded at the ASEAN+3 Finance Ministers' Meeting in May 2000 were met with little resistance from the United States or the IMF, unlike the earlier Japan-initiated "Asian Monetary Fund" proposal of August 1997. The prospect remains that this is the first step towards monetary integration in East Asia; there are hopes that in the short-term this will abet trade integration efforts by reducing the risk of crisis and the potential for competitive devaluations. There is no bilateral Japanese activity on this front, except at the trivial level of filling in the various swaps.
• Foreign direct investment (FDI) flows. These are the most decentralized forms of integration, with little or no intergovernmental agreements governing their behavior. Japan has been a major source of FDI to the region, particularly to China of late. Given Japan's high wage structure, uncompetitive environment, and excessive costs of inputs to production, Japanese business stands to gain a great deal from shifting production abroad. Japan also is almost unique in the region in its potential to transfer technology and management to other countries along with investment.

As in Europe, the pursuit of monetary integration is largely a symbolic matter, especially given the relatively responsible macroeconomic policies and reserve positions of most of Japan's neighbors. Meanwhile, the anchor country always stands the least to gain from monetary integration-it inherently gives up total focus of monetary policy on its own domestic needs, while presumably has little to gain on the interest rate/credibility front (or else it would not be the anchor currency). In the case of Northeast Asian monetary integration, though, there is the additional question of whether the yen could even serve as the anchor currency for the foreseeable future, given the prospect for increased inflation. If the process goes on too long, the renminbi will become the anchor, and the economic incentives for Japan to participate are further decreased. Thus, the only potential upside from integration has to come on the real, that is the trade and investment, side¹.

The prospects for Japan to conclude meaningful free trade agreements with any of its current negotiating partners must be deemed very small, although the economic benefits to Japan are potentially very large. These apparently opposing facts stem from the same source-as METI recognizes, protectionist forces in Japan (e.g., agriculture) are the same as or are closely allied with those blocking structural reform. Though there has always been the hope that outside pressure (gaiatsu) could motivate reform, and there is some precedent for this in the model of EU integration, the fact remains that these domestic industries are fighting for their lives, they have Diet members dependent upon them, and there is little that anyone else in Japan can offer to buy them off.

Reflecting this reality, while Japan has concluded what it calls a free trade area with Singapore, it excluded a large amount of agricultural trade from the agreement. With Singapore, an island that even if entirely planted with rice rather than covered with banks and public apartment buildings could not export enough to threaten even Japan's totally uncompetitive farmers, there could not be real integration. If one were making up a joke before it happened about the power of the Japanese agricultural lobby, this would have been it. The claim can be made that when more is at stake than Singapore, say trade with the Philippines or Korea, countervailing forces will be more willing to engage-this is a speculative claim at best, and one with little to support it.

Context will not help. The current escalation of agricultural subsidies in the United States and the hanging on to the full CAP in Europe, even as enlargement approaches, not only illustrate how effective agricultural lobbies are in the rest of the G-7 where they are politically weaker than in Japan, but give additional excuses for Japan to hold on to its own protections. Now extend that logic to steel, construction, and a dozen other industries. There will be no meaningful free trade areas that will come through Japanese initiatives. The only hope, if one could call it that, would be an ASEAN+2 free trade area that included China and was set to exclude Japan might compel Japan to accept liberalization on any terms, but this possibility of capitulation to China would likely draw direct attention from the United States, and a push towards multilateralization of the process.

Japanese economic weakness and the irrelevance of regionalism: As already indicated above with regards to the prospects for monetary integration, the issue of regional integration may be moot for an economically declining Japan (even if some Japanese officials hope to use integration to stem that decline). Unless the Japanese government faces up to its twin problems of debt-deflation and eroding fiscal sustainability, the Japanese economy will fall into financial crisis somewhere between now and the reaching of its constraint on rolling over new public debt (around FY2005)². In the meantime, it will continue to barely grow. The irresponsibly deflationary policies of the Bank of Japan will discredit it as a potential leading central bank for any sort of exchange rate mechanism within East Asia, while the very real prospect of increased inflation to deal with the excess of Japanese government debt will eventually erode the yen's value. A declining yen (whose decline will be expected to accelerate), combined with withdrawal of Japanese lending and longer-term investment from the region, will in turn reduce other countries' willingness to conclude trade agreements with Japan.

The record of governments managing to push through trade liberalization over domestic opposition during times of economic contraction is poor, and during financial panics is abysmal-in fact, there is a strong correlation between increases in unemployment and in protectionism. The course of Japanese government pandering to inefficient producers throughout the last decade, as exemplified by the increase in construction's share of the workforce from under eight to over eleven percent, reinforces this relationship. This kind of political pressure tends to reinforce the nationalist ideological response, at the expense of the peaceful integrationist view. We are already seeing evidence of this in Japan, where there is mounting opposition to "cheap imports" and "deflationary pressures" from China, to the "hollowing out of Japanese industry" and the "export of jobs" via outward FDI, and to even inward FDI from "vulture funds" buying Japanese assets at "sale prices." This danger could conceivably increase the incentive of Japan's neighbors to lock Japan in a web of regional constraints before such pressures might become extreme, but it is unclear that would outweigh the drive in the other direction from within Japan.

Finally, should there be financial crisis in Japan, whether in the next few months or the next few years, the critical process will be what happens after the bankrupt financial system (banks, life insurers, etc.) is largely nationalized. When those businesses are sold back to the private sector, there will be a clear choice between openness and national preference. As I have argued elsewhere, the combination of market pressures, potential economic gains, and Japanese government recognition (discrediting of those in power today), will probably lead to significant American participation in the Japanese financial sector, providing competition, takeovers, exposure to best practices, and FDI on the model of Japanese auto industry's role in the US economy in the 1980s³. This will take some years, but will ultimately lead to smoother US-Japan relations and tighter financial and economic ties.

Under this scenario, however, the Japanese government will have little political capital or time, let alone incentive, for Japan to focus on regional integration rather than moving back towards an emphasis on relations with the United States. Should the alternative hold, and the Japanese government turn the reprivatization of the financial system in a nationalist direction, Japan's economic stagnation will turn into collapse. Either way, in the meantime of the next five years, China will be opportunistically assuming the leadership role in regional economic integration. It is my very reluctant assessment that the squandering of Japan's wealth, domestic political capital, and world role in the last ten years of economic mismanagement may not be recoverable in the near-term, and this renders Japan's interest in regional economic integration an unfortunate distraction.

Notes

1. Some would suggest that an additional advantage of monetary integration would be that the creation of a currency union would lead to a major expansion of intra-regional trade. Even if this claim were valid (and the evidence is mixed), it would still be premised on sufficient trade liberalization to allow markets to respond to currency integration, which means that consideration of trade integration comes first.

2. I have argued that the financial crisis is actually likely to occur much sooner, in the next few months before the fall 2002 supplemental budget (see Adam S. Posen, "The Looming Japanese Crisis," PIIE Policy Brief No. 02-5, May 2002). This is an extreme minority view, with most responsible observers in contrast expecting Japan to grow weakly but stably through the current cycle of expanding exports to the US.

3. See Adam S. Posen, "Finance," in U.S.-Japan Relations in a Changing World, ed. Steven K. Vogel, Washington: Brookings Institution Press, 2002, pp. 198-238.