Challenges for Japan:
What Can and Should Japan, the U.S. and the G7/8 Do?
Remarks to the G8 Research Group and the Asian Centre,
Munk Centre for International Studies, University of Toronto
March 12, 2003
It is always a pleasure for me to join you here in Toronto and to engage in lively discussions. I have now been connected with the G8 Research Group for more than a decade. And on each visit I find myself engaged in a challenging set of discussions. I would like to address some economic issues in my remarks, but during our discussion period I would be delighted to discuss any topic on your minds – from geostrategic to geopolitical to economic to what it is like to live under high-alert terrorist threats in the Washington DC area.
As many of my colleagues in the audience know I have worked on Japanese economic issues since the early 1970s – yes, I am a glutton for punishment! But fundamentally I continue to be a longer-term optimist on the Japanese and their economy.
I would like to begin my presentation by removing one on the topics from the title of my remarks. What can and should the G7/8 do about the problems in Japan? Absolutely nothing!
It has been my experience over the years that the Europeans have essentially no interest in Japan. They care little about its people, its economy, its problems or the solutions. Yes, Europeans have historically feared the Japanese export machine and have been very good at protecting their European markets from the vast array of Japanese exports that we see here in Canada and in the U.S. They have historically been imaginative at preventing the access to markets that Japan has acquired here in North America remember that single inspector for VCRs in northern France going through the import boxes one by one by one?
I remember a sherpa meeting in 1994 when my German colleague turned to me quietly and said, "Bob, why do you call our Japanese colleague Matsuura-san. What does the san mean?" Then we had discussions with the other European sherpas about Japanese food and culture. My sherpa colleagues had virtually no exposure to Japan or its culture. And these are the sherpas of the G7 countries. You will not be surprised to learn that my Canadian colleague Reed Morden shared my shock at their lack of understanding and knowledge. Needless to say Reed understood Japan.
Given this lack of interest and understanding, the voice of Europe has very little moral suasion in Japan or with Japanese policymakers. Often in G7 dinance meetings, the Japanese have attempted to align themselves with European finance deputies. But my experience suggests that there have been only a few cases when the interests between Japan and Europe have intersected. And in these cases the match-up has been when others (the U.S. or Canada or UK) are calling for policy actions and neither the Germans nor Japanese want to take action. So the teaming up is essentially a negative blocking action, not a positive force for change.
The question of a role for the G7/8 is interesting from another perspective. In part I suspect that the answer about a role for the G7/8 depends on the kind of economic issue or problem under discussion. In the case of Japan, I believe that most economic analysts have concluded that the broad set of problems is not fundamentally related to macroeconomic policy decisions. That is, they are not the result of monetary or fiscal policy choices. The G7/8 has historically focused on macroeconomic issues and not on microeconomic issues. Should the G7/8 broaden its outreach to include topics relating to domestic regulatory issues and microeconomic policy issues? I would hope not. Not because of the sanctity of these issues. But given the view of deregulation and competition policy in France and Germany, I would not want the European Union to set the policy goals for deregulation and competition in other G7/8 nations. And given the degree of the regulatory problems in Japan I clearly do not want the European view of competition and deregulation to win in Japan.
So my choice would be that there is no role for the G7/8 in working out the solutions to Japans long-standing economic problems. But as a hint of things to come, let me add that I do believe that there is a role for North America to play. More later on this.
In 1989 I moved from the U.S. Treasury Department to the State Department, which was a strange and unusual move in the U.S. career civil service. But I was fortunate to be asked by Secretary Baker to move with him and to work on economic issues for him at State. I joined the Asian Bureau at first and found lots of fascinating and interesting tasks ahead of me. They were not all focused on Japan, and I was fortunate to be the first senior official to APEC and helped establish the first meeting.
But I often heard the phrase "challenges and opportunities." I eventually learned that this was diplomatic speak for very, very tough problems with little chance of solution. So I look at the title "Challenges for Japan" that Dr. Kirton suggested for this address with somewhat of a jaundiced eye.
