China’s economy faces tough challenges. Japan’s was never as weak as advertised. Now the world faces the prospect of the two countries facing each other from positions of strength for the first time in history.

”Buy my Abenomics!” was Japanese Prime Minister Shinzo Abe’s exhortation from the podium of the New York Stock Exchange one day last September. His message to Wall Street: Japan will once again be a good place to make money. If Gordon Gekko could make a comeback, Abe said, referencing the fictional financier who became an icon of greed and profits in the 1980s, so too can countries. ”The Japanese economy that now surrounds us is exceptionally good,” the Prime Minister declared before ringing the exchange’s closing bell. ”Japan is back.”

The world seems to be buying. Since November 2012, when the Prime Minister announced the bold reflationary economic program that bears his name, foreign investors have poured a record US$110 billion in capital into the Tokyo stock market. In US dollar terms, the Nikkei Index stands at its highest point since the turn of the century. The Japanese public is on board as well. Abe’s poll ratings remain astonishingly high for a Japanese leader and he has won resounding victories in both the lower house and upper house elections in the space of nine months.

With Japanese GDP growth humming along at a best-in-show 4 percent in the first half of 2013, the 59-year-old Abe has put his stamp on events in a way that most leaders only dream of. Long locked into endemic low growth, Japan’s economic progress has become as smooth as the ride in one of Japan’s new double-decker bullet trains.

Yet the ultimate purpose of the Abenomics project is not economic. It is an attempt to restore Japan’s influence as a global player, to strengthen its geopolitical profile, to change the strategic dynamics in the Asian region.

If he succeeds, the impact may be felt for many decades. Arresting the country’s economic decline is essential if Japan is to counterbalance Chinese power in Asia and beyond. And that begins with reviving national confidence that has been undermined by years of sluggish growth and deep unease at China’s rise.

Abenomics is Japan’s attempt to reverse the tide by arresting Japan’s slide both economically and strategically. If it is successful, for the first time in history Japan and China will be strong powers  —  at the same time.

It was just a year ago that both China and Japan changed their leadership. Understandably, most of the world’s attention focused on the appointment of Xi Jinping as general secretary of the Chinese Communist Party, given a touch of extra drama by the still-unexplained ”disappearance” of the heir apparent a few weeks before his confirmation by the Central Committee of the Communist Party.

In all likelihood, Xi will be in the driving seat of the world’s most populous nation and fastest-growing economy until 2025, without, of course, worrying about the inconvenience of election campaigns, unfavourable poll ratings or regular lambasting in the press.

The contrast with Japan could not have been starker. When Abe took office a year ago, Japan had seen six prime ministers in the previous six years, none of whom had achieved anything of note. The first in this inglorious sequence was none other than Abe himself back in 2006. No surprise, then, that his reemergence was greeted with weary shrugs, rather than anticipation.

The contrast in economic fortunes and geopolitical presence between the two countries was equally telling. Two decades after the bursting of the economic bubble, Japan appeared trapped in deflationary stagnation. Nominal GDP was no higher in 2012 than it had been in 1992. Some of the great names of Japanese manufacturing, from Sharp to Panasonic and Sony, were in a near-terminal state of uncompetitiveness relative to Asia’s rising stars, such as Samsung and Foxconn.

Japan seemed to be last century’s story, resigned to a fate of steady, if polite, decline. China had displaced it as the world’s second-largest economy and was moving inexorably to a position of regional  —  and potentially global  —  dominance. Their roles represented a microcosm of a broader theme resonating from the global financial crisis of 2008: the decline of the aging, over-leveraged, over-consuming developed world and the rise of the emerging economies, led by China and the other BRIC countries.

One year on, the picture is a lot more complex. Across the emerging economies, political and social strains have become apparent as growth has undershot expectations. The reversal of fortune in India and Brazil has been especially intense. The idea that Egypt would be one of the world’s 10 largest economies in 2050, as respected analysts at global banking giant Citi predicted in 2011, now seems bizarre.

China is still posting the highest growth numbers in the world, but it is embarking on what is likely to be a long and delicate process of transition from an economy reliant on super-charged, government-directed fixed asset investment to a more sustainable model based on household consumption. The most likely scenarios see growth ratcheting down from the double-digits levels of the last 20 years to the 3 to 7 percent range.

Japan bomber
CP Photo

The political risks of China’s transition from rapid to manageable economic growth are formidable. Trends in China’s foreign reserves over the past few years suggest the country faces significant capital flight, which would match the disguised flight in human capital evidenced by the elite’s predilection for having its children educated overseas. The breathtaking wealth divide that has opened up between the elite and the average citizen far surpasses anything seen in the United States. Despite China’s phenomenal growth of the last 20 years, the average American is eight times richer than the average Chinese citizen.

