Testimony

Only Japan Can Solve Japan’s Problems

Subcommittee on Trade
Committee on Ways and Means
United States House of Representatives

Mr. Chairman and members of the Trade Subcommittee, I appreciate the opportunity to come before you today to discuss the current economic problems in Japan and their impact on U.S.-Japan trade relations.

Putting the matter bluntly, Japan’s economy is a mess. The 1990s have been a lost decade, with growth since 1992 averaging around 1 percent a year. A recession, and perhaps a serious one, is now under way. Unemployment is at record highs. A black hole of bad debt has sucked the life out of the banking system.

Those are just the short-term problems. The deeper structural flaws of the Japanese system are even more daunting. Japan’s whole system for allocating capital is broken. The rate of return on capital has now fallen below that in Europe and is less than half the U.S. rate. And over the next two decades, the working-age population will fall by 20 percent - bad news for growth, and even worse news for the country’s public pension system.

These grim facts are certainly cause for concern, but they should also be cause for acute embarrassment on the part of those Japan “experts” who not so long ago were claiming that the Japanese economic model was vastly superior to our own. As we discuss in a paper to be published shortly by the Cato Institute, those so-called “revisionists” believed they had discovered in Japan a new and superior form of capitalism: the so-called capitalist development state. James Fallows put it this way back in 1989: “Japan and its acolytes, such as Taiwan and Korea, have demonstrated that in head-on industrial competition between free-trading societies and capitalist developmental states, the free traders will eventually lose.” Clyde Prestowitz wrote a book the year before in which he alleged that the United States and Japan were “trading places.” And as recently as 1995, Chalmers Johnson went into print with his wisecrack: “The Cold War is over, and Japan won.”

What happened? Why did these men, and many others as well, get things so wrong? At the root of the matter is the fact that they completely misread the significance of Japan’s distinctive system of allocating capital. They thought it was a major source of Japan’s strength. It turned out to be an Achilles’ heel.

The Japanese financial system systematically insulated decisions about allocating capital from market signals. With a heavy reliance on bank lending, an absence of transparency and full financial disclosure, and a suppression of equity markets through stable cross-shareholding, the Japanese system allocated funds according to established relationships and government targeting of “strategic” industries rather than in pursuit of the highest return.

The revisionists praised this system for its long-term focus. Access to “patient capital,” they believed, took pressure off managers to achieve short-term profitability and freed them to concentrate on market share. In fact, however, the absence of market discipline and feedback has caused the Japanese economy to flounder, and has wasted the hard-earned savings of the Japanese people on a truly mind-boggling scale.

Despite the shortcomings of its financial system, the Japanese economy was able to perform impressively as long as it was playing technological catch-up with the more advanced West. It is much easier to grow and improve productivity quickly by adopting and adapting technologies invented elsewhere than by developing those new technologies internally. And capital can be allocated productively even when market returns are more or less ignored, provided that the trail of economic development has already been blazed. Once, however, Japan reached the technological frontier, the absence of direction from market signals became a serious hindrance.

Ultimately, the blame for Japan’s current problems lies with its failure to make the transition from “capitalist development state” to a mature economy at the technological frontier. Instead of making that transition, Japan first faked prosperity by inflating the bubble economy in the late 1980s; then, after the bubble burst, it refused to introduce market accountability into the system. Rather, the Japanese authorities let the bad debt problem fester and worsen. This rot at the core of things has crippled the whole economy.

To regain economic health, Japan must address the bad debt crisis. Insolvent institutions must be allowed to fail, weak institutions must be merged into stronger ones, good assets must be separated from bad, and bad assets must be foreclosed on and written off. Without resolution of this central problem, the Japanese financial system will remain paralyzed, and any other beneficial reforms are therefore unlikely to do much good. After all, it’s hard to have capitalism without capital.

In concert with cleaning up the bad debt mess, Japan does need to make additional, broader reforms if it is to recapture its former vibrancy and dynamism. Most importantly, Japan must restructure its entire financial system. It must allow foreign money in, and domestic money to leave freely. It must break down artificial barriers and allow competition to hold sway. In addition, an overhaul of Japan’s tax system - and especially a reduction in marginal rates on personal and corporate income - is needed to unleash the productive energies of the Japanese people.

