Abe heads south, bloodied but unbowed

Following in the wake of last month's APEC summit in Hanoi, Asian leaders are gathering in Manila for the second annual East Asian Summit.

Prime Minister Abe has departed, but he leaves behind a sticky political situation at home. He is facing declining popularity (his cabinet is polling below fifty percent for the first time since assuming office), his landmark education bill has yet to pass the Diet, the economy is showing mixed signals, and his governing LDP has been divided over the readmission of the "postal rebels" (LDP members booted from the party for resisting Koizumi's postal reform), the nuclear weapons issue, and now the question of how Japan should fund road construction and maintenance. These concerns (ought to) raise questions about Abe's ability to manage his party and his cabinet. Mr. Abe has shown himself to be surprisingly timid in governing, despite presenting himself as Koizumi Junichiro's natural, reformist successor in advance of the LDP's leadership elections.

That's not to say that Abe's cabinet is doomed to be short lived, or that the LDP is sure to be soundly defeated in next summer's Upper House election. But it does mean that Mr. Abe has a lot of work to do if he's going to govern for the maximum five years. Given the difficulties that have dogged him in the special Diet session winding down this month, expect the regular session that begins in January to be especially crowded.

Asia changes -- will Japan change with it?

Chinese President Hu Jintao's visit to India this week supposedly signifies a shift in Asia, as Hu's visit indicates that the region's two emerging giants are drawing closer to one another. This conventional wisdom perhaps contains not a small amount of wishful thinking, because, as this article in the FT suggests, major differences remain between the two powers.

The visit nevertheless contains an important lesson for Japan.

Experts are quick to point out that this is the first time that China and Japan have been strong at the same time, but that won't be the case for long unless Japan remains a top-tier economic and political power.

Continuing economic and administrative reforms initiated under Prime Minister Koizumi are important, but the government needs to develop a comprehensive aim for reform. Why is Japan reforming? Is it simply to revive the manufacturing powerhouse that looked like it would overtake the US in the early 1980s? If so, Japan will find that the manufacturing field is more crowded than in the 1980s -- and China is leading the way as the workshop of the world. With a declining, aging population Japan will eventually be completely out-classed (although China is due to age rapidly in coming decades).

The task for Japan? Make the same leap to a post-industrial, service-based economy, just as the US and European economies are in the midst of doing. Shirakawa Hiromichi, chief economist at Credit Suisse, made this argument in an op-ed in the English version of the Asahi Shimbun.

His main point:

A rise in the share of the service sector in the overall economy can stoke job and wage growth, which in turn can bolster consumer spending, leading back to yet more job and wage growth. This virtuous cycle would make companies more willing to distribute accumulated profits to their employees.

This shift would have massive implications for Japanese society, beginning, perhaps, with education, because a service economy has to educate its children to be flexible, creative, and enterprising -- very different than the education provided to students in an industrial society.

The Abe Cabinet does not appear to be thinking in this terms; Finance Minister Omi Koji has, in fact, insisted that Japan will remain focused on industrial production. In a time of change in the region and the world, the government -- and all of Japan's governing class -- has to be more imaginative in thinking about how Japan can retain its international position in a rapidly changing region. The first step should be conceiving of broad renovation of Japanese institutions.

The Susanoo boom?

Once again David Pilling, the FT's Tokyo correspondent, has a superb analytic piece on Japan, in this case the Japanese economic recovery (unfortunately subscription only). He reports that forthcoming statistics are expected to confirm that the economic recovery that began in 2001 will surpass the fifty-eight-month "Izanagi" boom that lasted from 1965 to 1970.

He cautions observers, however, from being overly optimistic about the current boom, which should perhaps be called the "Susanoo" boom, Susanoo being the mythological offspring of the creator god Izanagi, characterized by a stormy temperament (hence he is known as the god of the sea and storms).

The current boom has been relatively smooth, thanks in large part to the reforms implemented by the Koizumi / Takenaka duo. But those reforms were, in Takenaka's words, reactive: "Mr Takenaka argues that the Koizumi administration pursued largely 'reactive reform' -- chiefly cleaning up the banking system's -- aimed at restoring a modicum of economic health. The only 'proactive reform', he says, was privatising the post office, a giant bank whose savings he hopes will be used more productively by the private sector. More proactive reform, including deregulation and further freeing the labour market, could raise the growth potential further, he argues."

Underlying indicators suggest, however, that like the sea that follows the whims of the tempestuous Susanoo, Japan's economic recovery could hit a rough patches if the government fails to manage demographic change carefully, or should it use contractionary fiscal policy restrict demand. I would add to this mix the consequences that could result from the BoJ's raising interest rates preemptively.

