Japan: Rising sun, setting PM
Koizumi is counting his final days. Japan's economy is buoyant. Can it last? The next Prime Minister will inherit problems that could sink the island nation.
By Clay Chandler, Fortune Magazine senior writer

(Fortune Magazine) -- A silver-haired prime minister furrows his brow as experts brief the Japanese cabinet on a looming national crisis. A trusted aide urges immediate action, but senior ministers scoff that nothing can be done. The chief cabinet secretary insists the danger be kept secret from the public.

Junichiro Koizumi's final days in power?

Junichiro Koizumi
Shinzo Abe
At a Glance
1.25% Japan's birth rate is much too low to replenish its workforce.
21% The percentage of people over 65 is the highest of any nation in the world.
78 Life expectancy for men has increased, but the retirement age hasn't.
170% Japan's debt-to-GDP ratio is the highest of any developed country.
1% The percentage of immigrants in Japan is one of the lowest in the world.

Not quite. It's a scene from "Nihon Chimbotsu" (Japan Sinks), a disaster flick that has played to packed theaters in Japan this summer. The movie, a remake of a 1973 sci-fi classic, turns on the premise that a collision of tectonic plates is dragging the Japanese archipelago to the bottom of the Pacific. The original "Chimbotsu" traded on Japanese insecurities during an oil embargo; as waves closed in, the world's nations refused to harbor Japanese refugees.

But the remake finds this island nation newly buoyant. When he steps down this month, Koizumi will bequeath his successor an economy in its best shape in nearly two decades. Unemployment is down, deflation has been all but licked, and wages and corporate profits are surging. Blue-chip companies like Canon (Charts) and Toyota (Charts) are doing so well they seem to inhabit a different realm in the global economy; even Sony (Charts) is turning around. Many analysts say the current expansion, now in its fifth year, will rumble on for another two with GDP growth of more than 2%.

Dithering in the face of calamity

Yet even in good times, Chimbotsu's subtext - that Japanese elites have a gift for dithering in the face of calamity - still rings true. In his five years in office, Koizumi blunted the worst excesses of the old Japan Inc. He rallied public opinion to face down special interest groups, slammed the lid on the government's pork barrel, and prodded banks to cut off unprofitable borrowers.

But he left huge problems unresolved. The nation's debt-to-GDP ratio has ballooned to 170%, the highest among developed countries. The birth rate has plunged to 1.25%, far below the level needed to replenish the labor supply. And Japan's population is aging at a pace without precedent in the industrial world.

Such challenges are best tackled in a growing economy. But chief cabinet secretary Shinzo Abe (ah-bay), the man all but certain to succeed Koizumi, doesn't seem willing to do what's needed to keep Japan afloat.

In campaign appearances ahead of the Sept. 20 vote to choose the next president of the ruling Liberal Democratic Party - and hence Japan's next Prime Minister - Abe has barely mentioned economics, stressing instead his determination to reshape foreign policy and rewrite Japan's pacifist constitution.

Abe has hinted that he won't raise taxes, at least for a while, and he endorsed an annual growth target of 3%. The good news: That's higher than the 2.2% assumed in the government's latest fiscal restructuring plan. The bad news: Abe has offered no new ideas about how Japan can attain that goal, and some of his recent statements suggest he favors spending policies more likely to hurt growth than help.

At an LDP forum in Yokohama last month, Abe and his two main rivals for the party presidency, Finance Minister Sadakazu Tanigaki and Foreign Minister Taro Aso, decried the widening gap between the best- and least-paid members of Japanese society and sought to outdo each other with promises to siphon more tax money from prospering cities to benighted provinces. "It's not very encouraging that suddenly all the candidates want to talk about giving losers a second chance," says Merrill Lynch economist Jesper Koll. "Koizumi made it clear that his policy was to back winners."

A cautious and pragmatic insider

Nor does Abe's leadership style inspire. Where Koizumi is a brash maverick who reveled in the slogan "Reform without sacred cows" and attacked his party's old guard with visible glee, Abe - the son of a former Foreign Minister and grandson of former Prime Minister Nobusuke Kishi - is a cautious insider, steeped in the tradition of consensus building and incremental change.

At 52, Abe will be Japan's youngest Prime Minister. He is a canny dealmaker and has shown flashes of charisma. Indeed, he consolidated his position as Koizumi's heir apparent early this year with appeals for Japan to take a tougher line against North Korea. When Kim Jong Il made good on his threats to conduct missile tests over the Sea of Japan, Abe's poll ratings soared.

University of California political scientist Steven Vogel predicts Abe will stay within the broad contours of Koizumi's economic agenda and dismisses fears that he's a throwback to the old Japan. "A lot of this is political posturing," he says. "Inequality is a hot issue now, so he's trying to present himself as a kinder, gentler reformer."

