The system that sacrificed everything in the pursuit of economic growth has proven too rigid following the collapse of the Japanese economy in 1990 and a programme of deregulation, reform and restructuring is now a necessity
Not so long ago, Japan's economic model and management techniques were the envy of the western world. Japanese products flooded western markets and Japanese asset prices rose precipitously. In late 1989, the market capitalisation of the Tokyo Stock Exchange stood significantly higher than that of the New York Stock Exchange and the grounds of Tokyo's Imperial Palace were supposedly worth more than the whole state of California. Then, in early 1990, the Bank of Japan finally decided enough was enough and, in an attempt to cool down the economy, decided to raise interest rates. The rest is history.
The resulting implosion in asset markets was quick and merciless. The equity market fell more than 60% in two years and real estate prices subsequently plunged. The sharp fall in asset values severely damaged the already over-stretched balance sheets of households and corporate Japan, while the banking sector saw bad debts pile up to astronomic levels.
Some 12 years later, the equity market has still not recovered, land prices have fallen each year for the past 10 years, the financial system is fragile and economic growth remains dependent on exports. So why has the world's second-biggest economy and former economic wonder of the world failed to recover its former glories? And, more importantly for investors, are we in the middle of another lost decade?
Many commentators blame Japan's prolonged malaise on the lack of strong political leadership and the absence of an effective policy response to the country's woes. Even during the economy's golden years, the Japanese themselves regularly used the phrase first-rate economy and third-rate politics to describe their nation.
However, at the root of many of Japan's problems is the very economic model that made it one of the world's most powerful nations. The model that once sacrificed everything for economic growth is now too rigid to meet the needs of the nation.
Japan badly needs to embark on a programme of deregulation, reform and restructuring at both the macro and micro levels. This would enable it to emerge as a post-industrial economy with an efficient domestic sector to add to its already globally competitive manufacturers.
Over the past decade, Japan's Keynesian economic policies have led to a ballooning in government debt to more than 130% of GDP as more and more public money has been squandered on unnecessary civil engineering projects. These include highways through remote rural areas, concrete riverbeds and numerous bridges and dams.
As a result, Japan boasts the biggest construction industry in the world. More than 10% of Japan's workforce is currently involved in building compared to less than 5% in the US.
However, the reason for this public works binge runs far deeper than an attempt to kick-start the domestic economy. Vested interest groups are a huge stumbling block to reform in any area of the Japanese economy but especially so in the construction industry. Bid-rigging scandals are commonplace, ex-bureaucrats run many construction companies and politicians arrange large projects for their prefecture to secure votes and funding from local construction companies.
This alliance between politicians, bureaucrats and big businesses, often called the iron triangle, has to be broken to ensure capital is allocated efficiently in the future.
The role of the government in Japan's economic model is usually cited as one of the reasons for the rapid post-war economic growth. The basis of the model was to suppress individual consumption via high prices and limited choice of products and services to encourage individuals to save money at banks or the government's post office. The government then used administrative guidance to channel this money towards industries they believed offered good growth prospects.
Meanwhile, they also encouraged Japanese companies to build up webs of strategic shareholdings in each other to guarantee stability and Japanese ownership. As a result, Japanese corporations were run with very little discipline, as they appeared to have a never-ending supply of debt from banks and a stable shareholder base uninterested in profitability.
This is the major reason the return on capital has been chronically low in Japan. The high level of government intervention has created a dual economy with a clear gap between first-rate exporters and inefficient domestic sectors.
In the first group, there are the world-famous manufacturing companies such as Toyota, Honda, Sony and Canon, which are the major drivers of economic growth. These companies are globally competitive with leading products and efficient production techniques.
In the second camp are domestic service companies in sectors such as construction, retail, transport and food, which have rarely been exposed to foreign competition and have tended to operate almost like cartels.
Surprisingly, when the prevailing view has been that the government has carefully managed Japan's economic boom, it is in the very sectors in which the government had least influence that Japan has prospered. Conversely, it is the domestic-oriented sectors in which the government's role was much greater that we find the greatest inefficiencies.
The need for deregulation is greatest within these service areas. By allowing existing industry players to compete with each other, and allowing new entrants into certain industries, the government can force companies to restructure, lower costs and thereby raise profitability. Increased deregulation will initially lead to a rise in unemployment in the affected sectors but, on the positive side, by raising consumer choice and lowering prices, Japanese consumers would be encouraged to spend more of their incomes.
Currently, Japanese consumers save approximately 15% of their disposable income compared to 4% for US consumers. Therefore, deregulation could promote micro restructuring and encourage consumer spending.
However, rising unemployment could be too bitter a pill for the iron triangle to swallow, which is why Japan has to encourage either domestic entrepreneurs or foreign companies to invest in new high-growth areas to soak up the excess workers from traditional industries.
This transformation from industrial to post-industrial economy is a stage through which all developed countries must pass, and it is a stage that Japan is struggling to move through. The amount of regulations involved in starting up a new business and the relatively high tax rates do not encourage Japanese entrepreneurial spirit.
Meanwhile, foreign direct investment (FDI) is limited due to the high cost of operating a business in Japan, as corporate services such as taxes, rents, electricity and transport remain relatively expensive by international standards. These problems are well illustrated in a 2001 study by the London Business School, which found that newly-established companies, those under 3.5 years old, accounted for less than 1% of Japanese employment, compared to more than 9% in Korea. Interestingly, at the time of the study, Ireland had even less entrepreneurship than Japan but had a booming economy as a result of the massive amount of FDI it attracted.
The choices for Japan are fairly stark. If the government continues to play a dominant role in the economy, inefficiencies will persist and Japan will remain totally dependent on global demand to fuel growth. However, if, through a programme of deregulation and reform, the government can foster competition, encourage corporate restructuring and promote a pick-up in entrepreneurial spirit and FDI, the future of the Japanese economy would look much rosier.
This process of creative destruction is not too dissimilar to that undertaken by the US economy in the 1980's era of corporate downsizing, when the discarded employees of industrial America were snapped up by vibrant small companies. Obviously, the scale of transformation needed in Japan is much greater than in the US and, so far, the pace of change has been disappointing.
However, the ability of the Japanese people to respond to the need for change should not be underestimated. The two obvious examples in Japan's history are the Meiji restoration period, when the country moved from a feudal society to an industrial superpower in 100 years, a shift that took most western economies more than 300 years, and the well-documented post-war industrial growth phase.
On both these occasions, the Japanese nation had to change to survive and the population was guided by a central plan. One problem now is that the Japanese people can continue to muddle along for a few more years living off their enormous savings, so there is a lack of pressure for change. More importantly, however, in a land famous for consensus decision-making, there is no consensus on how to revive Japan.
Many commentators blame Japan's prolonged malaise on the lack of strong political leadership.
Japan needs to embark on a programme of deregulation, reform and restructuring at macro and micro level.
Foreign direct investment is limited due to the high cost of operating a business in Japan.
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