So what are the challenges for Japan? Simply put, the primary challenge is for Japanese authorities to develop a set of economic policies that will return the domestic economy to a path of sustained, positive real growth with rising employment. For more than a decade now, Japan as experienced essentially no real growth. Their financial bubble broke in 1989. The level of gross national product is essentially unchanged today from that peak level. For more than three years, the level of prices in Japan has continuously declined. I know that many of you here in Canada and my fellow Americans would be delighted to experience a period of deflation. But deflation is a serious problem for Japanese authorities. Falling asset prices lead to increased savings in a country already beset with excess savings. And the aging society needed positive interest rates to provide retirement returns. Insurance companies are struggling to provide returns on life policies and are now reducing previously guaranteed payments. Confidence in the financial system is declining sharply. Interest rates are essentially zero. The Bank of Japan is struggling with alternative policy goals ranging from interest rate targeting to inflation targeting. But so far with little success. Unemployment is setting new historic highs virtually each month. Banks are not lending to good customers and are instead lending to virtually bankrupt firms in order to temporarily protect their balance sheets and prevent bankruptcy from leading to full loan write-offs.
So the Japanese economy is a mess.
Why is there no public revolt? In either Canada or the U.S., we would have already experienced an outpouring of public resentment against officials. Elections would have resulted in real changes in the political leaders. But in Japan, little has happened on the political front. Why? Because the living standard reached at the peak of the financial bubble was very high. If you still have your job today in Japan, your salary actually buys more today than it did in 1989. So you are content with the status quo. The largest group negatively affected by the current situation is the youth of Japan. College graduates no longer have much of a choice in finding a job. Many are unemployed after graduation. This is unheard of in Japan. Despite a declining population, the declining domestic demand situation has devastated the youth of Japan. Youth unemployment rates are in the double digits in Japan today.
Fear of the unknown is the second factor behind the lack of public outcry. I believe that most Japanese citizens are reluctant to see the status quo change. And the problems of today are so deep seated that solutions will require fundamental change to the Japanese system. Citizens believe that postponing change may be the best short-term outcome.
First and foremost among the key problems facing Japanese policymakers is the issue of bad loans. All of you have heard about the bad loan problem in Japan often called the NPL problem the non-performing loan problem. Most of the focus has been on the banks and their financial problems with bad loans. But as I remind my Japanese colleagues, on one side of a bad loan is a bank problem, yet on the other side is a bad corporate problem! And it is the corporate problem that will shake up Japan at its foundation. These problems will change the old relationship style of business (Keiretsu relationships) and will change the nature of cross shareholding of stocks within Japan. Indeed, the concept of corporate restructuring is a major issue for Japan. I know of a Japanese bank that merged 20 years ago with another Japanese bank. Today the bank still has separate personal offices, separate salary tracks and separate promotion tracks. Twenty years after a merger! Long resistant to M&A activity, corporate Japan is not ready for the objective analysis of balance sheets, profits, focus liability exposure and shareholder rights that a significant restructuring of corporations will require.
So two key issues will be the restructuring of commercial banks and the restructuring of many corporations within the Japanese domestic economy.
Progress on these two key fronts is necessary for the eventual return to positive sustained real growth. But they are not sufficient. In addition, considerable further reforms in the domestic economy are required. First, there are a range of issues dealing with corporate Japan. These issues range from tax policies pertaining to M&A activity, the use of stock options, venture capital, and so on. They also include corporate governance issues that affect the transparency of corporate Japan. Stockholder rights, outside directors, and auditing and accounting practices are included in corporate governance issues.
Second are a variety of issues centred on competition policies. It would be important to bring a new focus on the use of anti-monopoly enforcement in Japan. Current practice involves essentially no costs associated with illegal behaviour. Fines are virtually non-existent. Jail time for corporate offenders is unheard of. Perhaps a new approach could put teeth into the use of antimonopoly policy in Japan.
Finally, issues in the information technology area would help revitalize the domestic economy. E-commerce, signature authentication, intellectual property issues, trade in digital products are all key issues for new policy approaches. Furthermore, telecom issues are critical to the success of IT growth and movement to the 21st century.
If these are they key issues, what can and should Japan do? Obviously, Japan needs to build the domestic coalitions needed to promote change. But for 12 years, the Japanese have been unsuccessful. Is it a question of willingness or commitment? It is a question of understanding the problems?
