Japan: The System That Soured
The Rise and Fall of the Japanese Economic Miracle

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CHAPTER ONE

Mainframe Economics in a PC World

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.... Soon or late, it is ideas, not vested interests, which are dangerous for good or evil.
--John Maynard Keynes, 1936

If Japan fails to end industrial policy, its postwar developmentalism may be judged a failure.
--Yasusuke Murakami, 1996

What Happened to the "Japanese Juggernaut"?

Generals, they say, are trained to fight the last war; that is why they lose the next one.

    That, in a nutshell, is why the high-flying Japanese economic miracle tumbled to earth. The ideas and strategies that worked so brilliantly in the era of industrial takeoff had outlived their usefulness once Japan's economy matured. And yet Japan could not bring itself to leave them behind. Over time, past strengths became the source of current weakness.

    As a result, the nation once predicted to dominate the world economy now struggles to keep up. The world's greatest growth machine spent much of the 1990s hardly growing at all. The economic system once seen as a model for the world is now viewed as the country's biggest ball and chain.

    Even some of the bureaucracies that managed Japan for so long seem shell-shocked. "[T]he economic system that has supported the fifty years of economic development following World War II is ill-suited for future growth" is how Japan's Ministry of International Trade and Industry (MITI) put it in a belated recognition of the problem. "Structural reform is a race against time and Japan is clearly falling behind in that race," the Economic Planning Agency warned in December of 1996. Many of Japan's once-vaunted economic practices, says the EPA, "are now nothing more than obstacles to future economic development."

    Without sweeping structural reforms, Japan will continue to stagnate. Japan's productivity growth is so dismal these days that, even if it operated at full capacity, economists say the fastest it could grow is around 2 percent or so. That's half the 4 percent rate it averaged from 1975 to 1990. And yet; because of Japan's myriad macroeconomic problems, Japan has commonly been unable to operate at full capacity. In four out of the six years since fiscal 1992, Japan has grown less than 1 percent, and in three of those four years less than 0.5 percent. Japan grew less over the entire five-year period from mid-1992 through mid-1997 than it did in the single year of 1990. Unless there is massive budgetary stimulus, this negligible growth is expected to continue through at least 1998 and 1999 (see Figure 1.1). By the dawn of the new millennium, Japan will have spent an entire decade growing more slowly than the United States, the nation it was supposedly "on track to overtake by the year 2000."

    Nor is this a temporary slump. According to official forecasts, without reforms, even at full capacity, the fastest growth Japan could sustain between now and 2010 is only 1.8 percent a year. After 2010, says the normally optimistic MITI, the combination of poor productivity and a declining labor force means it will get worse. Japan's growth potential will plunge to only 0.8 percent a year.

    How did this happen? How could the world's most acclaimed economic miracle have stumbled so badly?

    The root of the problem is that Japan is still mired in the structures, policies and mental habits that prevailed in the 1950s-60s. What we have come to think of as the "Japanese economic system" was a marvelous system to help a backward Japan catch up to the West. But it turned into a terrible system once Japan had in fact caught up. Korea's current trevails are a more tumultuous example of the same phenomenon.

    In the "last war," the battle to industrialize Japan in the 1950s-60s, the "developmental state" policies that gave rise to the nickname "Japan Inc." worked brilliantly. But that was so only because the country was in the "catch-up" phase of its economic evolution. All along the economic horizon were a host of infant industries, from autos to electronics, with the potential to become world-class competitors. However, these industries needed a jump-start to get over the initial hurdle. They had not yet acquired either the economies of scale or the learning-by-doing efficiencies to be competitive. Without protection, they might have been strangled in their cradles. The auto industry, for example, was almost wiped out by a flood of European imports during a brief interlude of free trade in 1953. And yet, these were industries that, if given an initial boost, could become powerful exporters able to compete without further aid. Indeed, as each grew, the ripple effects stimulated the others. The growth of steel lowered steel prices, which in turn lowered car costs, leading to more car sales, hence more demand for steel. The same kind of economies of scale and inter-industry synergy applied to TVs and semiconductors. Hence, when Tokyo applied promotional policies in the catch-up era--from stiff import quotas, to massive subsidies, to authorization of export cartels--it fostered an industrial takeoff the likes of which the world had never seen.

    Admittedly, even in the catch-up era, Tokyo also aided many industries with no potential to become exporters, from aviation to chemicals. And when it did, the measures flopped.

    Yet, the very nature of an economy in the state of catch-up is that it contains a plethora of true infant industries. Consequently, on balance, Japan's promotional policies well deserved the label "economic miracle." Would Japan have industrialized even without such developmental policies? Undoubtedly. Would it have done it anywhere near as fast? Hardly.

    Unfortunately, at the very point in Japan's evolution when the "developmentalist" policies should have been loosened, they were reinforced. By the 1970s, when Japan had matured economically, "catch-up economics" had turned counterproductive. There were no more infant industries needing an initial push. "Developmental state" policies make sense only for an economy still in the "state of development."

    Nonetheless, Japan continued to use the same economic tactics of protection and promotion in the 1970s and beyond. Indeed, when the oil crises of 1973 and 1979 hurt basic industries, protection of these industries was intensified. The "Japanese economic model" that we see today is not, as some have suggested, a different kind of capitalism. It is rather a holdover from an earlier stage of capitalism. It is the spectacle of a country vainly trying to carry into maturity economic patterns better suited to its adolescence.

    For Japan, this turned into a recipe for debilitation. Instead of turning infant industries into export stars, the same tools amounted to a cocoon that protected inefficient---but politically connected--industries from competition, domestic as well as foreign.

    If industrial policy is a matter of "picking winners and losers," then the essence of Japan's malaise is that it gradually shifted from promoting winners to protecting losers.

