Will a Rudderless Japan Drift Into Crisis?

Japan Needs a Captain

The upper house election in Japan last Sunday dealt a huge blow to the ruling Democratic Party of Japan (DPJ), leaving the country with a "twisted" parliament and no clear path forward. In contrast to the previous decades of nearly uninterrupted single-party rule, the new, messier political environment is a positive sign for Japanese democracy.

But this difficult transition to a new mode of governing comes at a time when strong leadership is needed to address a possible sovereign debt crisis that could hit within five years. Ironically, the DPJ's defeat last Sunday was partly the result of Prime Minister Naoto Kan's flip-flopping over a consumption tax that was meant to help stave off any problems emanating from its exceptionally large debt-to-GDP ratio (near 200 percent). Most voters support the tax but the prime minister buckled under criticism on the issue, fostering the impression that he is simply an opportunist. The party's loss may have made prospects for reform "an uphill battle."

I had the chance to talk with people from media, politics, government, business, and academia in Japan during the week leading up to election day. Consistent with the polls, many of the people I spoke with were undecided about which party to support, and the murky election result may delay financial reforms. Rating agencies Standard & Poor's and Fitch have warned of possible credit rating downgrades due to Japan's expected political gridlock, which may hinder the country's ability to reign in its sovereign debt.

Hatoyama's Parting Gift

Yet there is good news. While the lower house election last August was a rejection of the long-ruling Liberal Democratic Party (LDP), last week's upper house election was about real issues while also serving as a referendum on the DPJ's 10 months in power. A political monopoly has been replaced by a period of what Japan expert Gerald Curtis calls political "creative destruction." One DPJ staffer told me that the current, more pluralistic public debate over policy issues was the legacy of former Prime Minister Yukio Hatoyama.

Whether or not by design, the two administrations of Kan and Hatoyama have put on the table thorny issues, including the logistical details and strategic importance of the U.S.-Japan alliance and the previously unpopular idea of a consumption tax, which led to the downfall of the Ryutaro Hashimoto administration more than ten years ago. I was told the DPJ expression for this expanded public square is "the new public."

Meanwhile, the new smaller parties actually stand for something other than an unbridled thirst for power. In particular, Your Party, analogous perhaps to American libertarians, seeks an inflation target and to shrink the government, thus unleashing Japan's entrepreneurial spirit and creating jobs. Your Party did quite well, gaining ten seats. It appeals to a common frustration in Japan with government in general and is populated with stars from Tully's Coffee Japan, JP Morgan Chase, and the Ministry of Economy, Trade and Industry (METI).

The outcome is a real multi-party system. But contrary to hollow calls for a revolution last fall, this is the new reality: the slow democratic politics of compromise.

Drifting into Troubled Waters?

Nevertheless, the slowness of Japan's new politics could launch the country adrift into a debt crisis. Although 95 percent of Japanese government bonds are held by domestic investors, several factors could create risks. First, with Japan's low savings ratio and low economic growth, if its aging population starts to draw on its savings, the government may be forced to rely on foreign funders who will demand higher interest rates. Second, a deteriorating Japanese current account, due to a stronger yen or weaker global demand for Japanese products, would also reduce a source of debt funding. Reuters has quoted one analyst as predicting a current account deficit by 2016. Finally, it isn't clear whether a consumption tax would generate enough revenue or whether the tax would only dampen an already stagnant economy.

But whatever happens, five to ten years seems to be the critical time horizon. The next lower house election will take place in 2013, and by 2015 Japan is expected to shift toward external funding of its debt and will therefore face higher interest rates.

"Three to four years from now I expect a sovereign debt crisis to hit Japan and long-term interest rates to surge," former Bank of Japan board member Teizo Taya said in a May interview with Reuters. Taya also believes that the five percent foreign holdings of Japanese debt would be sufficient to trigger a crisis if there were a sell off.

One government official echoed these views when I visited Tokyo last week, saying the current account was the figure to watch. But interestingly he said that while some had hoped the election of the DPJ would have provided the "shock" to the Japanese system to bring about economic reform, the DPJ's failures over money scandals, mishandling the U.S. alliance, and the consumption tax have killed that hope. Instead, he and his colleagues are looking to a debt crisis to provide the necessary shock for economic reform. Changes could occur in Japan's tax structure (reducing corporate taxes and increasing consumption taxes over time) as well as in its industrial policy to spur growth. Can't change occur without the need for a crisis?

