Japan is right to pursue a strategy of fundamental economic and financial reform, but it is wrong to do so without also stimulating growth and employment at the same time. The Japanese economy is already in an economic downturn and Prime Minister Junichiro Koizumis proposed reforms will mean bankruptcies and layoffs that increase unemployment directly and that will further depress consumer sentiment and spending. Without explicit policies to increase demand, the current downturn will worsen, undermining support for long-term reforms.

Monetary policy is now the sole focus of Japanese attempts to breathe life into the economy. The short-term benchmark interest rate has been driven down to zero and the interest rate on long-term bonds is under 1.5%. The Ministry of Finance continues to urge the Bank of Japan to ease monetary policy even further. But additional reductions in interest rates are unlikely to stimulate borrowing and spending by firms that worry about surviving the economic and banking reforms, and by households that worry about unemployment and about the loss of government retirement benefits.

Because prices are now falling in Japan, with the consumer price index down 1 % from a year ago, consumers who wait to buy are rewarded with lower prices. The Bank of Japan is nevertheless wise to reject the pressure to adopt a formal target of some positive inflation rate in order to encourage consumer spending, since there is nothing that the bank could plausibly do to bring about a significant rise in prices. Although the Bank of Japan has officially adopted a "quantitative" approach to monetary policy (i.e., emphasizing the growth of the money stock rather than interest rates) the monetary aggregates have increased very slowly. The broad money supply is only 3% above its level a year ago because banks are unwilling to take deposits and make loans. They fear that the write-offs of existing bad loans that will be required by the governments reform plan will leave them with inadequate capital to support even existing assets under international capital requirement rules.

Even if the Bank of Japan could increase the money supply substantially by purchasing a large volume of long-term bonds, the primary effect would be to drive down the international exchange-rate value of the yen. Since Japan already has an annual trade surplus of more than $100 billion, such a deliberate policy of making the yen even more competitive could damage relations with the U.S. and with other Asian countries.

Japan has also pursued a traditional Keynesian fiscal approach to stimulating the economy by large budget deficits. This has succeeded only in creating an enormous government debt and in propping up inefficient local construction companies and their political patrons in Tokyo. The annual deficit of the central government now exceeds 7% of gross domestic product and the national debt is more than 100% of GDP. Servicing that debt and shrinking it relative to GDP is one of the major long-term challenges for the Japanese economy. Prime Minister Koizumis promise to cut government borrowing in the coming fiscal year by about 10% is, however, another way in which the long-term reforms will be a short-term drag on the economy.

What Japan needs to stimulate spending are targeted fiscal incentives. For example, a broad, two-year temporary investment tax credit that pays 20% of company outlays for equipment and structures between now and the middle of 2003 would substantially raise business spending by making such outlays 20% cheaper today than they would be after July 2003. A similar tax incentive for individual home-building could have a major effect on residential construction and on consumer durable spending.

The government could also temporarily suspend the value added tax, which is currently 5%, and announce that the tax will return at a 10% rate in the middle of 2003. Consumers would have a strong incentive to spend now, especially on consumer durables, because of the resulting 10% price rise that will occur in 2003. In effect, the Ministry of Finance could achieve a temporary 5% annual inflation for the next two years instead of assigning to the Bank of Japan the impossible task of using monetary policy to reverse the current negative inflation rate.

If these steps succeed in preventing a deep decline in economic activity, the result could be only a small increase in the size of the budget deficit, or even a small decrease. But to the extent that it is necessary to offset a revenue loss, this would ideally be done by cutting pork-barrel spending, which has exploded in recent years. If that proves impossible, the net cost of the targeted tax incentives should be financed by temporarily raising corporate and personal income taxes, effectively getting those who benefit from the fiscal incentives to pay for them. This would be essentially a change in the form of taxation and not a net tax increase. As a result it should not meet significant political resistance.

A different way to encourage household spending is to reduce the uncertainty about government pension benefits. The rapid aging of the population in Japan has caused the Japanese government to warn that it will not be able to continue to pay the benefits specified in current law. Fearing the worst and wanting to protect themselves, many households are probably saving substantially more than they will need to compensate for the actual benefit cuts that will occur.

If those who are currently retired were told that their benefits would not be cut, they would feel free to spend more of their current income and assets. And if employees between 55 and 65 were told that their benefits would not be less than (say) 90% of the amount projected under current law, they too might increase their spending. Continued uncertainty about pension policy serves only to depress spending.

Failure to stimulate demand as Japan begins its structural economic reforms would mean unnecessary unemployment and wasteful output declines. It would also be likely to mean a loss of public and political support for those fundamental reforms that could allow the Japanese economy to escape the past decade of stagnation. If Japan slides into a long-term decline, the result could be a political chaos and a renewed nationalism that no one will welcome.