    As this happened, Japan turned into a deformed dual economy--a dysfunctional hybrid of super-strong exporting industries and super-weak domestic sectors. Under the pressure of stiff competition overseas, exporters like autos and machinery learned to offer some of the best technology and highest productivity in the world. Just as Washington overestimated the strength of the Soviet Union by extrapolating from its mighty nuclear arsenal, so many Americans, who were exposed only to the exporting sectors, naturally presumed that all of Japan was as efficient as the exporters. Within Japan, however, the picture was quite different. Domestic manufacturing sectors from food processing to textiles, which were protected from competition, let themselves become woefully backward by international standards. In food processing, for example, Japan's productivity is one-third of U.S. levels and falling further behind. And yet, more people work in food processing than in autos and steel combined.

    Gradually, over the course of the 1970s and 1980s, Japan's unique dual economy worsened. Slowly, almost imperceptibly, the country's economic arteries became increasingly clogged and rigid.

    Even worse, the dual economy was gradually sowing the seeds of its own destruction. The dual economy was sustainable only so long as efficient exporters earned enough to prop up weak domestic sectors. The high prices Toyota paid for glass, rubber, basic steel, and so forth were, in effect, subsidies to these suppliers. But, by the late 1980s, the exporters found it harder to bear the burden. They were caught in a squeeze between high costs at home and a rising yen, which made it harder to pass on those costs in export markets. As a result, more and more of the efficient exporters were being driven overseas. They were investing in offshore markets rather than in Japan itself. Step by step, Japan's efficient export sectors were being "hollowed out." As this happened, the productivity of the entire economy started being dragged down to the level of the stagnant sectors.

    Precisely because the process was so gradual, no alarm bells went off.

    Sure, a few productivity experts spoke of the dual economy and of the dangers of "hollowing out." Most people, however, were so bedazzled by Japan's trade performance that the dry rot eating away at the nation's domestic foundations went virtually unnoticed.

    At the end of 1989, when Japan's "bubble economy" was at its height, the country felt on top of the world. The crippling heart attack was but a few months away, but Japan felt stronger than ever.

    Japan's exporting industries had conquered one piece of economic terrain after another: from TVs and steel, to cars and computer memory chips. Year after year, the country racked up the world's largest trade surpluses.

    Not only that, Japan's GDP expanded more quickly than that of any other industrialized country. Later on, some economists would discover that the apparent high growth of the 1980s was achieved by methods that were unsustainable. Japan compensated for its domestic inefficiencies--and thereby temporarily hid them--by pouring on tons and tons of investment. Japan by that time was so unproductive that it needed to invest 35 percent of GDP just to get the same growth that a typical country could have gotten with 25 percent. This was the opposite of the situation in the 1950s-60s, when Japan truly did achieve a growth miracle.

    This path to growth, unfortunately, had clear diminishing returns. Japan had to run ever faster just to stay in place. That is, unless Japan devoted ever-larger portions of its national income to investment, its growth would inevitably slow. Japan's extraordinary savings and investment rates were not a sign of vigor, but a response to weakness. At the time, however, they were the envy of the world.

    By the late 1980s, Japan seemed on the verge of doing in finance what it had previously done in manufacturing. Its banks, the world's largest, were spreading out internationally. At one point, they accounted for 17 percent of new loans in the U.S. True, profits were razor thin. Sure, these banks dispensed with the creditworthiness screening that is elementary in the U.S. No matter, they were growing bigger every year. To some, it seemed as if Japan could, and did, influence a U.S. presidential election by either dispensing or withholding its money so as to influence American interest rates. The claim was dubious, but even some well-connected people believed it at the time.

    Most wondrous of all was Japan's high-flying stock market. It seemed to defy all the laws of valuation that constrained prices elsewhere. It gave America's Japanese competitors access to money far, far cheaper than anything U.S. firms could obtain. For a while, the cost of capital was effectively zero. Borrowers using so-called convertible bonds could repay their lenders in their own stock rather than cash. Since stock prices didn't seem limited by these companies' own earnings performance, it was almost as if these companies had a license to print money. No wonder Toyota, Matsushita and others could afford to put factories all over the world, thereby gaining even more market share. No wonder Japan, with only half of America's population, was investing more than the U.S.

    As it turned out, much of this investment had no more economic value than the fabled pyramids of Egypt. At least the latter brings in tourist dollars. But in Japan it was a pyramid of bad debt that was being constructed. Only a few years later, the Japanese landscape would be dotted with empty office buildings and unused factory space. Still, while the party lasted, the economy boomed.

    All along there was an Achilles' Heel. If the stock market ever fell--or even stopped rising--the boom would end. Japan's companies would be forced to repay all their loans in real money, not paper shares. They would be burdened with a mountain of debt that could threaten both them and their banks. No need to worry about that, however. Study groups composed of the nation's "best and brightest" patiently "explained" to skeptics that stock prices unthinkable elsewhere reflected the "unique" character of Japanese finance.

    Not only in Japan, but also in the U.S., some analysts began to speak of a "Japanese economic system" that had gone "beyond capitalism." Journalist James Fallows, in support of his view that Japan's trade threat needed to be "contained," conjured up the image of a peculiar nation with an unbeatable economic model, a hybrid of Confucius and Friedrich List. As late as 1992, Lester Thurow, who as Dean of MIT's business school was responsible for training hundreds of America's future business leaders, wrote of a Japanese system of "producer economics" that was far superior to the "free-market consumer economics" prevalent in the U.S.

    To some in the U.S., particularly the so-called revisionists, Japan's supposed superiority loomed as a dark threat. In Asia, Japan was said to be positioning itself as the "brain" and "headquarters country" of the world's fastest-growing economic region. In the U.S., "Japan"--never this or that Japanese company, but "Japan"--was using its cheap money to buy up America's property, its companies, its movie studios, and even its government officials.

