Japan
Politics and Policy in 2009: Caught in the CRIC
January 08, 2009

By Robert Alan Feldman, Ph.D. | Tokyo

Stuck in the Crisis Phase of the CRIC Cycle

As the new year starts, Japanese policymaking remains disrupted by political factors. Both major parties remain disunited, due to internal differences on both policy and leadership. The result of these disruptions is that Japan is trapped in the Crisis phase of the CRIC cycle – the cycle of crisis, response, improvement and complacency that has characterized policymaking for the last 20 years (see Cobwebs and CRICs, April 4, 2001).  For 2009, the key question for the economy and for financial markets is clear: can Japan move into the Response phase, and if so will the response enhance growth or diminish it?

The Debate: Economy and Foreign Policy

We clarify the reasons for disarray in policymaking, showing the location of the political parties in the Diet vis à vis the two major axes of policy debate. In the economic debate, the key question remains large versus small government. In foreign policy, the key question remains whether Japan takes an active or a passive role in global affairs.

The members of the ruling Liberal Democratic Party (LDP) largely favor an active foreign policy but are highly divided on economic philosophy. The conservative groups (these groups are epitomized by PM Kakuei Tanaka, who was prime minister from 1972-74, and who pushed large public works and welfare programs) have long based their political networks on public works, agricultural support policies and big government welfare and education policies. In contrast, the liberal groups (these groups are epitomized by PM Hayato Ikeda, who was PM from 1960-64, and who sponsored the ‘income doubling plan’) have been pro-growth, pro-deregulation and small government. For most of postwar history, these two agendas overlapped, and hence the LDP served the needs of that era. With the maturation of the economy, globalization and aging of the population, however, the fiscal consequences of the big government approach created unsustainable deficits. Thus, the economics behind the old political deal have collapsed. The internal strife in the LDP is largely a product of this contradiction between the political structure of the LDP and current economic reality.

The members of the largest opposition party, the Democratic Party of Japan (DPJ), have an even more diverse set of policy preferences. The DPJ is an amalgam of center-left and center-right groups, along with LDP splinter groups from the 1990s. Since the 1990s, many ambitious young politicians, who would normally have sought LDP seats, flocked to the DPJ. This flow occurred for many reasons, including the lack of open seats in the LDP. As a result, the DPJ has a very broad range of opinions, from the old left (large government, passive foreign policy) to the new right (small government, active foreign policy).

Given this structure, the outcome of an election, in terms of the seats won by the parties, may have little connection to the policies that are implemented. A perfect example is the election result from September 2005. In that general election, PM Koizumi ran on an aggressive reform platform and won a landslide for the LDP. However, his successors in the LDP reversed course and returned to the big government, anti-reform agenda.

What Next? (I): General Election Timing Is Highly Uncertain

Even in the face of severe global contraction, Japanese policymakers remain constrained by the philosophical divisions both inside and between the parties. Moreover, the arithmetic of the Diet is daunting: in the Lower House, the LDP and its partners have a two-thirds-plus majority. However, in the Upper House, no party or coalition of parties has a majority. Although controversial laws can be passed using the override provision in Article 59 Section 2 of the Constitution, this override process is time-consuming. The result has been gridlock. (Article 59 states, “A bill becomes a law on passage by both Houses, except as otherwise provided for by the Constitution. 2) A bill, which is passed by the House of Representatives, and upon which the House of Councillors makes a decision different from that of the House of Representatives, becomes a law when passed a second time by the House of Representatives by a majority of two-thirds or more of the members present. 3) The provision of the preceding paragraph does not preclude the House of Representatives from calling for the meeting of a joint committee of both Houses, provided for by law. 4) Failure by the House of Councillors to take final action within sixty (60) days after receipt of a bill passed by the House of Representatives, time in recess excepted, may be determined by the House of Representatives to constitute a rejection of the said bill by the House of Councillors.”)

No one is happy with gridlock. A general election is therefore constantly under discussion. However, the political calculations involved in whether to call a general election prior to expiration of the current term are very complex. (Article 45 of the Constitution limits the term of the Lower House to four years. Since the previous election was on September 11, 2005, the current term expires on September 10, 2009. In addition, Article 54 of the Constitution requires that a general election be held within 40 days after the dissolution of the Lower House. Since Japanese elections are held on Sundays, the latest date at which a general election could be held is therefore October 18, 2009.) From the LDP side, the low popularity of the current government is clearly a factor arguing for delay; however, delay itself makes the LDP even less popular. Moreover, there are parts of the LDP that publicly are calling for an early election. From the DPJ side, the official position is that an election should be called as early as possible. However, in fact, the DPJ might not be in a rush. Allowing the LDP’s popularity to fall further would clearly help the DPJ. Moreover, the fall of LDP popularity has not translated into significantly higher popularity for the DPJ. In the end, the decision on whether to call an election depends on the prime minister. (Article 7 of the Constitution says that dissolution of the Diet is a duty of the Emperor, on advice and consent of the Cabinet. In practice, the PM makes the decision.)