"The Deadlocked Japanese Economy"

Underneath the sovereign debt risk is an economy that is in irons. Just as its political system faces drift, so does Japan's economy, according to a METI report released last month.

METI minister Masayuki Naoshima puts it this way last month when he unveiled his ministry's new industrial vision:

Some people say that the Japanese economy is recovering from the economic and financial crisis triggered by the Lehman Shock the year before last. However, in reality, many Japanese people probably find no improvement in the sense of stagnation they feel in their everyday lives. They even seem unable to see any new light for the future. I believe the reason for this lies in the uncertainty about "what will drive Japan's revenue and employment in the future."

Naoshima goes on to underscore the economic conundrums Japan faces: People think that Japanese people save too much, thus dampening demand, but actually the household savings ratio is one of the lowest among major economies; on the flip side, domestic consumption is stagnant since wages haven't risen in the past decade; an export-led recovery may seem appealing, but Japan's export ratio is low by international standards, and stagnant wages in the past 20 years call into question the country's industrial structure; specializing in high tech products would also seem logical, but Japan's global market share "has rapidly declined" and low levels of profitability suggest that the business model for Japanese industries that has "caused them to lag behind the world."

In response to these challenges, government officials told me last week that the broad strategy is to globalize Japan, making its social systems, ports, and infrastructure attractive to businesses that create value and jobs. Naoshima puts it like this: "If Japan wants to save itself from decline, Japan has no other choice but to aggressively push forward with globalization. However, if Japan pursues only globalization without taking action to stop the decline in its international competitiveness as a business location, Japan will lose both domestic jobs and added value."

A major element of this strategy will be to "globalize human resources." This means the country's education system must be modified in order to create a more worldly mentality among the next generation of leaders, thus slowing the inward-looking direction or "Galapagos syndrome" as I have called it. One of the most creative proposals I heard last week is to encourage university students to study abroad by offering a ten-year income tax break to those who take advantage of the program. As these more cosmopolitan leaders enter the job market, they must find companies with a more globalized governance structure, diverse board of directors, and global business strategy, one official told me.

Japan Needs More Mavericks

It's nearly a cliche to say that in Japan, the nail that sticks out gets hammered down. Harmony and conformity are prized in big organizations. But these qualities can also lead to stagnation. Entrepreneurship requires a bit of rebelliousness.

During my trip last week, I traveled to Numazu for a day to visit one of the most innovative breweries in Japan. Baird Brewing Company is a joint partnership company that was founded in 2000, and in recent years has received much acclaim for its high quality, creative beers. I had the great fortune to meet the company's founders Bryan and Sayuri Baird, a husband and wife team. Bryan graduated from Johns Hopkins SAIS in the early 1990s and came to Tokyo to enter the corporate world but had another calling. "I didn't know much about brewing at the time but I knew how to study," he said. Using passion and determination, he founded the company with some friends. For the first few years, his beers were dismissed as too challenging. His customers were initially afraid to try something new. For the same reasons, Bryan's competitors in Japan were brewing up pale, uninspired, safe lagers. Bryan stuck to his principles and kept making a great product that emphasized Japan's proud tradition of craftsmanship (monozukuri) until his customer base caught up with him.

"The Japanese people need to overcome their fears and be the nails that stick out," Bryan told me. Bryan is an entrepreneur who embodies what Japan needs--globalized human capital creating a business that adds value and jobs. Another notable maverick who has been globalizing Japan includes Rakuten CEO Hiroshi Mikitani who is making English the official language at Japan's biggest online retailer. Fast Retailing, Nissan Motor, and Toyota Motor also are moving in the direction of adopting English at the workplace.

In politics, LDP star Taro Kono recently published a book on how he is going to revive his party. The main message is: As a nail that has stuck out in the LDP, he knows how the party can revive the economy. Japanese culture is famous for its perseverance and the country's history proves it. The country needs some major changes in order to prosper. For it to create real change, Japan needs more mavericks. And to pilot away from the rough waters, it will need a bold leader; it needs a captain.