    Warnings were sounded that "the Japanese" were using their money to buy up America's best high-tech companies. If Japan weren't "contained," it would soon become unstoppable. "The fear was palpable," recalls a State Department official. He remembers examining one proposed Japanese buyout of an American firm when he served on the inter-agency Committee on Foreign Investment in the U.S. (CIFIUS). The committee was originally set up to prevent adversaries from surreptitiously investing in defense contractors. In the late 1980s, it turned its attention to Japanese investment in U.S. high-tech firms. In this particular case, the man from State suggested that the Japanese investment was innocuous and should not be barred. Suddenly, he heard the epithet "traitor" being hurled at him from across the table by his Commerce Department counterpart.

    So great was the illusion and the hysteria that even one of America's most highly regarded economists, Lawrence Summers, was taken in. In December of 1989, he wrote:

Today, Japan is the world's second largest economy. ... Furthermore, an Asian economic bloc with Japan at its apex ... is clearly in the making. This all raises the possibility that the majority of American people who now feel that Japan is a greater threat to the U.S. than the Soviet Union are right [emphasis added].

    That comment stands as a monument to bad timing. Only a month later, Japan's roof caved in. It began with a crash of the stock market and real estate that wiped out hundreds of billions of dollars of wealth overnight. Soon, the collapse spread to the rest of the economy. The nation that had defined growth suddenly seemed incapable of growing. This was no ordinary recession. This was a downshifting of the whole economic trajectory compounded by a financial crisis. For three years, from the beginning of 1992 to the beginning of 1995, Japan barely grew at all. As of early 1998--eight years after the stock market crash--the economy has yet to recover.

    The banks' huge assets quickly turned into a liability. In the colorful metaphor of Ken Courtis, chief economist at the Tokyo office of Deutsche Bank, the banks had "Himalayan balance sheets and Saharian returns." The mountain of bad debt dwarfed America's S&L disaster. While the government let a few banks go under, most were kept alive. Some survive only through hundreds of billions of dollars of government bailout money.

    Even the pride of Japan--the mighty manufacturing industry--was caught up in the malaise. As of late 1997, industrial production was barely higher than in 1990. One million manufacturing jobs disappeared between 1992 and 1996 and another 1.25 million were expected to evaporate by decade's end. This would stretch out over a decade's time a loss comparable in percentage terms to the abrupt loss the U.S. rust belt suffered in the 1979-83 recession.

    A decade ago, U.S. forecasters had warned Japan would leverage its dominance in computer memory chips to capture leadership in computers themselves. Today, however, the world's biggest chipmaker is not NEC or Toshiba, but Intel. The world's biggest memory chipmaker is no longer Japanese, but Korean. IBM was humbled, not by Fujitsu or Hitachi (which were too busy trying to be like IBM), but by Microsoft and Intel.

    For a while, the illusion of recovery seemed to emerge in 1995-96. But that was only due to artificial props that could not be sustained indefinitely. One prop was a massive campaign of public works that sent the budget deficit to 6 percent of GDP--far higher than American deficits during the worst of the 1980s. The second prop was an export drive propelled by the tailwind of a cheapening yen. Unfortunately, the illusory recovery allowed Japan's leaders to delude themselves that they could muddle through without undertaking the deep reforms needed to overcome the economy's structural ossification. Tokyo completely underestimated the depths of Japan's problems. Hence, when the government removed its fiscal prop by cutting back public works and then, in the spring of 1997, hiking the consumption tax, the economy plunged once again.

    The economist who had so worried about the Japanese "threat," Lawrence Summers, was now Deputy Treasury Secretary of the U.S. He had to acknowledge that neither he nor others had foreseen the shaky reality behind Japan's imposing facade:

Four years ago ... few would have forecast the range of difficulties that Japan has encountered. ... Financial problems, deflation, structural rigidities and difficulties in innovation have held back Japan's economic growth. In 1993, the IMF forecast long term growth for Japan of 4 percent; today, the figure is half that.

    To be sure, all economies are subject to shocks. And some analysts suggest that Japan's travails are nothing more than a temporary reaction to the excesses of the late 1980s financial bubble. But a seemingly healthy economy does not either experience such an extreme bubble, nor descend into years of malaise, unless something is very rotten at the core. The bubble was not merely an aberration caused by misguided monetary policy; it was the last hurrah of a faltering system trying to pump itself up. It was as much a symptom of Japan's deep-seated problems as a cause.

    By the late 1990s, few in Japan still denied that the economy was in deep trouble and in need of big change. Even the Japanese government has said that, unless Japan reduces high costs at home, its most efficient exporters will continue to drift overseas. Matsushita will continue exporting air conditioners from Malaysia instead of Japan. The key, says MITI, is to end the regulatory and other practices that shield its domestic sectors from the pressure of competition:

The Japanese economy is characterized by the existence of a dual structure in which efficient manufacturers and inefficient service-related sectors co-exist. This is one of the main reasons for the high-cost structure.

    In particular, productivity is low in such key sectors as transportation, telecommunications, finance, energy, and distribution.... Furthermore, low productivity in the aforementioned sectors acts as a drag on manufacturing and other service sectors, preventing their development and lessening their international competitiveness. This is the thing which feeds the hollowing out phenomenon of the manufacturing sectors, and the replacement of non-manufacturing sectors by foreign service companies [emphasis added].

    As a result, within the sectors that are not exposed to international competition, there is an urgent need to forcefully move ahead with deregulation and competition promotion policy in order to increase productivity and competitiveness.

    The Economic Planning' Agency has finally acknowledged that Japan's pervasive import barriers are part of the problem, and increased imports a necessary part of the solution. In its 1996 Economic White Paper, it declared, "An increase in imports would stimulate incentives to raise productivity of domestic industries."

