Guest Article

GUEST ARTICLE

Japan's Economy Needs Structural Change TAKATOSHIITO

features of the Japanese economy are fre- makes workers versatile and prepares them Japan's economic miracle quently cited as contributing to this rapid for higher positions, is common. This growth. investment in firm-specific human capital appears to be waning. Struc- Lifetime employment. The conven- helps to increase worker productivity in the tural changes are needed to tional wisdom highlights the importance long run. for growth of the long-term relationship It is often said that productivity increases put the economy on a reason- between Japanese firms and their workers: in Japan were due mainly to a combination ably high growth path once regular workers are virtually guaranteed a of innovations in the manufacturing pro- again. job for life. As a result, involuntary job cess and better communication between changes are rare and the unemployment employees at all levels in the firm. This was rate has been low—around 1-2 percent in made possible by teams of versatile work- the 1950s and 1960s, and between 2 and 3 ers who went through on-the-job training N THE four years from 1992 to 1995, percent since the mid-1970s. Although together. In addition, competition in the Japan's growth rate was around employment is to some degree guaranteed, domestic labor market and a system of 1 percent or lower, the lowest among job assignments, work hours, and rates of "deferred" payments—characterized by a the G-7 countries. Although the reces- pay are quite flexible. Given that workers steep age-earnings profile and substantial Ision touched bottom in October 1993, the are unlikely to quit, a firm can afford to pro- severance pay upon retirement linked to recovery has been extremely weak; the vide often costly on-the-job training. length of service and final salary—deters growth rate did not pick up again until Rotation through different job skills, which workers from shirking work or quitting 1996, when it is thought to have risen above 3 percent. The appreciation of the yen during most of this period and the neg- Prices and growth in Japan ative effect on wealth of the collapse of the (percent change 1980s' share and land price bubble have been singled out as immediate causes of the recession. However, the slowness of the recovery suggests that other factors must have been at work as well. Specifically, features of the Japanese system that were once considered its strengths may now be holding back growth. The Japanese system Japan's growth record, especially from the 1950s to 1990, was certainly re- spectable for an economy without major resources (see chart). Several institutional Source: IMF, International Financial Statistics Yearbook, various issues.

Takatoshi Ito, a Japanese national, is a Professor at the Institute of Economic Research, Hitotsubashi University. He was a Senior Advisor in the IMF's Research Department when this article was written.