Will these things happen? On the positive side, the recently announced “total plan” at least creates a structure for dealing with the bad debt crisis that could work; also, the “Big Bang” reforms on financial sector deregulation are promising, and some kind of permanent tax cuts appear to be in the works. But implementation is everything, and the political obstacles that stand in the way of successful follow-through are formidable. At this point, healthy skepticism remains in order. And even if Japan does everything right, the next couple of years promise to be rough ones.

Whatever happens, we must face the fact that there is little the United States can or should do to affect the situation. This is a Japanese domestic problem, and it will be handled - or not - by the Japanese in accordance with domestic political realities. The United States can helpfully point out necessary reforms, or it can confuse the issue with bad ideas and irrelevant diversions. But whatever it does, it does from the sidelines. Japan’s future is up to Japan.

It is important to distinguish our present concerns about Japanese policy from our long history of trade disputes about access to the Japanese market. Trade disputes should deal only with government policies that discriminate against goods or services of foreign origin. The dysfunctional Japanese policies at issue don’t fit that description. Failure to clean up banks’ bad debts does not discriminate against foreigners. Neither do punitive tax rates on corporate and personal income. Neither does the hopeless attempt to jump-start economic growth with wasteful public works spending.

It is argued, though, that Japan’s problems do affect the rest of the world. Japan’s economic weakness is exacerbating the larger crisis in East Asia, and a full-scale Japanese meltdown could drag the rest of the world into recession. There is validity to this line of analysis, although the point can be overstated. After all, the situation in the rest of East Asia is hurting Japan as much or more than the reverse. Furthermore, the U.S. and IMF bailout of Mexico is more to blame for the Asian crisis than anything Japan did.

Nevertheless, it is true that we live in an interconnected world. Prosperity in Japan is good for us, and problems in Japan are bad for us. Our present concerns about Japanese weakness should serve as a lesson to those who used to argue that Japanese strength was a threat to our welfare.

But if this is an interconnected world, it is also a world of sovereign nations. As much as it pains us, we do not control the domestic economic policies of other countries. Western Europe, for example, has suffered for years now from chronic double-digit unemployment. This problem saps the vitality of that continent, and may over the long term breed serious social pathologies. At the root of the problem are bad policies - namely, rigid labor market regulations and dependency-generating social insurance programs. Although Americans would certainly benefit from a more dynamic Europe, we realize that we have little standing or leverage to affect domestic policies there.

We need to come to the same realization with respect to Japan. Unfortunately, standing in the way is a longstanding dynamic in which the United States makes demands and Japan eventually makes concessions. That dynamic has been profoundly unsatisfactory to both sides: the Japanese bridle at being treated like less than a sovereign nation, while we are often frustrated when concessions turn out to be hollow and meaningless gestures.

But whatever the questionable merits of gaiatsu, or foreign pressure, in addressing specific market access issues, it stands no chance of being effective in the present situation. It has been estimated, using fairly conservative assumptions, that the Japanese bad debt mess is six times larger than the U.S. savings-and-loan crisis relative to the overall national economy. Successful resolution would surely cause a wave of bankruptcies and a dramatic rise in already record levels of unemployment. On the other hand, failure to come to grips with the problem could lead to a total collapse of the financial system. In short, the domestic stakes are so tremendous that U.S. nagging will barely even register in the balance.

If Japan does make necessary reforms, the process will be driven not by foreign political pressure, but by economic pressure. Japan announced its “Big Bang” reforms not because of U.S. haggling, but because of the perception that Tokyo was becoming a financial backwater compared to the more competitive and dynamic markets in New York and London. Likewise, the pressure of yen leaving the country in search of a decent return will do more to promote financial restructuring than any amount of U.S. table-pounding. In this regard, it should be noted that currency interventions to prop up the yen perversely alleviate that pressure, although the effect is probably only fleeting.

Over the long term, the most effective thing we can do to encourage market-oriented reforms in Japan is to set a good example. If the United States keeps its own house in order, our superior economic performance will act as a spur to the Japanese, and other countries around the world, to follow our lead. In the end, though, we cannot force the Japanese to do what’s good for them.

Thank you again for inviting me here today, and I look forward to answering any of your questions.