What can others do? Here is where I see a glimmer of hope.
I believe that there is a unique and critical role for the U.S. and perhaps for Canada. I think that foremost among the problems faced in Japan is the lack of confidence on the part of business and consumers. Lately, I feel that the lack of confidence is also being felt in the halls of government. Some kind of shock is needed for the domestic economy. Make no mistake about it there will be a shock coming for the Japanese economy. It can be a negative shock, and it could be either externally or internally generated, as in an exchange rate crisis, a domestic debt crisis or deflation shock.
Or the shock could be positive one. I would prefer a positive shock. First, the role of foreign direct investment can provide a positive shock to the Japanese economy. I have participated in numerous seminars with Japanese government and business leaders who are trying to understand better the role of FDI in promoting positive change in Japan. Some real progress has been made on this front. But the positive run of FDI seems to be dwindling off, largely because the promised reforms in Japanese domestic policies have not been followed through. FDI is fickle. If not satisfied, it looks to new countries.
Another avenue for a positive shock would be the creation of a super free trade agreement between the U.S. and Japan. I have called this potential arrangement either an "FTA squared" or a Comprehensive Economic Partnership Agreement. Fundamentally, it takes the concept of an FTA and adds to it purely domestic policy issue areas. If NAFTA were a starting point and then a considerable range of new issues were added to that framework, then there could be a significant positive shock to the consumers and investors of Japan. I believe that the range of issues was first set forth during the bilateral negotiations between Japan and the U.S. during the 1989–92 Structural Impediments Initiative negotiations. Issues range from land use policies to corporate governance. They range from labour market policies to mutual recognition of testing for products. They range from accounting standards to portable pensions. They range from use of stock options to IPR enforcement. A vast array of key issues which prevent the full working of the market in Japan. These imperfections prevent the proper economic signals from being sent and received by firms and investors. A deep integration of the two economies of Japan and the U.S. could provide unique new investment opportunities and new opportunities for growth and stimulation of ideas. The potential for creating the worlds largest single market would be staggering. And while considerable attention today is focused on China and its market potential, the U.S.-Japan market would be the highest per capita market in the world. This represents huge potential for Japanese industry, North American industry and for the industry of ASEAN as well. This positive shock could be an important factor in restarting the Japanese economy – and with it, the rest of Asia as well.
Q: Ive been reading about the WTO negotiations and I would say the chances of the system surviving are very small. I dont want to go into all the reasons for it but clearly one is that all previous trade policy was a joint of the U.S. and Europe. How does that change the role? If you take the worst case of war, if the U.S. reviews its geo-economic policy?
RF: This is off the record, right? First, I share your view that the WTO is in serious straits. Its come up to the conundrum of agriculture policies that Europe is not ready to deal with, at least not France. And as France goes, so the rest of Europe goes, in a number of issues. Im troubled by the lack of progress and I think we learned in the last round that the number of issues the community can handle at once is limited. At Uruguay we tried to handle too many issues at once. You need to make trade-offs that you can understand. When it gets so complicated that individual ministers cannot understand the trade-offs they freeze. I happen to believe that the U.S.-Canadian FTA led to progress in Uruguay round. NAFTA posed a threat to the Europeans that made them rethink and move forward. One reason in the geo-strategic sense that Ive become interested in with regard to the FTA is that it could have similar push dime effect if we could solve the division between U.S. and EU on agriculture, we might be able to move the WTO forward. Short of that, were treading water and we hope we dont move backward, but holding steady will be the best we can hope for. Unless we can find a stimulus to the trading system. I see an FTA as a comprehensive economic partnership, true single-market integration including domestic microeconomic policies.
Q: A great deal has focused on Japan in Asia, in the 1980s. Until 1994, 1995, Asia was falling more and more into the hands of the Japanese. I wonder in a geo-strategic sense, given your positive scenario about ties and connections to the U.S., how that effects Japan and the rest of Asia. Historically, Japan has looked both ways but this has not been feasible so it looks toward Asia. Even now theres a great deal of economic interest in Japan.