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©International Monetary Fund. Not for Redistribution altogether. Thus, lifetime employment is takeovers. Management can therefore con- economy grew and firms gained experience supported by a system of implicit contracts. centrate on long-term investment projects, in production, the successful ones were able Moreover, it is self-sustaining: lifetime rather than on dressing up quarterly earn- to expand. Increasing returns to scale employment contributes to the growth of a ings reports. Conversely, if the management brought down production costs, and firm, and growth makes it possible for the of a company has failed, the group firms returns to scale were further enhanced firm to maintain lifetime employment. can collectively decide to replace those who when these firms started to export and The system works especially well in an are responsible. became more competitive in the world mar- expansionary environment, since the rela- Industrial policy. Despite the popular ket. When the sector reached this stage, tively large pool of "underpaid" younger image of interventionist government, public restrictions on imports were liberalized. workers makes possible more "deferred" expenditure as a percentage of GDP in This strategy was most visible in the steel payments to retiring workers. When the Japan has been relatively small compared and shipbuilding industries. organizational hierarchy of a corporation with other industrial countries. Never- In fact, this kind of targeting was almost grows, more management positions are cre- theless, public policy has been used to inevitable in the 1950s because the yen was ated, and therefore "deferred" payments promote growth in a variety of ways. overvalued and import restrictions (includ- increase. Thus, lifetime employment can During the 1950s and 1960s, the govern- ing quotas, tariffs, and foreign currency allo- also be seen as a type of pay-as-you-go ment targeted certain industries as sunrise cations) were necessary to maintain the company pension scheme. exchange rate. The Ministry of The main bank system. Strong International Trade and Industry long-term relationships between (MITI) and the Ministry of Finance banks and firms are often cited as a effectively "promoted" particular in- source of strength in the Japanese dustries simply by allowing them to economy. Typically, a firm develops a use foreign currency allocations to relationship with a particular bank buy raw materials. and relies on its financial support over Opponents of this view point to the long term. The bank not only pro- failures in the government's attempt vides loans to, but also holds shares to identify prospective sunrise in- in, the firm. In return, the firm uses dustries: coal, petrochemicals, oil the bank for major transactions from refining, and aluminum are exam- which the bank earns profits. A bank ples. In fact, some studies suggest that has this type of primary relation- that if productivity increases are ship with a firm is called a main bank. related to loans from the Japanese The main bank acts as an agent for Development Bank at the industry investors and lenders to the firm, level, the relationship is negative. examining the viability of investment Consumer electronics, probably one projects and monitoring the perfor- of the most successful export indus- mance of management. Individual tries, never was on MITI's list. The stockholders do not monitor manage- automobile industry is another inter- ment efforts, and Japanese institu- esting case. In the early 1960s, MITI tional investors have not exercised the attempted to merge several automo- kind of monitoring power, such as Takatoshi Ito bile manufacturers into two groups pressing for higher dividends, that of firms, arguing that there were too investors have in the United States, for many automobile manufacturers in example. Because a main bank takes a Japan. The firms fought back and long-term view, a firm's management industries, providing them with various maintained their independence. If is able to embark on long-term investment advantages to stimulate their expansion. MITI had succeeded in reducing their num- projects with committed funding. They were given low-interest loans through ber, domestic competition would have been Keiretsu. In addition to the strong rela- government financial institutions and stifled and Japanese automobiles might not tionship between banks and firms, the received hard-to-obtain foreign exchange have dominated the world market in the Japanese economy is characterized by long- allocations. The government also restricted 1980s. term relationships between businesses in entry to markets that were considered There is a broader consensus on the ben- the form of keiretsu, or enterprise groups. important and crowded, and some markets eficial effects of the government's com- There are horizontal keiretsu (across were segmented to limit competition. mitment to exports in general. Pushing different industries) and vertical keiretsu One influential but controversial inter- exports was certainly an important aspect (between a manufacturer and its suppliers, pretation of the industrial policy of this of industrial policy in the 1950s and 1960s, or its wholesale distributors, dealers, and period goes as follows. When a chosen sun- but it too was largely a necessary response retailers). rise industry was in its infancy, the gov- to the overvalued currency. The evidence Conventional wisdom on the significance ernment protected the domestic market suggests that the phenomenal success of of the keiretsu to the Japanese economy is through quotas and high tariffs, but Japanese exports reflects a variety of fac- similar to that for the main banks; they allowed domestic firms to compete within tors, including the rapid response of private monitor the performance of management. the captive market. Japanese firms either firms to changing market opportunities. Since group firms hold each other's shares, licensed foreign technology or reverse engi- Indeed, the composition of Japanese they are effectively safe from hostile neered foreign products to catch up. As the exports changed quite rapidly during the

