The Economic Effect of Japan's Election

Japan is heading into a landmark election in a state of freefall. Stagnant since the early 1990s, Japan's economy fell off a cliff in the last quarter, dropping 15.2 percent in the worst collapse of any industrial nation in decades. Automakers—Toyota, Nissan, and Honda, once the heart of the Japanese industrial miracle—saw exports fall 70 percent in April, and were forced to shutter factories to clear inventory. Since pocketbook issues decide elections, it's not surprising that Japanese voters appeared poised to toss out the ruling Liberal Democratic Party (LDP), only the second time it has lost power in half a century.

Meanwhile, China is launching direct challenges to Japan's position as the leading economy in Asia. Beijing recently launched an official campaign to build a green car industry, a field in which Japan still holds a commanding lead. Some Japan watchers compare China's green car project to Sputnik, the Soviet satellite that trumped American preeminence in science and technology in the 1950s. Just as alarming, China has been making noises about replacing the dollar as the sole international reserve currency, and has begun conducting regional financing deals in Chinese yuan instead, a push Japanese officials see as a direct threat to the yen as well. "It brought home the fact that the yen is not used in this way by others," notes Yasuo Ota, an editorial writer for Nikkei. The worry grew in July, when top Chinese officials flew to Washington, D.C., to continue their high-level "strategic dialogue": "That caused concern, because the Japanese feel that we need to be involved in any conversation about security in the region," notes Shinzo Kobori of the Institute for International Policy Studies in Tokyo.

So Japan is preparing to usher in a new government against a backdrop of worry that the nation is already Asia's political and economic also-ran, prematurely playing No. 2 to China. It's all happened fast. When this decade opened, Japan's economy was still almost four times the size of China's, but in recent years China looked set to surpass Japan by 2010 or shortly thereafter. Now, with China still growing at 8 percent a year and Japan shrinking, commentators in Japan have been forced to admit that the switch will likely come even sooner. "It's nonsense for us to continue talking about competing with China [for sole leadership in Asia] when their economy will surpass ours by next year," says Kobori, echoing the sentiments of other academics, writers, intellectuals, and even younger politicians within Japan.

There's a growing, reluctant consensus that Japan will have to find a new role. From the Meiji Restoration—the great flowering of Japanese innovation and reform in the 1860s—until recently, Japan "had basically one goal: catch up with the West and be accepted as a great power. They achieved that in the '80s, but they've never figured out what to do for an encore," says Columbia professor and Japan expert Gerald Curtis. "Japan today is a tired country." The old model—work hard and save to finance exports to the West—is clearly broken. (The other top developed export power, Germany, has also been particularly hard hit by the global recession, as all the rich consuming nations of the West enter what looks to be a long period of slow growth and weak demand.) With Asia emerging as "the center of the global economy, its new growth engine, Japan now has to figure out how to put itself at the center of that center," says Curtis.

The opposition Democratic Party of Japan (DPJ) clearly sees Japan as a regional Asian power, and no longer a nation tied only to the West. DPJ leader Yukio Hatoyama has denounced the global free-market consensus, of which Japan was once a happy member, blaming "globalism" and "U.S.-led free-market fundamentalism" for the current crisis. His vision amounts to a retreat inward, beefing up "fraternity" at home with a stronger welfare state, and more generous pensions and child support, while refocusing Japan's trade and investment strategies on East Asia. Alarmingly, however, the DPJ manifesto did not even mention "growth" until it was attacked by the LDP, suggesting that the DPJ doesn't quite get its predicament. Maintaining Japan's comfortable standard of living won't be possible without growth.

American and Japanese intellectuals have compared Japan's new position to Canada's, or Switzerland's—rich, content powers that have learned to thrive alongside giant neighbors. The problem, says MIT Japan expert Richard Samuels, is that it would be a painful "deep dive" for Japan to go the way of Canada, which has an economy more than three times smaller, and smoother relations with the U.S. than Japan has with China. The Asian powers have a rough history dating to the Japanese occupation of China in World War II, and often competing interests in trade and security. Japan is still protected by the U.S. nuclear umbrella, now primarily against possible future threats from China.

Others have suggested that a more fitting model could be found in France, the wealthy co-leader with Germany of a powerful regional bloc. Japan and China might play this role together in Asia. The DPJ has even proposed French-style child subsidies to boost the country's birthrate, which would revive some of the economic dynamism Japan has lost as a result of having the world's most rapidly aging population. Of course, the EU started as the European Coal and Steel Community, a postwar French-German alliance to share resources; China and Japan are still fighting over offshore oil rights and atrocities from World War II. The huge gap in average yearly incomes—$34,080 in Japan and $2,000 in China—will make it difficult for them to work together as regional leaders, the way Germany and France do.

Yet the benefits of an aggressive regional strategy are clear—France, for example, has boosted its per capita income by 42 percent since the formation of the European Union in 1993, and no one doubts that it has gained greatly by leveraging the common market. Japan could do the same. Goldman Sachs predicts that the major emerging markets, led by China and India, will overtake the combined GDP of the G7 by 2027, a decade faster than previously thought. By 2010 China will account for an amazing 30 percent of global consumption growth, more than the G3 and double that of the U.S. The Japanese, who have hitherto focused more on economic ties to the U.S. and Europe, are slowly beginning to realize that they would do well to ride this train.

