Quotes of the Day

Junichiro Koizumi has left Japan's economy in better shape than he found it upon becoming Prime Minister in 2001. The most consequential achievement was stabilizing the banking system by slashing nonperforming loans (NPLs). This was indispensable to the recovery of the past few years. Koizumi also cut wasteful public works. Still, with so much unfinished business, it is vital that his successor (and Japan as a whole) resists complacency.

It is imperative that Shinzo Abe, who will be elected as Prime Minister by the Diet this week, continues financial progress. While NPLs at the megabanks were down to 1.8% of total loans as of March, they remain at 4.5% at the regional banks. The latter lend almost as much as the big banks. Furthermore, NPLs have fallen partly because more than 26% of all loans charge an interest rate of less than 1% and 9% charge less than 0.5%. How will these borrowers fare as interest rates return to normal?

To sustain solid growth, the sources of demand need to be rebalanced. The current recovery has been fueled by business investment more than any recovery since the 1950s. But investment cannot grow faster than GDP indefinitely. The second pillar of the recovery has been a rising trade surplus, fueled by strong growth in the U.S. and China and the lowest price-adjusted value of the yen since 1986. That, too, has limits.

Consumption has lagged. That's because household income has stagnated, due to wage austerity, the rise of part-time and temporary workers, and near-zero interest rates. Total private-sector consumer income (wages, interest, self-employed income, etc.) was lower in 2004 (the latest year for which figures are available) than in 1997. The main source of any income growth has been government transfer payments, such as social security and health care, but these programs are being cut back to reduce the budget deficit. As households have dipped into their savings, so consumption has lagged. The household-savings rate has tumbled from 10% in 1997 to 3% in 2004. Very nearly one-quarter of all Japanese households have no savings at all, up from 10% a decade ago.

Japan's rapid aging is a daunting challenge to Abe's growth targets. Because Japan was operating far below full capacity in 2002, a big spurt of demand could produce good growth figures for a while as the economy got back to full capacity. The government says full capacity has now been reached, and going forward, sustaining growth will be tougher. The working-age population will fall by around 0.7% during 2005-2010 and 1.1% during 2010-2015. Not only will each worker have to support more retirees as a result, the only source for GDP growth will be productivity growth. The government's goal is 2.2% real growth per year through 2015. That would require productivity growth—which has averaged about 1.5% a year for the past 15 years—to rebound to around 2.9% during the next five years and then to 3.3%. Recent productivity figures look good, but these figures always fall during slumps and rise during recoveries. The jury is still out on whether long-term productivity growth has improved and by how much. But it seems doubtful that structural reform has yet reached the critical mass to raise Japan's long-term growth potential substantially.

Future reforms must tackle Japan's "dual economy," i.e. an efficient export-oriented sector but woeful inefficiencies in large parts of the domestic economy, such as food processing, home construction and many service sectors. A chief cause of this weakness is insufficient competition, either from homegrown firms or from imports. Japan has initiated many reforms in recent years to induce efficiency and profitability. These range from the financial "Big Bang" to a series of accounting reforms. There have also been a lot of mergers, acquisitions, and spin-offs. Some have led to greater efficiency, but others to less competition. The latter brings profits, not through efficiency, but through stronger pricing power by oligopolies.

The risk now is that the government and firms may believe that corporate reform has gone far enough. In reality, Japan needs to do more to spur fiercer competition at home, as well as to attract more foreign investment and imports. All of that will have to take place in a new political climate. Growing income inequality and a rising poverty rate have become big issues. Some opponents of reform blame this on Koizumi's alleged "market fundamentalism." In fact, the trend began two decades ago—though it has intensified in recent years. Abe's challenge is to combat inequality and provide a better "social safety net" while continuing with market reforms. Such reforms, and the sustained growth they will bring, will have the desired effect of reducing Japan's chronic budget deficit—which is a symptom, not a cause, of Japan's problems. The question everyone is asking is whether Shinzo Abe—who has never shown much interest in economics—has both the desire and the capability to continue reform. On this, too, the jury is still out.

• Richard Katz
• To keep the economy rolling, Japan's new leader must push ahead with reform