    The rapid aging of Japan's population makes the whole situation particularly dire. Japan's labor force is now declining, and it will keep on shrinking in coming years. In part because of the long work hours that keep husbands away from home, many Japanese women are now delaying marriage until late in their 20s and are reluctant to have more than one child. As the years go on, there will be fewer workers for each retired person. Unless the remaining workers can produce a big rebound in productivity growth, warns Robert Feldman, Salomon Brothers' Tokyo economist, eking out any increase in living standards over the next 20 years is going to be tough.

    Actually, Japan has two problems hindering growth: a supply-side problem and a demand-side problem. The supply-side problem is low productivity growth. This is caused by a system that protects the inefficient sectors at the expense of the efficient sectors. Even if Japan were to run at full capacity, it could not grow at more than 2 percent a year on average.

    The demand-side problem is that Japan finds it difficult to run at full capacity. The dual economy has so distorted the normal economic mechanisms that Japan is chronically unable to consume all that it produces. On the one hand, with economic maturity, the country's investment needs have slowed down. And yet, unlike in other mature economies, personal consumption has not risen to take up the slack. Consumption as a share of GDP is lower than in other advanced economies. The consequence is that Japan suffers from a kind of economic anorexia--a chronic deficiency of purchasing power.

    The only way Japan avoids chronic recession is by artificially stimulating demand. One method to stimulate demand is for Japan to export the excess production by running huge trade surpluses with the rest of the world. A second method is for the government to run mammoth budget deficits sometimes as high as 6 percent of GDP. However, whenever the financial strains of big budget deficits and the political strains of huge trade surpluses cut off those routes to growth, then Japan is stuck.

    This anorexia is the ultimate reason why the bubble was launched. The 1985 Plaza Accords, which sent the yen soaring, cut off the trade surplus route to growth and the economy began to slow. Tokyo responded by artificially pumping up real estate, stocks and capital investment with monetary steroids. Since much of even the physical investment had little real economic value, the bubble collapsed and banks are loaded with mountains of bad debt. The bubble was not a mere mistake; it was a false solution to a real problem.

    Once the bubble collapsed and investment fell, anorexia returned. Despite budget deficits that hit 6 percent of GDP in 1997 and a rebounding trade surplus, Japan has found it very difficult to dig itself out of its economic hole. As of early 1998 the economy was still limping along.

    Japan's economic anorexia did not exist in the high-growth era when rapid investment drove growth. As with much else in the dual economy syndrome, it began to emerge in the 1970s and 1980s.

    Japan now finds itself in the same turning point as other industrial economies before it. No industrial economy can progress beyond a certain point without becoming a mass consumption economy. America faced this problem in the 1930s and successfully responded with the New Deal. The Soviet Union was unable to meet this challenge and collapsed. The famous Maekawa Commission Report of 1986 pointed out the need for the same transformation in Japan. Instead, Japan launched the bubble. Now, ten years later, the pressing need to make the transformation is back again, but with the economy in far worse shape.

    Japan won't sink into the Pacific, of course. And its multinational firms will remain formidable competitors. Still, increasing portions of the exports of these multinationals are from overseas plants. "What's good for Toyota" is no longer necessarily "what's good for Japan."

Thorough Reform or Just Muddling Through?

There are some analysts who say that, once Japan finally gets past this patch of bad growth and recovers to a long-term growth rate of about 2 percent, then it can "muddle through." After all, the U.S. doesn't grow much faster. But, for a nation whose corporate debt loads, social security needs, and political institutions are geared to higher growth, such mediocre expansion is a recipe for lingering financial fragility and political instability.

    For one thing, warns MITI, by 2020 such low growth would leave Japan unable to meet its social security obligations unless it took 60 percent of every worker's salary in taxes and ran a budget deficit at 20 percent of GDP. That's four times as high as the U.S. peak in the mid-1980s--a clear financial impossibility.

    At 4 percent growth, Japan's workers had no fear of a trade-off between job security and growing wages; at 2 percent, they do. At 4 percent growth, businesses could readily pay their debts; at 2 percent many cannot. College graduates used to have no fear of finding jobs with room for advancement; at lower growth, many have trouble finding jobs at all. At 4 percent growth, nearly everyone in Japan enjoyed a steady improvement in living standards. At 2 percent or less, some people will gain; others will not. At higher growth, there was enough wealth for Japan's efficient sectors to subsidize its inefficient sectors via high prices. With lower growth, the burden of those high prices becomes intolerable.

    Even under the best of circumstances, Japan will not return to 4 percent growth. Its economy is too mature. Still, with sweeping reforms, economists say Japan could grow at 3 percent a year between 1996 and 2010 instead of 2 percent. In that case, its GDP would be $850 billion larger. That's enough to pay not only for all the investment Japan does every year but for all the houses it builds as well.

    Unfortunately, if there are millions who would benefit from reform, there are also millions who would temporarily lose out. The big losers would be all the people in the inefficient sectors who have been protected from competition all these years. According to economist Iwao Nakatani, thorough reform would eliminate 10 million jobs. It would also eventually create 11 million new jobs. But those whose jobs are in jeopardy are not likely to be mollified. And that--not simply the resistance of hidebound bureaucrats--is why reform is so hard to achieve. How many politicians want to risk putting their voter base through wrenching changes that dwarf what the U.S. Midwest experienced in the 1980s?

    This is what worries one of the foremost reformers among Japanese business leaders, Fuji-Xerox chieftain Yotaro Kobayashi. Speaking to an audience at the New York Japan Society, Kobayashi was quite candid about his frustrating experience on the Hiraiwa Commission. This was a blue-ribbon panel that, like so many before it, had produced vague proposals for study rather than calls for concrete action. "Maybe growth at 1.75 percent over the next decade is not scary enough for the Japanese people," he wondered. Too many of Japan's voters might prefer stability to the risks that reform entails. If so, then Japan could be stuck in the worst possible situation: growth so low as to preclude vitality, but not low enough to compel reform. The nation that was supposed to dominate the 21st century would be reduced to trying to "muddle through."

