Transcript 3. How Have These Economic Institutions Responded? (cont.)

Crumbling or Transforming?
Japan’s Economic Success and its Postwar
Economic Institutions
Hugh Patrick
Introduction
Japanese economy, the 2nd largest in the world, had become a
mature economy by the 1990s.
Its growth performance in the first half of the 1990s particularly poor
(with virtually zero growth, its worst economic performance).
It was the consequence of the confluence of several major factors:
1.
2.
3.
Inevitable cyclical slowdown, following the domestic investment boom of the
late 1980s.
The bursting of speculative bubbles in 1990-91, with the continued sharp
declines in urban land and stock market prices.
The sudden convergence of accumulative past pressure for restructuring,
especially in labor-intensive manufactures.
Introduction (cont.)
At the same time, Japan pursued an unwise set of policies
 Mismanagement of fiscal and exchange rate policies
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Not wise in expanding fiscal expenditure (on budget deficit).
Lack of adequate import enhancing measures or others, to prevent
continued Yen appreciation.
Asset bubble formed and shattered (many believed that land
prices would never decline deeply or for any sustained period.)


The bursting of the bubble has left huge amounts of NPL.
The bad loan problem created serious difficulties for banking
system (or broader financial system)

Many still hidden and unresolved.
Introduction (cont.)
The economic difficulties of the 1990s put great pressure on many
institutions, challenging their persistence (even the existence of it).
* These institutions developed in the high growth period (1950s
to 1970s), contributing to the high growth.
Q: Will they crumble and fall apart, or will they be transformed
and continue to be effective?
The goal of this paper is to provide an overview of the evolutionary change of
three of the major postwar economic institutions.
1.
The (large firm) industrial relations system.
2.
The main bank system of large firm corporate finance.
3.
The keiretsu system of various forms of business ties among group of firms.
1. The High Growth Era and the Flourishing of Economic
Institutions
Japan’s decades of rapid growth– not a miracle, but a result of the
interactions of the followings:
1.
2.
3.
4.
5.
6.
Available and improving human capital.
Rapidly growing business investment financed by equally rapid increases in
savings (particularly, high private saving rate).
Huge import of foreign technology.
Growth-oriented enterprise managers and entrepreneurs.
Supportive government policies.
Favorable international economic environment.
However, this characterization makes it sound too easy and straightforward.
1. The High Growth Era and the Flourishing of Economic
Institutions (cont.)
Industrial enterprises, as the engine of growth, had to overcome
many obstacles.
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Labor relations initially were typically hostile (strikes were frequent and bitter).
Workers needed on the job training to utilize effectively the firm-specific
requirements of new technologies (& equipments) being imported and adapted.
Constrained in their ability to produce components internally, large enterprises
needed to build stable supplier relation with subcontractors.
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Facing rapidly growing demand for their products & seeking lower cost labor.
The growth opportunities of firms far exceeded their internal financing capabilities,
so that they needed stable mechanism for long term and short term finance.
Economic and business information was scarce, with uncertainty about Japan’s
economic future high, and markets were imperfect, etc.
1. The High Growth Era and the Flourishing of Economic
Institutions (cont.)
The institutional developments of high growth era were designed to:
1.
2.
3.
4.
5.
Reduce transaction cost.
Reduce uncertainty and risk.
To ensure stable supplies of labor and finance to growing large companies.
To enhance information flows.
Develop trustworthy, long term relationships among firms doing business
with each other.
The following institutions made possible a series of ‘positive-sum games’ for the
participants, from which all benefited.
1. The High Growth Era and the Flourishing of Economic
Institutions (cont.)
(1) Lifetime employment system
All regular workers have essentially been guaranteed employment by the firm
from initial hiring until retirement (only in large firms)
In a rapidly growing economy (with high-quality new workers in short supply), this
was a rational & efficient arrangement.
: Presuming that the employee would remain long with the firm, it was advantageous for
both company and employees to invest in developing firm-specific skills.
* Good to be combined with seniority wage system (paid below their MPL earlier in their
career, reap rewards later in their career.)
* Good to be combined with enterprise union: (interests of workers (union) tied to the
success of the firm.)
1. The High Growth Era and the Flourishing of Economic
Institutions (cont.)
(2) The main bank system
Developed in the early postwar period in response to the difficulties for lenders
(banks) in obtaining good information about firms (borrowers) & their projects,
and in monitoring their performance & behavior.
The main bank takes responsibility for monitoring the borrower, as typically being the
largest single lender (not the sole lender).
Under financial & business distress of a firm, the mainl bank takes the lead the
restructuring process, incurring disproportionately larger share of the losses.
1. The High Growth Era and the Flourishing of Economic
Institutions (cont.)
(3) The Keiretsu system : Groups of affiliated business enterprises.
There are at least four types of Keiretsu.
1. Financial Keiretsu
They are the ‘Big Six’, with a bank at the center. Mitsubishi, Mitsui, Sumitomo, Fuyo,
Dai-ichi Kangyo, and Sanwa groups.
Members of each group give preference to each other in business relations, but since they
are in different industries and the group comprises a small share of total number of large
enterprises, the overwhelming proportion of their business is with non-group companies.
2. Vertical Keiretsu (economically very important)
Over time, supplier-buyer relationships developed, based on repeated business and trust,
which made supplier investment in product specific equipment and parts R&D innovations
less risky and mutually beneficial, and the ‘just-in-time’ production system possible.
Toyota a clear example of vertical Keiretsu & many consumeer electronics companies.
1. The High Growth Era and the Flourishing of Economic
Institutions (cont.)
3. Distribution Keiretsu
Refer to the distributions networks of consumer goods manufacturers. The manufacturer
maintains a network of wholesalers and small, nominally independent retailers, who
sell the company’s products (sometinmes, only the company’s products).
Examples: Matsushita in consumer electronics and Shiseido cosmetics.
4. Enterprise Keiretsu
Conglomerates of firms in related industries (one industrial firm at the center & other
affiliated firms surround it), without the same degree of central ownership and control.
One important purpose is to internalize economies external to a single firm.
Eg, urban commuter railroad companies such as Tokyu have built department stores at
the central end of the line, housing or an amusement park at the other end, and
developed land and housing along the line.
Firms such as Hitachi, Toshiba, or Nippon Steel are also enterprise keiretsu
(CONT’D)
Although Japan was a producer-oriented economy, achieving high growth with the
above institutions, virtually all Japanese benefitted during high-growth period.