Growth is imperative, whether the DPJ acknowledges it or not. Economists often talk about how the Japanese need to boost domestic consumption, which has been flat for a decade, to make up for falling exports. But the domestic market is shrinking. The population peaked in 2004 at 128 million, and is projected to fall to 90 million by 2055. The ratio of working-age to elderly Japanese fell from 8:1 in 1975 to about 3:1 in 2005, and will probably shrivel to about 1.3:1 in 2055. This means "there is no viable model for increasing domestic consumption [to the extent needed]," says Kobori. The Japanese are currently putting 5 percent of their GDP into fiscal stimulus, and still nothing is happening. America is putting 2 percent in, and is now in recovery. "What we need is a new model based on more regional integration," says Kobori. "If we can't find that model, we are in trouble."

Japanese businesspeople are hunting for one: on a recent visit to top companies in Japan, Curtis found executives talking less about naiju (domestic demand) than about jun-naiju (pseudo–domestic demand), a new phrase that means demand in the home region of Asia. "The idea is to integrate Japan into the heart of this new and growing Asian 'domestic' market, not only by selling to middle-class Chinese and Southeast Asians, but also by increasing Japanese investment in Asian companies; further liberalizing import and export markets, particularly in very closed areas like agriculture; and working more closely with China and other less-developed countries in areas like the environment, technology, and energy," says Curtis.

In recent years, trade flows to China in particular have increased rapidly; in 2000 exports to the U.S. from Japan were about five times those to China; now the figures are nearly equal (though it's important to note that most of what goes to China are high-tech components for assembly versus finished goods). Flows could be further increased if Japan would dismantle trade barriers and encourage more export of, for example, expensive luxury agricultural products like its very high-quality rice to Asia's nouveau riche, while allowing penny-pinching Mrs. Watanabes at home to buy more cheap, mass-produced foods from China. Ultimately, trade in finished goods will rise, too. Manufacturers are starting to focus more research and marketing dollars on Asian consumers rather than Western ones in order to boost regional exports of Japan's upscale cars and consumer goods. The DPJ platform calls for an increase in aid to develop Asia as a way of helping bolster those middle-class consumers.

In other ways, Japan is still strikingly Western-oriented. It is typically one of the top four investors in China, yet it still sends nearly three times more of its direct investment in factories and companies to the United States. Experts say Japan tends to pigeonhole China as a place for low-end outsourcing, and is particularly fearful of intellectual-property theft in China because relatively high-cost Japanese manufacturers lose everything if their ideas are stolen. Stronger protections against intellectual-property pirates could yield all kinds of collaboration, even a world-beating green car capital of the world run by Japan and China, Japan market analysts say.

Closer ties to China require some semblance of trust. There are positive signs. DJP leaders have said they would not continue visits to the Yasukuni Shrine, a bone of contention because Japanese war criminals are buried there alongside regular World War II soldiers. And the two countries recently struck a deal to strengthen Asian currency reserves—putting equal amounts of yen and yuan into the reserve pot, underscoring a joint commitment in Asia. Peter Petri, a senior fellow at the East-West Center in Honolulu, calls this deal "a very important event" that says "we're in this together, and even though the future is that China will be the dominant economy, Japan has a lot to contribute, too."

For Japan, Asian development must mean more than tighter economic relations with the Middle Kingdom. Japanese officials and companies are looking to strengthen ties with Australia, India, and Southeast Asia. The only high-profile Japanese corporate acquisition in Asia recently was Daiichi Sankyo's purchase of the Indian drugmaker Ranbaxy, and India has replaced China as the No. 1 destination for Japanese aid money. Japanese aid to ASEAN countries is growing, too. "The Japanese are increasingly going to invest in India, Vietnam, and Indonesia to balance the growth of China," says Michael Green, the Japan chair at the Center for Strategic and International Studies. He also notes that the Japanese lobbied hard to include India, Australia, and New Zealand in the East Asian summit, first held in 2005, in order to "buffer Chinese influence."

Tokyo's new focus on Asia could, conceivably, restore its image as a power in the world. To become "the center of the center of global growth," as Curtis puts it, would make Japan more central to global diplomacy and politics as well. Closer ties to China could set up Japan as more of a buffer between the U.S. and China, and less of a protectorate of the United States. It could make Japan more of a major player in multilateral diplomacy, and less of a junior partner in a special relationship with the United States. "You can see Japan making a broader strategic outreach with new bilateral security agreements reached with Australia and India," and in the June meeting of defense ministers from the U.S., Japan, and South Korea, notes Green. But Japan has always been a one-dimensional economic power and, to regain global clout, it needs a return to real world-leading growth. That's not what Japan's next governors—whether from the LDP or the DPJ—are talking about. They dream of middle-power models, at most.