    Kobayashi may be right. And yet the momentum for reform has taken on a life of its own. Already, the strains produced by lower growth and need for reform have shattered the former consensus of Japanese politics. For almost four decades, the Liberal-Democratic Party (LDP) held power continuously as a catchall coalition of the efficient and inefficient. But, as the economic strains turned into political division, the LDP split and fell from power. Although the LDP has since regained the Prime Minister's post, it has a shadow of its former power.

    More importantly, even LDP Prime Minister Ryutaro Hashimoto, a lifelong benefactor of the protected vested interests, has had to rule by offering up reform programs like the proposed "Big Bang" reforms in finance. A debate rages over whether this will really prove to be a "Big Bang" or just a "Wee Whimper." The fact remains: neither Hashimoto nor anyone else can any longer rule by openly opposing reform. Even reform's bitterest opponents are compelled to pay it lip service, at least in public.

    As of early 1998, Japan seems to be caught in a tug of war between two eras. The Old Regime has collapsed and its defenders are surreptitiously trying to resuscitate it; yet, not even the reformers are quite sure what should replace it. While the old mandarins, like the once-exalted Finance Ministry, have been discredited, no new respected institutions, leaders or clear visions have arisen to take their place. The opposition parties, divided by both lack of ideas and personal squabbles, have been amazingly ineffective. The country is floundering and could take years to find its bearings.

    So far, real reform is still hard to come by. Even when concrete actions are taken, reform has all too often been reduced to a narrow issue of deregulation that ignores widespread private anti-competitive activities. What is needed is not simply less bureaucratic meddling, but an overhaul of all the private anticompetitive activities that stifle Japan's cartelized dual economy.

    Nonetheless, Humpty-Dumpty cannot be put back together again, either economically or politically. That simple reality means that the fight over reform will continue to dominate Japan's economic and political life for years to come.

    It is certainly true that Japan's current political leaders prefer to patch up the cracks in the system rather than change it. Indeed, once the LDP finally regained its majority in the Lower House of the Diet in the summer of 1997, the arrogance of the party machine returned, as did its desire to protect the vested interests backing the party. The dinosaurs in the LDP put huge roadblocks in the way of even the weak-kneed reforms that Hashimoto had offered. In private, the LDP former chief cabinet secretary Seiroku Kajiyama lashed out at both reform and opposition leader Ichiro Ozawa, the man whose defection led to the downfall of the LDP in 1993. "Ozawa's always talking change, change, we have to change. But why do we have to change? Our system has been working well for 100 years."

    Such attitudes have led some analysts to suggest that Japan's elite will somehow find a way to muddle through to recovery without any fundamental overhaul. While the current leaders will no doubt make such an attempt, it is getting harder and harder for them to succeed. Their options are narrowing. The reason is that there is a genuine and growing conflict of interests among the different sections of Japan Inc. These can no longer be smoothed over as easily as before because growth is so low. As a result, Japan's elite is neither leading reform nor completely stonewalling. Instead, it is wavering. It is indecisive. One day it resists change and the next day it scurries to catch up to processes it can no longer control. This indecisiveness is the classic sign of a regime in trouble.

    Every time Tokyo plugs one hole in the dike, that action just causes another one to appear. For example, the Bank of Japan has lowered interest rates to almost nothing (0.5 percent) in an effort to shore up the banks. Yet, this is decimating the regulated insurance companies, who can no longer earn enough interest to pay off their pension obligations. As a result, Nissan Life has gone bankrupt and there are rumors of other bankruptcies waiting in the wings. Meanwhile, in the Nissan Life failure, the policyholders were left holding the bag. People counting on insurance annuities for their retirement lost much of their life savings. As a result of that, many Japanese policyholders are now withdrawing their policies or not renewing their insurance policies. For the first time since World War II, in 1997 the insurance premiums paid into insurance companies actually decreased. That pushes weaker insurance companies even closer to failure.

    The bottom line is that the current system is not tenable and cannot be sustained. There are too many cracks in the webs of mutual support that previously underpinned Japan's political economy. Until Japan undertakes sweeping reforms, it will lurch from crisis to crisis -- in politics, in finance and in economics.

    No one can predict how new realignments will come about--just as no one predicted in January of 1993 that the LDP was about to fall. But one can confidently say that sooner or later there will be another shakeup, and then another, until finally--probably years from now--fundamental reform is achieved.

The Need for Countervailing Institutions

When we ask why the Japanese miracle soured, the fundamental cause was neither a power-hungry bureaucracy nor vested interests. The ultimate cause was that too many of Japan's practical men remained the slaves of defunct ideas.

    Blinded by the glare of past triumphs, Japan continued to adhere to obsolete policies just because they used to work. As Bowman Cutter, a management consultant who served as deputy director of the National Economic Council (NEC) during Clinton's first two years, put it:

I analogize Japan to a big corporation like IBM or GM that has had a very successful business model for a long time. But now that business model is obsolescent.

    Many in Japan say that, as soon as they get past this bad patch of low growth, they can return to an economic structure of export-led growth with low personal consumption. I disagree. Given Japan's size, its structure of export-led growth is not sustainable in the world today, politically or economically.

    The caterpillar, not believing it had turned into a butterfly, refused to leave the cocoon. No wonder it couldn't fly.

    In one sense, Japan is not unique. All over the world, institutions, whether in government or business, hold onto strategies long after they have outlived their usefulness. The mistakes born of success are often the most stubborn, the most difficult to correct.

