Kato Koichi Official Site

It is a great honor for me to speak at this distinguished club. Many friends in the foreign media have been critical of the Japanese government and the ruling Liberal Democratic Party for their handling of economic policy in the past several months. We have also been receiving a fair amount of "dvice" from foreign government officials, especially Americans, on how we should adjust our domestic economic policy. It is not my intention to try to rebut every criticism nor comment on all the advice. Nor will I offer excuses and apologies for what some regard as a lack of leadership on the part of the Prime Minister as head of the government or myself as a person responsible for party affairs. What I wish to do is to offer my perspective on the economic difficulties we are facing and the expected impact of our reforms.

Let me begin by trying to set our current situation into historical perspective. I do this because I believe an appreciation of the broader context is essential to fully understand both the seriousness of today's economic challenges as well as the longer-term strategic direction established by ourselves as Japan's political leadership.

Japan's modern history can be best understood as a series of transformations, each based on a vision of the future, each generating enormous progress, but each eventually losing steam and establishing the need for the next transformation. The first of these began with the Meiji Restoration exactly 130 years ago. The Meiji leaders envisioned a modern society, taking their cues largely from Europe. The first revolution was associated with the creation of modern infrastructure, modern industry and a modern educational system. Japan avoided colonization and became the first Asian country to be accepted as a major world power. But Japan's course became distorted by the ascendancy of the military in the 1930s. Politically and economically, the prewar leadership increasingly looked to Germany rather than the England or America, and they eventually led our country to its greatest national disaster.

The second transformation was borne out of the ashes of the war. This transformation is associated with the flowering of democracy and the rise of civilian and export-oriented manufacturing industries. The prewar zaibatsu were broken up and an extensive land reform program was undertaken. Again, Japan set as its vision the catching up economically with the West, meaning this time basically the United States, but unlike the United States, government-led industrial and financial policies played an enormous role in Japanese economic policy. As is well known, the bureaucracy, particularly the Ministry of Finance, led the postwar transformation of Japan, providing strategic guidance and intervention. For many years, this in fact worked and worked quite well. Japan again experienced remarkable economic advance and by the early or mid-1980s could be said to have finally accomplished its historic task of "catching up to the West."

The mix of government policies and practices that guided the second transformation of Japan remain very much with us today. Producer interests were favored, and consumer interests were sacrificed to what were thought of as the basic requirements of rapid "catch-up"î development. Favored industries were protected and regulated, again to serve national goals. Major firms were rarely allowed to fail, and this particularly included the big financial firms that were at the heart of each industrial group. As you all well know, the Japanese financial sector operated for many years under a "convoy system," whereby the Ministry of Finance exercised strong control, making sure that banks and other institutions were moving in the same direction at more or less the same speed.

Although the system worked for many years, it increasingly caused friction with foreign powers and eventually it sputtered out in the spectacular and disastrous bubble economy of the late 1980s. As a system of financial and economic management that relied upon direction from above, it stifled creativity and initiative. With tight controls over the financial institutions, the ability of bankers to make sound judgments atrophied. They ended up relying mechanically on a system of collateral, taking land in most cases as backing for their loans. So when land prices plunged in the 1990s, the banks had no idea what to do and continued to hope that government regulators would somehow save them.

The bureaucracy as an institution also responded mechanistically. Thoughtful bureaucrats recognized the fundamental nature of the problem, but institutionally bureaucracy tinkers with current policies and cannot be expected to lead a revolution. More fundamental reappraisal and reform is the responsibility of political leadership. The LDP, under Prime Minister Hashimoto's leadership, stepped up to the place and developed a vision and program for a third transformation of Japan, one based on individual choice exercised through free markets. This transformation is not simply an economic one, although economic policy reforms are an essential element. Most of all, it involves a transformation in our thinking about the appropriate roles of government, markets and the role of individuals. It means a new liberation of markets from the dead hand of government bureaucrats and regulators. In the process it should liberate and empower savers and consumers by offering a wider range of both investment and buyer choices.

This transformation is intended to prepare Japanese to participate fully and effectively in the globalized world economy of the twenty-first century. Thus it offers great promise, but it is not an easy road. Although it frees the private sector and the individual to maximize their own welfare, it also requires tremendous responsibility of them in setting their own destinies. In short, a price of freedom is responsibility, a level of individual responsibility and accountability that is fundamentally at odds with government-led and pampered system of the second transformation. We do not and cannot expect this new thinking to appear overnight, but we have confidence that despite some current pain and adjustments, the Japanese people will want and be able to respond creatively to the new opportunities that await them. Indeed they must if Japan is to remain a leading economic power.

A central element in this transformation is the so-called "Big Bang." Let me first clear up one fundamental misunderstanding in much of the foreign and even domestic press about the origins of the Big Bang. This was not a decision that the Japanese bureaucracy could have made on its own. It was Japan's top political leadership that took the initiative to move forward with basic financial reform and for establishing the broad outlines of Big Bang program.

Many in Japan have criticized the Big Bang, especially those interests who favor the old system of government protection. Some assert that by allowing foreign firms to compete openly in the Japanese financial markets and offer a higher rate of return on capital, Western business practices will dominate and we will lose our distinctive Japanese ways. I think this is a misreading of history. The distinctive Japanese ways are not the excessive controls that were imposed in World War II and remained in modified form into the postwar era. A central purpose of the Big Bang is precisely to recover the competitive and creative instincts that characterized Japanese banking in the Meiji, Taisho, and even the Edo periods.