At the present instant, there are two scenarios of when the next general election might occur. One scenario foresees PM Aso pushing the main budget legislation through the Diet by March, and calling the election in April. (Budget bills are treated specially by the constitution. In effect, only the Lower House approval is needed, and a budget takes effect 30 days after passage by the Lower House. Specifically, Article 60 of the Constitution says, “The budget must first be submitted to the House of Representatives. 2) Upon consideration of the budget, when the House of Councillors makes a decision different from that of the House of Representatives, and when no agreement can be reached even through a joint committee of both Houses, provided for by law, or in the case of failure by the House of Councillors to take final action within thirty (30) days, the period of recess excluded, after the receipt of the budget passed by the House of Representatives, the decision of the House of Representatives shall be the decision of the Diet.” Despite this clause, implementation legislation is NOT considered to be part of the formal budget, and therefore is normal legislation. Hence, the government may be able to pass the budget itself, but not be able to pass the implementing legislation.) The second scenario foresees a further decline of the government’s popularity by April, making dissolution too risky for the LDP, regardless of the budget; hence, the Diet would serve its full term until September 10, and an election would be called then, and take place in October. There is no firm basis for favoring either scenario.

What Next? (II): There Are 27 Scenarios for the Outcome of the General Election

The timing of the next general election remains highly uncertain, but the result is even more so. The reason for the uncertainty is the multiplicity of potential outcomes.

The multiplicity of outcomes comes from the interaction of three factors. The first factor is the seat outcome, by party. In scenario 1, the LDP gets only 150 seats, or 35% of the total of the two major parties. (The minor parties are assumed to get about 50 seats, roughly the same number that they have now.) In scenario 2, the LDP gets 46% of the two-party seats (this is about the number of seats for the LDP predicted by a simple statistical model of the election, based on translating recent public opinion surveys into Diet seats – see Appendix I), and in scenario 3, the LDP gets 52% (this is the number needed for the LDP to retain a bare majority in the Lower House, once the seats of its partner the Komeito are included). The second and third factors are the breakdowns of reformers and anti-reformers within the LDP and DPJ, respectively. The three possibilities are 70%, 50% and 30% for the reformers, and the remainder to the anti-reformers. Thus, there are three scenarios for seat outcome, three for the LDP breakdown and three for the DPJ breakdown, for a total of 27 (=3x3x3).

The next problem is how to attach probabilities to each of these 27 scenarios. There is no scientific basis for calculating such probabilities, but recent public opinion polls suggest that momentum is against the LDP, so there could be a major defeat in excess of the showing of standard polls. Hence, I assign 65% probability to scenario 1 (i.e., 150 seats for the LDP), 30% to scenario 2 and only 5% to scenario 3.

The probability for the reformer breakdowns in the LDP depends in part on how well the party does. I have tilted the subjective probabilities in favor of the reformers if the LDP does poorly. That is, the anti-reform forces in the LDP take the hardest hit if the party loses badly. That said, such a result is not a foregone conclusion. One must also consider the possibility that the reformers lose most heavily. Hence, I have given a 50% chance to the LDP reformers doing very well in the event of a major LDP defeat, but have left a 25% chance that the LDP reformers take only half the LDP seats and a 25% chance that they do very poorly in that case.

For the DPJ reformers, I have tilted the probabilities somewhat in favor of the reformers, although a 50:50 outcome remains most likely. I posit no linkage between the share of DPJ reformers and the overall seat outcome.

The derived probabilities for the nine most likely scenarios are listed. For example, the scenario where a) the LDP does badly (65% probability), b) the LDP reformers do badly (25% probability) and c) the DPJ reformers do badly (15% probability) has an overall probability of 2% (=0.65 x 0.25 x 0.15). An enumeration of all of the scenarios and all of their (admittedly subjective) probabilities is given in Appendix II of the full report.

The highest probability occurs in the scenario where a) the LDP loses badly, b) the LDP reformers do well, and c) the DPJ reformers take half of the DPJ seats. The subjective probability for this case is 16%. The case with a) and b) but where the DPJ reformers also do well has a subjective probability of 11%.

