This Week's Weekly: Continued: "The New Cold War Between Japan and China Is the Final Blow to Japan's Collapse"

 

This Week's Weekly: Continued: "The New Cold War Between Japan and China Is the Final Blow to Japan's Collapse"

 

Monday, December 8, 2025

 

① Regarding the Nikkei Editorial: "China's Military Provocations Are Absolutely Unacceptable"

 

While today's Nikkei editorial has some merit, it does not negate the issue. The Chinese military's radar illumination of Japan Self-Defense Force aircraft over international waters southeast of Okinawa is an extremely dangerous provocation that crosses a red line.

It is absolutely unacceptable, and the government's strong protest is understandable. Given historical precedents where accidental conflicts have escalated into war, thorough crisis management is essential.

However, the problem does not lie solely in China's provocations. Just one month ago, Prime Minister Takaichi stated in a Diet response that "a Taiwan emergency could pose an existential threat."

By failing to assume U.S. involvement and speaking as if a Taiwan emergency were a Japanese emergency, it could be said to have provided an excuse for provocation.

If both Japan and China continue to insist that the other is at fault, the Cold War-style conflict will only escalate, and there is a risk that it will become impossible to resolve.

It will not be easy for Japan and China to find a meaningful solution. The international community, not just these two countries, will have to decide which side is right.

Will the world side with Japan, or lean toward China? Which side the United States chooses under the Trump administration will be particularly crucial.

In this sense, the current situation, in which "Sanaenomics" appears to be running against history, is extremely unsettling.

Unfortunately, as detailed in last week's Weekly, Sanaenomics, which seems to be rushing headlong back down the prewar path represented by sonno joi (revere the emperor, expel the barbarians) and by Fukoku kyohei, ie. enriching the country and strengthening the military, could once again isolate our country, as happened during the last war, and send us spiraling down a slope to self-destruction.

 

② The first long-term interest rate in 18 years, 1.95%, is the "canary in the coal mine" for the Japanese economy to explode.

By the way, the December 1st Nikkei editorial, "The Bank of Japan Should Normalize Policy at Its Own Judgment and Responsibility," was persuasive in its insistence that the Bank of Japan's independence should be respected.

However, the problem lies in the lack of urgency. The Japanese economy is now in the midst of a crisis, and there is no room for leisurely discussion.

A rate hike is a drop in the bucket.

Currently, inflation is around 3%, and the supply-demand gap is roughly equilibrium. Under these circumstances, even if the policy interest rate were raised by only 0.25% from the current 0.50% level to 0.75%, it would be a gradual, delayed response and would be a drop in the bucket in terms of stabilizing prices and the currency.

As the Taylor principle dictates, the necessary conditions for price stability cannot be met without interest rate hikes exceeding the inflation rate.

Exceeding the Target for 43 Consecutive Months

It should not be forgotten that the government and the Bank of Japan have exceeded their 2% inflation target for 43 consecutive months since April 2022.

The "double whammy" of a high consumption tax rate and rising inflation is eroding consumer purchasing power, and the inflation tax continues to rob people.

According to the October Household Survey released by the Ministry of Internal Affairs and Communications last Friday (the 5th), real spending for that month was down 3.0% year-on-year, marking the first negative figure in six months.

Furthermore, the Ministry of Health, Labor and Welfare's Monthly Labor Survey for October (preliminary results, for those with five or more employees) released on the 8th showed that real wages, excluding the effects of price fluctuations, were down 0.7% year-on-year. While nominal wages have increased, they have not kept pace with inflation, marking the 10th consecutive month of negative growth since January 2013.

The Risk of an Incorrect Policy Mix

In any case, assuming an extremely expansionary "Sanaenomics" policy, the risk of accelerating inflation increases. Therefore, it is essential to not only raise interest rates by 0.75%, but to raise them continuously without delay.

Otherwise, rising inflation expectations will lead to currency depreciation and uncontrollable inflation.

According to my calculations, the appropriate interest rate, based on the Taylor rule (using an inflation rate of 3% and an unemployment rate of 2.6% as of October), should be 3.8%. The discrepancy with the current situation is quite serious.

Canary in the Coal Mine

The delay in aggressive fiscal policy and monetary tightening amid inflation appears to be pushing the vicious cycle of currency depreciation, inflation, and a bubble to the brink of exploding.

Coincidentally, long-term interest rates hit a record high of 1.95% last weekend, the lowest level in 18 years, leading to a sell-off of government bonds. This recent surge in long-term interest rates is a sign of a "canary in the coal mine."

Historically, in 1995, when the policy interest rate was 0.75%, long-term interest rates were at 3.19%. Therefore, it's possible that long-term interest rates will soon surpass not only 2% but even 3%.

