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Worst case scenario

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Japan's problems make prospects for the U.S. economy look downright sunny. But the chaos of the past week in Japan, to say nothing of the past 10 years of malaise, worries some. Will Japan's problems hurt the U.S.? Could the U.S. end up in a similar tailspin? And what can the U.S. learn from Japan's dreadful decade?

Japan's ministry of trade occupies a 17-story granite tower in the heart of Tokyo's political district. The building looks as sturdy as ever. The bureaucrats inside are still recording trade surpluses with the rest of the world, month after month after month. This is the powerful agency--known as MITI, or the Ministry of International Trade and Industry--that two decades ago provoked fear and loathing in Washington because it was masterminding a protectionist and predatory strategy that vaulted Japan to the summit of the world's economies. Or so it was thought. But that era of Japan bashing has been made irrelevant by stuff nobody had heard of then, like portals and dotcoms and e-business software.

The interior of the ministry is still outfitted partly with rotary-dial phones. And typewriters. Bells chime every workday at 3 p.m. to remind employees to do their calisthenics. Small things, of course, but they are signs that while the U.S. zipped along a new technological path in the 1990s, Japan was stuck in a slow-motion devolution from economic miracle to financial debacle, doing things the old way by subsidizing money-losing industries. "I used to be asked quite a lot to give advice to Americans, to explain our success," says Ryozo Hayashi, a vice minister. "But it's been a long time since Japan was seen as a rising sun."

Setting sun is more like it. The stock markets plummeted last week to depths Japan hasn't seen since 1984. By the end of this month, total government public debt will top $5.5 trillion, a head-spinning 130% of GDP. (America's $3.4 trillion in federal public debt is 35% of GDP.) "Japan's public finances are very near collapsing," Finance Minister Kiichi Miyazawa said in uncharacteristically blunt remarks on March 8. He wouldn't say he was trying to drive down the price of the yen, but that's exactly what happened. The next day he backtracked.

While the economy appears close to imploding, the political machinery is grinding to a halt. Prime Minister Yoshiro Mori, who plans to meet President Bush in Washington this week, has overseen a scandal-ridden administration. His political colleagues are maneuvering to replace him within a month. Bush, meanwhile, has promised to treat Japan less as a pupil and more as an equal, which sounds diplomatic but not perhaps helpful. "They're going to have to figure out for themselves what to do," Treasury Secretary Paul O'Neill told MONEY magazine.

If Japan is suddenly registering on Washington's radar screen again, it's because a Japan in free fall coupled with a U.S. slowdown could imperil the world's economy. A deflated yen, already at 20-month lows, could tilt the trade imbalance further in Japan's favor. And the noise of a bursting stock-market bubble heard across the U.S. last week sounded eerily similar to what Japan experienced a decade ago. "It wasn't a miracle for Japan in the 1980s," says Tadashi Nakamae, an economist who co-authored the alarmist tome Wake Up, Japan! "And it wasn't a miracle for the U.S. in the 1990s either."

While there are important differences in the two economies' slumps, the parallels are instructive. The strong-yen policy of the 1985 Plaza accord sucked money into the Japanese stock market, which soared 300% from 1985 to 1990. Treasury Secretary Robert Rubin's strong-dollar stewardship did much the same for the U.S. stock market in the 1990s. The boom was characterized in Japan by inflated land prices, in the U.S. by the NASDAQ. Japan in its heyday, and the U.S. in its later boom, both experienced huge boosts in worker productivity, high growth and low inflation. Japan's manufacturing and management prowess were held up as a new model; in the U.S., technology was the salvation. Both countries were thought to be on to something revolutionary, and a resulting euphoria deluded people into thinking the booms could be permanent.

The differences between the two countries, however, are in America's favor: U.S. banks are in better shape; businesses are quicker to react; and workers are more mobile. Even if the U.S. follows Japan into recession, that doesn't mean Americans will experience a decade of descent. At least not if they learn from Japan's mistakes.