Resurgent Japan -- perhaps playing the role of Amaterasu in this tale -- has emerged from its cave, once again shedding its radiance on the regional and global economies. But Japanese policymakers must be careful to ensure that stormy Susanoo does not lead Amaterasu to retreat back into her cave.

Takenaka criticizes Fukui (and the Abe cabinet?)

With the Bank of Japan sending signals that it will raise Japan's interest rates soon, Takenaka Heizo, former Prime Minister Koizumi's point man on the economy and structural reform, has criticized the BoJ (and implicitly its president) for prematurely tightening monetary policy, reports the FT.

For a high-ranking "Koizumian" to criticize Japan's monetary policy -- which was defended in the FT by current Finance Minister Omi, as I discussed here -- suggests that the LDP might be fractured on more than the nuclear weapons question.

Are we looking at the beginning of an LDP crackup leading up to the Upper House elections?

It is too early to say, but the DPJ has been aggressive recently, pushing back on all fronts in the special Diet session. It has sought to delay the passage of the bill upgrading the Japan Defense Agency to a full ministry, demanding answers to questions regarding a bid-rigging scandal in the JDA's Defense Facilities Administration Agency that rocked the JDA earlier this year. It has hammered, albeit with uncertain success, the Abe Cabinet on nuclear weapons. And now it is looking to prevent the revisions of the education law from coming to a vote.

Should economic growth soften, as observers fear, and the BoJ raise interest rates regardless, economic management could become another contested front, particularly if others join Takenaka in criticizing Japan's monetary policy (and the cabinet, implicitly, for not questioning the BoJ's wisdom publicly). Japan's Democratic party could then borrow from its American counterpart's playbook and run on a campaign criticizing the Abe cabinet's lack of competence.

Unfortunately, this chain of events would mean borrowing from Lenin -- the worse things get, the better for the DPJ -- but it might be the only way for the DPJ to win a major victory next summer. The policy differences between the LDP and the DPJ are too slight for the DPJ to build a campaign on anything other than personality and competence at governing.

A mountain of debt, 1,400 times higher than Mt. Fuji

That would be the height of Japan's debt if converted into ￥10,000 notes, according to a Japanese Ministry of Finance (MoF) budget report cited by FT columnist Guy de Jonquières, in his column, "No need to panic about Japan's debt mountain" (sorry, subscription required).

No need to panic, maybe, but certainly need for concern -- and there's certainly been no lack of concern, first under Koizumi and now under Abe.

But de Jonquières is right to put out that the situation may not be so bleak as commonly assumed. He questions the statistical method used by MoF to conclude that Japan's public debt is 170 per cent of GDP, suggesting that a method that deducts government assets reduces that figure to a more manageable ninety per cent of GDP. He further observes that Japan's debt burden has yet to have serious negative consequences for its economy -- despite the significant amount of debt, the government has yet to "crowd out" private lending.

De Jonquières concludes, rightly in my opinion, that the onus will continue to rest with the national government to slash public spending, which won't come without difficulty, as the government will have to tackle entrenched interests across sectors.

The case for thorough public sector reform would be compelling, even without fiscal pressures. Achieving it, however, will mean not only taking on powerful vested interests in the bureaucracy, the professions and the public services. It will mean carrying a conservative-minded electorate, whose appetite for reform has been dulled by the economic hardships and upheavals of the past decade.

Some of Mr Abe's most influential advisers appear ready to think radically. But it is still unclear how hard he will push their ideas. He will be unlikely to risk serious unpopularity before next year’s upper house elections, widely seen as a test of his political authority. But if a successful outcome is to serve as a credible mandate for ramming through painful changes, he will need to prepare public opinion beforehand.

It will not be an easy balance to strike. Until Mr Abe shows whether he really means business, Japan cannot afford to relax about the state of its public finances. But given the margin of safety still available, there is no reason to panic, either.

The mention of the 2007 elections in the upper house is important. It would be wise not to expect any substantial reforms in any area before the elections -- Abe may hint at reform to come, like constitutional reform, but the remainder of this year's special session and the whole of next year's regular session of the Diet will likely be used to pass no-brainer reform legislation that burnishes Abe's credentials without touching any sacred cows. That could be one reason for Abe's refusing to provide a detailed agenda. Better to not commit too early, minimizing the risk of having his tenure truncated by a major electoral defeat next summer.

In any case, expect Abe to focus on spending cuts that can be made with minimal toe smashing -- and don't expect the annual decline in the defense budget to be reversed anytime soon.