Other central elements in our vision of Japan's economic future are those of administrative reform and fiscal restructuring. Japan today has the largest budget deficit by far of any advanced country, about 6 percent of GNP. For this reason, it was not too long ago that many of our foreign friends who are now advocating permanent tax cuts and new stimulus spending programs were praising Prime Minister Hashimoto for his determination to do what the United States has so successful done - reduce the massive budget deficit. Over the longer-run, this remains a high priority with the Liberal Democratic Party. We cannot simply spend far more than we earn, particularly as our society ages.

Last year's increase in the consumption tax from 3 to 5 percent and in health insurance charges were in line with this policy. It was the judgment of many leading economists at the time that Japan was coming out of the long recession of the early 1990s, and that the restoration of fiscal balance was needed to further strengthen business confidence.

However, a number of factors in addition to the tax hike, caused the recovery to falter. One of these was precisely the Big Bang program. While its longer-term benefits are undoubtedly positive, there was also bound to be short-term pain in the financial sector as the barriers began to fall that had long sheltered most of the industry from vigorous competition. The banks, already saddled with a high level of non-performing loans, became increasingly nervous about their capital adequacy ratios. Many virtually stopped new investing and loaning. In retrospect, it can be said that the health of the financial sector was over-estimated.

In my judgment, we can attribute this over-estimation to several factors: the lack of transparency on the part of financial institutions in Japan, the protective nature of the bureaucracy which also sought to minimize the seriousness of the problems in the financial sector, and lack of independent, nongovernmental policy-oriented research institutions which might have provided our political leaders with alternative economic analysis and advice.

The Asian financial crisis that began in July 1997 in Thailand was also unforeseen. No one predicted the so-called "contagion effect," which buffeted the economies of Indonesia, Malaysia, the Philippines, and South Korea within a few months. This financial crisis has had serious implications for Japan, whose economic interdependence with the developing economies of East and Southeast Asia had been growing over the past decade. Compared to the United States or Western Europe, a much higher proportion of overseas Japanese investment, Japanese bank lending, and Japanese exports are with developing Asian countries.

For these reasons, we have been making needed adjustments in our economic policies to meet the requirements of the immediate economic situation in the region and in Japan. In December, the Prime Minister decided that the government would need to use public funds to help the financial sector to strengthen its capital adequacy ratio by a sizeable capital injection. By then the full dimensions of the problem were clear. For historical reasons, the failure of institutions are typically seen in Japan as a sign of weakness rather than of resolve to allow the market forces to eliminate noncompetitive players. Thus we continue to face the challenge of instilling a new perspective that there can be losers in the free market economy, whether in the financial sector or in the manufacturing sector borrowing funds from such financial institutions. Needless to say, we have to pay careful attention to make it sure that such failures will not take place in an excessive or an abrupt manner.

More recently, the Prime Minister announced the largest stimulus package in Japanese history, including significant tax cuts. This package has been interpreted as a departure from our earlier reform strategy. This is not accurate. Our commitment to a new strategic vision for Japanese society and the economy remains firm. Japan will continue with its long term program of deregulation, with the Big Bang as the central, but certainly not the only element. We will not compromise on this program.

Clearly, however, for the reasons I indicated earlier, the difficulties associated with the financial reform efforts were much greater than expected when the reform was planned. In order to alleviate the strain and continue the program, we recently decided a tactical modification was needed. There were two possible approaches: tax cuts or increased investment in social infrastructure. There was vigorous debate within our party over the respective merits of these options. Prime Minister weighed the two options, took account of our economic situation and the growing concerns expressed here and abroad and decided on a mix of the two policy options. He felt it important to maintain an economic and political environment in which the more fundamental reform package, including administrative reform and fiscal restructuring, can proceed forward over the longer term.

Despite this tactical decision, the resolution of the bad loan overhang and the deregulation of the market remain fundamental priorities. Without confidence in the banking sector and without deregulation so that consumers and investor can make appropriate economic choices, no fiscal stimulus, no matter how large, can have the desired multiplier effect in the private sector.

I do not in any way want to minimize the economic difficulties Japan is in. Quite the opposite, these difficulties represent fundamental problems in our economic system and thus fundamental reform is needed. The decades of success of the government-directed second transformation has entrenched deep-rooted mistrust of the market mechanism in the minds of many in the Japanese bureaucracy, the private sector, and the public. For the new transformation, which we in Liberal Democratic Party seek to lead, we need to change this thinking and rely more on market freedom, placing trust in the collective judgment of consumers. I elaborated on this argument in my Legislative Interpellation this past February, calling it a logical extension in the economic sphere of the concept of liberal democracy in the political sphere. (I believe a copy of my remarks at the Diet interpellation has been distributed to you for your reference.)

I want conclude by calling attention also to my closing thoughts in that interpellation. In the current political environment, there is no force other than the Liberal Democratic Party that is capable of governing and leading Japan into the new era. To me, as a believer in competitive democracy, this is a very sobering thought. It places tremendous responsibility on the LDP, not merely to carry out its task effectively but to work with other parties in promoting responsible and good government. It would be quite easy for our party to take the easy course and run away from the challenge of reform. But this is not an option for either Japan or for the LDP. Our mission is to grit our teeth and carry on with the reform program, hard though it may be.

Thank you.