    Consider IBM's unrequited love affair with the mainframe computer. In the 1960s-70s, "Big Iron" had brought IBM to the pinnacle of world technological and business leadership. IBM just couldn't bring itself to shift gears during the 1980s, when the personal computer started to change the very nature of computing. The great irony is that IBM itself was the first to widely commercialize the PC.

    In a way, IBM's viewpoint was understandable. As long as computers and mainframes were synonymous, IBM would remain on top of the world. Like bureaucracies elsewhere, it had learned to become very efficient at operating within a given environment and was reluctant to see that environment change.

    There were warnings, of course. As far back as 1987, a study commissioned by then-Chairman John Akers showed that the mainframe was losing steam. And IBM's stock started to slip. But neither Akers nor other IBM execs ever acted on these warnings. On the contrary, IBM repeatedly put other promising technologies on the shelf because they seemed to undermine the mainframe.

    How could any maverick inside IBM challenge the dogma? Look at our profits, the Old Guard could, and did, answer. Indeed, just as Japan's stock prices were hitting their highest point in 1989, so were IBM's profits. It earned more money than almost any other firm in corporate history. Three years later, the firm lost more money than almost any other in U.S. corporate history. It had to lay off 200,000 workers and its very survival was in question.

    Still, there is one big difference between the IBM story and the Japan story: the absence of countervailing institutions. While individual institutions almost always suffer from excessive conservatism, a country can still prosper as long as it is hospitable to new institutions that introduce new ideas.

    In the U.S., as IBM dug in its heels, Microsoft and Intel rose to take its place. What keeps Microsoft on its toes is Bill Gates' fear that there is some bright, brash 18-year-old out there gunning for him--and knowing that the American financial system will provide the money to try. When the American Big Three automakers started wasting man-hours putting out defect-ridden gas guzzlers, the American political economy let in their Japanese competitors. Today, no one doubts that, precisely due to the competition, the Big Three's productivity and quality are way up.

    In Japan, unfortunately, such countervailing institutions are harder to find.

    One corruption-ridden party, the Liberal-Democratic Party, has ruled the country almost continuously for the past four decades. Japan still lacks an effective opposition with a realistic chance of taking power.

    In the Japanese corporate world, there are few analogues to American upstarts like MCI, Home Depot, or Wal-Mart. It's not that individual Japanese are any less imaginative or ambitious or entrepreneurial than people elsewhere. It's that a corporate setup dominated by collusive oligopolies and cartels makes it difficult for new companies---whether foreign or domestic--to break into the club.

    The corporate "old boys club" is reinforced by a bank-dominated financial system in which a dozen large banks own, and are owned by, their biggest customers. Would-be challengers often find it hard to get the necessary financing. Japan's stock market is not a free-wheeling vehicle for shifting capital out of declining firms and into promising new ones. Instead, it's an anti-takeover device in which 60 percent of the shares are held by each corporation's own corporate allies, customers, suppliers, and banks--and sometimes even competitors. Instead of new companies arising to start new industries, large companies in mature industries use their huge retained earnings to diversify into new fields in which they are often ill-equipped: Nippon Steel going into amusements parks; Komatsu Construction into computers; Matsushita Electric into Hollywood. When these ventures fail, no heads seem to roll.

    Japan's exporters do, of course, face stiff competition in the overseas markets; that is what has compelled them to become so efficient. But at home, companies are not forced to pay the price for holding onto obsolete practices--until it is too late. Hence, Japan's unique dual economy: super strong exporters and astonishingly inefficient domestic sectors.

    Unfortunately, once companies and their labor forces have learned how to make money in a certain institutional framework--whether it's making the world's best car or forming cartels to rip off consumers--they have a stake in keeping things as they are. They find politicians willing to support them; develop ideologies that rationalize their behavior; and discover professors willing to give those ideologies a respectable veneer. If, in addition to all this, countervailing institutions are few and far between, institutional change becomes very hard.

    This is why in Japan, as in so many other countries, trade opening is the sine qua non of overall economic reform. It takes imports from companies which are not part of the club to shake up all the collusive arrangements that prevent competition at home. Imports, in effect, provide a powerful countervailing institution. They substitute for the competitive political and economic mechanisms that are missing within Japan.

    It's not that trade opening is more important than domestic deregulation and trust-busting at home. It's that the necessary domestic reforms are more likely to occur if competition from imports is increased. Analysts have long talked of gaiatsu (literally, foreign pressure) in political terms. Reformers in Japan have often surreptitiously used U.S. pressure to create changes that Japan's one-party state was unable to achieve on its own. Gaiatsu has been so important that the U.S. is sometimes called Japan's unofficial opposition party. Imports are, in effect, economic gaiatsu. It's unfortunate that economic gaiatsu is necessary, but it does seem unavoidable.

    One of the best examples of economic gaiatsu is the explosive growth in Japan's cellular phone industry. Today, it seems that everyone in Japan walks around with a handyphone. It wasn't that way a few years back, when high prices suppressed demand. Motorola's pressure to open the market and change regulations and practices created a revolution. Companies sold phones cheaply instead of leasing them at high rates. Phone call rates tumbled. And, in response, demand soared. Motorola had always contended that the measures it asked for would help its competitors. It may have sounded disingenuous, but it has been proven right -- in spades. From January 1994 to June 1997, the number of cell phone subscribers increased from 500,000 to 24 million. In fact, according to Takashi Kiuchi, chief economist at the Long-Term Credit Bank (LTCB), the purchase of cell phones and use of them increased GDP by about [yen]1 trillion, or 0.2 percent of GDP, during that period. For an economy struggling to achieve 1 percent growth, that's nothing to sneeze at.