Election Outcomes, Policy Outcomes

The election outcome is one thing, the policy outcome is quite another. It is important to look at each of the scenarios and see which policy outcome might occur. We illustrate a philosophy map of the basic stances of the subgroups and a matrix of political compatibility. (Since there are seven sub-groups in this analysis, there are 21 (= 7! / [2! x 5!] ) possible combinations of two subgroups and 35 ( = 7! / [3! x 4!] ) possible combinations of three. Thus, there are 56 potential combinations for each of the 27 potential outcomes of the election, or 1,512 cases. Fortunately, many of the potential coalitions are philosophically impossible, such as the DPJ pro-reformers linking with the small right-wing parties. The analysis below considers only the combinations that are politically feasible.) If there were to be a political realignment, for example, it is easy to see LDP reformers and the DPJ reformers coming together, either into a single party or into a coalition. However, it is very hard to see the DPJ reformers coming into a coalition with the small rightist parties.

It is possible to connect these philosophy and compatibility observations with the election scenarios given above. We show the Diet seat strength of each set of philosophically compatible sub-parties, for each of the nine election outcomes, in the case of a major LDP defeat. In the case given above, with 16% subjective probability, the combined seats of the two pro-reform groups (case LR+DR) come to 245. This is an extremely strong showing – but only barely reaches a majority (with 480 seats in the Lower House, a majority requires 241). Hence, to make a credible pro-reform party in the Lower House in this case, it would be necessary to bring the Komeito into the coalition and raise the tally to 265 (case LR+DR+KM).

There are other pro-reform outcomes possible. For example, the current DPJ could combine with a break-off group of LDP reformers (LR+DR+DA). Although the DA group is not philosophically compatible with the other two, there could be political factors that bring them into such a coalition.

There are anti-reform possibilities as well. For example, there are several cases in which the anti-reform LDP group combines with the anti-reform DPJ group to form a majority. This is particularly possible if the Komeito decides to join such a government.

Triggers for Realignment

A perennial question from investors is what event might trigger a political realignment. There are many, from both the LDP and DPJ sides. Moreover, an event in one could trigger an avalanche elsewhere.

In the LDP, there are both policy and political factors that could trigger realignment. The policy factors are mostly in economic policy, and include postal reform, road tax revenue allocation, the consumption tax and civil service reform. The fault lines run between big- and small-government philosophies. The political factors include factional struggles, leadership struggles, generational differences and simple fear of a major loss at the next election.

For the DPJ, the potential triggers are different. If the DPJ takes office, internal differences over foreign policy would be blatant. In economic policy, issues such as postal reform, civil service reform and labor market reform are also potential triggers for a split. Political factors could also be important. There is dissatisfaction with DPJ Party President Ozawa from both the right and left wing of the party.  His aggressive leadership has irked some members, and his relatively low levels of voter approval are a source of concern.

At this point, I believe that an LDP break-up seems more likely than a DPJ one, since political momentum now lies with the DPJ. That said, an LDP split could easily trigger a DPJ split because a major attraction of the DPJ in many voters’ minds is that it is not the LDP. If the LDP splits, the DPJ’s support could wane, in favor of a new party.  And if the DPJ’s support wanes, there is little to keep many members in the party.

What Would a Pro-Reform Government Do?

The current gridlock gives a very good idea of what an anti-reform coalition would do, e.g., in the scenario of a coalition between anti-reform parties. In this case, prospects for growth would remain modest, and investors would be unlikely to discount any vibrant rebound of earnings. The nation would remain in the ‘shallows and miseries’ scenario, with low growth, high fiscal deficits and weak asset markets (see Japan in 2013: Winners and Potential Winners, Feldman, Kamiyama, Sato and Yamaguchi, September 26, 2008). This scenario appears to be the default scenario that investors are now discounting. The only change, in the case of an election result favoring an anti-reform coalition, would be the disappearance of the option value of a pro-reform outcome.

At the moment, both pessimism and cynicism about politics are very high, and so even that option value is likely to be low. I would argue, however, that the reform policy potential is much higher than investors currently perceive. My view is based on a broad range of policy discussion groups, with all sides of the debate. In fact, there is a huge amount of innovative and creative policy debate, both within parties and across party lines. There is a significant chance that the pro-reform factions coalesce. What would the policy stance look like under such a regime, and where would the business opportunities be?

The economic crisis has prompted the pro-market reformers and the pro-safety net reformers towards a new consensus. The implicit compromise is that safety net improvements are combined with productivity-enhancing market reforms. The latter improve productivity enough to pay for the safety net, while the former improve social equality enough to gain political support. The result is a set of five areas for ‘protection’ and five areas for ‘reform’.

