No More Games in Japan's Referee-Free Capitalism

Masaru Kaneko, Professor of Public Finance, Faculty of Economics, Keio University [About | Email]

Volume 1, Issue 1 (Discussion Paper 4 in 2001). First published in ejcjs on 29 August 2001.


Japan's economic stagnation is rooted in its "referee-free capitalism." Economic reform is certainly needed, but legal reform is as well. In particular, stricter rules must be applied to bankers and regulators, and the merry-go-round chicanery of investigations into non-performing loans (NPLs) must come to end. This should be a precondition to the use of public funds to resolve the NPL problem. But the "structural reforms" advocated by Prime Minister Koizumi Junichiro's cabinet are worrisome. They are predicated on market fundamentalism and are likely to push the Japanese economy even deeper into recession.

The Economic Crisis: Bad Debts

The Japanese economy is again in serious crisis. In response, the cabinet of Prime Minister Koizumi Junichiro have staked their reputation on a painful round of reforms. Their proposals of course lack detail, in large part due to worries about spooking too many voters in advance of the recent July 29 Upper House election. But the flagship of Koizumi's reform drive is the Council on Economic and Fiscal Policy. Its publications and various other sources tell us that the Koizumi team's guiding philosophy is neoliberal.1

Their approach rests on the clear assumption that Japan's problems can be solved by supply-side reforms and reallocating public spending to the cities. These politically bold moves represent a frontal assault on the old regime, and thus reprise the 1980s neoliberalism of Reagan and Thatcher, minus the union-bashing.

The opinion polls and the July 29 election results suggest that most Japanese voters want radical change and have little confidence that the fragmented opposition parties can deliver it.2 The Koizumi boom is also clearly a rebound effect after the profound embarrassment of the Mori regime. Confronting another "lost decade" of debt and poor economic performance, most voters appear desperate for an alternative and are ready to believe that Koizumi can do something for them.

But in desperate times, people easily make rash choices. So let us think clearly. This crisis is serious and poses grave political and economic risks to Japan as well as the global economy. Japan, the world's second-largest economy, is once again sliding into recession. The other Asian economies, the United States, and most of Europe are also either in a recession or quite near it. We appear, in fact, to be slipping into the first synchronous global recession since the oil shocks, at a time when economic globalization has amplified the risks of "contagion" from one country to another. Shocks in one economy, even a small one like Thailand or Turkey, can spread rapidly to its neighbours and throughout the global system (Roach, 2001). In this dangerous context, what Japan does will have enormous consequences, whether for good or for ill. In short, the scale of the catastrophe that could ensue from yet another round of bad economic policies puts a premium on correct analysis of the underlying problems.

A Lost Decade of Failed Policymaking

The foremost challenge confronting the Japanese economy over the past decade has been its exhaustion through NPLs. These bad debts stem from the excesses of the bubble economy and the consequences of its collapse. The NPLs should have been dealt with in the early 1990s through a clean-up operation, as we saw in the resolution of the Swedish banking crisis in the early 1990s (Backstrom, 1997) and the US Savings and Loan crisis during the early 1980s (Ostrom, 1998). But in an incredibly protracted case of policy immobilism, Japanese policymakers dawdled and allowed the problems to get progressively more debilitating.

The NPL problem has worsened considerably since December of 1988, when the former Obuchi Administration's Economic Strategy Commission released its interim report.3 The report led to the decision to bury the issue of bank executives' responsibility for three years. The government then injected 7.5 trillion yen of public funds, in March of 1999, to recapitalize the banks. Leaving the responsibilities of the bankers and the regulators unresolved, and their ranks unscathed, the next step was to try pumping up the stock market with hype about the IT revolution. Gains from a home-made IT boom were to be shifted to the banks which would then use them to write off the NPLs. But the plan came to naught. The American economy continued its slide and then the Japanese stock market went into its current free-fall, wreaking further havoc on the banks' balance sheets.

There are various estimates of total NPLs, depending on the agency doing the calculations as well as the types of loans that are included. Loans are graded into 4 categories according to the risk of default, with Category 1 loans being the least risky and Category 4 being uncollectable. No one knows what the real totals of NPLs are because the banks have strong incentives, including tacit encouragement from their supposed regulators, to hide clearly failed loans in among their less risky liabilities.4 Calculations done on the basis of the Financial Reconstruction Law suggest that Japan's NPLs stood at 32 trillion yen as of the end of March, 2000. The main banks' self-assessments yield a higher figure, at about 64 trillion yen. What is certain is that in the wake of the Asian financial crisis of 1997, Japan's NPLs have increased.

