By Michael E. PorterJapan: What Went Wrong
Mr. Porter is a professor of competition and strategy at Harvard Business School and a co-author of "Can Japan Compete?" (Perseus, 2000).
A sense of gloom has settled over Japan, as once more the economy has failed to recover and the stock market has hit 17-year lows. With price deflation, a public debt that is the highest percentage of gross domestic product of any advanced nation, and no strong U.S. economy to absorb exports, Japan's degree of freedom has diminished.
Political leadership is in shambles. Prime Minister Yoshiro Mori, who earlier this week met with President Bush, is expected to resign within months. There are fears that a Japanese meltdown will harm the already fragile economic situation in the U.S. Comparisons are being made between the collapse of the Japanese bubble, and the decade-long malaise that followed it, and the Internet-led meltdown in the U.S.
What went wrong in Japan? Why have the reforms of the past several years failed? The answers to these questions are crucial to any effort to arrive at a prognosis for Japan, test the analogy between Japan and the U.S., and assess the likely effects of further Japanese stagnation on the U.S. economy.
Going Nowhere
Since the 1980s, there was a generally accepted explanation of Japan's postwar success. It had two parts. One was an activist government role in economic policy through a variety of mechanisms, among them targeting and supporting attractive industries, relaxing antitrust, managing competition to avoid its excesses, and encouraging joint research. The second part of the explanation was the so-called Japanese management system, characterized by continuous improvement of cost and quality through flexible manufacturing and reduced time to market.
The reality is that Japan's activist government policy explains Japan's failures much better than its successes. Government had a surprisingly small role in many of Japan's most impressive export successes, such as cars, robotics, cameras and video games. It was in uncompetitive sectors, such as chemicals, aircraft, software and financial services, that there was extensive government regulation and subsidies, legal cartels, government-sponsored collaborative activity, and sustained protection.
Government intervention and protection not only made the cost of living for Japanese consumers extremely high, but drove up the cost of doing business or Japanese companies. Policy makers thought they could create an efficient export sector while at the same time protecting and subsidizing domestic industries. Instead, inefficient local industries such as construction, agriculture, wholesaling, retailing and transportation exerted a tremendous drag on the entire economy. Japanese companies moved offshore in droves in the 1980s and 1990s to escape these high costs. Companies could prosper if left alone; the problem was the government-led system.
On the corporate side, Japan's style of competing on total quality and continuous improvement -- on doing the same thing as rivals but doing it better -- led to success in many industries in the 1970s and well into the 1980s. But even in their heyday, Japanese companies were far less profitable than Western competitors. Weak corporate governance and little pressure from shareholders led to imitation, product proliferation and widespread diversification. By the mid- to late 1980s, Western companies began to close the productivity gap by adopting Japanese practices. Then they surged ahead, capitalizing on Japanese weaknesses in white-collar productivity and information technology. With no distinct strategies, Japanese companies were drawn into a zero-sum competition that eroded prices and further undermined profitability.
Why have reforms failed? The simple answer is that they were hardly reforms, and mostly targeted at the wrong problem. The cornerstone of Tokyo's response has been massive government spending -- intended to pump up domestic demand and bail out companies -- to the tune of more than $1.1 trillion. Structural reforms have been marginal, so that stifled competition, a regulatory morass, weak corporate governance, and a high cost of doing business still remain.
Couple this with increased taxes on consumption, capital gains and property transfers, and Japanese economic growth has gone nowhere. Companies have started to restructure, but most efforts have been timid in order to preserve employment. Japanese corporate investment continues to flow overseas.
There is little comparison between Japan's situation and that of the U.S. A little history is instructive The collapse of the Japanese bubble exposed a fundamentally flawed system, and the nation failed to respond. The U.S. faced significant challenges, but the system is sound and adjustment has been rapid.
Consider the U.S. situation in the late 1980s, with the savings-and-loan question, defense downsizing, a real-estate bust, weaknesses in corporate quality and efficiency, and a huge budget deficit. Self-corrective mechanisms took over, with competition and financial-market pressure stimulating rapid and vigorous adjustment. The U.S. entered a recession in July 1990 but was growing again by April 1991. The government's role was modest, and focused on facilitating restructuring and streamlining regulation. Japan, in contrast, has delayed or avoided reforms, making adjustment slow and painful.
