Japan in Crisis
Are its economic and social problems solvable?
By David Masci

Once the economic envy of the world, Japan now is entering the second decade of a nearly continuous recession, with no end in sight. Unemployment, homelessness and crime are on the rise, and the banking system is lurching toward collapse under the weight of a trillion dollars in bad loans. Even the election last year of Prime Minister Junichiro Koizumi on a radical reform platform has produced little. . . .

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Banking System Faces Collapse

During the 1980s, Japanese banks were among the world's largest and most profitable. But today, the industry is headed for a total meltdown.

“The banking system is on the verge of collapsing, and many of Japan's biggest banks are already technically bankrupt,” says Edward J. Lincoln, an expert on the Japanese economy at the Brookings Institution.

Although estimates vary, most private analysts say the nation's banks have between $1 trillion and $2 trillion in bad loans on their books, an amount equal to between 20 percent and 40 percent of Japan's gross domestic product (GDP). By contrast, the value of bad loans during America's savings and loan crisis in the late 1980s and early '90s represented 5 percent of the U.S. GDP.

“I think [Japan's] system will begin to collapse in the next six months,” predicts Adam Posen an economist at the International Institute for Economics.

But others say predictions of imminent collapse may be premature. “There are a lot of non-performing loans, and, of course, that's bad,” says Miles Fletcher, a professor of history at the University of North Carolina at Chapel Hill. “But people have been talking about the dire condition of Japan's banks for almost a decade and they haven't collapsed yet.”

The roots of Japan's banking crisis lie at the heart of the system that vaulted the country from a post-World War II basket case into an economic superpower. After the war, the economy was micromanaged by an army of government bureaucrats, who directed and oversaw every industrial sector.

Banks were often directed to lend money to certain parts of the economy — like steel or petrochemicals — deemed by government officials as crucial to the country's economic health. The usual factors that lending institutions consider, such as whether the loan would be put to good use or paid back, often were set aside in favor of political considerations.

“The system is comparable to the command economy in the old Soviet Union in the sense that market forces aren't really the major consideration,” says Tsuneo Watanabe, a fellow at the Center for Strategic and International Studies.

The system worked remarkably well through the 1980s. Indeed, the Japanese model of directing the economy was often touted as the wave of the future. But government officials during the 1980s nudged banks to lend massive amounts of money to the construction and real estate sectors, which were growing almost exponentially. The almost complete collapse of real estate prices in the early 1990s left banks holding hundreds of billions in bad loans. Moreover, many other businesses that had nothing to do with construction had borrowed money to invest in real estate, widening the circle of heavily indebted businesses.

Since then, according to Lincoln, the government has largely ignored the problem. “They say that there are $300 billion in bad loans and the industry can solve its own problems,” Lincoln says. But Japan's banks are beyond self-help, he contends. “Prime Minister Koizumi needs to go on TV, declare a national emergency and tell the Japanese people that everything that they've heard about the banks, including from his own government, is untrue.”

Watanabe agrees, arguing that the banks should be nationalized. “They need to take over all of the banks and close the ones with too many bad loans on their books and clean up the ones that can be revived,” he says. The government should finance part of the cleanup by selling the banks' assets, he says, with the rest coming from the taxpayers. In a few years, the banks would be fiscally healthy and could be resold to private investors.

The cleanup costs would surpass the hundreds of billions in taxpayer funds needed to resuscitate the banks. “Thousands of companies would be forced into bankruptcy because their loans would be called in,” Lincoln says. “The construction and real estate industries would suffer the most, but retailing and manufacturing would also have some bankruptcies.”

Such a radical overhaul would lead to a near doubling in unemployment, Lincoln predicts, from the current 5.5 percent rate to about 9 percent.

“It would be very painful, but in the years following [the bankruptcies] the people laid off would be reabsorbed back into more productive parts of the economy, and the rate of unemployment would drop.”