Japan's economic model is no longer roadworthy

Hamish McRae on the fall of Japan

Forget about Korea, Malaysia, Indonesia and the other East Asian "tiger" economies; it is Japan we should worry about. Even a light reader of newspapers will have been aware that many East Asian nations are in difficulties, for hardly a day passes without some dire item of news. For most people, the latest movement of the Bangkok bourse or whether Korea agrees with the IMF's terms for a loan seems irrelevant. We may have learnt a new vocabulary of currencies, such as the baht, the ringit and the won, but the crisis hardly touches our lives.

Japan, however, is different. It is the second largest economy in the world. It is an enormous investor in the UK, revolutionising our motor and consumer electronics industries. Japan has had a profound practical impact on our daily lives: not only because we use the products it has developed every day - cars, TV sets, VCRs, cameras - but also because we have been both attracted by some of its ideas (for example, the emphasis on product quality, or the egalitarian structure in factories) and disturbed by others (such as the lack of career opportunities for Japanese women, and the quality of life of many Japanese men).

Until a few years ago Japan's economic prowess aroused awe: it seemed to be buying up most of America; it appeared to get through the recession without a surge in unemployment. Many in Britain envied the close relationship between companies and banks, and the education system that funnelled the brightest students into large companies.

This perception has shifted. We are vaguely aware that things are not quite as good as they used to be, that Japan stills seems to be in recession, that banks and securities houses seem to be in trouble. However we have assumed that things would perk up, just as they have here and in America - I certainly did, even though my Japanese friends would suck their teeth and explain that things were really still pretty dire.

In recent weeks it has become clear that things have become still worse. There is a new economic package being outlined in Tokyo, designed to boost the economy, but it is the third that the Liberal Democrats have introduced and the previous two have failed. Third time lucky, or three strikes and you're out?

The package includes a plan to support customers of financial institutions that go under, and tax cuts directed mainly at companies. There are not, however, any cuts in income tax, or any reversal of the rise in sales tax, which went up from 3 to 5 per cent in the spring and plunged the economy back into recession this summer.

To understand Japan's problem, think back to the last recession in the UK. We escaped because sterling came out of the Exchange Rate Mechanism and interest rates were cut: the first boosted foreign demand and the second home demand. In Japan there has already been a sharp fall in the currency, but much of the impact of the latest part of the fall has been blunted by even larger declines of other East Asian currencies. So in its fastest-growing markets, the yen's value has gone up. Until the autumn, Japanese exports were doing very well: now thanks to this increased competition from the rest of Asia, plus the fall in demand there, prospects suddenly appear sombre.

At home, demand is flat. Why? Well, in the UK, a cut in interest rates would jack up house buying, and prices, and we would then fill our houses with new things. In Japan, they can't really cut interest rates as the official rates are below 2 per cent. The housing market is less fluid, partly because people do not move so often and partly because there are rafts of regulations which inhibit new building. There is no impetus to spend more on consumer goods because these markets are saturated: once you have four TV sets you do not really want a fifth; if you possess two high-technology loos (which squirt warm water up your backside) you do not need a third. Besides, there is no room.

It is easy for an outsider to see how demand in Japan might be stimulated: by having a bonfire of regulations. Perhaps the most damaging are those that affect land use: some prohibit building larger houses, others protect inefficient builders and discourage new construction methods. Privately, senior Japanese people admit that excessive regulation, justified on the grounds of social cohesion, is strangling domestic demand. Ultimately, deregulation boosts an economy, but since in the short-term regulations protect jobs, progress in lifting them is slow.

Until a few months ago it seemed, however, that a consensus was building that Japan had to change, and deregulation is a large part of that change. You could see Japan in the early stages of a process similar to that which took place in the US and UK, but done in a more consensual way. Gradually, over a decade or more, Japan would bring in transparent financial markets, proper accounting, looser building regulations, privatisation, more entrepreneurship - all the things that have helped to stimulate demand in the US and UK. Japan would change, but without the sometimes searing social tensions that we have had here.

Gradual change would have been fine if luck were on Japan's side. But in the past few weeks the collapse of East Asian economies has created a new urgency. The country cannot rely on exports. Somehow it has to jack up domestic demand.

It is funny, isn't it? All the old virtues, the "save, don't spend" culture, the big companies with their disciplined workers, maybe even the social cohesion, if the price for that is heavy regulation - all these virtues seem to be almost vices. The very things that made Japan successful seem to be holding it back. They need to be less puritan, more epicurean. Just as 20 years ago we needed to become more like them, now they need to become more like us.