Today's U.S. situation is less troubling in most respects than the last recession. While stock-market excesses, the dot-com meltdown, and higher energy costs are near-term problems, competitiveness remains sound (the U.S. has competitiveness issues, but they are longer-term ones). Productivity growth, the fundamental driver of prosperity, is high. The nation continues to be a leader in information technology, health care, financial services, and knowledge creation, among other things, which will be driving forces in the economy for years to come. With few new entrants into the work force, unemployment is unlikely to rise as much as in past downturns. Demographic changes promise to continue to boost the pool of savings to be invested. And there is no new competitive power on the horizon.
A slowdown in information-technology investment was inevitable after the heady growth of recent years, but rising investment as a percentage of GDP is a 20-year trend. The Internet is here to stay, and there is a healthy new maturity about how to deploy it. More realistic stock-market valuations will lead to better corporate decisions.
Finally, the U.S. is once again in the middle of feverish adjustment, with a burst of bankruptcies, restructurings, mergers, and buyouts, all of which are reshaping the economic landscape. Provided that government supports this adjustment with sound monetary policy (such as the Fed's half-point interest-rate cut yesterday), lower marginal tax rates, and continued efforts to streamline regulation, there is every reason to believe that economic growth will recover.
The contrast with Japan is striking. Japan, too, has fundamental competitive strengths, including world-class companies, well-educated citizens, strong technological capability, and high savings. The core problem is not companies, workers, or even consumers, but the system. The system is beginning to change, but too slowly. No vision for a future Japan has emerged, and no political leadership has come forward to articulate and implement it. With only modest internal reforms and no plan, Japanese citizens and companies have lost the confidence to spend and invest. No amount of government pump-priming can overcome this.
Could Japan's difficulties hurt the U.S.? A growing Japan would certainly help, but Japan's malaise is unlikely to have a large negative impact. Japan has been depressed for a decade, and a significant decline in the appetite for critically needed U.S. goods and services such as information technology, pharmaceuticals and financial services is unlikely. Japan accounts for only about 9% of U.S. exports, and exports to Japan in recent years have been stable or growing. Some Japanese portfolio capital invested in the U.S. financial markets might be withdrawn to strengthen domestic balance sheets, but net flows of capital from Japan are modest and there is no obviously better place to put it. On the corporate side, Japanese companies, if anything, are likely to be growing investors in the U.S. to access technology and diversify out of the slow-growth Japanese market.
While the threat is modest, Japan represents a large opportunity for U.S. companies and investors. As reform and restructuring proceed, even if slowly, acquisitions, private-equity opportunities, and the ability to enter formerly restricted markets should proliferate. U.S. investors are already involved in workouts of distressed loan portfolios, and early results are encouraging.
Overall U.S. corporate investment in Japan has been growing rapidly. What should the U.S. be advising Japan to do? First and foremost, the Bush administration should stop the pressure for pump-priming that has proven so disastrous. Instead, the focus should be on helping Japan facilitate restructuring, open its markets, improve corporate governance, and eliminate barriers to competition. Instead of government spending, Japan needs to reduce the tax burden to provide incentives for consumer and corporate spending. Instead of fearing "deflation," Japan should see the decline in domestic prices as fundamentally healthy. As the cost of living and the cost of doing business go down, the domestic market will expand and Japanese companies will be less prone to invest abroad.
A Red Herring
On Monday, Bank of Japan Governor Masaru Hayami signaled a new course, declaring the central bank will act to ensure that a key interest rate falls to zero and stays there until consumer prices stop falling. But while bringing down interest rates may be psychologically important, I believe Japanese interest rates are a red herring. They have long been near zero. The real problem is to restore confidence and find a way to rapidly restructure bank loan portfolios so that banks and corporate borrowers can put the past behind them and start focusing on the future.
Doing this could involve some combination of tax credits for write-downs, establishment of an insurance fund into which banks will pay over time to reimburse the government for losses, and encouraging private-equity infusions and acquisitions that do not unduly limit competition.
The greatest challenge for Japan, in many respects, is demonstrating leadership and developing a plan to rebuild confidence. Accelerating the reform process and accepting its short-term costs are the only answer. The Liberal Democratic Party must stand up to powerful vested interests such as farmers and the construction industry, a move that will pay large dividends in future elections. A plan for Japan will involve replacing intervention with incentives, and challenging Japanese companies and citizens to deal with their own problems. Japan can compete, but only if it allows competition.