Japan's Seeds of Malaise

November 7th, 2013
in Op Ed

by John West, Asian Century Institute

Japan's iron triangle of big business, bureaucrats and politicians drove its post-war rise. But they also planted the seeds of its present malaise, which Abenomics must now tackle.

Japan's iron triangle of big business, bureaucrats and politicians drove the country's post-war rise. They also planted the seeds for its present malaise, which Abenomics must now tackle. But as Akira Amari, Japan's minister in charge of economic revitalisation, has said, Abenomics will take a long time to achieve its desired results.

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The Japanese government understood the importance of trade for the economy. Being highly dependent on imported natural resources, Japan needed to export in order to finance these imports. But the government (notably the Ministry of International Trade and Industry) believed that the guiding hand of government was necessary to drive this export-oriented development (this is often referred to as the "developmental state").

In the immediate post-war period, labor-intensive industries like textiles and toys exploited Japan's comparative advantage based on its large pool of low-wage workers. But the government wanted to create new comparative advantages, notably heavy industries involving higher technology and value added.

So MITI targeted certain industries by providing incentives like easy access to low-cost finance, duty-free imports of necessary machinery, infusions of foreign technology, and protective trade barriers against imports. The idea was to encourage Japanese companies to invest, develop and climb the technological ladder.

Exporting to global markets was key to the strategy, because competition with American and European companies forced Japanese companies to become efficient, high quality producers. Since the goal was creating home-grown industries, multinational companies were not welcome in Japan, as they might stifle the development of Japanese business. Even today, Japan still has an extremely low amount of foreign direct investment.

The other arm of the "iron triangle" was government money that financed Japan's outstanding infrastructure. All too often, however, the objective was to indirectly buy votes for local politicians, thanks to the business and jobs created in local regions. Companies underpinned social stability by providing job security, often life-time employment to their employees. And most companies also had a group of small and medium enterprises that supplied components and parts, and were treated as part of the corporate family.

The policy of targeting certain industries had some early successes, like steel and shipbuilding, and later on, semi-conductors. There were also failures like the high-profile, but unsuccessful attempt to build a commercial air craft industry. And some of Japan's most successful industries, including motorcycles, robotics, fax machines ad consumer electronics, prospered without significant support from MITI.

Overall, MITI's policies were effective in nurturing entrepreneurship, encouraging industrial upgrading, and taking advantage America's open markets and security blanket. The magic of its approach was that its interventions were generally "market-conforming", meaning consistent with Japan's comparative advantage -- in contrast with the import-substitution policies of many Latin American and African countries.

The policy also sought to create globally competitive companies. And Japan managed to create world-beaters in many industries like semiconductors, motorcycles and pianos.

When American and European protectionist pressures rose against Japanese exports, and the Japanese yen appreciated following the 1985 Plaza Accord, many Japanese companies transferred production facilities to foreign markets. The classic example was the Japanese automobile industry which conquered the US and other markets.

Japanese automobile producers rose to the top of the global pack, becoming more efficient than American auto producers, thanks to innovations like: "lean manufacturing systems"; "kaizen" or "continuous improvement" by which workers were encouraged to suggestions for efficiency improvements; and "just-in-time" production systems which minimised stock holding and wastage. Moreover, they produced small, fuel-efficient models, which American producers did not.

But when Japan's real estate and stock market bubbles burst in the early 1990s, the seeds of malaise became evident -- even though MITI's interventionist policies had declined in importance from the 1950s and 1960s.

The cosy relationships of the iron triangle had many perverse effects. Easy finance encouraged over-investment, especially since credit was often granted because of connections, rather than rigorous credit analysis. The drive for export market share led to low profitability. Hubris resulted in extravagant investments like the Rockefeller Center, and Columbia Pictures. And there were many corruption scandals and abuses of corporate governance.

Many companies awoke to the reality of the three "excesses", namely excessive workforces, excessive debt and excessive production capacity, created by the iron triangle partnership. The initial reaction was denial, and hope that stock and real estate markets would recover.

Eventually Japanese companies had to face reality. Thus many underwent a long adjustment period, as they unwound these excesses and progressively off-shored more parts of their production operations. Many of these companies were "zombies" which should have gone bankrupt, but were kept afloat by connections with banks and government. And while corporate Japan was slowly getting itself back in shape, dynamic enterprises from Korea, Taiwan and more recently China and India moved to the center of the global stage.

Today Japan remains very competitive in some sectors like automobiles. It is still a world leader in high tech components for planes, mobile phones, automobiles, and in many other areas. And it is also strong in areas like environmental technologies, and robotics. But its once-famous electronics industry is struggling, and its banks have faded from the global scene.

The iron triangle proved effective at pushing Japanese companies up the development and technological ladder, by absorbing, developing and refining existing world technologies. But it became less relevant and effective in taking Japan forward as an innovation-driven economy.

Indeed, while the guiding hand of government is less present than it used to be, the Japanese government still has too many hands on the economic levers, when the country's creative energies need to be fully unleashed.

For example, starting a business can be a nightmare! Japan may still have the world's third biggest economy, but according to the World Bank it ranks 114th in the world (out of 185 countries) in terms of how easy it is to start a business. Paying taxes is also not easy, with Japan ranked 127th. Other challenges include dealing with construction permits (72nd), and registering property (64th).

Of all the advanced OECD countries, Japan has the most restrictive policies for foreign direct investment according to a recent OECD study, only exceeded by non-OECD countries like India, Jordan, Indonesia, Saudi Arabia and China! It is thus not surprising that Japan has one of the world's lowest stocks of inward foreign investment. It represents just 3% of GDP, even lower than its Asian neighbors with worse policies, like China (10% of GDP), Indonesia (22%) and India (12%). A recent World Economic Forum report was also critical of Japan's financial system which lags in terms of information disclosure, and is weak in providing access to financial services.

At a time when Japan needs innovation-driven growth, it is lagging in the global innovation race, and ranks well behind Hong Kong, Singapore and Korea in the Global Innovation Index, and is not very far ahead of China.

While Japanese industry is still a global force, it is not a "relentless juggernaut destined for global hegemony", many had feared. Indeed, with GDP per capita and labor productivity well below OECD leaders, Japan is underperforming -- at a time when strong performance is necessary to cope with its massive debt burden and dramatically aging population.

The Japanese government must make a very serious effort to implement the full Abenomics program, even if it will take a long time to succeed. In particular, it is imperative remove the interfering hands of elite government, business and finance which are holding back the necessary renewal of the country. The days for the iron triangle and the development state policies are long past.

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