Dangerous Road Ahead; Facing an eventual financial crisis, Tokyo should be pushing reform harder, not slowing down.

Byline: Robert Madsen (Madsen is senior fellow at MIT's Center for International Studies.)

After four years of robust GDP growth, many Japanese reckon they've fixed the problems in their economy and that additional structural reforms are no longer necessary. This return to conservatism, however, comes at precisely the wrong time.

It is true that Japan has made great strides. The banks are stronger, corporations have written off much of their excess capacity and the labor market is considerably less rigid than in the past. But contrary to popular opinion, these improvements do not explain the country's 2002-2006 recovery. Over the last 15 years, Japan's biggest problem was insufficient demand for its products. Stronger GDP growth only became possible when new sources of demand materialized in the form of China's insatiable appetite for Japanese exports, a surge in corporate investment--itself largely intended to serve future Chinese customers--and an incipient upturn in household consumption. Corporate and financial restructuring therefore wasn't the reason for Japan's commercial resurgence.

But it will be essential to the country's future. Within a year or two, Japan's surplus production capacity will disappear. That fact, combined with the shrinking labor force, will gradually depress the long-term growth rate--to just 1 percent or 1.5 percent annually for perhaps two decades. Such a tepid growth rate could invite a financial crisis. The national debt has reached a vertiginous 160 percent of GDP--and is still expanding at some 5 percent of national output each year. Exacerbating this problem is the impending retirement of a large proportion of the work force--a development demanding much greater public health-care spending. To thwart these trends, Tokyo must hike taxes significantly, something that will only be possible if aggressive structural reforms have been put in place to raise production capacity and facilitate faster growth.

Japan, however, is having second ...