The NPL problem is becoming especially grave at regional financial institutions. The 70 top regional banks and second-tier banks comprise 60 percent of the whole. Assessed on the basis of the Financial Reconstruction Law, their NPLs have increased by 16 percent (roughly 1 trillion yen) over the previous total, and write-offs now exceed 8366 billion yen. Their total of NPLs is close to 7 trillion yen.

As for the 16 major banks, even if we restrict our attention to loans that are probably unrecoverable, new NPLs amount to nearly 3.4 trillion yen. On the surface, NPLs have declined due to write-offs of 4.39 trillion yen. But the real totals almost certainly greatly exceed this. For example, the powerful Bank of Tokyo Mitsubishi mounted a thorough investigation and in September of 2000 raised its NPL totals from 1.58 trillion yen to 4.53 trillion yen. This was widely referred to as the "Tokyo Mitsubishi shock."5 While a comparatively strong bank such as Tokyo Mitsubishi is capable of making such facts public, much weaker regional banks do not have the same institutional fortitude. This is one reason why the true scale of NPLs remains concealed. But the Financial Services Agency's (FSA)6 data suggest that the broader category of "special attention loans" has reached about 150 trillion yen. Were the stricter standards of Tokyo-Mitsubishi applied across the board, there is fear that the totals could exceed 200 trillion yen.7

The Political Crisis: No Referee

The Koizumi Cabinet claims that it will be able to deal with the NPLs within 2 to 3 years, but this is at best disingenuous. The scale of the NPL problem is such that it is no longer possible nor prudent to leave its resolution to market principles alone. This is because there are no disinterested institutions dedicated to keeping the markets behaving as markets. Japan, in fact, has a referee-free variant of capitalism.

Imagine trying to have a meaningful game of soccer or baseball if the owners of the contending teams called the plays, and you can get the gist of what we mean. The claim will no doubt seem offhand and journalistic to many readers. But view the issue from the lofty executive-level perch of one of Japan's technically bankrupt financial institutions. The banks' management have, for years, engaged in all manner of malfeasance and window dressing in order to hide their institution's true level of liabilities. But the lies go unpunished. Indeed, they have long been given official imprimatur and have been concealed by the Ministry of Finance (MOF) and then by the FSA. The bank executives take no responsibility as managers, the FSA bureaucrats accept no responsibility as regulators, and the entire structure of deception and double-dealing goes on.8 That is why it is reasonable to declare that Japanese capitalism has no impartial referee on the field to enforce any rules.9

In a different sociopolitical regime, one candidate for referee might be State Minister for Financial Affairs, Yanagisawa Hakuo. He has a strong image as a reformer in the overseas press, but he is an old-boy from MOF and a long-time overseer of financial affairs. He simply continues with the deception in claiming that market principles can deal with the NPLs. Market principles are supposed to fix the problem through discipline and a cathartic release of "blood on the floor." But note that nowhere in this grim tableau of discipline and punishment do we see the heads of the bankers and regulators. They are primarily responsible for creating the crisis in the first place, but are deemed too important to sacrifice. It is no wonder that many critics regard market principles as the principles of irresponsibility.

The show continues, as we see in the news. For example, the estimates of crisis-ridden general contractors' debts vary greatly among the banks. This is true of NPL estimates at the Daiichi Kangyo Bank, Fuji Bank, and the Industrial Bank of Japan. The three banks are planning to merge in 2002 as the Mizuho Financial Group, becoming the world's biggest bank. It is not without reason referred to as the Godzilla Bank in the international business press. But one of the conditions attached to the plan is that the assessments concerning NPLs be standardized. Considering the size of the Godzilla Bank, and the background of increasingly shocking NPL revelations elsewhere, there can be little doubt that a truly gargantuan disclosure is marching towards the citadels of global finance.10

Japan's referee-free capitalism is thus mired in the mud of NPLs. The enlargement of the NPL totals goes hand in hand with a contraction of trust in the system, and both of these exacerbate the deflationary spiral. The deflation then compresses the system, forcing an increase in NPLs and bringing more concealed amounts to the surface. In consequence, there is an ever-receding goal in the NPL totals, followed closely behind by a never-ending succession of proposed and failed plans for the loans' "final disposition."

