After more than a decade of economic stagnation and minimal structural change, Japan stands on the brink of outright financial crisis—the only debate is whether the Japanese government can dodge its imminent economic threats for another six months at most, or ride the wave of global expansion to throw still more money at these problems with decreasing effectiveness until the public debt becomes unsustainable (which should be no later than 2005). Either way, volatility in Japanese asset markets will be extremely high for the next 36 months, with significant declines on average in asset prices and the yen.
Japanese savers remain highly riskaverse and this puts a drag on change in general and provides a buffer for policy mistakes—their passivity should not be exaggerated, however, and cannot be depended upon to stave off crisis. In the last six months, in anticipation of deposit insurance limits and bank failures, over ¥100 trillion in household savings has been moved from weaker banks to cash, gold, offshore accounts, and the four “too-big-to-fail” merged banks. Given the ongoing drain of liquidity from Japanese asset markets, the movement of even a few percent more of household savings, along with the remaining mobile international capital in Japan, could produce large declines in asset prices. Such movements would rapidly intensify both the current credit crunch for Japanese smalland medium-sized enterprises and the Japanese government’s mounting fiscal difficulties.
A reasonable baseline forecast for the Japanese economy is for modest growth, driven by exports of manufactures and the end of the inventory cycle. I argued in early 2001, however, that the Japanese government then faced a choice between decisive preemptive action and outright financial crisis. But no decisive action has been taken since the Koizumi cabinet took office in April 2001. Therefore, the downside risks make it very unlikely that the baseline forecast will be achieved—in fact, the Japanese economy is likely to tumble into crisis sometime before the Diet’s supplemental budget process begins in September 2002. This reflects Japan’s increasing vulnerability to shocks, now that it is caught in the tightening vise of debt-deflation and fiscal erosion. There is no shortage of potential triggers for such a crisis in coming months. One most likely trigger would be contingent claims becoming explicit on the government balance sheet, the impact of which would be amplified by policy mistakes. A crisis in Japan would not be Argentina redux, but it would have severe consequences for the country and the world economy.
Crisis in Japan is not yet inevitable. A comprehensive policy package of bank closures and recapitalization, money-financed Bank of Japan (BoJ) purchases of long-term Japanese government bonds (JGBs), and replacement of public works spending with tax cuts could still save the Japanese economy from this fate. By putting distressed assets back on the market and removing uncertainty, asset markets would soar and Japan would grow at or above potential for an extended period (2.5 percent plus per annum). Increased explicit pressure from the US and other governments could somewhat increase the chances of such a policy package being adopted. This policy brief makes the sober but realistic assumption, however, that there will be no meaningful change in Japanese economic policy until a crisis hits, and actions taken then will likely be too late to forestall the negative impact.