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©International Monetary Fund. Not for Redistribution 1 decade, it is quite likely that workers who Productivity growth has been slowing are now in their forties will retire to find that their age-earning profiles have not 1960-71 1971-81 1981-92 been as steep as those of the previous Tradable generation—a subtle breach of implied Total 10.22 5.677 4.599 contract. The recent increase in the unem- Agriculture 4.644 3.18 2.79 Manufacturing 10.16 5.318 3.999 ployment rate foreshadows this prospect, although firms, concerned to maintain their Nontradable reputations in the eyes of prospective Total 6.83 2.533 1.900 3 recruits, have so far honored their implicit Energy and transportation 8.08 1.955 2.822 Construction 5.818 0.277 1.99 contractual obligation not to lay off Distribution and finance 8.755 4.799 2.868 workers. Services 4.000 1.066 0.48 The type of innovation needed for Difference (tradable less nontradable) 3.399 3.144 2.698 today's environment seems to be difficult to Whole economy 8.922 3.966 2.88 generate with the current Japanese system of labor relations. The growth industries Source: Author's calculations based on Organization for Economic Cooperation and Development, National of the future are in the high-technology, Accounts, Vol. 2, Detailed Tables (various years). Note: Productivity growth in a given sector is the annual percentage change in the ratio of total production to total service-oriented sectors, such as computer employment for that sector. 1 software, communications, and financial Annual percentage growth in productivity. products. These industries are typically financed by venture capital and employ workers with highly specialized skills. In this context, the Japanese way of educating postwar period, shifting from textiles and Education. Illiteracy is extremely rare and training workers to perform a wide toys to other light manufactured goods in in Japan. Elementary and high school edu- variety of jobs within a typical manufac- the 1950s; to consumer electronics, steel, cation emphasize basic skills in language turing firm may be counterproductive. and ships in the 1960s and 1970s; to sophis- and mathematics, as well as group activi- Moreover, international competition in the ticated optical products in the 1970s; and to ties. Curriculums are nationally standard- tradables sector requires more flexibility on automobiles and semiconductors in the ized, and it is not possible to skip a grade. the labor front, both from the standpoint of 1980s. The structural transformation of University admission is by examination, product innovation and to prevent Japanese industry was one source of Japan's continu- with stiff competition. It is widely accepted production operations from moving abroad ous success in achieving trade surpluses that the Japanese educational system to take advantage of cheaper labor costs, and rapid economic growth. produces highly qualified and effective The main bank system. The role of Saving and investment. The Japa- workers. the main bank system in the 1990s is also nese household saving rate—which has open to question. There are two strands to fluctuated between 15 and 20 percent since From asset to liability the argument. First, and this is not really the 1950s—has long been the highest The very features for which the Japanese specific to Japan, banks generally play a among the major OECD countries and economy has been praised in the past may diminishing role in financial intermediation explains a good part of the country's high now be holding back growth. Declining as industrial economies mature. Second, the investment rate. Japan's high saving rate productivity may be one symptom of the behavior and performance of the Japanese has been the focus of much study. Opinions problem (see table). Productivity has been banks during the 1980s' asset price bubble differ on whether the saving rate can be slowing over the past three decades. The and its collapse have cast doubt on the con- understood purely in terms of the life-cycle effect is seen across the board, but is espe- ventional view of the rational, farsighted, hypothesis—the idea that people save dur- cially noticeable in the nontradables sector. and growth-enhancing role of the main ing their productive years for retirement. Slower productivity growth, particularly banks. Although this theory seems to fit the after the very high levels reached in Japan Throughout the 1980s, the industrial Japanese experience, the size of this effect from the 1960s through the early 1970s, countries, including Japan, rapidly liberal- has been questioned. In particular, some may be inevitable as the economy matures. ized their financial markets. Regulations on economists have suggested that, in Japan, However, it may also be a sign of the need interest rates were abolished; entry into household saving decisions are dominated for fundamental structural change. Let us new services and geographical regions by the bequest motive—the desire to leave consider how Japan's key institutional (domestic and international) was increas- an inheritance for future generations. strengths may be affecting growth in the ingly liberalized; and new products and Determining which hypothesis best fits the 1990s. markets, most notably derivatives, were Japanese experience is important. If indi- Lifetime employment. The system of developed. In Japan, most controls on capi- viduals save mainly for retirement, then a deferred payments to motivate workers that tal inflows and outflows were lifted in the demographic shift toward a larger, older is implicit in the lifetime employment guar- first half of the 1980s. On the domestic population would have important negative antee is now in danger of self-destruction front, all interest rate regulations were consequences for the saving rate. In con- for the same reasons that a pay-as-you-go effectively lifted by the beginning of the trast, if the bequest motive predominates in pension system runs into difficulties in an 1990s. The Bank of Japan's restrictions on saving decisions, the saving rate should be aging economy: arrangements that worked lending increases by the major banks were relatively unaffected by the aging of the in a high-growth environment begin to fail. abolished in 1994. As regulations on capital population. If slow growth continues for about another controls, corporate bond issues, and new