The Koizumi Cabinet's "structural reform" is not going to fix these problems. Rather, the minimum necessary measures are the following. The first priority in the legal process is to undertake a proper estimation of NPLs while simultaneously investigating bank executives' and regulators' responsibilities for the past years of subterfuge. This will help restore public trust in the system as well as encourage more exemplary behaviour. This is particularly important because public funds will have to be used, yet again, to recapitalize banks whose capital base has been rendered insufficient to comply with international rules on capital adequacy.11 Judging by what is generally known about the banks, as well as the continuing downturn in the stock market and real-estate values, a massive infusion of funds will be required. Moreover, assets held by bankrupt debtors will have to be taken over by a resolution trust agency and then sold off. This process calls for steady hands. It is not only important to get the current NPLs off the balance books; it is also important not to flood the market with assets and thus create new NPLs through asset deflation.12

The second major order of business concerns the public debt. Japan's has reached over 130 percent of GDP, by far the highest among the industrialized states. A further injection of public funds into the financial system, though probably unavoidable, will certainly worsen matters. The scale of the debt so far cannot be redeemed within the current institutional order, which is very opaque (Ando, 2000, OECD, 2000: 143-5) and centralized. The lack of transparency and the excessive centralization create far too many incentives and opportunities to engage in the kind of window-dressing that characterized the 1990s. This makes it imperative to shift to a debt management state structure that puts a lid on the steady accumulation of the stock of public debt.13 The Koizumi regime calls for holding deficits to 30 trillion yen per year, but holding deficits to this level even for an additional three years would produce an additional 90 trillion yen more in debt. This is close to 20 percent of GDP. The need for a major shift in policy is obvious, lest the market finally rebel and bring on a catastrophic drop in Japanese bond prices. The potential for this kind of crisis has, in fact, been strengthened by market-oriented reforms undertaken over the past decade (Kaneko, 1999).14 In order to prevent a sudden drop in bond prices, it is necessary to stop the stock of public debt from growing further.

Structural Reform and the Acceleration of Deflation

The current situation is thus even more challenging than the Koizumi Cabinet imagines. To the extent that the Koizumi Cabinet continues simply to bash the bureaucrats and the Hashimoto faction of the LDP, "structural reform" has little content. The Economic and Fiscal Council's most recent reports symbolize this. They throw out the slogans of deregulation and privatization, decentralization, freeing up fiscal resources, fixing the safety net, and so forth, but offer very little of substance.

The problem is that the Koizumi Cabinet starts from the wrong set of assumptions. With the exception of a few members, the bulk of the Economic and Fiscal Council (and particularly Takenaka Heizo, the Minister of State for Economic and Fiscal Policy), are devotees of Thatcher and Reagan-style market fundamentalism. But even granting that Reaganism and Thatcherism had their positive effects on the stagflation-era Anglo-American economies, the fact is that their brand of reform is an unsuitable solution to the Japanese economy's problems. This is because a policy of deregulation predicated on market fundamentalism will increase unemployment and lead to a further drop in prices.

We have already seen three consecutive years of negative nominal growth. Moreover, deflation has produced an abnormal situation wherein the real growth has barely stayed in positive territory. If the two worst classes of NPLs are handled according to market fundamentalism, various analysts forecast a 0.5 to 1.3 million person increase in the number of jobless. The unemployed already total about 3.5 million people, or 4.9 percent of the labour force. The Economic and Fiscal Council's projections of 5 million new jobs created via deregulation seem fanciful in the face of this stark prospect. Takenaka himself has apparently admitted that they are a gamble.15 If we look back on the Thatcher-era reforms, the striking aspect is the large-scale unemployment and price deflation they brought about. It is mere faith to assume that a drastic reform of the regulatory regime will automatically give birth to new industries and employment. Rather, there can be little doubt that a full dose of market fundamentalism will worsen the current deflation and thus hasten the economy's downward spiral.