But in China’s case, the most glaring inequities land on the doorstep of its political leaders. According to an analysis by Bloomberg, the net worth of the 70 richest members of China’s National People’s Congress was roughly US$90 billion as of early 2012. By comparison, the combined net worth of the 535 members of the US Congress, the President, his cabinet and the Supreme Court justices is (just) US$7.5 billion. (For its reporting on the riches of the political elite, Bloomberg has since had its consumer websites blocked in China.)

Just as the challenges facing China and other developing economies tended to be underestimated, so were the strengths of the developed economies, Japan in particular.

From the mid-1990s onward, Japan had been the recipient of a great deal of free advice from the West, and the United States in particular, on how to deregulate, reform and reenergize its economy. The underlying message was always the same: ”Be more like us.” Not all the recommendations were misguided by any means, but they tended to ignore something that has become crystal clear to the West since the Lehman Brothers shock of 2008. The collapse of an asset bubble changes reality significantly and for the worse. Growth suddenly becomes very hard to come by.

Comparing the recent US housing bubble with the Japanese bubble of the 1980s is like lining up the Incredible Hulk with Godzilla. The scale is simply different. By some reckonings, the collapse of the Japanese real estate and stock markets in the 1990s wreaked more damage on the national balance sheet than the Second World War.

Given what we know now about the difficulty of post-bubble adjustments, Japan’s economic performance of the last two decades looks very different. The sudden shift from solid growth to stagnation looks less like a feeble dunce-of-the-class effort than a reasonable achievement under the circumstances. If Ireland, Spain and Greece could substitute Japan-style flat-lining for what actually happened to them after 2008, they would surely jump at the offer.

Although Japanese consumer electronics is a shadow of its former self, the auto industry has come roaring back to peak profitability. There are still plenty of Japanese companies  —  including some medium-scale enterprises  —  that are world leaders in their fields. And Japan’s reserves of social capital remain unmatched, as was demonstrated by the public’s disciplined response to what the Japanese refer to as the 3.11 triple disaster of earthquake, tsunami and nuclear meltdown in 2011.

Can Japan regain its animal spirits and reconfigure itself for the realities of the early 21st century? It seemed an unlikely prospect until the dawn of Abenomics.

The political innovator who spawned Abenomics is a different order of phenomenon than the underwhelming conservative Shinzo Abe who served as prime minister for an unmemorable 12 months in 2006-07.

Abe 1.0 never showed any interest in economics; Abe 2.0 sounds like he has just completed a master’s in finance at the University of Chicago. Abe 1.0 was a cultural conservative who seemed to believe a woman’s place was in the home and schools should teach patriotism and traditional ethics. Abe 2.0’s targets include boosting child care facilities to help increase female participation in the workforce, encouraging more young Japanese to study overseas and having more than 10 Japanese universities ranked in the global top 100 by within the next 10 years.

Abe 1.0 was keen to hold on to the rural vote and showed no sign of opening up Japanese agriculture, traditional positions of Japanese conservatives. But just weeks before the upper house elections, Abe 2.0 announced that Japan was joining the Trans-Pacific Partnership talks over a still-to-be-negotiated free trade zone that includes many Asian and Pacific Basin countries, the United States and Canada  —  but not China. In doing so, he put Japanese agricultural subsidies on the table.

Japanese politics is driven not by individuals, nor even by parties, but by coalitions of interests that must include powerful figures in the bureaucracy, business world and media if they are to have any chance of governing successfully. If Abe’s thinking has changed, it’s because the thinking of the people behind him has changed. Engagement and opening have become priorities. Or, to put it the other way round, Japan’s formidable isolationist instincts suddenly seem less desirable.

Essentially, Abenomics is a product made in China.

The answer to ”Why now?” lies across the East China Sea.

Abe 1.0 and Abe 2.0 share one characteristic: on national security, they are both hawks. Abe is a product of the Japanese school that is tired of its neighbours holding a grudge for the country’s past imperial aggressions and wants to shuck off the pacifist (American-written) constitution that prevents it from asserting itself as at least a regional power. This view is suspicious of Chinese intentions and believes Japanese security requires challenging Beijing when it throws its weight around in the region.

During his first time in office, Abe tried to sketch out a containment strategy but got little traction. At the time, Japan’s pro-China business lobby was ascendant. And the logic of deeper economic engagement with China became even more compelling after the 2008 financial crisis, with the collapse of the US auto market coinciding with a wild Chinese infrastructure spending spree. Japanese politics followed the economic lead. Abe’s Liberal Democratic Party (LDP) lost the monopoly on power it had enjoyed for 50 years and was replaced by the Democratic Party of Japan (DPJ), whose leadership included men with pacifist, pan-Asian leanings.

