The Japanese economy remains in a serious deflationary situation even while experiencing a cyclical recovery phase in mid 2002 underpinned by inventory correction and a sharp pick-up in exports. But the recovery is too narrowly based to represent a break with the pattern of generally low growth experienced through the 1990s. The still high capital/ output ratio is likely to limit any pick-up in investment to a short term adjustment, while continuing weakness in the labour market is expected to restrain consumption growth to around one per cent per annum. More recently, a combination of factors – particularly low share prices in Japan and elsewhere, a marked appreciation of the yen and a moderating export expansion – has dampened growth prospects going into 2003. All in all, the economy may grow by only around ½ to 1 per cent per annum to the end of 2004 with deflation continuing. But the balance of risks is now on the downside given signs of slower growth in the world economy and the possibility of a further deterioration in financial conditions, which might lead to a worsening of deflation. Thus Japan continues to be faced with the daunting challenge of radically and quickly improving the functioning of its economic system and halting deflation...

Despite continuing deflation and weakness in the financial sector, the Japanese economy has recovered at a moderate pace since early 2002, led by a sharp increase in exports. The weak yen in early 2002 and the already low level of inventories have supported export growth and increased production, which in turn have led to an improvement in business sentiment. The recovery has been particularly strong in electronics and in other exporting sectors, especially automobiles. Activity in domestic sectors has also started to recover, though at a modest rate...

The policy environment has been very difficult over the past year because of unexpected changes in economic and political circumstances and the pressing need to "fight fires" on several occasions. As the government has moved from setting broad reform objectives to considering specific budgetary measures and legislation, opposition from entrenched interest groups and from factions within the ruling parties has become intense. Moreover, the political power of the government to enact its reform programme has weakened significantly, leading to difficult compromises, which in turn have served to impair the government’s policy credibility. This has been compounded by the seeming difficulty of the government to get its message and news of its accomplishments across to the public...

A return to growth is increasingly urgent in Japan to facilitate dealing with the serious fiscal situation and the rapid ageing of the population. Maintaining living standards in the face of an ageing and shrinking population requires substantial increases in productivity per worker. But to underpin this, multi-factor productivity will need to accelerate, reversing a trend that has been in place since the first oil price shock of 1973. Labour and per capita productivity have been driven increasingly since that time by high rates of investment but the marginal returns have been declining. The problems essentially arise from the inability of the Japanese economic system to reallocate resources efficiently, be they human, entrepreneurial, intellectual and financial, thus requiring reforms in a wide range of areas...

This chapter takes up some key regulatory issues concerning the network sectors as well as policy questions more directly linked to growth, including human capital formation and the arrangements for R&D and for university research. The first section examines reforms of the network sectors – telecommunications, electricity and gas and posts. In the context of growth, the sectors are playing different roles.  Telecommunications prices and the availability of services has a direct connection via costs with the diffusion of information and communications technologies (ICT). Despite the hype of the late 1990s, the diffusion of ICT appears to have an effect on productivity and growth although the process is complex, and can involve productivity gains in traditional sectors. The linkage of the other network sectors to growth is less direct. Electricity prices are high by world standards so that a reduction in costs due to competition would be expected to raise the steady state level of real incomes so that the direct impact on the growth rate would be only temporary. The postal sector is important because of its control of a huge amount of savings. However, in other  ountries courier and fast mail services have been an important growth sector. The second section deals with human capital formation covering not only tertiary education but also skill formation more generally that has traditionally been provided by enterprise training. The third section covers the difficult and hard to define area of technology including how policy and institutions affect the way enterprises go about furthering their research and innovation capability. The incentive structure the universities face appears to be an important determinant of their behaviour, and recent policies to improve the productivity of these institutions are also reviewed...