The public's worries about the future are a primary cause of the current deflation. Recent data show that consumers' spending as a proportion of their disposable income has fallen to 68.9 percent, its lowest level since 1975 (Yomiuri Shimbun, 2001). Therefore, institutional reforms towards a stable social security system are essential. But the Economic and Fiscal Council has little to say on this score save for calling for the construction of individual pension accounts and hiking the consumption tax. At best, the former is little more than the 401K system that is deeply controversial in the United States. Under the slogan of "individual responsibility," the Japanese 401K program would shift the burden of pension funding onto labour and therefore exacerbate worries about the future. Moreover, in the current regime of depressed consumption, it is not realistic to project an increase in the consumption tax. Rather, the reform that is necessary is a comprehensive pension reform that puts an end to the old pension system and converts pension funding to a contribution-based system based on a proportional income tax.16

Another problem is the projected worsening of the regional economies. It goes without saying that bolstering the safety net by extending the period of unemployment-insurance coverage is necessary. But more fine-grained policies are needed at the local level. The sine qua non of crafting the appropriate policies is a full-scale decentralization of the national finances. From this perspective, the May 31 publication of the Economic and Fiscal Council's report is clearly inadequate and only threatens to deepen the deflationary spiral.

Local economies lag by about half a year, but we will soon see the effects of the downturn. If the NPL problem is left as is, the regional financial institutions will suffer an enormous shock. On top of that is the huge shock they will experience at the end of March 2002, when the end of deposit insurance takes effect.17 Third, with the parlous state of local finances, the local governments do not have the fiscal room to initiate new public works.18 Fourth, agricultural commodity prices are suffering huge and rapid declines.

To cope with these policy challenges, fine-grained and nuanced reforms are required. The Koizumi reforms for rural areas center on redirecting the flow of road-building funds to general revenues, cutting fiscal equalization payments, and promoting the amalgamation of municipalities.19 These are seen as bold and innovative measures, but in fact they are short-sighted and will worsen conditions in the regions. Take the example of reforming the finances of the road-building regime. There is no doubt that revision of this porkbarrel-ridden system is necessary. But if this occurs in a context where NPLs are left unreformed, then the effect will be to transfer the spending to the cities and rescue the big general contractors. This will leave the local economies twisting in the wind.

The Koizumi regime has an opportunity to make serious and systemic reforms to the Japanese political economy. They could choose to bolster the fiscal and administrative institutions that will fix the debt problem and set the economy back onto a path towards balanced and equitable growth. At present, however, they advocate reforms that will worsen Japan's current problems and thus compound those confronting the global economy. The Koizumi team can only avoid catastrophe if they step back and rethink their outmoded neoliberalism.


Ando, Albert (2000), "On the Japanese Economy and Japanese National Accounts," NBER Working Paper 8033, December 2000

Backstrom, Urban (1997), "What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience." Paper presented to the Federal Reserve Bank of Kansas City Symposium, 1997. Internet edition.

Bremer and Pettway (2001), "Market Discipline of Japanese Banks: Regulation, Environment, and Disclosure", Nanzan University Website.

Bremner, Brian and Chester Dawson (2001), "A Peek at Plan Koizumi," Business Week Online, June 18. Internet Edition.

Chandler, Clay (2001), "Tokyo Unveils Reform Strategy," Washington Post, June 22. Internet Edition.

Choy, John (1999), "Japan's Banking Industry: The Convoy Disperses in Stormy Seas," Japan Economic Institute Feature Article, Number 10, March 12

Economist (2001). "The Koizumi Effect," Economist, July 30. Internet Edition.

Fujiwara, Sakuya (1999), "The Safety Net after April 2001," Bank of Japan, Speeches and Statements. Internet Edition.

Hanazaki, Masaharu and Akiyoshi Horiuchi (2001), "A Vacuum of Governance in the Japanese Bank Management," CIRJE, University of Tokyo, Discussion Paper CIRJE-F-29 : Internet Edition.

Jinno, Naohiko and Masaru Kaneko (2000). Zaisei Houkai o Kuitomeru: Saimukanri Kokka no Kousou [Stop Japan's Fiscal Collapse: The Structure of a Fiscally Responsible State], Tokyo: Iwanami Shoten.

Johnson, Chalmers (2001), "Japanese eCapitalism' Revisited," JPRI Occasional Paper No. 22, August 2001

Kaneko, Masaru (1999), [The Political Economy of the Safety Net]. Seefutii Netto no Seiji Keizagaku, Tokyo: Chikuma Shinsho

Kaneko Masaru (1998), "Donoyouna Shinchihouzei ga Hitsuyou ka" [What Kind of New Local Tax is Necessary?], in Jinno Naohiko and Kaneko Masaru (eds.). Chihou ni Zeigen o [Devolve Taxes to the Local Governments], Tokyo: Toyo Keizai

Katz, Richard (2001), "Anorexia: Japan Becomes a Stimulus Addict," The System That Soured, New York: M.E. Sharpe, Chapter 8 Website Update.

