REVIEW & OUTLOOK

It was almost a year ago that the Japanese Ministry of Finance took its first swing to crack the huge nut of Japan's bad debt, by presenting bills that would let the government liquidate seven bankrupt housing loan institutions. Although the jusen, as they are know, reflected only a tiny fraction of Japan's larger problems, the solution had to begin somewhere and we were cautiously optimistic that if newly elected Japanese Prime Minister Ryutaro Hashimoto got the reform ball rolling, it would snowball.

But the more things changed, the more they stayed the same. For all the fits and starts through 1996 - including a public outcry at the prospect of being asked to foot the tax bill for a bailout, the eventual liquidation of the targeted jusen, and much committee activity on deeper structural reform - Japan has not really left the starting gate. No doubt there is a much firmer and broader consensus for reform than ever before. But the sinking Tokyo stock market indicates that no one expects the government to bridge the gap between talk and action any time soon.

Officials at the newly empowered Bank of Japan claim that the market is being "irrational" and that pessimists have overshot the mark. Given what we know - that banks which used to paper over problems with unrealized gains on equity holdings are now being prodded toward the unrealized loss zone - the market would seem to be behaving most rationally.

To be sure, the Nikkei's collapse and the weakening yen are not easy signals to respond to - an especially serious dilemma for bureaucrats schooled in the Wizard of Oz just-pull-the-right-levers-and-you-can-fix-anything style of governance. Japanese policy makers say their options are being clouded by all sorts of uncertainties, like the possible impact of the coming hike in the consumption tax to 5% from 3%. Consumption figures are up over the past few months; but are people buying things because they feel good about the future, or are they just scurrying to pay for big ticket items, such as cars, before the tax kicks in in April?

If the men who run Japan want to shore up the market, and the only way to do this is to prove that the government is wholly and wholeheartedly committed to reform, they need to do something swift and decisive. Specifically, they need to resolve the banking crisis. Richard Werner, senior economist at Jardine Fleming Securities in Tokyo, says that the situation calls for the most dramatic and aggressive action.

When banking systems collapse, governments are tempted to nationalize the banks, a response that leads to bigger problems down the road, as France is finding in its struggle to decide what to do with its huge invalid, Credit Lyonnais. In the United States in the 1980s, the government created a special body to liquidate failed Savings and Loans in what amounted to a huge banking bailout financed by the American taxpayer. The U.S. Federal Reserve also rigged the short-term credit market to give banks big spreads between their borrowing and lending interest rates, a technique that the Bank of Japan has copied with far less success.

Mr Werner proposes what he calls a "free lunch" where banks would issue preferred stock that is then bought by the BoJ, or an entity underwritten by the Bank. In an atmosphere of deflation, he says, this would be a relatively painless way to raise real capital for debt-burdened banks, shore up their capital adequacy ratios and make their balance sheets 'normal' in one swift stroke.

This would be a bank-specific form of money creation, and no doubt would improve the capital bases of banks. Mr Werner has argued in the past for more vigorous money creation in Japan on the same grounds, that the environment is deflationary. That the BoJ's moves in that direction last year didn't jump start the economy is either an argument that the fix didn't work or that the BoJ didn't push down the gas pedal hard enough. But no doubt the weaker yen is one consequence and we have to admire Mr Werner's prescience in predicting 18 months ago that the yen would be at 120 to the dollar in this quarter.