We’ve written on the subject of Japan before, and revisiting the topic seems particularly timely at the moment. Japanese stocks, represented by the Nikkei 225, are up more than 33% year-to-date, in contrast to the S&P500’s more modest 17% advance. That’s attention-grabbing performance for sure. In addition, Japan’s second quarter real GDP advanced 3.9%, beating out the US by 3.1%. So, are happy days finally here again for Japan?

The rally in share prices has boosted economic confidence, and helps to ensure that Prime Minister Koizumi’s Liberal Democratic Party (LDP) will easily maintain its position as head of the ruling coalition in the general election, scheduled for November 9. Depending on how many seats the LDP gains in the election, Koizumi may finally have the mandate he needs to make good on his original election promise of “reform with no sacred cows”. Unfortunately, no one really knows what that means, or how it will help Japan emerge from more than a decade of stagnation.

What is known is that the Prime Minister’s pet projects are privatizing Japan’s highway corporations and post office. While the privatizations could be considered “reform”, neither would have a major impact on the broad economy. The real drag on growth is the same as it has been for years: the terrifying magnitude of bad corporate debt being carried on banks’ balance sheets. By keeping insolvent companies alive, rather than letting them die a natural death, banks and regulators are allowing too great a burden to fall on more productive companies. The real reform needed is the use of government money to help the banks write off bad loans faster. The resulting bankruptcies and layoffs are unpalatable to Mr. Koizumi’s critics and opponents, even though new companies and jobs would be the likely long-term outcome.

Whether the election result will give the Prime Minister the power to sacrifice the sacred cows of unprofitable companies is still uncertain. However, without real progress in tackling the debt issue, the recent recovery in economic growth and share prices will fade away once again.