Only Japan Can Solve Japan’s Problems

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Mr. Chairman and members of the Trade Subcommittee, I appreciatethe opportunity to come before you today to discuss the currenteconomic problems in Japan and their impact on U.S.-Japan traderelations.

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

Those are just the short-term problems. The deeper structuralflaws of the Japanese system are even more daunting. Japan's wholesystem for allocating capital is broken. The rate of return oncapital has now fallen below that in Europe and is less than halfthe U.S. rate. And over the next two decades, the working-agepopulation will fall by 20 percent - bad news for growth, and evenworse news for the country's public pension system.

These grim facts are certainly cause for concern, but theyshould also be cause for acute embarrassment on the part of thoseJapan "experts" who not so long ago were claiming that the Japaneseeconomic model was vastly superior to our own. As we discuss in apaper to be published shortly by the Cato Institute, thoseso-called "revisionists" believed they had discovered in Japan anew and superior form of capitalism: the so-called capitalistdevelopment state. James Fallows put it this way back in 1989:"Japan and its acolytes, such as Taiwan and Korea, havedemonstrated that in head-on industrial competition betweenfree-trading societies and capitalist developmental states, thefree traders will eventually lose." Clyde Prestowitz wrote a bookthe year before in which he alleged that the United States andJapan were "trading places." And as recently as 1995, ChalmersJohnson 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, getthings so wrong? At the root of the matter is the fact that theycompletely misread the significance of Japan's distinctive systemof allocating capital. They thought it was a major source ofJapan's strength. It turned out to be an Achilles' heel.

The Japanese financial system systematically insulated decisionsabout allocating capital from market signals. With a heavy relianceon bank lending, an absence of transparency and full financialdisclosure, and a suppression of equity markets through stablecross-shareholding, the Japanese system allocated funds accordingto established relationships and government targeting of"strategic" industries rather than in pursuit of the highestreturn.

The revisionists praised this system for its long-term focus.Access to "patient capital," they believed, took pressure offmanagers to achieve short-term profitability and freed them toconcentrate on market share. In fact, however, the absence ofmarket discipline and feedback has caused the Japanese economy toflounder, and has wasted the hard-earned savings of the Japanesepeople on a truly mind-boggling scale.

Despite the shortcomings of its financial system, the Japaneseeconomy was able to perform impressively as long as it was playingtechnological catch-up with the more advanced West. It is mucheasier to grow and improve productivity quickly by adopting andadapting technologies invented elsewhere than by developing thosenew technologies internally. And capital can be allocatedproductively even when market returns are more or less ignored,provided that the trail of economic development has already beenblazed. Once, however, Japan reached the technological frontier,the absence of direction from market signals became a serioushindrance.

Ultimately, the blame for Japan's current problems lies with itsfailure to make the transition from "capitalist development state"to a mature economy at the technological frontier. Instead ofmaking that transition, Japan first faked prosperity by inflatingthe 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 festerand worsen. This rot at the core of things has crippled the wholeeconomy.

To regain economic health, Japan must address the bad debtcrisis. Insolvent institutions must be allowed to fail, weakinstitutions must be merged into stronger ones, good assets must beseparated from bad, and bad assets must be foreclosed on andwritten off. Without resolution of this central problem, theJapanese financial system will remain paralyzed, and any otherbeneficial reforms are therefore unlikely to do much good. Afterall, it's hard to have capitalism without capital.

In concert with cleaning up the bad debt mess, Japan does needto make additional, broader reforms if it is to recapture itsformer vibrancy and dynamism. Most importantly, Japan mustrestructure its entire financial system. It must allow foreignmoney in, and domestic money to leave freely. It must break downartificial barriers and allow competition to hold sway. Inaddition, an overhaul of Japan's tax system - and especially areduction in marginal rates on personal and corporate income - isneeded to unleash the productive energies of the Japanesepeople.

Will these things happen? On the positive side, the recentlyannounced "total plan" at least creates a structure for dealingwith the bad debt crisis that could work; also, the "Big Bang"reforms on financial sector deregulation are promising, and somekind of permanent tax cuts appear to be in the works. Butimplementation is everything, and the political obstacles thatstand in the way of successful follow-through are formidable. Atthis point, healthy skepticism remains in order. And even if Japandoes everything right, the next couple of years promise to be roughones.

Whatever happens, we must face the fact that there is little theUnited States can or should do to affect the situation. This is aJapanese domestic problem, and it will be handled - or not - by theJapanese in accordance with domestic political realities. TheUnited States can helpfully point out necessary reforms, or it canconfuse the issue with bad ideas and irrelevant diversions. Butwhatever it does, it does from the sidelines. Japan's future is upto Japan.

It is important to distinguish our present concerns aboutJapanese policy from our long history of trade disputes aboutaccess to the Japanese market. Trade disputes should deal only withgovernment policies that discriminate against goods or services offoreign origin. The dysfunctional Japanese policies at issue don'tfit that description. Failure to clean up banks' bad debts does notdiscriminate against foreigners. Neither do punitive tax rates oncorporate and personal income. Neither does the hopeless attempt tojump-start economic growth with wasteful public works spending.

It is argued, though, that Japan's problems do affect the restof the world. Japan's economic weakness is exacerbating the largercrisis in East Asia, and a full-scale Japanese meltdown could dragthe rest of the world into recession. There is validity to thisline of analysis, although the point can be overstated. After all,the situation in the rest of East Asia is hurting Japan as much ormore than the reverse. Furthermore, the U.S. and IMF bailout ofMexico is more to blame for the Asian crisis than anything Japandid.

Nevertheless, it is true that we live in an interconnectedworld. Prosperity in Japan is good for us, and problems in Japanare bad for us. Our present concerns about Japanese weakness shouldserve as a lesson to those who used to argue that Japanese strengthwas a threat to our welfare.

But if this is an interconnected world, it is also a world ofsovereign nations. As much as it pains us, we do not control thedomestic economic policies of other countries. Western Europe, forexample, has suffered for years now from chronic double-digitunemployment. This problem saps the vitality of that continent, andmay over the long term breed serious social pathologies. At theroot of the problem are bad policies - namely, rigid labor marketregulations and dependency-generating social insurance programs.Although Americans would certainly benefit from a more dynamicEurope, we realize that we have little standing or leverage toaffect domestic policies there.

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

But whatever the questionable merits of gaiatsu, or foreign pressure, in addressing specificmarket access issues, it stands no chance of being effective in thepresent situation. It has been estimated, using fairly conservativeassumptions, that the Japanese bad debt mess is six times largerthan the U.S. savings-and-loan crisis relative to the overallnational economy. Successful resolution would surely cause a waveof bankruptcies and a dramatic rise in already record levels ofunemployment. On the other hand, failure to come to grips with theproblem could lead to a total collapse of the financial system. Inshort, the domestic stakes are so tremendous that U.S. nagging willbarely even register in the balance.

If Japan does make necessary reforms, the process will be drivennot by foreign political pressure, but by economic pressure. Japanannounced its "Big Bang" reforms not because of U.S. haggling, butbecause of the perception that Tokyo was becoming a financialbackwater compared to the more competitive and dynamic markets inNew York and London. Likewise, the pressure of yen leaving thecountry in search of a decent return will do more to promotefinancial restructuring than any amount of U.S. table-pounding. Inthis regard, it should be noted that currency interventions to propup the yen perversely alleviate that pressure, although the effectis probably only fleeting.

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

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

Brink Lindsey

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