The escalating dispute between Japan and China over ownership of the tiny chain of islands known as the Senkaku (to the Japanese) and Diaoyu (to China) changed all that. The Japanese claim goes back to the 1890s, when, the way the Japanese tell it, the islands were uninhabited terra nullius. The Chinese version has their claim going back centuries, to the appearance of the islands on official maps.

When China and Japan restored diplomatic relations in 1972, then Chinese premier Deng Xiaoping agreed to shelve the Senkaku/Diaoyu issue, leaving it for the next generation to solve. That generation has arrived. By 2012, China was ready to flex its buff new muscles in what it considers its Asian backyard and exact redress for the century of humiliation it had endured at the hands of Japan and the West. Deng-style pragmatism was out. Hardball was the name of the game.

When the skipper of a Chinese fishing boat was arrested after a clash with the Japanese coast guard, the Chinese government’s response was aggressive and highly effective. An embargo was imposed on the export of rare earth metals, vital for Japanese industry and supplied almost totally by China. Japan faced the choice of making a humiliating climbdown or seeing production slump in its auto and electronics industries. It plumped for the former.

The flare-up of tensions in September 2012, just two months before Abe’s comeback, was even more alarming from the Japanese perspective. Rioters torched a factory belonging to Panasonic, the first Japanese company to set up in China after normalization. Consumer boycotts took a huge chunk out of the market shares of Japanese auto companies. Worse, the eruption of rage seemed to have an official imprimatur in a way that previous spates of -anti-Japanese unrest had not. Some highly placed Chinese officials even went so far as to question Japanese sovereignty over the entire Ryukyu island chain, which includes Okinawa.

In the political world, the ”soft-on-China” leaders of the DPJ went from heroes to zeroes in record time, and their party was effectively annihilated in the election of December 2012. Corporate Japan began to make alternative arrangements for overseas production bases. In the first six months of 2013, Japanese direct investment into the ASEAN countries exceeded direct investment into China for the first time ever.

Japanese prime ministers rarely come back from political oblivion, but cometh the hour, cometh the man. Shinzo Abe owes his second bite of the persimmon to a string of tiny uninhabited rocks equidistant between Taiwan and the southern Ryukyus.

Essentially Abenomics is a product made in China.

Fukoku kyohei means ”rich country, strong army.” That was the motto of the leaders of the Meiji Restoration, the great change of 1868 that kicked off the headlong modernization of Japan.

Nineteenth-century China, unable to resist the encroachments of the Western powers, ended up being sliced into pieces like a Peking duck. In Japan, the samurai of the Satsuma and Choshu domains who toppled the Tokugawa shogunate and ”restored” the emperor (in reality, used him as symbolic cover for what amounted to a coup d’état) understood that a different approach was required.

If the West’s military superiority was based on technological and economic advances, the only way to secure independence was to copy those sources of strength. In other words, Japan had to buy into the prevailing world order. If that meant that the samurai would have to give up their swords and go to work in government offices, that the higher echelons of society would have to learn to foxtrot, that there would have to be political parties and a free-ish press, so be it.

Ironically, the fukoku kyohei slogan, like many elements of Japanese culture, was originally a borrowing from ancient China, specifically the Warring States period (470-220 BC). But China appeared to have forgotten the lesson from its own golden age. Under the Qing dynasty and again under Mao Zedong, China adopted a ”poor country, strong army” strategy. The result in both cases was social collapse and chaos.

Japan’s extraordinary success in integrating Western knowledge and systems achieved the required result. Thanks to rapid industrialization, the Japan of the first part of the 20th century could count itself among the world’s rich countries, and for the first time it had a military strong enough to project force overseas.

Japan came late to the imperial party that had created the West’s great colonial empires. But it was good at playing catch-up. Japan won two territorial wars in the space of a decade, showcasing its new military strength and geopolitical ambitions: a successful war against China in 1894-45 over the control of Korea and the stunning defeat of Russia in 1905 over competing interests in Manchuria. When Japan’s Glasgow-made warships sank the Russian navy in the Straits of Tsushima, it marked the first Asian victory over Westerners since the Mongol armies laid siege to the gates of Vienna in the 13th century.

From the vantage of our knowledge of what was to come in the 1930s and 1940s, we might judge these early examples of Japanese aggression as first steps on the road to national disaster. But that’s not how it seemed at the time. Japan was merely using the template established by the world’s leading powers. It showed its allegiance to the prevailing world order when it declared war on Germany in 1914 and grabbed its small collection of Asian colonies. The same applied in 1918 when Japan made a large-scale incursion into Siberia as part of the Anglo-American-French military campaign against the Bolsheviks.