Krugman, Paul (2001), "A Leap in the Dark," New York Times, July 8, Internet Edition.

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OECD (2000b), "Economic Survey of Japan: Policy Brief," OECD, October 2000

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Tilton, Mark (2001), "Under-regulated Japan: Telecommunications and the New Economy," paper prepared for "How Politics Undermine Economic Reform in Japan," June 8, 2001, Washington, DC.

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[1] The Council's reports as well as the minutes of its meetings are available online.

[2] The LDP-led coalition won 78 out of 121 seats at stake in the Upper House, largely on the strength of P.M. Koizumi's popularity (Economist, 2001).

[3] For information on the Council click here.

[4] On these issues, see Rasche, 2000 and Katz, 2001.

[5] On this, see the several articles in the June 26, 2001 edition of the Japanese weekly, Ekonomisuto.

[6] The Agency's web site can be accessed here.

[7] Many overseas analysts are even more downbeat in their assessments. A recent Bank of England study, for example, argues that the scale of Japan's NPL problem is such that a clean-up will likely cost as much as US $800 billion, or roughly 20 percent of Japan's annual GDP (The Times, June 25, 2001).

[8] On some of the problems in Japan's financial sector, see Bremer and Pettway, 2001 and Hanazaki and Horiuchi, 2001. On the background of Japan's "no losses, no failures" style of banking regulation, see Choy, 1999.

[9] As Chalmers Johnson put it recently, the roots of Japan's contemporary problems lie in underregulation, inadequate supervision, and the free play of LDP-style politics (Johnson, 2001). See also Tilton (2001).

[10] Frequently updated and highly critical coverage of Mizuho can be found here.

[11] This rule, the 1988 Basle Capital Accord, requires banks to maintain capital equal to 8 percent of their assets. On this, see the International Financial Risk Institute's internet site.

[12] The Koizumi reforms foresee the use of the Resolution and Collection Corporation to dispose of remaining NPLs in three years time, but have been criticized for offering scant detail on how the scheme would work and who would bear the costs (Chandler, 2001). The proposal also lacks any attention to prosecution for past wrongdoing.

[13] On this, see Jinno and Kaneko (2000).

[14] The OECD notes that regulatory and other reforms undertaken over the past several years are dramatically changing the institutions through which Japan's public debt is financed. The Japanese state's ability to tap freely into the country's pension funds and other pools of capital is being constrained. In consequence, "market forces and market sentiment will be much more important in the future in setting interest rates for financing the public sector and this will make it even more important to avoid an unsustainable spiral of debt" (OECD, 2000b: 5-6).

[15] Takenaka recently conceded, in an interview with Paul Krugman, that the Koizumi Cabinet's reform proposals centre on the supply side. He expressed his hope that supply-side reforms would eventually stimulate consumption. Krugman refers to this approach as "a leap in the dark - radical measures taken because they might work, not because there is solid reason to believe that they will work" (Krugman: 2001).

[16] For a detailed description of this reform, see Kaneko, 1998.

[17] On the system of Deposit Insurance and its reforms, see Fujiwara, 1999.

[18] See, for example, Takahashi, 1999.

[19] A concise outline of the reforms can be found in Bremner and Dawson, 2001.

About the Author

Masaru Kaneko is Professor of Public Finance in the Faculty of Economics at Keio University in Japan. His best-known recent publications are: Zaisei Houkai o Kuitomeru: Saimukanri Kokka no Kousou [Stop Japan's Fiscal Collapse: The Structure of a Fiscally Responsible State], co-authored with Jinno, Naohiko (Tokyo: Iwanami Shoten, 2000), and Seefutii Netto no Seiji Keizagaku [The Political Economy of the Safety Net], (Tokyo: Chikuma Shinsho, 1999). Altogether, over the past five years he has authored and coedited several highly regarded books and articles in such journals as Sekai, Ronza, and others. He also a frequent guest on Japanese television programmes that focus on contemporary Japan's fiscal and financial challenges.

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