Analysts are sharply divided over the outlook for Japan. Some think that Japan's failure to monetize its growing stock of debt aggressively and set inflation targets to stem the growing deflationary pressure will provoke a full-blown deflationary crisis. In one gloomy scenario from respected Lombard Street Research analyst Brian Reading, a "deflationary fiscal consolidation will cause depression and unemployment over 10 percent." Reading's other alternative is a sharp reflation that undermines the credibility of Japan's public finances.

In contrast, other analysts see encouraging signs of restructuring in Japan. In "Japan: The Darkest Hour Comes Just before Dawn," Guyerzeller Bank AG of Zurich argues that Japan has initiated the restructuring that will lead to a sustainable recovery and steep increases in Japan's stock prices.

Whatever their outlook for Japan, analysts agree that the limits to a successful macroeconomic reflation policy are being reached and that there are no macroeconomic solutions to Japan's microeconomic problems. Those problems can be solved only by a radical restructuring that sweeps away Japan's ossified and inefficient domestic sector and financial system.

This Outlook explores the potential for global creative destruction to transform Japan from the outside, not from within, and examines the conditions that might do so. Chances for such a turnabout--through large injections of capital by well-capitalized and well-managed global investors--may be slightly better than even. The outcome depends on how fast Japan's managers and government catch on to the restructuring process and on whether the Japanese government will tolerate the degree of foreign investment needed.

Discussions of how Japan reached its current depression have noted the ironic transposition of the Japanese and American economies over the past decade. At the end of the 1980s, Japan could do no wrong, while the American economy was struggling with bad debts and a weakened banking system, budget deficits, and a feeling that American managers were out of step with practices that had transformed Japanese producers into world-class winners.

As it turned out, Japan was at the end of a classic demand-led overheating expansion, which was halted by the Bank of Japan's justified fears of a speculative bubble, manifested in stock and land prices. In 1989, the grounds of the emperor's palace in the center of Tokyo were said to be worth more than California. Few reflected on the difficulty of arranging a market-clearing trade on those terms. But since then, land prices in Japan have collapsed--they fell by more than 50 percent from their peaks and erased 10-12 trillion yen of wealth (three to four years' gross domestic product). Meanwhile, stock prices have fallen by two-thirds and have wiped out another 4.75 trillion in wealth (more than a year's gross domestic product). Altogether, Japan's losses of 17 to 19 trillion yen in wealth equal nearly five years of the 1998 gross domestic product (3.7 trillion yen). There is some quarrel over the exact size of losses in the real estate market because there have been few transactions in that immensely depressed sector, but no bank or insurance company doubts that the losses are massive while the market is illiquid.

Recovery--The Only Option

The optimists on Japan's future reason that after all this destruction of wealth and the consistent failure of macro policies, Japan has no avenue open but the correct restructuring micro policies that could lead it back to a sustainable recovery and even to a golden age. The model for a golden age was laid out in the United States over the past decade and a half. The restructuring and cost-cutting efforts begun in the late 1980s and the clearance of bad debts out of the banking system in the early 1990s set the process in motion. During that period the Federal Reserve's control of the growth of aggregate demand was critical. Maintaining or improving profitability required investment to cut costs without raising prices.

Could Japan follow a similar path to a golden age in the first decade of the next millennium? Is the 20 percent rise in Japan's stock market over the past two months just another trick at Japan's fiscal year-end of March 31, like those seen in the past two years, or is it a glimmer of what might be possible if that remarkable nation finally starts to remedy fundamental problems within its economy and financial system?

A Japanese golden age--rising growth and falling prices over half a decade or more--is an omelet requiring many, many eggs. Japan's basic macro problem, noted with increasing frequency, is that its savers save far more than can be profitably invested in its highly regulated economy, which is, in turn, constrained by outmoded ties among keiretsu (business conglomerate) members, who have dealt for years with each other instead of with low bidders on inputs and high bidders on outputs. Too much investment outside Japan eventually drove real returns to zero by the end of the 1980s. A decade of too much public investment (about 800 billion dollars' worth) has not helped the Japanese economy to move back onto a sustainable growth path.

To create the necessary preconditions for sustainable growth without inflation, the government must undertake some radical micro-policy steps, while simultaneously navigating some difficult short- and intermediate-run policy challenges. To create a surge of investment opportunities inside Japan, the government must sharply accelerate the restructuring of its financial and domestic sectors. Japan's international sector is, in effect, subject to global competition and therefore far more efficient than the domestic sector. Much of the latter is an inefficient system for the distribution of goods and the delivery of financial and nonfinancial services inside Japan.