RF: Up until a year ago I would have shared your philosophy. China by its economic diplomacy has blown Japan out of the water in Asia. China offered an FTA to ASEAN out of the blue, caught Japan with its mouth open. Japan for 30 years had been quietly using our assistance, to what it thought would build inroads in ASEAN and in those regions. China makes all bets off. The dramatic move in the Mekong Delta with Laos, Cambodia and Vietnam and Korea and Japan can join to, by the by totally took away the diplomatic initiative of Japan, and they dont know where to turn. Theyve lost face and impetus and initiative and unless they can figure out a solution to the China problem theyll be a third seater from here on in. They need to look at their strategic partnerships and figure out where their interests lie.
Q: What do you think about relations between South Korea, U.S., and North Korea, in light of the new presidents government in South Korea who will continue the legacy and in light of North Korean nuclear crisis? Will the U.S. eventually resolve these issues?
RF: Eventually is such a long time. It is clear that my administration firmly believes that North Korea is a regional problem, that it must have the active participation of Japan, China, South Korea and Russia in any longer term solution to North Korea. The administration does not want to have a bilateral solution that is the U.S. government talking to the North Korea government at the exclusion of the regional powers to have an even stronger vested interest in a non-nuclear North Korea than we have. North Korea flies missiles over Japan for target practice Japan has a vested interest in working about a solution. None of the players have been willing to take the hard decisions to find a solution. North Americans were surprised when Roh said if there were problems hed rather see them go nuclear. That changes the equation of the balance of power between South and North Korea for the last 40 years. In Washington we were surprised that he and South Korea were so worried about economic collapse that theyd accept the nuclear North. Over the longer term, we would have thought unification would be the answer... Given the lessons of Germany, the economic consequences would be staggering for the South, but a lot of us were quite surprised by the explicit trade-off he was willing to make. I hope he reconsiders. The danger of a known proliferator of WMD, which the North is the North invented scuds and exported them to a number of terrorist and rogue states, so I think its not a safe presumption that the restarting of the "scientific" plant and the ability to build new fissionable material is not healthy for the region and its incumbent in the region to join in multilateral talks. If all else fails and we are several years from now it would be a bilateral negotiation, but thats a very third choice by the current administration.
In an earlier life I studied the cost of unification. There are ways to design a unification that would not put undue financial burdens on the South but would allow for peaceful federation without the free movement of labour. There are technical solutions to unification if there is a political will that would overcome the lessons we learned from Germany. I believe the economic collapse of the North would not be the "end of the world," but we need to think about what the unified peninsula would look like.
Q: What are Japans prospects for normalizing relations with Russia?
Japan has already initialled a new pipeline from the Sakhalin Island, with Exxon. There will be an one pipeline that will bring gas from the island to the northern islands. I think theyre moving on economic issues. They should have acted in 1991, when the breakup of the Soviet Union was taking place. We held extensive negotiations with Japanese friends urging them to bring forward a creative solution. We failed, so they passed on the opportunity. Theres a second opportunity through economic development. Im optimistic.
Q: What about the pension crisis in Japan?
The Japanese labour ministry has spent considerable years focused on and almost underwhelmed by aging problems. All of us are facing an upward move of our age distribution. In the U.S. were solving it by immigration, so that even if the native population has a declining birthrate we have higher immigration rate. The Japanese have not found a solution. One of my favourite lines: two choices in the labour market either let women have real jobs or let in immigrants. They havent yet come to grips with it. From a financial perspective they know the current return rates on assets are killing the pensions. The underinvestment of pension funds are huge. There is a staggering amount of unfunded pension liability among Japanese corporations. The government has looked at its social security side and given up, extended out, taken the easy way out and postponed the payout year by one, two, three years. The solution so far is not to pay as early.
The youth population is agnostic on politics in general. When I go to Japan, I have a group of 15 to 20 people between 25 and 35 years old, all college educated, some married, some single, men and women, some with careers. Not one has a savings account in Japan. Some are sons and daughters of finance ministry officials, and they realize it might not be legal to have that bank account in Hong Kong. But they all have their savings offshore. A damning comment.