Theoretically, long-term interest rates are thought to be composed of the potential growth rate, expected inflation rate, and risk premium. Both the government and the Bank of Japan estimate the potential growth rate to be approximately 0.6%. Furthermore, while the inflation target is supposed to be 2%, the actual inflation rate has been around 3% recently.

Even without considering the increased risk premium from increased issuance of government bonds due to a worsening fiscal balance, the risk of long-term interest rates rising sharply to 2.6% or even 3.6% cannot be ruled out.

Bank of Japan Accountability

Ahead of the final monetary policy meeting of the year on Friday, December 19, Governor Ueda has emphasized that "interest rate hikes are not a brake on the economy, but rather an adjustment to the accelerator toward achieving economic and price stability." Therefore, given that the government is also wary of an excessively weak yen, interest rate hikes should be tolerated at a cautious pace.

However, in a Japanese economy where the neutral interest rate remains low, continued interest rate hikes will eventually no longer be considered "adjustment in an accommodative environment." Ultimately, the Bank of Japan has a responsibility to more carefully explain to the government, the market, and the general public the appropriate pace and destination of interest rate hikes.

However, while the path to Japan's revival lies in the gradual normalization of real interest rates in addition to the abolition of the consumption tax, the Sanae and Ueda economics have fallen into the wrong policy mix of excessive fiscal spending and a continued monetary easing stance.

Thus, while it is truly regrettable, I am forced to warn that needlessly stimulating aggregate demand in the Japanese economy amid the quadruple hardships facing the general public -- a declining birthrate, long-term stagnant consumption, a weak yen, and inflation -- could lead to a major derailment from price stability and sustainable growth, and sooner or later to a major collapse of our economy. 

③ Focus on the Final FOMC Meeting of the Year

By the way, the biggest event of the week will be the US FOMC meeting, taking place on the 9th and 10th. Below, I will predict the outcome of this year's final FOMC meeting, basically following a Yahoo! Finance article from last weekend.

Since NY Fed President Williams' support for a rate cut the weekend before last, the market's view of monetary policy has been shifting. A 0.25% rate cut is now almost certain. However, according to the CME FOMC countdown as of last weekend, there is still a slightly less than 14% chance of the policy rate remaining unchanged, which may be a point of caution.

In any case, the focus will be on whether Chairman Powell's press conference and the dot chart in the latest economic outlook will change views on the pace of rate cuts in 2026.

Chairman Powell's press conference is likely to reiterate his previous view that policy decisions will be made based on data collected at each meeting, which may be perceived by the market as being somewhat hawkish.

The last dot chart, as of September, showed one 0.25% interest rate cut in 2026, one in 2027, and none in 2028. Therefore, it's highly likely that this will reinforce the sense that interest rates have already been cut in the short term.

By the way, National Economic Council Director Hassett, who is expected to become the next Fed Chairman, is "expected" to push for rate cuts, but Chairman Powell's term runs until May, so the view that rate cuts will cease at least until then may become more prevalent.

This is because, according to a Bloomberg article last week, there is an unprecedented difference of opinion among Fed officials regarding where the Fed should stop cutting interest rates after the total number of rate cuts implemented by the FOMC since the fall of 2024 has reached just over one percentage point.

Over the past year or so, the gap in views on the endpoint of the policy interest rate has widened to the widest point since 2012, when Fed officials began issuing forecasts. This situation has led to an unusually public exchange of opinions surfacing over whether to further cut interest rates at this week's FOMC meeting and what steps to take afterward.

Fed Chairman Powell has acknowledged that there are significant differences of opinion within the FOMC over which to prioritize: maximum employment or price stability. Ultimately, it boils down to whether further stimulus is needed to support employment, or whether stimulus should be withheld because inflation could exceed target and tariffs could push it higher.

Moreover, the Fed has struggled to grasp the more abstract but crucial question of the so-called neutral interest rate—the interest rate that neither stimulates nor inhibits the economy. In forecasts released in September, 19 officials suggested 11 different neutral interest rates, ranging from 2.6% to 3.9%.

In any case, it cannot be denied that the two extreme movements of the US interest rate cut and Japan interest rate hike may lead to a reversal in the foreign exchange market, with the dollar weakening and the yen strengthening, and a relative reluctance to invest in Japanese stocks. 

④ The Recklessness of the "Predetermined Conclusion" Bill

The December 3rd Asahi Shimbun editorial, "The Recklessness of the 'Predetermined Conclusion' Bill to Reduce the Number of Houses of Representatives," presents a very persuasive argument.

The crux of the problem lies not in the number of House of Representatives seats themselves, but in the deeply rooted structure of hereditary succession, privilege, and vested interests within the ruling Liberal Democratic Party.

Therefore, the true political reform priority should not be "reducing the number of seats," but rather reducing annual salaries. The first step toward regaining public trust is for lawmakers to demonstrate a willingness to cut into their own privileges.