    The potential of trade opening was particularly seen in the early 1990s when a sharp rise in the yen drew in more imports. These imports unleashed a wave of "price destruction" that weakened the power of domestic cartels, brought down monopolistic prices in a host of industries, and helped spur support for reform among exporters. Unfortunately, once the yen reversed course in 1995 and became cheaper, the flow of imports slowed and so did the momentum for reform. Without significant trade opening, it is hard to see how the forces of reform will be strong enough to defeat the power of entrenched interests.

    In countries without strong countervailing institutions, it usually takes a crisis to force change. That's what began to happen to Japan when the bubble popped. That led at least some of the nation's leaders to reexamine all their long-held myths. Sakura Shiga, the former director of the Economic Planning Agency's Planning Division, described the shock effect:

All of our long-cherished assumptions--that the Japanese economy will always grow, that asset prices always rise, that full employment is virtually guaranteed, that financial institutions are invulnerable, that Japan has the safest society in the world--are now being overturned. People in Japan are losing self-confidence and wondering what has gone wrong. In short, we are aware that we are in crisis for the first time in these fifty years of postwar prosperity, and we know we have to revamp our society and economy....

    Although experts had long recognized these ... structural problems, the problems were unfortunately obscured by the euphoria of the economic bubble period. The bursting of the bubble revealed the problems to have worsened considerably.

Rethinking has occurred in the political world as well. In 1996, Yukio Hatoyama, the grandson of one LDP Prime Minister and the son of an LDP Dietman, quit the LDP to help form a new opposition party, the Democratic Party. As of 1997, it was the third largest party in the Diet. Calling for thorough reform, Hatoyama declared:

Until the seventies, the Japanese bureaucracy had performed well in the goal of helping the economy catch up with the West. Once it had achieved this goal, however, the bureaucracy lost its sense of purpose. Self-preservation and self-aggrandizement became its goals.... This ancien regime has put political decision-making beyond the reach of citizens and driven innovative industries out of Japan. The vaunted industrial policy, which had nurtured many infant industries in the fifties and sixties, degenerated into the protection of sunset industries and never-do-well industries at the consumers' expense.

And, of course, the economic storms hitting most of East Asia at the end of 1997, punctured much of the hubris surrounding the so-called Japan model or Asian model of economics. In a sense, Japan was lucky. After years of disguised sclerosis, it finally received an unmistakable wake-up call. Without a crisis, as Mancur Olson writes in The Rise and Decline of Nations, the sclerosis induced by cartel-like activities can persist indefinitely.

"The System That Soured": Toward a New Paradigm about Japan

If new ideas are needed in Japan, then new thinking about Japan is needed in America.

    For two decades, American policymaking about Japan has been polarized around an increasingly bitter and sterile debate. Guided more by contentious issues of U.S. trade policy than by a dispassionate look at Japan itself, the debate has produced both flawed analysis and ineffective policies.

    At one pole, there are those--epitomized by some of the so-called revisionists--who insist that Japan still benefits from its protectionism. For example, in a 1996 letter to Orbis, Chalmers Johnson accused the journal of spreading Japanese "disinformation" after it printed an article by David Asher analyzing Japan's bubble and bust. Johnson even resigned from the Orbis board over this matter. The financial frenzy of the late 1980s, Johnson insisted, was "not a bubble; this is governmental policy." The bubble and the high yen were really "a wonderful political cover" for a Finance Ministry scheme to "recreate the Greater East Asian Co-Prosperity Sphere." Any accounts of post-bubble economic difficulties are just part of a deliberate "deception" campaign from Tokyo:

Japan's policy in the world today is to buy a little more time--to milk the Americans a little longer and wait for conditions in East Asia to ripen. Within a few years they will either offer their own leadership in Asia or else guide their people into accepting Chinese hegemony. In order to buy time, Japan sends out messages of change, disarray, or catastrophe whenever it looks like the Americans might be about to take action.

    Eammon Fingleton's Blindside (1995) is a book-length rendition of the same "deception" thesis.

    At the other pole, many orthodox economists argue on the basis of neoclassical theory that any Japanese interference in the market, even in the 1950s and 1960s, had to have been either inconsequential or outright detrimental. Hugh Patrick contends that accounts of the role of government in Japan's development are "exaggerated," insisting that "quite free markets for commodities and labor" produced the high growth era. Yet, for much of that period, no imports could get in without government approval while government-authorized cartels controlled 30 percent of manufacturing. David Weinstein and Richard Beason argue that "Japanese industrial policy seems to have transferred resources out of high growth sectors and into low growth sectors." The critical role of industrial policy in the promotion of such export superstars as autos, steel, and electronics is discounted.

    However, if we deny the reality of what so many Japanese leaders experienced firsthand, then it is hard to understand why such policies continue to retain a grip on the minds of those leaders.

    Many neoclassical economists and traditional political-military experts act as if merely conceding the existence of Japanese trade barriers might somehow give too much ammunition to the trade hawks. In 1994, economist Jagdish Bhagwati recruited dozens of economists to sign a letter denouncing the Clinton Administration for a "crude and simplistic view that Japan is importing too few manufactures owing to structural barriers." But such assertions deny the reality of what so many American and other non-Japanese companies have repeatedly experienced. As a result, these economists unwittingly and unnecessarily undermine the credibility of a free trade response to Japan's barriers. In any case, perfectly respectable neoclassical economists have long since disproved Bhagwati's claim.

    Neither the "revisionist" nor "traditionalist" paradigms have been good guides to policy.

    The "revisionist" view treats Japan as a monolith that will respond only to pressure. When this analysis influenced policy in the first two years of the Clinton Administration, the policy backfired. It elicited a nationalist defensiveness that pushed Japanese reformers into bed with conservatives. Tokyo became, if anything, even more intransigent.