"It's very simple," says Eisuke Sakakibara, a former Ministry of Finance vice minister for international affairs. "Japan delayed the structural reforms that were needed." It's not as if Japan did nothing. Sectors long shielded from competition, like financial services, have been opened to foreign investment. Foreign firms that now run car companies Nissan and Mitsubishi are closing factories and revamping inefficient supply systems. And the Sonys and DoCoMos of Japan have flourished in part because they separated themselves from the old cartels and figured out how to combine technological know-how with marketing savvy.

But at the core of Japan's problems are its banks. Starting in 1998, when the banks were on the verge of collapse, the government authorized spending 70 trillion yen (nearly $600 billion) to shore them up. Trouble is, the government hasn't forced banks to reconcile bad debts, which now total at least $246 billion. Meanwhile, corporations are beginning to whack away at the cross-shareholdings, the financial bindings of the old business networks. These reforms are necessary. But they are also a big part of why the stock market is reeling, as corporations and banks alike sell off their investments. That process is expected to accelerate this week and next because of the softened yen and because the end of the fiscal year--March 31--is near, and under new accounting rules, banks will have to write down their market losses.

As Japan takes some radical steps, though, it continues to support unprofitable enterprises with ties to the entrenched Liberal Democratic Party. These sectors--agriculture, transportation, construction and thousands of small businesses around the country--have escaped attempts to weed out the weak. If the banks start calling in their bad loans, companies from these sectors would be first in line, so it has been in the interest of the L.D.P. to stave off such a day of reckoning. "Say there are five companies in one industry," says Yasuhisa Shiozaki, a reform-minded L.D.P. lawmaker. "Government interference makes them all as unproductive as the weakest one of the five." It does that with direct subsidies, by shielding them from imports and by not forcing lenders to call in bad loans.

Following up on initial steps toward reform would help Japan's fundamentals over the long term. But the really scary part is that dramatic attempts to rev the economic engine right away have had minimal effect. The government, originally acting on the advice of Washington, tried to stop the initial slide by slashing interest rates and funding huge public-works projects. But the government spending has been directed toward things the country really doesn't need: expressways in rural areas and bridges to nowhere. The Bank of Japan has dropped interest rates to near zero, but that hasn't worked to stimulate the economy either.

The central bank and the Ministry of Finance have openly feuded over what course of action to take. Last summer the bank defied the finance ministry by raising short-term rates from zero to 0.25%. But after the GDP declined, the bank lowered interest rates again, to 0.15%. And when officials meet next week, they are expected to discuss dropping rates to zero again by April.

Last week government officials finally admitted what everyone else has known for a long time: Japan is in a deflationary spiral. This is where it gets dangerous. Companies aren't investing, so they don't expand, so unemployment rises, so people put off spending, so prices decline, so people save their money because they figure things will cost less in three months or a year than they do now.

Is there any way out? "The younger members of the party recognize this is a crisis," says Shiozaki, a member of the lower house of parliament. "I think some of the old ones even understand that now." Shiozaki and a gang of younger Liberal Democratic pols are attempting a coup, trying to grab control of the party. This kind of thing is breaking out all over, even at MITI. After 17 years at the ministry, Yoshiaki Murakami, 41, quit in 1999 to start an investment fund. His plan: to shake up boardrooms by challenging the cross-shareholding system that protects troubled banks and companies. He attempted a hostile takeover, the first in Japan, of a small electronics company last year. It failed, but Murakami is not deterred. "Look at Yahoo," he says. "It lost money, so suddenly the CEO leaves. Of course! In Japan? Never happens! Now is the time for shareholder power."

If Murakami learned this kind of thinking at MITI, the symbol of Old Japan, it was by observing what not to do. The rest of Japan has had plenty of lessons in that in the past decade. Now it's time to see what it has learned.

* Percentage change over the past 12 months (Source: Tokyo Price Index)


Cover Date: March 26, 2001



4:30pm ET, 4/16

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