The world's central banks wield enormous influence over the economies they are setting interest rates for. The mistakes they make can render an entire impecunious, so the question of who runs the central banks and what the policies are is of more than just ephemeral academic interest. The worst performer of the G-7 economies has been Japan for a long time, so the question there is especially acute. Earlier this week, Japanese prime minister Koizumi announced the successor to current Bank of Japan governor Hayami. The new man is Fukui, whose profile had been steadily rising in preparation for this moment. Fukui is very much an orthodox choice, and the speculation that Koizumi might nominate someone from outside the cozy sphere of Bank of Japan or Ministry of Finance officials has thus been proved wrong. Fukui used to work at the Bank of Japan until he was forced to resign as the result of a scandal in 1998. Despite the interlude since then, which he spent as the director of the Fujitsu Research Institute, he is still very much a BoJ man. More importantly, his views aren't significantly different from those of outgoing governor Hayami. Both are opposed to any form of inflation targeting, although Fukui might be more amenable to further non-conventional monetary easing than Hayami has been. With interest rates at zero, monetary easing has to take the form of liquidity injections. The BoJ has been buying Japanese Government Bonds (JGBs) in the secondary market for some time now, but further measures that have been floated include buying more bonds, buying corporate bonds, buying foreign bonds and buying equities. Since the BoJ can create the money necessary to buy these assets at zero cost to itself, it could amass a huge amount of assets. Of course, the idea is that as the supply of yen increases, the value of the yen will fall and that the economy will reflate. This is a perilous course to take. For if the BoJ buys more JGBs, perhaps even in the primary market (thus in effect underwriting any government borrowing by monetizing it), it would eventually have the effect of squashing the yield curve as flat as a dime at zero.

There's not much chance that will happen. Fukui, like Hayami, believes that the deflation that is gripping Japan is primarily a structural phenomenon, and that it therefore cannot be cured by purely monetary means. He is likely to keep up the pressure on (or pass the buck to, depending on one's point of view) the Koizumi administration.

Two deputy governors were also nominated, Toshiro Muto and Kazumasa Iwata. The former is a Ministry of Finance official, whose current job is in the government as Cabinet Office Director General for Economic and Fiscal Management. As such he is close to both prime minister Koizumi and finance minister Takenaka. He could provide the bridge between the BoJ and the government in order to coordinate policy better. But as someone with a Ministry of Finance background Muto also tends to be hawkish on the budget, favoring fiscal consolidation rather than further deficit spending. Iwata on the other hand is an academic, who is the farthest from the Hayami orthodoxy. He has advocated on several occasions the introduction of an explicit inflation target in order to battle the deflationary spiral. So the three nominations of Fukui, Muto and Iwata represent three main reservoirs from which Koizumi could have picked his candidates: the Bank of Japan, the Ministry of Finance and academia. The much-rumored private sector candidate has not materialized.

None of these nominations are going to change the outlook for monetary policy much in the short term. Fukui's voice will be dominant and he will be able to sway the six sitting members of the BoJ Policy Board. With inflation targeting off the radar, the policy options for Japan to deal with its deflationary spiral are bank reform (and the cleanup of non-performing loans), deregulation and structural reform, yen depreciation and fiscal stimulus. Bank reform and deregulation have been making scant progress, so hoping for salvation from that front is futile. Yen depreciation is politically problematic and would not necessarily solve Japan's problems; inflation generated solely by currency effects could steer the economy into stagflation rather than new growth. Fiscal stimulus has been tried many times in the last decade and has never produced a strong enough response to pull the economy out of its slump. What we are likely to see is further policy stalemate between the BoJ and the government, with each blaming the other for the current situation.

The Koizumi administration has been in power for almost two years now, and the initial promise of reform has never been realized. There has been some progress, but no major milestones have been reached. For instance, the commission that was supposed to cut down on unnecessary road building seldom meets, which of course means that more unnecessary roads are getting built in order to fatten the pockets of the LDP's traditional construction cabal. Koizumi's popularity was grounded in the percepetion that he was different, that he was a new kind of prime minister who really would tackle Japan's problems. Now that he is proving just as impotent as his predecessors in slaying the dragon of deflation and pushing through reform, he popularity is waning. A recent Yomiuri poll put his approval rating at 49%, while Asahi put him at 44%. These numbers are down very considerably from earlier in his tenure as prime minister. Since Koizumi is an outsider within the LDP, he has no real power base with the party. The only reason why he has not been ousted yet was because he was seen as the LDP's only electoral hope. With his popularity sliding and a leadership election looming in the fall, Koizumi's position is coming under pressure. There is still a large reservoir of yearning for reform (perhaps more in the abstract than in the painfully concrete), and none of the political parties are doing a good job of addressing this. The same Yomiuri poll that showed Koizumi's sliding popularity also gave the LDP 30% of the vote. What is more striking though is that more than half of those questioned did not have a preference for any party. This shows the disconnect between the desire for reform amongst the electorate and the political leadership.

In short, it looks like the Japanese economy is not going to recovery anytime soon. The export sector is doing OK, and that is also the home of Japan's best corporate governance, with CEOs actually paying some attention to concepts such as return on capital employed, rather just blindly pursuing market share at all costs. But the prolonged slump in the Japanese economy has had repercussions far and wide. With the Japanese out of the picture, only the US and Europe remained to keep the world economy afloat after the Asian crisis of 1997. And Europe's not doing too well either. A return to health of the Japanese economy would be a boon to the entire world. Structural reforms are badly needed, as is a cleanup of the non-performing loan problem. But until the politicians in Japan can dispose of their ossified mindset, it's hard to see how such an economic revival might take place.

And that brings different dangers with it. A country that's long been suffering from poor economic performance and a general feeling of hopelessness is a fertile breeding ground for all sorts of nasty, illiberal tendencies. Creating a feeling of wounded pride and resentment is but the first step. The most extreme case of this has been Nazi Germany, which went from defeated empire to world-threatening menace in less than a decade. The situation in Japan is not as bad as it was in post WW I Germany, so such an extreme outcome is unlikely. On the other hand, Japan never faced up to its war crimes of WW II, and to this day is grossly unsensitive to the victims of its imperialist past. So what is Koizumi doing in visiting the Yasukuni shrine, where all war dead, including the worst war criminals, are honored? Is it because he's too dim to realize the effect this has abroad? Is he forced into it by the dark side of the LDP? Is it a cunning plan to inure the public, both at home and abroad, to a more militaristic Japan?

I don't know. Koizumi is hard to read. His track record as a reformer is very disappointing. He could be a ruthless opportunist who uses whatever issues he needs to stay in power. Or it's a long-term strategy planned by the darker forces in the LDP to lay the groundwork for a new, more assertive Japan in the international sphere. Having Japan play a larger role in international affairs need not be a bad thing, but a Japan that will separate itself from the West would be (insofar as we can still speak of a monolithic West these days). An arms race between Japan and China would raise tension in a part of the world that is capable of generating a large amount of economic growth and prosperity. The world is complicated enough without having another wildcard thrown into the mix; I'd much rather the Japanese continued to rely on US troops as a guarantee of their safety than have a new inimical Imperial Navy ply the seas of the orient. The missile tests by North Korea won't have helped though.

The most likely scenario is that nothing much will change in the short term. There'll be piecemeal reform efforts, more economic stagnation and not much action. As always, Japan will keep muddling on. For how much longer? That depends on the pain threshold of the Japanese electorate.