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Japan As Number Three

TOKYO – China has now officially supplanted Japan as the world’s second largest economy. The question for Japan is whether or not the country will continue to tumble down the list of the world’s great economies, or whether its politicians will return to a path of reform that can revive growth. That the ruling Democratic Party of Japan now seems trapped in a power struggle between Prime Minister Naoto Kan and party power broker Ichiro Ozawa suggests that serious economic reform is not at the top of the DPJ agenda.

In the 1980’s, Japan’s annual GDP growth averaged 4.5%; since the early 1990’s, the economy has been virtually stagnant, averaging barely 1% annual growth. In the 1990’s, Japan’s government, grossly misjudging the sources of the economy’s difficulties, vastly increased government expenditures on public works, but ignored supply-side adjustments.

This policy created new vested interests, and thus a new political environment, as construction companies and other beneficiaries of government contracts began donating heavily to the ruling Liberal Democratic Party. This kept the LDP’s coffers brimming, but posed the risk of a serious financial crisis in the late 1990’s.

It was in these circumstances that Prime Minister Junichiro Koizumi took office in April 2001. Under Koizumi’s leadership, insolvent banks were made whole again. At the start of Koizumi’s government, 8.4% of bank loans in Japan were non-performing. By the end of his tenure, the rate was down to 1.5%, restoring the country’s potential for growth. Indeed, this was one reason why Japan was so little affected by the “Lehman Shock” that incited the global financial crisis.