    The "traditionalist" view has fared no better. In the attempt to maintain strong U.S.-Japan ties, traditionalists have often minimized trade issues as a mere irritant in an otherwise sound relationship. They have limited their own conceptual options by accepting the notion of a trade-off between security and trade issues. "Is it really worth jeopardizing American F-16 bases in Japan just so Florida can sell some more oranges?" traditionalist security officials have, in effect, argued.

    Such a view, however, fails to appreciate how the same mindset responsible for Japan's closed market also leads to Japan's insularity on security matters. As Peter Ennis, editor of The Oriental Economist Report, puts it, these two problems are "two sides of the same coin." Moreover, the ineffective trade policies resulting from the traditionalist view created a dangerous vacuum often filled by revisionists, protectionists and other trade hawks. The very posture that traditionalists adopted to maintain good U.S.-Japan ties helped lead instead to their corrosion.

    Clearly, we need a different paradigm to analyze Japan and guide policy. This paradigm would understand Japan as a case of a "once-successful system that soured."

    This is not a new notion, but one that has been tragically overlooked. Back in 1982, University of Washington Professor Kozo Yamamura published an essay on this topic entitled "Success That Soured." In that essay, Yamamura pointed out that Japan was still dominated by legal and illegal cartels, import restrictions, and other vestiges of the high-growth era, but that any positive role had run out of steam. A similarly balanced and evolutionary view was presented in a 1985 book called The Competition, by three analysts from the Hudson Institute, Thomas Pepper, Merit Janow and Jimmy Wheeler. On the one hand, it critiqued Patrick and his co-thinkers for limiting their discussion of government's role to a paradigm of government versus the market. Then, commenting on Johnson, it pointed out that, since industrial policy was best used as a device to help "late industrializers" catch up, its vestiges were becoming "increasingly costly to the domestic economy" as Japan matured.

    In Japan, too, analysts warned that carrying on a once-successful industrial policy for too long was a policy fraught with peril. As early as 1975, Professor Hiroya Ueno, of Seikei University, sounded the alarm:

One might say that this [the late 1960s] was a period in which Japan was drunk with the spectacular results of its industrialization plan and its industrial policy.... We should have recognized that industrial policy, which had been justified until then, and systems adopted on its behalf, had already finished their roles....

    [T]he collusive oligopoly system prevailing in heavy and chemical industries ... may... become even more prolonged and troublesome aftereffects [of industrial policy] for the Japanese economy. The reason is that, as a general political rule, a system, once established, cannot be dissolved or reformed until a revolutionary event or considerable abuse takes place. It means that groups and organizations that were artificially created to meet the need of a specific system tend to grow with this system into powerful champions or political pressure groups that can no longer be controlled by this system.

    Unfortunately, in the heat of the 1980s ideological wars between "revisionists" and "traditionalists," these more nuanced views of Japan fell by the wayside.

    Now, however, as people try to understand why the Japanese miracle failed, new analysts are picking up the trail. We will discuss these new analysts in Chapter 13.

    A policy guided by the "system that soured" paradigm would appreciate that Japan does still differ from most other capitalist nations, but that Japan is crippled by many of its differences. It would recognize that this situation gives rise to internal political pressures for change, including more openness to imports and foreign investment. It would understand that the change in mindset needed to revitalize the economy would engender a more cosmopolitan attitude in Tokyo on all kinds of topics, including security. It would seek to further those changes, or at least take them into account, in designing policies. No one should expect or desire Japan to become a carbon copy of America, no more than Europe or the Asian NICs are. But, certainly, Japan can become a lot more open and, in its own interests, it now needs to be.

    Trade negotiators have long recognized that America has enjoyed the most success in negotiating with Japan when its trade agenda coincided with the needs of internal forces in Japan, and therefore when it could find implicit allies in Japan. Because Japan cannot solve its problems without greater trade openness, the current crisis in Japan is likely to produce a lot more allies. As Undersecretary of Commerce Everett Ehrlich put it in a recent report:

The structural opening of Japan's economy is inevitable. When it happens, not only will U.S. exports find a new and welcome home, but then and only then will Japan's economy finally find the basis for the new and sustained round of growth that has eluded it in this decade.... We have too often thought of these policies [the U.S. trade agenda] as unilateral concessions we demand of the Japanese. It is time to think of them instead as tonics for what ails Japan.

None of this implies that Japan is about to "embrace the American model." America has its own problems, some of them more difficult to solve than Japan's. How, for example, does America, with its huge "education gap," find a new job for a 50-year-old autoworker with a 10th-grade education?

    In America, especially since the Reagan era, the dominant philosophy has been: Let the train of economic efficiency roll on as fast as possible regardless of who gets crushed in the wheels. That is hardly a compelling model for a country with a communitarian social ethic. Nor is Europe an attractive alternative. There, the social safety net is so thick that employers are reluctant to hire, the unemployed are content to remain so, unemployment hovers at or near double digits, and right-wing demagogues exploit the situation to win electoral gains.

    Japan will have to find its own path, one that combines the need for efficiency with its own social values. Certainly, Japan needs to improve productivity. And to do this, it will have to allow more competition, including competition from imports. It also needs a financial system that can direct money to its most efficient use and screen companies for their ability to pay back. Assuredly, it needs competitive elections. But nothing dictates that Japan has to accomplish these tasks in the same way that America does.

    Saying that Japan is embracing the American model because it gives the market more sway is like saying Franklin Roosevelt adopted the Japanese model because he created the New Deal. In fact, like the 1930s Marxists who claimed capitalism could not reform itself, it is the opponents of reform in Japan who claim that reform means Americanization. Twenty years from now, Japan will look very different, but it will still be Japan.

    While nothing dictates that reform will succeed, it's hard to imagine that a nation as intelligent and resourceful as Japan could let itself fail. At the same time, it's difficult to chart the path that will let Japan overcome its institutional roadblocks in the near future. In all likelihood, Japan will not reform within five years; within twenty, it almost certainly will.