FROM THE OFFICE OF PUBLIC AFFAIRS

I am a Japan fan. In my private sector experience, I developed the highest respect for Japanese industry's ability to rise to the challenge of world competition, and to challenge the rest of us to do the same. Japanese companies like Sony and Toyota, among others, defined the notion of world-class manufacturing, offering the world's consumers value-priced, better products year after year, and daring companies around the world to do the same.

In many ways, it was Japan's challenge that forced the U.S. economy to shake off its malaise of the late 70s and early 80s, and become what it is today. The fact that American companies rose to that challenge, and greatly improved their own productivity and quality is in no small way due to the competition that they faced from their Japanese counterparts.

Japanese workers, too, are among the most diligent and productive in the world, and they rightly feel great pride for their country's economic accomplishments in the past half-century.

But the past decade has been difficult for all of us who believe in the potential of the Japanese economy. After decades of world-leading growth, Japan's GDP grew by an average of just one percent annually over the past ten years. Unemployment has been rising, deflation has cast a long shadow on consumption and investment, and banks and corporations are heaped with bad and doubtful debt.

With such potential, and historic accomplishment, why has Japan performed so poorly over the past decade? More importantly, how can Japan return to growth? The costs of underperformance are high, both for Japan and for the rest of the world. Japan's citizens miss out on higher living standards and Japanese young people are frozen out of the job market. The rest of the world lacks a dynamic Japanese market for its goods and services.

In fact, if Japan's economy had grown over the past ten years at its full potential of, say, 3% annually, real GDP would have been more than 20% larger in 2001 -- that's a difference of nearly $900 billion alone. And over the past decade, growing below potential has cost Japan a total of nearly $5 trillion in lost income or almost $40,000 in foregone income per person. That lost income translates not just into lower living standards, but also into $760 billion less investment to support future growth.

There are three areas for action in Japan that would restore growth:

1) Ending deflation;

2) Overcoming financial sector problems; and

3) Deregulating and opening the economy to competition.

I believe the last one is the most important, but I'll address them in the order I've listed them.

For the last seven years, Japan has been mired in deflation, as the broadest measure of prices, the GDP deflator, has fallen by nearly 1% annually.

The phenomenon of deflation is corroding Japan's economy, multiplying the burdens faced by debtors, while discouraging investment and consumption. Japan has to end expectations of persistent deflation for the economy to recover and grow.

Last March, the Bank of Japan committed to expand the money supply until inflation was at least zero. Since then, the BOJ has sharply expanded the growth rate of base money. But the growth rate of broader money supply has not changed much, and deflation remains entrenched.

While sustained monetary expansion is an important step for addressing Japan's economic woes, the expansion of base money has not produced an expansion in bank lending.

Why are banks not lending? It is not because of a lack of liquidity. Rather, anemic lending reflects deep weakness in the balance sheets of the Japanese banks and the corporate sector.

An important role of financial institutions is to allocate capital between savers and investors by pricing credit fairly and accurately. A healthy financial sector supplies funds to companies that can put the money to the best use for their level of risk.

That has not been happening in Japan. There is plenty of capital there, but too much of it continues to prop up old investments gone bad, instead of going after better opportunities and fueling growth. Some banks are stuck in so many old, bad loans, they are afraid to take any new risks, even in promising areas, further stunting the economy.

By some estimates, as much as a quarter of all bank loans in Japan are in or near bankruptcy.

Many of these loans are described as "non-performing." Non-performing means "non-productive." Loans that are not performing are not producing for the Japanese economy, or at least, they are not producing enough to justify their existence.

Bank lending is supposed to be an instrument for growth, not a life support machine.

If Japan's financial markets were functioning properly, companies that cannot pay their debts would restructure, or if necessary, liquidate, so that their capital assets could go toward more productive opportunities.

Financial institutions have to make tough choices on their non-performing loans, and start making new loans, priced appropriately for the level of risk. For example, banks should offer the cheapest credit to the world-beating export companies, which also get financing from the international markets. They should offer higher priced credit for entrepreneurs and well-founded start-ups, which are riskier than some established firms, but offer promise for future growth and new industries. And they should impose the highest rates on credit to unproductive and highly-indebted firms that have no real plans for restructuring.

Because too much investment is going to low-return uses, investment productivity has foundered. Japan's business capital stock increased more rapidly than any other major industrial country over the past ten years, but it did not produce much growth.

Look at this another way: GDP in Japan is less than half GDP in the United States, but business capital stock in Japan is roughly equal to that in the United States. Therefore, U.S. fixed investment is on average twice as productive as Japan's.

Investment resources in Japan aren't going where they can be most productive. In too many cases good money is going after bad.

The new generation of bank managers and corporate leaders should put the failing companies out of their misery, and not waste the hard-earned savings of Japanese workers. It is better to do it now, when there is still some value to salvage, than to wait until the desperate, bitter, bankrupt end.