As often happens with Japan, the leading edge of pressure for restructuring is coming from abroad. However, years of falling profits at home have speeded up the pace of layoffs of redundant labor and a sharp drop in investment spending by Japanese companies in the face of excess capacity and wrongly configured capacity. Rising unemployment and falling investment are a painful medicine in a long-depressed economy such as Japan's, but they are the right steps toward an eventual supply-side recovery driven by a surge of investment into more efficient delivery systems for goods and services, especially financial services. Japan's banking system desperately needs to be transformed into one worthy of a modern industrial economy, one to replace largely dormant banks still unable, because of a lack of capital or opportunity, to serve as viable financial intermediaries that would sustain, rather than hinder, economic recovery.

Foreign Capital, Not Control

We may be entering a period when the policies needed to avoid a deflationary depression in Japan would enhance the contribution of foreign investors to the restructuring of the economy. Increasing foreign investment in this process is already evident. The 20 percent rise in Japanese stocks since mid-February was driven by foreign buying. The trigger for the stock rise was the February 12 statement from the Ministry of Finance that it would oppose unchecked strengthening of the yen. This statement, implying an easier money policy aimed at a weaker yen, followed the January 12 direct intervention by the Bank of Japan to avoid the yen's appreciation.

Specific examples of foreign investment in Japanese restructuring abound. In the first quarter of 1999, GE Capital purchased Japan Leasing for $6.5 billion, the largest foreign acquisition recorded thus far in Japan. Meanwhile, Nissan Motors and Mitsubishi Motors have offered parts or all of themselves for sale to foreign investors in a move suggesting a willingness to obtain the know-how and capital necessary for restructuring anywhere--even from foreigners. Last year Nikko Securities sold a 25 percent equity stake to Citicorp, while Mitsubishi Oil agreed to merge with Nippon Oil. Both moves were taken without consultation with other keiretsu members.

If a gush of foreign capital to buy real assets in Japan moves the restructuring process along and forces domestic capital to follow, we shall see an example of transnational creative destruction, perhaps beyond the scope envisioned even by Joseph Schumpeter. The immense pressure for such a process is propelled by a desperate global search by huge pools of capital for the 20 percent and higher annual returns that are becoming more and more elusive in the capital markets of America, Europe, and emerging economies--despite promises and expectations.

Japan's immediate need to fight deflation could accelerate global creative destruction with a weaker yen that would, in turn, make it less costly for foreign investors to buy real assets in Japan. Indeed, a fear of too much foreign control may be causing Japanese policymakers, always protective of Japan's insular domestic sector, to hesitate over a much-needed policy of aggressive monetization by the Bank of Japan. The Japanese are by no means alone in their fear of foreign control. The same fear obsessed Americans just a decade ago, when Japanese investors were buying up landmark American buildings (Rockefeller Center) and golf courses (Pebble Beach). A quick read of Michael Crichton's Rising Sun or a viewing of the movie version will refresh faded memories of American paranoia in the late 1980s.

Japan's macro-policy overlay on the microeconomic restructuring so desperately needed is at a critical stage. Partial monetization of the growing public debt, with an eye to pushing up domestic demand, might accelerate the weakening of the Japanese yen. A sharp rise in domestic demand would increase domestic spending and lower Japan's large current account surplus; in turn, such action would help weaken the yen. A weaker yen would lower the price of real Japanese assets for foreign investors.

There is a yen exchange rate that would escalate foreign investment into Japan to help speed up the much-needed restructuring in the domestic sector. In this sense, a weaker yen would substitute for the much-needed domestically driven deregulation of Japan's domestic sector, which the politicians are loath to pursue with sufficient vigor. Let foreign companies buy Japanese companies and restructure them. The indispensable investments beyond GE Capital's purchase of Japan Leasing would follow a decline of the yen.

If foreign investors became sufficiently interested in buying into restructuring opportunities in Japan, the world's greatest exporter could eventually become a net importer of capital with a current account deficit. This seemingly bizarre outcome would be a natural counterpart of an active reflation that created a sudden surge of investment opportunities swamping the immediate flow of domestic savings. Domestic absorption, consumption, and investment would intensify--a result consistent with a current account deficit. After an initial drop to set off a Japanese reflation-restructuring binge with attendant higher capital inflows, the yen would probably strengthen on the back of a sustainable recovery, perhaps as the current account deficit rose further. That was the experience after 1995 in America's golden-age expansion, which has included 4 percent growth and falling inflation.

These apparently odd phenomena for Japan--especially a current account deficit--would be the natural byproduct of a transformation of the inefficient domestic sector into a modern, efficient delivery system for goods and services. An invasion of foreign investors would do for Japan's sheltered domestic companies what Commodore Perry's black ships accomplished for Japanese society well over a century ago: a transformation that would turn Japan's remarkable energies and adaptability toward a restructuring of its economy.

With domestic restructuring underway, Japan's leading companies could accelerate their transformation (also underway) into true world-class firms. They would not be Japanese companies any more than Coca-Cola is an American company. They would be global businesses with headquarters in Tokyo or Osaka but with production, financing, and distribution systems located wherever they can operate most efficiently.