It is important to note, however, that ‘protection’ in this context is not merely a matter of transferring income, tightening rules or increasing bureaucratic oversight. Rather, market incentives and rationalized regulation are crucial for improving protection. For example, in agriculture, productivity enhancement on farms is essential for raising food security, and can only be achieved through rationalizing production and distribution incentives. In real estate, the poor quality of price data has hindered efficient land use, and thus improved data are a key part of improved productivity.

The economic and equity market opportunities implied by this synthesis are many. (For an enumeration of various ideas being discussed in various policy study groups, see Appendix III in the full report.) For example, the combination of special economic zones with major agriculture reform could give agricultural-related firms (e.g., trading companies, meat-packers, some machinery makers) major new business opportunities. An aggressive electronic medical records system (such as that now being discussed in the US) could provide software engineers new opportunities, and free medical funds for better patient care. A more uniform approach to financial institution inspections could spur reorganization in the regional banking industry. The combination of stricter anti-monopoly enforcement and equity crossholding limits could trigger industrial reorganization in a broad set of sectors.

The exact set of measures adopted by any pro-reform government will depend heavily on the people in the key positions and the dynamics among them. The bad news is that the personnel structure of any such pro-reform government is wholly opaque. The good news is that information on the members will be readily available, once names are mentioned. Indeed, virtually all Diet members have home pages, including biographies and policy statements. Once the personnel alignment in a new government is clear, it will be relatively easy to see the policy direction. (A recent example of judgment by personnel selection was the Cabinet reshuffle by PM Fukuda on August 2, 2008. The new Cabinet included a number of anti-reform politicians, while the few pro-reformers were in relatively low-profile jobs. This personnel structure trumpeted the retreat from pro-reform policies and had a negative impact on financial market expectations.)

What Should Investors Do?

In light of the analysis of politics and policy above, it seems quite unlikely that Japan will move from the Crisis phase of the CRIC cycle into the Response phase during the first few months of 2009. Indeed, even if there is an early election and even if a pro-reform government takes office, the impact on growth and earnings will likely lag.

Of course, a pro-reform government could well bring a relief rally. However, now that markets have been disappointed for more than two years in Japanese policymaking, it will take more than a change of government to renew excitement about Japanese assets. After all, the Japanese equity market went from 14,425 when PM Koizumi took office at end-April 2001 to 7,607 at the market low in April 2003, just before financial reforms became credible. Skeptical investors will need to see policies announced, adopted, legislated, implemented and becoming effective before giving full credibility to the impact of reform policies on earnings.

In short, investors are facing near-total uncertainty about when the next general election might occur, what policies might be adopted and what may be legislated. Hence, the default is to expect nothing and wait for proof that something constructive may occur.

The Three Strategies: Stay Away, Compile a Buy-List, Consider Derivatives

In such an environment, there are three strategies: investors may a) stay away, in light of the uncertainty, b) compile a buy-list and wait for the policy news to turn better, or c) develop derivative strategies that balance the positive and negative risks in the situation against the pricing of those risks in the market. The ‘stay away’ strategy and the ‘compile a buy-list’ strategy are self-evident. Indeed, the decline of foreign holdings in Japan suggests that ‘stay away’ has been the default. The derivatives strategy requires complex calculations of risks and returns on both upsides and downsides of the position, and is suitable only for investors who understand its risks.

Appendix I: Simple Model of Electoral Outcomes

In order to make a statistically based forecast of the election outcome, I use a simple statistical model. The simple model translates public opinion polls into party vote shares in the proportional districts, and then uses linkage regressions to translate the vote shares into seats. The model is based on public opinion results in which voters are asked which party they will support in the proportional district portion of the general election vote. (In a Japanese general election, each voter gets two votes: one for the ‘proportional district’ seats of the region where the voter resides and one for the ‘single-seat district’ where the voter resides. In the proportional seats, the voter selects a party, and the final number of seats for a party is determined by the d’Hondt method, based on the total votes for the parties the region. In the single-seat districts, the seat goes to the candidate with the most votes (i.e., first-past-the-post system). The LDP has tended to do better in the single-seat districts than in the proportional districts.)

