As March 31 approaches, Japan faces critical decisions regarding the future of its economy. This deadline, which marks the end of the financial year, is crucial because Japanese banks must account for their assets and performance, which may fail to meet investors' expectations. The fear is that a loss of confidence in the banks will cause widespread distress in the financial system, which could affect the United States.

Bad news in the Japanese economy is not new. Japan has experienced stagnant growth and four recessions since 1990. Real estate prices have fallen to their 1982 value, and taxpayers have paid for approximately $1 trillion in failed stimulus packages over the past decade. What makes the current recession more ominous than the previous three is that it marks the first time in modern Japanese history that asset and labor values have fallen simultaneously.

While the Bush Administration cannot spearhead the process to reverse this downturn, it can and should clearly communicate U.S. priorities to the Japanese government and people and provide unequivocal political support for efforts to enact reforms. The United States should also consider assembling key economic and financial advisers to assist the Japanese leadership in implementing reforms; creating an inter-agency task force in the Administration, overseen by the National Security Council, to coordinate communication with Japan and underscore the critical security aspect of restoring vitality and confidence in the Japanese economy; and formulating a last-resort contingency plan to insulate the U.S. economy from a possible crisis in the Japanese financial system. The contingency plan should promote strong economic growth and trade with the rest of East Asia. It should also ensure that the U.S. banking system is not unduly exposed to Japanese banks and alert U.S. businesses and investors that they will not be bailed out in the event of a Japanese financial crisis.

The Japanese government has been in denial about its economic problems for more than a decade. This denial has gradually escalated a difficult financial problem into one of enormous proportions, with potentially serious consequences for the global economy. The Bush Administration obviously cannot solve Japan's economic malaise. That task awaits action by the government of Japan under the leadership of Prime Minister Junichiro Koizumi.

Koizumi's government must end the dangerous spiral of deflation. The latest gross domestic product (GDP) figures for the fourth quarter of 2001 reveal that there was a 12 percent drop in private-sector investment. This, in effect, nullifies a 1.9 percent increase in private consumption and a 2 percent rise in household consumption for the same quarter. The leadership must act quickly to counter the prevailing mood of political paralysis.

The public's lack of faith in the Japanese leadership's commitment or ability to implement hard reforms has depressed consumer spending. In order to jump-start the economy, the leadership must therefore:

• Terminate ineffective Keynesian infrastructure projects. Japan spent $1 trillion on 10 different stimulus packages in the 1990s with no lasting positive impact on economic growth. Worse, as a result, public debt has ballooned to 140 percent of GDP--over $6 trillion, the highest level of any major developed economy.
• Resolve the problem of non-performing debt. Non-performing loans have become an increasing portion of overall bank assets, resulting in a decline in new loans that weakens the overall financial system and impedes recovery. Foreclosures are necessary to resolve these problems. The Resolution Collection Corporation was established in 1998 for this sole purpose. But the RCC has purchased and resold only $139 billion in non-performing loans, an amount that is dwarfed by the private sector's $1.768 trillion estimate of non-performing loans. The RCC should be encouraged to be more aggressive in disposing of bad debt.
• End government subsidies and protection for private businesses. The government should end its support of the private sector, such as its implicit bailout of the debt-laden retailer Daiei. It should instead, through legislative changes, encourage corporate restructuring and more flexible deployment of workers. In 1999, the government injected banks with $56 billion of taxpayers' money to prevent them from collapsing but did little to encourage distressed corporate borrowers to downsize efficiently. That failure contributed greatly to the impending crisis in the financial sector.
• Embrace free-market competition. Japan should increase domestic competition by allowing large and inefficient businesses to fail unless they are restructured into slimmer, potentially profitable operations. This may entail painful mass layoffs, which traditionally are anathema to the Japanese. Competition can be further increased by deregulating and breaking up the old cartel structure of the nation's banking system. The government already has made efforts to further this goal with plans to end government guarantees of bank assets, but this reform measure has been delayed several times due to political pressures. Prime Minister Koizumi must ensure that these plans are implemented without delay, for they are key to reforming the failing the banking system.
• Reduce taxes. Resuming economic growth requires increasing private consumption. The most efficient way to accomplish this is to increase the resources that are available for individuals to spend by lowering the tax burden.

Recovering from the economic problems resulting from 10 years of willful inaction is no simple task and will not be accomplished quickly. However, failure to undertake these tough reforms will consign Japan's economy to a steeper decline that will lead to an economic crisis that harms other economies, particularly in East Asia, and undercuts a global economy that is just now recovering.

Balbina Y. Hwang is Policy Analyst for Northeast Asia in the Asian Studies Center, and Brett D. Schaefer is Jay Kingham Fellow in International Regulatory Affairs in the Center for International Trade and Economics, at The Heritage Foundation.