SYNOPSIS: 'No Pain, No Gain' is not a valid Economic argument The world's second-largest economy has its next prime minister, and hope is in the air. Junichiro Koizumi doesn't look or sound like a conventional Japanese politician. He could turn out to be Japan's Franklin Roosevelt. Alas, judging from his platform he seems more likely to be Japan's Herbert Hoover.

Mr. Koizumi has not given many specifics. But what he has said amounts to a promise of blood, toil, tears and sweat or anyway their financial equivalents. "There will be companies going bankrupt and increased unemployment," he has admitted. "But if we are fearful of unemployment, we will never see the recovery of the Japanese economy."

It's a hard-headed and courageous position. It is also reminiscent of the disastrous advice given by Andrew Mellon, Hoover's Treasury secretary: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. . . . It will purge the rottenness out of the system. . . . Values will be adjusted, and enterprising people will pick up the wrecks. . . .."

What was wrong with Mellon's advice, aside from its callousness? He confused supply with demand.

When an economy's production is limited by its capacity to produce the normal state of affairs it is important to make sure that scarce resources like capital are used efficiently, put to work where they yield the highest return. Japan's postal savings system, which channels money into public works projects that have little if any social payoff, is monumentally inefficient; so is the practice of rolling over the debts of companies that will never regain profitability and hence keeping capital employed producing goods nobody wants. So if Japan's production were limited by its capacity, Mr. Koizumi's proposals to privatize postal savings and force banks to write off bad loans would be right on target.

But Japan isn't limited by its capacity. It is plagued by chronic insufficiency of demand that is, consumers and businesses are unwilling to buy as much as the economy is already capable of producing. And in such an economy, attempts to increase efficiency often do more harm than good. Freeing capital by reducing the budget deficit and closing down unprofitable businesses sounds great but if that freed capital is simply put under the mattress (or stored in a bank vault), the result is not faster growth but a deeper slump.

Now there are many pundits who claim that such a slump is exactly what Japan needs, that purging the system will create the conditions for a future surge in demand. But why? If the economy remains depressed, why should either consumers or businesses start spending? Banks, in particular, are already awash in cash, but cannot find good new loans to make. Why would forcing them to write off bad old loans make any difference?

Nonetheless, Mr. Koizumi is right about one thing: Japan cannot go on like this. Swelling public debt will eventually threaten the government's solvency; the festering financial problems of the banks will soon require a government bailout that will swell that debt even further. Something must be done. But the actions Mr. Koizumi has proposed could tip Japan into full-blown depression.

There is an answer to this dilemma, one that has become almost orthodoxy among economists who have tried to think seriously about Japan's plight. This answer involves unconventional monetary expansion, with the Bank of Japan buying dollars, euros and long-term government bonds; it also involves accepting and indeed promoting mild inflation and a weak yen. I could explain why this would probably work, but what's the point? It's not about to happen.

For the real tragedy right now is that however innovative and open- minded Mr. Koizumi may be, he will fail unless other important players mainly the Bank of Japan, but also the U.S. Treasury Department are prepared to learn from Andrew Mellon's mistake. And all the evidence is that they are not. The head of the Bank of Japan insists that the country's continuing slump is the result of inadequate reform that is, insufficient purging of the rottenness. And although the details are in dispute, the U.S. Treasury secretary, Paul O'Neill, appears to have warned Japan not to let the yen weaken too much.

Poor Japan. It is the victim of those who refuse to learn from the past, and thereby condemn others to repeat it.

Originally published in The New York Times, 4.25.01