Japan had formally become a member of the insiders’ club in 1902 when it signed an alliance with Great Britain, still the world’s dominant power. Only when that alliance was dissolved in 1923 did Japan become ”unclubbable.”

This golden age of fukoku kyohei animates Prime Minister Abe’s politics. He referenced it in his speech to the London Guildhall in June 2013, recounting the story of Korekiyo Takahashi, ”the Keynes of Japan,” who came to London in 1904 to arrange the flotation of the bonds that would finance Japan’s war against czarist Russia. Abe’s speechwriter had dug out the fact that one of Takahashi’s counterparties was Sir Ewen Cameron, London head of the Hong Kong and Shanghai Banking Corporation and great-grandfather of David Cameron, Britain’s current prime minister. It was an adroit way of highlighting the long history of Japan’s engagement with financial capitalism and the personal connections that came with it.

Abe went on to say that Takahashi’s reflationary policies in the 1930s were the inspiration for Abenomics. But before going on to give chapter and verse on his own ideas for economic recovery, he made another sharp political point. Japan, he noted, granted universal suffrage to males in 1925, just seven years after Britain.

The not-so-subtly implied contrast was with countries that have yet to reach the same level of democratic development 90 years later.

Never in history have China and Japan had to contend with the other being so strong at the same time. Until the 19th century China was the dominant power to which its smaller neighbours paid tribute. Japan’s sun rose with the Meiji Restoration. Over the next century, Japan grew to become the world’s second-largest economy, while China reeled from disaster to disaster.

The apparent reversal of fortune began around 1990. The collapse of the bubble economy slipped Japan into deflationary stagnation at the very time that China was astonishing the world with what would become two decades of supercharged growth, lifting hundreds of millions of its citizens out of poverty in the process.

The logic of numbers guarantees that China will become the world’s largest economy sometime in the next decade, and that in itself bestows great influence and power. But a reenergized Japan would also be a major force, particularly if allied with the United States and India, thus creating a triple entente whose combined economic scale would far exceed China’s. The ability to make alliances, form trading blocs and project soft power will be crucial to the 21st-century version of fukoku kyohei.

In his nicely judged speech at the Guildhall, Abe didn’t touch on what happened to Anglo-Japanese relations after Korekiyo Takahashi was assassinated by ultra-nationalists in 1936. Nonetheless it must have been in the minds of his audience. Japan’s challenge to China is not just that of a competitor and strategic counterweight. Japan’s own historical trajectory offers the clearest example of the great benefits of conforming with global norms and the disastrous consequences of rejecting them.

Among Abe’s personal political projects is a desire to rewrite the country’s pacifist constitution, which restricts Japan’s military to self-defence. It is debatable whether the Japanese public is ready to take that step, but it reflects the belief in parts of Japan’s security establishment that it must be allowed to negotiate new military partnerships and alliances.

Japan seemed to be last century’s story, resigned to a fate of steady, if polite, decline.

Abe’s bullish words at the New York Stock Exchange were not aimed just at financial professionals, or at the Japanese public alone. He was asking the world to buy into the world view behind it, of a Japan no longer passive, self-absorbed by its own decline, but of one ready to play a role as a global power. It is a message pointedly aimed, too, at the powers that be in Beijing.

It is hard to tell how China, newly recovered from its age of darkness, will respond over time to a Japan that asserts a claim to major power status. There is no reason why China’s various territorial quarrels with neighbouring countries should not be handled diplomatically, like Japan’s long-running island disputes with Russia and South Korea, rather than by force majeure. There is no reason why China should not join the Trans-Pacific Partnership, if it could clean up its act on intellectual property and reduce subsidies to state-owned enterprises. There is no reason why China, which has benefited so mightily from the trade and investment flows that the system generates, should not become an insider too. The reform proposals recently announced by the Communist Party Central Committee suggest that at least in terms of domestic economic policy the leadership is prepared to be flexible.

It is hard to exaggerate how much is at stake here. With Japanese and Chinese planes and naval craft circling around the disputed islands, a misjudgment by either side could set off a violent chain reaction embroiling many other powers, Sarajevo 1914-style. Yet, on the other hand, the economic tensions have already faded. Chinese tourist arrivals in Japan have soared to new peaks and Japanese autos are once more selling like steamed buns in the Chinese market.

If the logic of economic benefit prevails, as it so disastrously failed to do in 1914, there will be a huge upside for China and Japan, the region and the entire world. But if not, we are in for a very bumpy ride, across uncharted waters.