Q: I lived in Japan when the bubble was bursting, and it strikes me when I go back that this does not superficially seem to be a society in any deep trouble. It seems as glossy and prosperous as it did at the height of the boom. Im sure youre right about the attitudes of the young but you dont see it. Id like to ask about what seems to me as a rather strange conservativism the Japanese banks, historically, had no difficulty with the restructuring, if you go back far enough. Youll find it developing with M&A and corporate deals on a scale that we would have been familiar to us, yet it seems to have reached a frozen plateau where they can no longer contemplate any changes. Were in a kind of plateau here too but it puzzles me that for some generations they could accommodate the notion that big banks swallowed up small banks and so on, but now, when restructuring is desperately needed, theyre incapable of facing it.
RF: On your first comment, today if you walk through parks in Japanese you see homeless asleep on benches. Ten years ago there were none. In the subway today, you see people sleeping. In a taxi, the driver is likely never to have driven in Tokyo before. Theyre people whove lost their white collar jobs. Its scary!
The M&A of Japanese banks historically took place in good times, in a strong economy, when banks had lots of profits, based on bank shares, in a heavily regulated economy. Most mergers and acquisitions took place because the finance ministry wanted them to take place. Often, the finance ministry played marriage broker, and said we think you and you would go well together and well help you... there were always sweeteners from the finance ministry. It was almost never taken from a purely economic decision. So its not classic M&A but an effort to save some depositors in order to save some borrowers in order to save supporters of the bank. Theres a systemic aspect that the regulators helped to make happen. Because of deregulation, the ministry of finance doesnt have that power today, and now we the horrible balance sheets of all the banks. Doing due diligence is so difficult in Japan. Trying to figure out who the ultimate owner of that loan, and whether they have all their fingers this is a reference to the mafia makes doing real due diligence or credit risk analysis is very difficult. Trying to guess the real value of the portfolio is so you can make the appropriate bid Ive watched the U.S. banks throw up their hands.
Q: How important is a continued U.S. military presence in Japan? Will it remain tolerated?
RF: The secretary of defence in the last two weeks made reference to moving 37,000 trips away from the DMZ in South Korea back off the line. There is, once very four years, a review on the forward deployment of troops, and for the last two time last eight years there has been serious focus on the level of troops in South Korea. Its clear weve become less appreciated in South Korea. The new government is less warm towards us as a military presence than previous governments were. I would not be surprised to see a substantial reduction of forces in South Korea.
Japan is more difficult. The political powers and strategic thinkers in Japan recognise that unless they want to change their constitution to have a proactive military, including development of a nuclear deterrent, the umbrella of the U.S. forces is cheap and a more acceptable alternative to most thinking elites in Japan. Ive not seen polling data on people under 40. Most of our troops are in Okinawa, in major metropolitan areas we did a better job of dispersing them than the 37,000 on the DMZ. Weve long believed we wouldnt stay where were not wanted. Id hope there is a presence of U.S. forces in Asia because it has historically had a stabilizing influence. There is change coming in South Korea, and it will be difficult to maintain forces in Japan if we dont also have a presence in South Korea. Were we to move out of South Korea totally, the political pressures against the Japanese government from the people would make it difficult to cope with. If Japan is the last outpost, the Philippines want to reopen negotiations, which we abandoned at their request in 1992. There is some possible movement of forces back into the Philippines thats a forward deployment, but not quite the same.
Q: Decline in trade imbalance?
RF: I would argue that the trade imbalance is almost as big today as during the 1980s. Were still running a large trade deficit were number two (China is number one). Had the Japanese undertaken the kinds of restructuring we had been urging in the 1980s, theyd be in a far different position today than they are. They felt quite confident in the late 1980s before the bubble broke in their own ability to work out the problems and manage the Japanese economy. They became slightly pregnant: they started to liberalize and got a whiff of the air of liberalization without going far enough. They froze, and instead of continuing to liberalize they stopped. In some sense they got partway there, which is worse than had they stayed grossly regulated in the 1970s and 1980s. My Japanese colleagues will blame us, Im sure they felt we pushed too hard. I believe we didnt push hard enough because failed in succeeding to get the kinds of changes that would make a real difference.