Hamish McRae: Japanese people are no longer ready to accept economic failure

Maybe Japan will wake up at last from its 25-year slumber. In a month's time, 30 August, Japan elects a new government. Elections are elections, but there seems to be an overwhelming probability that the opposition Democratic Party of Japan will take power, ending half a century of virtually uninterrupted one-party rule by the Liberal Democratic Party. And it is just possible that a change of government will trigger the sort of structural reforms that could rescue the country from economic stagnation.

Visit Japan and all seems calm and comfortable. Tokyo at least appears prosperous and, of course, spotlessly clean. You could eat your breakfast off the pavements. It is also the safest large city in the world, with very low crime against the person. But underneath that calm lies profound concern, for Japan has become one of the least successful countries in economic terms in the world.

If you take the straightforward measure of growth of GDP over the past 10 years, Japan has barely grown at all. (That is in dollar terms. In yen terms, the economy has shrunk.) One result is that China will this year probably overtake Japan to become the second largest economy after the US.

You can see this in practical terms in things such as industrial production and car sales. Industrial production has collapsed this year and is now back to the same level as it was in 1983. New car sales at a little over 4 million a year are half that of the peak in 1990 and way below the 5 million or so in the middle 1980s.

For most of the past 25 years the Japanese people have been prepared to accept this. Indeed, it is an extraordinary tribute to their social resilience that people have put up with a generation-long stagnation in living standards. Efforts to kick-start the economy by increased public spending have failed and Japan's debt is now a eye-watering 170 per cent of GDP. Low interest rates have failed, for the country has had near-zero rates since the middle 1990s. Nothing has worked.

Now the Japanese people seem to be no longer prepared to accept failure – or at least prepared to take the risk of new economic policies. If the DPJ is indeed returned with a clear majority, there is the prospect of a sharp change in direction. The analogy would be the sort of change that Margaret Thatcher brought to Britain in 1979, after the electorate here rejected economic failure, or maybe even the changes in China that began about the same time.

I have been looking at two papers chronicling the scale of the possible changes, one from Stephen Church at Japaninvest, a company that does independent Japanese equity research, the other from Tadashi Nakamae, who runs Nakamae International Economic Research in Tokyo. The first focuses on the policy changes and their implications for investment, the second on what is happening to the economy and why structural reforms are the only effective way forward.

To understand what has gone wrong, you have to grasp that under the present government economic policy has been subcontracted to the bureaucracy. It is as though the Treasury and other Whitehall civil servants determine the policies, which are then rubber-stamped by Gordon Brown and his colleagues. For many years, indeed from the middle-1950s to the middle-1980s, this seemed to work. Western writers praised the system, contrasting it with the state we were in here in Britain. The result since the mid-1980s has been mismanagement on a mega scale. As Stephen Church argues, the Ministry of Finance mismanaged tax and spending policy by increasing taxes at the wrong time in an effort to contain the deficit, while the Ministry of the Economy, Trade and Industry mismanaged industrial policy, with its "export or bust" policies, trying to preserve low and medium-technology manufacturing industries.

He argues that under the DPJ both these policies are likely to be reversed. It will worry less about the deficit as such, but start to cut it back by selling unproductive state assets. It will also intervene less strongly in the foreign exchange markets in an effort to hold down the yen against the dollar and so protect less competitive industries. Once Japan abandons its mistaken polices, he argues, there is every reason that the economy will start to perform better, as do other East Asian economies.

Tadashi Nakamae's key argument is that Japan needs supply-side structural changes instead of a fiscal stimulus. (In the interests of full disclosure I should acknowledge that 10 years ago Tadashi and I co-authored a book published in Japanese calling for such changes.) His argument is that Japan should not rely so much on export demand to maintain growth but figure out ways of improving domestic demand. While Japan has to some extent been helped by the Chinese boost to demand and the economy may as a result be bottoming out, this does not solve the longer-term problem.

The ideal way forward would be to allow private demand to rise and allow interest rates to rise too. That would lead to weaker firms closing but give a spur to the most efficient ones. The non-manufacturing sector is actually suffering from a lack of capacity, but it is held back by bureaucratic regulations. Sweep these away and growth in areas such as health care and private-sector services for the elderly would take off. Retailing is another sector that is extremely tightly regulated and has considerable potential for growth too.

It is difficult, writing from London, to know quite how the economic programme of the DPJ will unfold. But then it is always difficult to know how an untried set of political leaders will perform. We have experience of that, both positive and negative, here in the UK. What is pretty clear is that Japan has experienced policy failure, and that we know from what has happened elsewhere that excessive and badly framed regulation inhibits economic growth.

The difficulty I see is that in the short-term many of these structural policies will cause disruption. For example, if the yen and interest rates both climb, that will put huge pressure on capital-hungry exporting industries. In the short-term, unemployment will rise. I think we have learnt in the UK that ultimately the best way to preserve jobs is to allow these changes to take place rather than resist them, and actually Japanese policies have not been successful in protecting employment.

Male employment has been particularly weak. At its peak in 1997 there were more than 37 million jobs for men in Japan; now there are a little over 25 million. Women have been less affected: employment is a little lower than at the peak, but not much. So in the longer term, trying to protect employment has failed. But in the short run, things are likely to get worse before they get better.

But I cannot help feeling, for the first time in perhaps 20 years, optimistic about Japan. Ultimately the country has a choice. It can carry on as before, and we know where that leads. Or it can reform.

Fortunately there is a blueprint for reform, the sort of supply-side policies brought in by the UK and many other European countries over the past 30 years. The fact that Japan is now the "oldest" nation on earth, in terms of the proportion of elderly people, will mean that it will not become the vibrant growth-oriented country it was until 1990. But it seems about to make the choices that will secure it a much more positive future. This is really important, not just for Japan, but for the world.