Over the past fifteen years, the transformation of America's economy in this manner created an American golden age, a supply-side recovery capable of sustained growth at falling prices. A similar transformation of Japan could create a golden age there.

Only a Dream?

But the golden-age scenario for Japan is, at present, no more than a tantalizing possibility. Japan's economy has demonstrated clearly that it is incapable, as yet, of a self-sustained recovery. Without large doses of government help, the country's economy shrinks at an average rate of 3.5 percent per year, as it has done since the middle of 1997. Last winter's 24 trillion yen fiscal stimulus package may create a zero, or even slightly positive, growth rate during the first half of this year, but without another fiscal stimulus package for temporary life support or without a weaker yen, the economy will drop back into negative territory--unless private sector domestic demand can be increased..

Hints of another stimulus package of 10 trillion yen have already circulated, but Ministry of Finance officials are eager to deny this possibility because Japan's budget deficit is already well over 10 percent of GDP, with its total debt obligations exceeding 100 percent of GDP. Into the indefinite future, the Japanese government must borrow an additional 4 trillion yen per month (about $36 billion per month). In an economy like that of the United States--twice as large as Japan's--that is the equivalent of borrowing another $72 billion per month, or $864 billion per year. That huge figure, surpassing 10 percent of U.S. GDP, seems unthinkable in America--but it is a current reality in Japan.

To keep long-term interest rates from rising further (they tripled from 0.8 percent to 2.4 percent between November 1998 and January 1999), Japan's central bank has attempted to ease credit conditions by pushing short-term interest rates to zero and flooding the banking system with excess reserves. These measures can add (at best) about 5 trillion yen of liquid resources for the banks to continue to buy the flow of government paper. But the Bank of Japan's recent extra injection of funds into commercial bank reserves equals about one month's additional supply of Japanese government borrowing this year. The central bank can hold down short-term rates, but long-term rates will continue rising to levels that will accommodate Japan's massive borrowing needs.

Japan must engineer some reflation by direct purchases of either government bonds or foreign exchange. That move will require printing money and setting an inflation target, both alternatives that the Bank of Japan explicitly rejected early in April.

The probable sequencing in Japan's progress will see another deflationary crisis accompanied by a stronger currency and higher interest rates, as in December. The BoJ will then be forced to prevent rapid appreciation of the currency by aggressively buying dollars. The Bank of Japan's commitment to maintaining virtually zero short-term interest rates will prevent it from selling government bills to sterilize the impact on the money supply of its dollar purchases. Therefore, a deflationary crisis in the form of a stronger yen will probably force Japan to a strategy of monetization.

If Japan were to sterilize its intervention to avoid a sharp appreciation in the yen, the result would be higher short-term interest rates, further weakness of the stock market, and a collapse of the bond market. If the BoJ is forced to monetize to avoid an appreciation of the yen, which would continue to weaken its traded-goods sector--Japan's only cushion against the total collapse of growth--reflation would eventually result. That reflation, along with continued inflows of foreign capital to help restructure Japan, could help restore consumer confidence, and thus domestic demand, in Japan.

Signs of a persistent and successful reflation engineered by the Bank of Japan would encourage further increases in the value of stocks. Japan would have to resign itself to a steep climb in interest rates as a part of recovery: the replacement of deflationary expectations with modest expectations of inflation would contribute to higher bond yields. So too would higher real yields, which would reflect the necessity of bonds to compete with rising equities as assets. But the rising interest rates in Japan, rather than being a problem, would be a signpost on Japan's path toward sustainable economic recovery. Japan's long-term interest rates have averaged 4-5 percent during most of its expansionary period; there is no reason why they shouldn't return to that level as Japan's economy returns to an expansionary phase.

And Japan's Decision?

Japan has yet to pull the reflationary trigger to start a reflation that would include a rising stock market, a weaker currency, rising interest rates, and, most important, large purchases by foreigners of potentially valuable franchises in the domestic sector. The price that Japan must pay for a sustainable golden-age recovery is the sale of some valuable real assets, franchises in the financial and domestic sectors, which can be rapidly transformed into profitable enterprises by foreign capital and foreign managers.

This process of global creative destruction, while expanding foreign ownership of Japanese enterprises, would not threaten the country's sovereignty or security. Japan is a huge economy, the world's second largest. Its corporate managers have demonstrated great skill and adaptability and are beginning to move quickly to modernize operations inside and outside of Japan.

Undoubtedly, in a few years the Japanese economy could be modernized and internationalized to include world-class banks and producers, in both the domestic and the international sectors. The only question that remains is whether Japan's single party parliamentary system, led for more than four decades by the Liberal Democratic Party, will stand aside and let that occur.

John H. Makin is a resident scholar at the American Enterprise Institute.