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Jewish World Review July 2, 2001/ 11 Tamuz 5761

Lawrence Kudlow

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Japan: Bad as it looks now, expect worse -- AFTER more than a decade of stagnation, deflation and generalized economic gloom, one would think a new-look Japanese political leadership team would want to offer the electorate some reason for hope that better times lie ahead. But in Japan's twisted and sclerotic political culture, such normal calculations do not necessarily apply. The supposedly fresh-faced administration of Prime Minister Junichiro Koizumi has deemed that the political capital generated by his popularity as a charismatic presence among a colorless and dour ruling elite should be spent justifying further economic hardship.

In an initial knee-jerk response to the much-anticipated "reform" plan sketched out late last week, Tokyo's Nikkei equity index had one of its best days since Koizumi moved into the prime minister's residence in late April. Already, though, that initial burst of enthusiasm is wearing thin. At under 13,000, the benchmark is more than 11% below its best levels seen in the rally immediately following Koizumi's election.

At one level, portfolio investors might want to give the new administration some credit for at least making an earnest effort to tackle the country's dire financial and fiscal straits. They cannot long avoid the reality, though, that the Japanese market is unlikely to yield competitive returns over any realistic investment horizon.

The plan outlined last week, presented as a "tough-love" approach to overcoming Japan's chronic malaise, is in fact another large exercise in missing the point. Various senior government figures seemed to take almost a swaggering pride in declaring that the country now faces several years of no better than 1% growth, as if austerity will itself put the economy on track to longer-term vitality.

It won't. Yes, the enormous portfolio of non-performing loans is a time bomb ticking at the core of the Japanese banking system. And, without question, the era of spendthrift, zero-return, public-works boondoggles served only to put the industrialized world's largest debt burden (130% of GDP) on the backs of Japanese taxpayers. Continuing along this course of mindless Keynesianism would be to court ruin, ultimately necessitating drastically higher taxes, an erosion of real debt burdens through inflation of the currency, or both.

Somehow, though, the government's attempt to address these problems is silent on the most obvious underlying cause that they share: the series of calamitous policy failures which plunged Japan into a lost decade of virtual economic stasis. Without a coherent, pro-growth tax, monetary and regulatory strategy to restore rapid, sustained economic expansion, no amount of bad-debt disposal or budget-deficit stringency can possibly return Japan to prosperity.

Consider, for one, the government's plan to impose a two- to three-year deadline on banks to write off the worst of their bad loans, after which a government-authorized entity -- Resolution & Collection Corp. -- would step in to buy all that remained. The thinking is that once these deadbeat loans are finally cleared from their balance sheets, banks will again be willing to open their credit spigots, helping to reignite growth.

What this formulation overlooks, though, is the long-running monetary deflation that is at the root of the banking system's parlous condition and continues to ravage collateral values. An index of commercial land prices covering Japan's largest urban areas, for example, is down more than 80% from its 1990 levels, and continues to decline at an annual rate of better than 10%. Broader price gauges, meanwhile, continue to fall. The GDP price deflator is running at a y-o-y rate of --1.2%, which also equals the average rate of price-level decline posted over the past three years.

The price destruction that Japan has been experiencing for most of the past decade may be without modern historical precedent, bankrupting debtors and placing creditor asset portfolios at extreme risk. Without the prospect of action to finally terminate the deflation, borrowers can't borrow and lenders won't lend. The volume of outstanding loans has contracted by some 16% since 1997, and continues to decline year-on-year at a rate of about 4%.

Yet, it's not at all clear that the Japanese monetary authorities even fathom the gravity of the reality they face. In March, under mounting political pressure, the Bank of Japan grudgingly incorporated a quantitative element in its operational approach, increasing its daily target for bank reserve holdings by 1-trillion yen. Realization of that arbitrary objective has shown up in some modest expansion of the Japanese monetary base, with y-o-y growth standing at 5.1% in May, versus 3.4% in February. But measures of liquidity supply are likely to plateau going forward now that the higher reserve target has been obtained.

Certainly, the BoJ's nod in the direction of quantitative targets has resulted in little if any indication of deflation relief in market-based measures of relative yen strength. At a rate around Y124/$, the yen is now stronger in dollar terms than it was in the aftermath of the BoJ's March policy adjustment. We estimate that overcoming the deflation will require sustaining a yen gold price of no less than 40,000 per ounce which, with dollar/ gold currently trading in ranges around $275/oz., would be consistent with a yen no stronger than Y145/$.

That may prove impossible, however, under current central bank leadership. BoJ Gov. Masaru Hayami regularly rails against calls for a softer yen, as if accepting the need for currency reflation would be tantamount to renouncing his membership in the central banker fraternity. Then again, there is scant evidence available that Hayami -- or the BoJ as an institution -- comprehends the monetary dimensions of Japan's plight.

The BoJ chief has recently become increasingly outspoken in asserting that monetary policy is hamstrung by the banks unwillingness to lend due to the overhang of bad debt, pleading for "structural reform" as the primary means to combat the problem. "No matter how much money we provide, economic growth won't be propped up under the current situation," he told a press conference last week.

What that fails to acknowledge, of course, is the damage being done to debtors and creditors by a falling price level, prima facie evidence of central bank error. Hayami's argument, then, can be seen either as a an effort to dodge accountability for the country's ongoing monetary debacle or as a tacit -- if inadvertent -- admission of incompetence by the country's top central banker.

Just two years ago, Japan appeared poised for better days, as a round of supply-side tax cuts brought the top individual marginal rate down from 65% to 50%, and the top corporate rate to 41% from 50%. With the Nikkei gaining some 43% for the year, Japan ranked among the world's top-performing equity markets in 1999. As suggested by the woeful record since, however, these positive fiscal impulses have been smothered by the unrelenting forces of monetary deflation.

We are conversant with analyses suggesting that the Japanese market is so cheap by any conceivable valuation standard, it must be considered an attractive buying opportunity. But cheap as asset values may appear, they're obviously not cheap enough, otherwise global portfolio capital would be showing some inclination to capture the market's outsized risk premia. The price of Japan risk, in other words, remains too high.

That said, we don't dispute the potential for a major sustained rally when -- and if -- Japan finally gets its monetary house in order, and follows up with additional pro-growth tax and regulatory reforms. Unfortunately, though, in none of these areas does the initial Koizumi effort meet the test.

JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


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