Results of recent public opinion polls from news organizations are presented. Unfortunately, results are available only for the largest parties. Therefore, for the other parties, I based the assumptions for proportional vote shares on the outcomes of the most recent three general elections and on recent micro information. For example, I reduced the share of the Komeito vote, in part due to its affiliation with the now-unpopular LDP, and in part due to the difficulties it has experienced in delivering the vote for the coalition in recent elections. I left the small right-wing parties largely at their levels of the last election. For the small left-wing parties, I increased the share of the Communist Party, on the basis of the reportedly hefty increases in party membership from recently laid-off workers, especially part-timers. For the Social Democrats, I reduced the share slightly, in light of recruiting difficulties.

The next step is to translate these party vote shares into seats in the proportional districts. Fortunately, the last three elections show relatively stable relationships between the share of votes in the proportional districts and the number of seats gained. This stable relation is a natural result of the d’Hondt system for seat allocation, which aims at precisely such a result. The seat results for models based on the elections of June 2000, November 2003 and September 2005 are presented. Note that the totals are not constrained in the estimation procedure to add to 180 seats; the gap between the total seats estimated and the actual number of 180 gives a rough estimate of the accuracy of the model for each year.

For the single-seat districts, estimation is harder. The problem is how to translate the party popularity into single-seat district outcomes. The method used here was to link the share of a party’s vote in the proportional constituencies to the share in the single-seat constituencies, and then link the latter to actual seats in the single-seat districts. This works reasonably well for the large parties. For the small parties, however, this method overestimates their seats because of the ‘first-past-the-post’ nature of declaring winners. That is, in virtually all of the 300 single-seat districts, one of the two largest parties will win. The exceptions are districts where a traditionally popular politician happens not to be in one of the major parties (often due to leaving the LDP) or because of an agreement between coalition partners not to compete in a given district. In order to account for the single-seat district effect, I have arbitrarily reduced the number of single-seat districts of the small parties by 75%. The results show the major parties indeed getting virtually all of the seats. The Communists take seven such seats (compared to none in each of the last three elections), and the other small parties get none in almost all cases.

One final adjustment is needed. There will be exactly 180 seats in the proportional districts and exactly 300 in the single-seat districts. Hence, the results in each model must be adjusted to reach these totals. I made this final adjustment with two steps. First, I made proportional changes to the numbers of seats, across the board, depending on whether the model had under- or over-determined the number of seats. For example, using the coefficients for the 2000 election, 311 seats for the single-seat districts were determined. Hence, I made proportional cuts of the seats of all parties by 300/311, for this result. Second, due to rounding, the proportional cuts still left cases where the totals were one seat below the needed levels. In these cases, I allocated the remaining seat to one of the small parties, based on recent election results.

The final outcome of the estimations and adjustments is shown. In this outcome, neither of the major parties wins an outright majority, although the DPJ comes close. In practice, the DPJ would have to form a coalition with a small party that takes more that nine seats. The only numerically possible coalition partners are the Communist Party and the Komeito. However, a DPJ-Communist coalition would not work because large parts of the DPJ are diametrically opposed to the platform of the Communists, and thus might bolt the party if such a coalition formed. Therefore, a Komeito-DPJ coalition would be the most likely outcome – if the parties all stick together after the election. For other potential cases, see Appendix II in the full report.

Note: In order to generate the outcome of 150 seats for the LDP from this model, the assumptions would have to change. For example, an LDP proportional vote share of only 15% would be needed to reach 150 seats, in the simplest case. Alternatively, a proportional vote share of 20%, along with 22 extra losses in tight single-district races would generate an outcome of 150 seats.

For the single-seat district outcome, much depends on local circumstances. However, some calculations suggest that a huge drop of single-seat outcome for the LDP is possible. First, the Communist Party has typically run candidates in every election district, a move that likely siphons votes away from the DPJ. This year, however, the Communists have reportedly decided not to take the same strategy. Second, the role of floating voters continues to rise; a large shift of voters from LDP candidates to DPJ candidates is possible.

An example of the impact comes from calculations for the combination of Fukuoka Prefecture (urban, with 11 districts) and Yamaguchi Prefecture (rural, with four districts). In the 2005 election, the LDP won 14 of the total of 15 seats. Based on the outcome of that election, a swing of Communist voters to the DPJ, and a swing of LDP voters to the DPJ could radically change the outcome. For example, if a) one-third of the Communist voters switch to the DPJ candidate, and if b) 7% of the LDP voters switch to the DPJ, then the LDP would win only six of the 15 seats. If all of the Communists vote for the DPJ, with a 7% switch from the LDP, then the LDP total falls to four seats.

This calculation suggests that investors should watch a) the behavior of Communist Party voters in the single-seat districts, and b) the behavior of floating voters who voted for the LDP in the 2005 election.

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