Japan economy: The wrath of Kan

TOKYO, Japan—If recent pivotal moments in Japanese politics have been characterized by disillusionment and incompetence, the upper house elections on July 11 left no doubt that the economy is firmly back on the top of the agenda.

The country’s new prime minister, the Democratic Party of Japan leader Naoto Kan, saw his coalition’s majority in the chamber slip away as voters registered their anxiety over his drastic plans to knock the world’s second biggest economy into shape.

Although the Democratic Party has a comfortable majority in the powerful lower house, last Sunday’s result, which left no single party with an overall majority, could lead to policy gridlock unless the ruling party can find a new coalition partner to restore its control of both chambers. Early indications are that it will seek policy support on an ad hoc basis.

If he is lucky, Kan might be able to persuade a junior partner to join him in his mission to prevent what he has described as a Greece-style meltdown in the world’s second biggest economy.

But the consensus is that the gridlock in parliament will thwart attempts to kick start growth and address Japan’s huge public debt, which at nearly 200 percent of GDP is the biggest in the industrialized world.

Kan’s undoing was the same issue that has felled previous Japanese governments: tax reform, or rather, tax increases.

In his zeal to underline the economic challenges ahead, Kan suggested he was preparing to raise the sales tax within two to three years to help fund Japan’s ballooning health and social security costs. The alternative, he said, was to continue to finance spending with fresh debt, putting Japan on a collision course with fiscal oblivion.

Just as the global recession forced the world to learn from Japan’s “lost decade” of stagnation in the 1990s, it is now keeping a close eye on how its debt is addressed.

Early indications are far from encouraging. Standard & Poor’s, the ratings agency, warned that it could cut Japan’s sovereign debt rating, while the International Monetary Fund said that the country’s export-driven recovery is likely to slow down as the impact of global stimulus packages wears off.

Are Japan’s debt woes as serious as Kan has suggested? His warning, soon after becoming prime minister, that Japan risked a Greek-style fiscal crisis unless the country curtailed its debt invited accusations of alarmism.

And for good reason. Almost all of Japan’s public debt is domestically owned, while about 70 percent of Greece’s sovereign debt is in the hands of foreign investors. Japan has a huge pool of domestic savings to draw on and remains the world’s biggest creditor nation.

Few are suggesting that Japan can continue to spend its way to recovery, as it has tried, and failed, to do for the last two decades.

Kan’s gamble with tax may yet pay off though. Polls suggest that most voters have resigned themselves to an increase in the sales tax to fund soaring welfare costs in one of the world’s fastest-ageing societies, while spending cuts are implemented elsewhere.

“It is possible to say that support for a sales tax increase may rise if persuasive arguments are presented to voters, including cutting government waste,” the Asahi Shimbun newspaper said.

The public’s gripe with Kan is rooted in his confused approach to the scale and purpose of his proposed tax changes, a criticism he accepted in the immediate aftermath of defeat.

“I am sorry that my remarks were misunderstood,” he said. “The election result shows that the country needs to have a proper debate before any decision is taken on tax.”

Martin Schulz, senior economist at the Fujitsu Research Institute in Tokyo, believes Kan could win the tax debate as long as he proves his credentials in other policy areas, such as social security spending and wresting power from the elite bureaucrats who have run Japan’s postwar economic policy.

“There is a general acceptance that the sales tax has to be raised eventually. But people are only willing to trust a government with a proven track record of acting responsibly, and the DPJ haven’t done that yet,” Schulz said, referring to the Democratic Party by its acronym.

Kan’s great election miscalculation, Schulz added, had been to suggest that the additional revenue would go into a raft of “third way” projects to bolster domestic demand. Voters, by contrast, want the cash directed toward bread-and-butter issues, such as the country’s creaking state pension scheme.

“Tax cost him the election, but he knew he was playing with fire and he went ahead and talked about tax reform anyway. He has invested a lot of capital in this,” Schulz said.

As it seeks to fend off a European-style debt storm, Japan could benefit from a modicum of political stability.

Kan is Japan’s fifth leader in four years, but if the recent election shambles tells us anything, it is that voters are, by fault or design, making their country all but ungovernable, with all the dire consequences that has for the economy.

Yet given the depth of the problems facing Japan, Kan may yet discover that a pledge to raise taxes is no longer the political suicide note it once was.

Instead, his challenge will be to persuade the electorate that the tens of billions of dollars in extra revenue will go to a deserving cause.