The Problems with the Reducing the Number of Houses of Representatives Bill

The LDP and the Japan Restoration Party have agreed to "reduce the number of seats in the House of Representatives by 10%," aiming for passage during the extraordinary Diet session. If no conclusion is reached within one year, they are seeking to introduce a system that automatically reduces the number of seats in 25 single-seat districts and 20 proportional representation districts.

This is a reckless approach based on a "predetermined conclusion" and disregards the broad consensus necessary for electoral reform, which is the foundation of democracy.

Why "Salary Reductions" and Not "Reducing the Number of Seats"?

Japan's parliamentary system is by no means large. Despite its smaller population than Japan, the British House of Commons has 650 seats, more than the 465 seats of the House of Representatives. A parliamentary cabinet system requires a certain number of members.

While I understand the "sacrificial attitude of politicians" advocated by the Japan Innovation Party, there are other effective reform measures, such as reviewing corporate and organizational donations and reducing party subsidies.

Furthermore, reducing the number of members of parliament due to population decline is unconvincing. The population decline rate since 1994 has been only 1.7%, and the number of seats has already been reduced from 500 to 465.

Danger of Narrowing the Channel for Delivering Public Will

Diet members represent the people, and needlessly reducing the number of seats will narrow the channel through which public will is reflected in national politics.

The current electoral system, consisting of single-seat districts and proportional representation, was introduced with a "two-party system" in mind, but the current situation is moving away from that ideal. Rather, it is time to reconsider the system for selecting representatives so that it is appropriate to the diversifying values ​​of the people. A system that states "if no conclusion is reached within one year, automatic reductions will occur" is tantamount to a threat to political parties that wish to engage in careful discussion.

Reducing the number of seats is a dangerous argument that distorts the essence of political reform. What is truly needed are reforms in which politicians themselves address vested interests, such as reducing Diet member salaries and reviewing corporate and organizational donations.

Substantial reforms to regain the trust of the people should be prioritized, rather than "predetermined" reductions that undermine the foundations of democracy. 

⑤ Budget Efficiency Requires Evidence-Based Policy Verification

 The December 4th Nikkei editorial, "Budget Efficiency Requires Evidence-Based Policy Verification," appears persuasive at first glance. However, it cannot be dismissed without problems.

 

Political "Reform Pretense" and Its Limitations

The LDP, increasingly hereditary, privileged, and vested interests, and the newly elected Ishin Party, are essentially no different. "Reform pretense" without soul is merely pie in the sky and lacks effectiveness.

Like the government's price control measures, policies that are supposed to be based on "evidence" actually lean toward worsening, ignoring reason and facts and pursuing a self-destructive path—that is the nature of "Sanaenomics."

Short-sighted performances to the public and the media will eventually lead to disappointment and alienation.

 

The Launch of the Japanese Version of DOGE (Ministry of Government Efficiency) and Its Challenges

The Takaichi Cabinet's "Japanese Version of DOGE (Ministry of Government Efficiency)" has been launched. The plan calls for a comprehensive review of special tax measures (Tax Measures), subsidies, and funds, and for funds to be restructured through revisions and abolition. This should be done without political motives and based on evidence-based verification of policy effectiveness.

The Japanese version of DOGE was proposed by the Japan Innovation Party, and is inspired by the DOGE initiative led by Elon Musk under the Trump administration. The LDP-Japan Innovation Party coalition agreement clearly states that "policy measures with low policy effectiveness will be abolished."

The role will be played by a dedicated office within the Cabinet Secretariat, overseen by Finance Minister Katayama. However, the Japan Innovation Party's aim is to secure funding for free high school tuition. It would be premature to directly link the review of tax measures and subsidies to issues that should be discussed in conjunction with the quality of education and the future vision of high schools.

Review of the Wage Increase and Research and Development Tax System

The Japan Innovation Party advocates a review of the wage increase promotion tax system and the research and development tax system. The total tax reductions under the special tax system will reach 2.9 trillion yen in fiscal 2023, of which 1.7 trillion yen will be achieved through both tax systems.

Markets are concerned about the Prime Minister's proactive fiscal policy, leading to rising long-term interest rates and a weaker yen. Looking back at the budget review conducted during the Democratic Party administration, it is extremely difficult to contain budget expansion through a Japanese version of DOGE alone.

Wage increases and R&D investment are fundamental to tackling rising prices and growth strategies, so it is essential to design systems that do not result in losses for proactive companies. Are tax systems truly providing incentives, or are they merely a retroactive benefit?

An evidence-based analysis is required, taking into account comparisons with policies in other countries.

Toward the core of administrative and fiscal reform

Improving government efficiency goes beyond special tax systems and subsidies. Policies that target those truly in need, such as tax credits with benefits, require the sharing of income and asset information between the national and local governments.

We must accelerate administrative and fiscal reform through digitalization and the use of AI.

Tomo Nakamaru, former World Bank economist