There is plenty of advice out there on how to resolve the bad loans and clean up the bank balance sheets. Everything that can be said, has been said.

The Japanese government has the right idea creating the Financial Services Agency and strengthening the Resolution and Collection Corporation. I am convinced that Prime Minister Koizumi's agenda is the right path. Now they have to make it happen.

Just as the U.S. and other countries in the past twenty years have had to deal with painful banking crises, and came out the better for it, Japan has to deal with its own. I am confident it will. The time for half-measures and postponement has passed. It has to be done, and the quicker, the better.

The finance problems in Japan are a reflection of problems in the real economy. Non-performing loans are symptomatic of bad investment choices. So even as Japan starts freeing its capital from the prison of bad loans, the private sector has to start identifying and moving capital into the real opportunities, those where investment will enhance productivity and produce a superior return. Moving capital and other assets out of low-return, low-productivity industries into activities that generate higher returns is the key to raising economic performance.

Making sure that high-growth opportunities exist, and that firms exploit them to the fullest, is necessary for any economy to achieve its full potential, and is of special importance to Japan.

There is no question that Japanese firms respond when the right conditions exist. Japan's export-oriented companies -- Toyota, Canon, and many others -- are among the most competitive in the world. They are constantly innovating and adjusting to the competitive landscape in other countries, and consumers, employees and shareholders worldwide are better for it.

Industries in which Japan's most successful firms operate share two characteristics. First, they cannot be controlled by domestic regulation -- there is no way to limit entry, set prices, or enforce restrictive standards -- because they are worldwide markets. Second, there is no way to shield firms from competition in these industries. Faced with competition, these firms rise to their best.

Unfortunately, too much of Japanese domestic industry is cocooned in a web of regulations and trade barriers.

Eliminating regulatory barriers and introducing competition throughout the Japanese economy entails thousands of smaller, highly important decisions in trade, regulatory, and fiscal policies. It is not my place or the place of the U.S. government to lecture the Japanese government on how to proceed -- these are decisions for the Japanese people.

The process is not painless. Increased price competition through deregulation and structural reform requires adjustments and some dislocation. But it also creates opportunities, encouraging new entry by both domestic and foreign firms, increasing employment, and renewing economic growth.

Prime Minister Koizumi has acknowledged that structural reform "with no sacred cows" is necessary for economic recovery and strong, sustained growth. He deserves our support.

Another revolution that Prime Minister Koizumi can take much credit for is emphasizing the role of private activity in producing growth, and de-emphasizing public expenditure as life support for the economy.

The Prime Minister has already outlined steps to cut back inefficient public works expenditures and to abolish or privatize Japan's public corporations.

He has also made it clear that Japan will need to reduce its budget deficit substantially in order to stabilize Japan's spiraling public debt. The Council on Economic and Fiscal Policy has begun this process, and I hope that budget planning and implementation will carry it through.

The adjustments required by cutting deficits can also be eased by assuring that fiscal choices provide the maximum benefits to private activity. Cutting taxes, particularly those that discourage private activity and investment, coupled with reducing expenditures, can generate higher growth and fiscal balance.

I have referred a number of times to the importance of international competition. International trade provides an environment where firms can compete with the best and rise to their best. But trade among nations also flourishes because we have agreed on governing rules for actions and responses.

An agreed-upon dispute settlement system is critical to maintaining a trade-friendly environment. Unilateral trade actions outside the WTO dispute settlement procedures set a bad precedent for the world trading system.

The U.S. spent nine months conducting and reviewing a safeguard investigation on steel, in accord with international trade rules. Any nation that has a complaint with this action should use the agreed WTO dispute resolution process to seek redress.

Earlier, I described the vast difference between Japan's economic potential, and the recent course it has taken. In 1991, Japan's economy was nearly nine times the size of China's, and three-fifths the size of the U.S. But if the trends of the past decade continue for Japan and the U.S., and if China grows at the 7% annual rate most analysts project, in 25 years the Japanese economy will be less than one-fourth the size of the United States, and only four-fifths the size of China.

If that day comes, our successors won't even debate these topics. Japan will no longer be a engine for the world economy, it will be a boxcar.

That scenario should not happen. Japan has to rejoin us, at full speed, as a leader in the global economy. If Japan grows by 3 percent annually over the next 25 years, in 2027 Japan's economy will be about 40 percent of the size of the United States, and 33 percent larger than China's. This should be the target. The leading economies in the world need to grow at their full potential, for the benefit of their own people and, more broadly, for the benefit of people everywhere.

The people of Japan have the capacity to make their own future and return to growth. Not by fleeing from the competitive world economy, but by embracing it and showing their true potential, as they have before. I believe they will, not only because I am an optimist about Japan, but because the stakes are too great to fail.

Thank you.