POINT OF VIEW/ Keiichiro Kobayashi: Future of failing economy lies in the environment

The Japanese economy is facing an apparently endless succession of tough challenges.

The yen has risen sharply against the dollar and other major currencies, delivering a heavy blow to the bottom lines of export-oriented companies. Domestic demand remains sluggish while exports are dwindling, accelerating a deflationary trend for lower prices.

Stoking economic growth requires massive fiscal expansion, but the government has little money to spend on fresh fiscal stimulus as it is saddled with a huge amount of debt, and tax revenue is plunging due to the recession.

The world economy is hardly in good health, with economic recovery in the United States on a shaky footing. It is now unrealistic to expect demand in the U.S. market to grow at a robust pace as in the past. Hopes are now being pinned on emerging countries as the next engine of growth for the world economy. Japan and the United States are locked in a battle to take larger shares in those fast-growing markets.

Against this backdrop, expectations are growing in Japan that the government will take additional monetary and fiscal policy measures to deal with the negative effects of the stronger yen and deflation on the economy.

The Bank of Japan has made clear it is firmly on the side of monetary easing and introduced a new lending measure that is close to so-called quantitative easing. The central bank's action, which underscored its determination to slay deflation, has created a sense of relief in markets, at least for the time being.

It can be argued that the measure could have produced greater effects if it had been delivered at a better time and on a larger scale. However, given the state of the domestic economy, there is a limit to what the BOJ can achieve with its monetary policy.

If the BOJ's new measure pushes down three-month and longer-term interest rates, companies will find it easier to finance their operations, to a certain extent. But a fall in interest rates is no immediate cure for the problem created by a huge gap between supply and demand. Many companies are in trouble not because of financing difficulty but due to falling exports and the concomitant drop in sales.

If the monetary policy is to produce immediate benefits for the economy, it must engineer a significant decline in the yen's value so as to ramp up Japan's exports.

But it is not easy for the BOJ to guide the yen lower through monetary easing because the United States also keeps interest rates extremely low and is shooting for a gradual decline of the dollar against the yen to help increase U.S. exports to emerging markets.

Japan's attempt to drag down the yen would conflict with U.S. economic interests. Considering the current situation of the Japan-U.S. relationship, which has been strained due largely to discord over key security issues, it is probably safe to say that Japan cannot afford to choose the option of the weaker yen at the risk of a square confrontation with the United States.

In other words, the BOJ's monetary policy could only offer limited benefits for the nation's economic recovery.

Reducing dependence on oil

The fiscal policy should be focused on making people feel more secure about their future by enhancing job security measures and welfare benefits for low-income earners. The government should also define a long-term direction of fiscal policy to ensure future economic growth.

The key word for charting a new course for the nation is, inevitably, environment.

The outlook for the ongoing international negotiations on a new framework to stem global warming remains unclear, with many more twists and turns expected. What is certain, however, is that the economic structure that depends on fossil fuels must be changed and that Japan and the rest of the world should seek to achieve a cleaner economic future built on renewable energies. Those efforts would serve the long-term interests of Japan.

According to the International Energy Agency's World Energy Outlook 2009, the prices of fossil fuels will remain on an upward trend in the long term. If its economy continues to be as dependent on oil as it is now, Japan will have to keep paying huge amounts of money to oil-producing countries, even if the world's oil reserves don't get closer to depletion.

New industries, new wealth

Investments for making the industrial structure less dependent on oil would add to the financial burden on the people. But if those investments slash consumption of fossil fuels, Japan will be able to save payments to oil-producing countries and other foreign parties.

There is no doubt that efforts to create an economic structure less dependent on fossil fuels would produce long-term benefits for both Japanese industry and people.

As for specific policy measures, the government should start investing massively in research and development, and spreading environmental technologies to help build new industrial and social structures that do not rely on fossil fuels.

In that process, many new jobs would be created in both the public sectors and environment industries. The investments would also help revitalize the economy by narrowing the gap between demand and supply. New industries would be driving forces of sustained growth of the Japanese economy.

The question is how to finance this kind of policy. In the meantime, the only way for the government to raise enough money would be to pile on fresh debt. That means the government would have to increase tax revenue sharply--most probably through the introduction of a new environment tax and a hike in the consumption tax--some time in the future.

If the government fails to raise taxes while expanding its spending, high rates of inflation would do the necessary adjustment, irrespective of the will of the government or the people. That would be tantamount to a tax increase.

This kind of fiscal adjustment may be inevitable when an old industrial structure is replaced by a new economy.

Our assets are, in their essence, capitally invested in equipment designed and built for the old industrial structure. The economy's shift to a new industrial structure would make the old capital equipment valueless. In other words, most of the assets built up by the present generation will eventually lose their value.

In return, new industries driven by environment-oriented values will emerge, creating new wealth. The new wealth will be possessed by the next generation.

Apart from inflation, a reduction in the value of the current generation's assets through tax increases may be part of the inevitable process of lowering the overestimated value of existing wealth to its correct level.

The emergence of a new industrial structure would create enormous wealth. If managed adroitly, the policy shift could help the nation avoid a fiscal catastrophe.

The government needs to lay out a new policy vision based on the expected long-term structural changes in the economy and devise effective ways to re-energize the economy in line with that vision.

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The author is a senior fellow at the Research Institute of Economy, Trade and Industry (RIETI). (IHT/Asahi: January 1,2010)