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©International Monetary Fund. Not for Redistribution stock offerings were dismantled, corpora- Industrial policy. The role of tradi- omy, and if the real exchange rate remains tions were able to raise funds directly in tional industrial policy and export promo- high, recovery is unlikely to be imminent. domestic and international capital markets tion is unquestionably minimal in Japan in Education. The Japanese education instead of borrowing from banks. Bor- the 1990s. Export expansion is not likely to system has successfully produced a homo- rowing costs started to reflect the credit play the key role in Japanese growth that it geneous, group-oriented labor force that risk of corporations, and corporate infor- once did. As a result of trade conflicts with is well versed in basic skills. However, mation was made available to the market, the United States in the late 1980s and the many now argue that the current system rather than being hidden in earnings early 1990s, the opening of the Japanese does not foster the creativity and special- reports that could be deciphered only by economy through the promotion of imports ized skills needed to make breakthroughs the main banks. Some firms took advan- has begun to be emphasized at the expense in research. In particular, it appears that tage of the new environment and repaid all of exports. students are not developing the sort of of their bank loans, thus freeing themselves Saving and investment. Rapid dem- highly specialized computer-oriented skills from the main banks. ographic change is projected to give Japan that will be necessary for tomorrow's thriv- In Japan today, healthy manufacturing one of the oldest populations in the world ing industries. firms can raise funds from capital markets by 2025. The ratio of productive persons The strong pressure to pass university on more favorable terms than banks are (ages 15 to 64) to retired persons (ages 65 entrance examinations encourages high willing to offer. And the banks' decision to and over) is projected to decline from 5.8 in school students to study hard without ques- extend large amounts of debt to the real 1990 to 2.3 in 2025. Even this estimate may tioning the material and trains them to estate sector in the speculative environ- memorize facts rather than to think ment of the 1980s—and the sizable independently. Moreover, since stu- losses they subsequently sustained— "What is needed in Japan dents cannot enter university early, cre- suggests that they are no more prudent is a reorientation of ative thinking and specialized training than other corporations in a deregu- typically must wait until students are lated world. If the banks are so smart at policies, from the 18. Some students are burned out by monitoring the investment projects and manufacturing to the that time. Finally, the use of computers management performance of the firms is limited in elementary and high to which they lend, surely they could service sectors." school education. The ratio of comput- have monitored themselves to avoid ers to students is typically lower in being saddled with nonperforming be too optimistic, since it was made in 1992, Japan than in the United States, for loans worth billions of yen. and in the past few years, the birth rate has example, and it appears that Japanese cur- Keiretsu. The keiretsu system does not fallen further. As noted earlier, the life-cycle riculums lag behind those in the United seem to have served Japan well in the hypothesis suggests that the more retired States in terms of information technology. 1990s. The current frontier of technological persons there are, the lower the saving rate innovation touches industries and compa- becomes. A lower saving rate will reduce Policies for the future nies that are not traditionally affiliated with Japanese current account surpluses (by What is needed in Japan is a reorienta- keiretsu. The horizontal keiretsu are typi- increasing domestic consumption without tion of policies, from the manufacturing to cally composed of large companies in the changing investment) or reduce growth (by the service sectors, and a move away from finance and manufacturing sectors. It is not lowering investment), or both. In any case, government guidance to deregulation of these established firms that are likely to demographic change over the next 30 years markets. More competition in the nontrad- experience the next wave of expansion, but will probably bring down the growth rate, able sectors, such as telecommunications, service industries, such as transportation, unless productivity increases can more airlines, and distribution, will enhance pro- discount retailing, and entertainment. than offset the lower investment rate. Even ductivity gains and lead to lower prices. For their part, the vertical keiretsu are if the bequest motive may have pushed up Thus, both industries and consumers will not generally suited to the organizational the saving rate in the past, it is not certain benefit from structural reform. Hollowing needs of the service sector. In manufactur- (or even likely) that it remains strong today, out of the manufacturing sectors may slow ing, further efficiency gains will depend on since the value of households' assets down if the costs of production are reduced the initiatives of large discount stores and (durables and financial assets) is now at home. However, the transition to a dereg- other retailers to eliminate intermediaries so much greater. Taking these factors ulated environment will no doubt be diffi- or at least to reduce transportation costs together, it seems inevitable that the cult for many sectors. Structural reforms and the profit margins of wholesalers, Japanese saving rate will decline in coming are needed not only in industrial organiza- rather than on the keiretsu relationship. years. tion but also in employment practices and Moreover, the relationship between the Investment in Japan is decreasing in the the education system. Careful implementa- manufacturers and suppliers faces a differ- 1990s. This is partly a correction after the tion of the necessary changes should pro- ent challenge. Although the yen has depre- high levels of investment sustained during vide new engines for growth without ciated against the dollar recently, its long the period of the asset-price bubble, but it is causing too much friction in Japan's period of prolonged strength has led a also partly a result of the fact that high pro- economy. IF&DI growing number of manufacturers to invest duction costs and rigidities in the system abroad, creating the so-called hollowing-out are pushing manufacturing firms to invest phenomenon. Some small suppliers that abroad. If investment abroad is only a tem- This article draws on the author's paper, "Japan have provided these firms with just-in-time porary phenomenon, then domestic invest- and the Asian Economies: A Mirack in deliveries in Japan are finding it difficult to ment in manufacturing will recover soon. Transition,"published in Brookings Papers on follow them to assembly sites abroad. However, given the rigidities in the econ- Economic Activity: 2 (1996).

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