Still, Vogel says it's hard to envision Abe doing anything comparable to Kozuimi's decision to kick anti-reformers out of the party ahead of last year's general election and draft his own slate of "assassins" to campaign against them. "It will be a long time," he says, "before we see another Japanese leader with [Koizumi's] political genius."

Allies say Abe is only being pragmatic - that his first task is ensuring that in next summer's Upper House elections, the party hangs onto the new seats Koizumi helped them win. If he succeeds, they argue, he'll have a free hand to open debate on debt and demographics.

But in the meantime Japan risks, if not sinking, shrinking. In the first half of this year Japan's fertility rate improved a tad, the first time that has happened in six years. But demographers dismiss the gain as a faint second-generation echo of Japan's postwar baby boom. Most believe total population peaked last year at 127.8 million and has begun a steep decline. The government estimates that by the end of the century, Japan's population will contract to half its current size.

Aging demographics

The problem isn't just that Japanese are having fewer babies; they're also living longer. With 21% of its population over 65, Japan has eclipsed Italy as the nation with the world's highest percentage of old people. And it is expected to continue graying faster than anywhere else.

The government projects that by 2050, nearly 40% of the population will be over 65, compared with just 6% in 1967. A shift of this magnitude would lop billions off Japan's GDP and heap a staggering tax burden on its workers. "No further data is needed to confirm that Japan is heading toward a demographic disaster," Japan's leading financial daily said in a recent editorial. "Unless something truly effective is done very quickly, the nation will face devastating social and economic consequences."

In his recent book, Toward a Beautiful Country, Abe demonstrates his familiarity with the dire scenarios and devotes a chapter to "The Future of the Low-Birth State." But he offers no suggestions about how those trends might be reversed.

If anything, he seems resigned to their inevitability. He blithely writes that the pain of demographic decline can be offset by higher productivity, and that as long as the economy keeps growing, a smaller population means there will be more wealth per person. Well ... yes. But how to achieve those things? Beyond vague references to "robots" and "software," Abe doesn't say.

But some policy options are obvious. One is to raise the retirement age, which remains stuck at 60, even as life expectancies have risen to 78 for Japanese men and 85 for women. Easing restrictions on immigrant labor would also help. For all of Chimbotsu's handwringing about the rejection of Japanese refugees, few nations are less receptive to foreigners than Japan, where immigrants account for 1% of the population.

The dearth of working women

The most powerful thing that Japan can do to ward off demographic doomsday, says Goldman Sachs's Kathy Matsui, is to make better use of its women, which she calls Japan's "most underutilized resource." Only about 55% of Japanese women work, compared with 65% in the U.S., and only 9% of managers in Japan are women, compared with 46% in the U.S.

Matsui says women are more willing to bear children the more opportunities they have to work outside the home. How much more willing is a matter of debate: The relationship between birth rates and female labor participation is a complex one, mitigated by social norms, family structure, child-care arrangements, and other factors.

The most remarkable thing about the debate, though, is that it isn't happening in the country where it matters most. "Every day I see businesspeople struggling to figure out how to make better use of the women on their payroll," says Kaori Sasaki, president of e-Woman, a Tokyo marketing consultancy and member of several government advisory committees on women's issues. "But when we talk about economic policy, it's all about taxes, interest rates, and exchange rates."

Japan's ambivalence about its birth dearth offers promise - and peril - for foreign firms. Swedish home-furnishing giant IKEA, which returned to Japan in April after a 20-year hiatus, has leaped into the fray with a marketing campaign questioning the commitment of Japanese men to domestic life.

While early ads hewed to IKEA's global slogan, "Home is the most important place in the world," later spots hit closer to, well, home. "What time will you leave work today?" asked one. But when another posed the question, "Why don't you skip work today?" it was too subversive for executives at East Japan Railway. They banned the posters from their trains.

Demographic decline isn't inevitable, as the Swedes themselves have found. And if the economy keeps growing, Japan still has time to get control of its debt. But for now many residents of the world's second-largest economy would just as soon not be hectored about reform, thank you.

A common refrain in conversations with Tokyo salarymen these days is that after all the turmoil of the '90s, things are "getting back to normal." In many ways things are better than ever. HSBC economist Peter Morgan marvels that Japan seems to have "finally found a sweet spot." In the absence of blatant policy errors, he says, "we might even get 2%-plus growth for another decade."

Maybe. But Japan's economic fate depends on Koizumi's successors getting back in reform mode before crisis overwhelms them. In "Japan Sinks", the do-nothing cabinet ministers board a plane and flee the country. Japan is saved by a band of scientists who risk their lives to blast the archipelago free from its downward slide. Would that Japan Shrinks ends as happily.

Reporter Associate Cindy Kano contributed to this article.

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