All (including consumers) shared the fruits of rapid growth (partially generated by the
institutions).
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Distribution & re-distribution policies were effective, resulting in fairly equal income
distribution.
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Real wages continued to increase rapidly.
Protected farmers and small shopkeepers, leading to higher consumer prices.
(accepted by the society).
Social elites (CEOs in big firms) restrained in their material rewards. <cf: US
It was a system with many costs, but the costs were hidden or tolerated as inevitable
byproducts of the rapid & shared growth.
2. Success Undermines Institutions Designed for a Different Era
Successful economic growth inevitably brings about profound structural
change and changes in economic & business environment.
* These systemic changes began to undermine the rationale and effectivess of
the prevailing institutions.
The mid-1970s mark a major turning point for Japan’s economy:
* Japan achieved its objective of “catching up with the “West” in terms of civilian
technology level, GNP per capita, capital labor ratio, and level of human skills, etc.
* Then, the economy shifted to a 4, 5% growth rate in 1975-1991, a sharp decline from
over 9% rate of the high growth era, rather than a gradual slowing down.
* The first oil crisis in 1973-74 was traumatic
: business became less optimistic about future growth prospects, so that increase in
investment slowed dramatically, until the investment boom in late 1980s.
2. Success Undermines Institutions Designed for a
Different Era (cont.)
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Shift from a Schumpeterian economy to a Keynesian economy.
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From an economy with (I>S) to an economy with (S>I),
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A surplus of saving over investment.
From AD>AS to AD<AS (Insufficient domestic private demand ever since 1974).
Banks had ample funds, with slower growth of loan demand.
Its depressing impact on the economic growth had been offset by
some other factors until 1990.
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Upto 1980, offset by government deficit spending.
During 1981-1985, offset by export boom (due to undervalued Yen), with
substantial current account surplus. (“export excess saving”)
During late 1980s, offset by business investment boom.
Serious recession (virtally zero growth) in the early 1990s. (‘lost decade’)
2. Success Undermines Institutions Designed for a Different
Era (cont.)
Internationally, the 1970s was a turning point, too.
Japan began to be perceived to be a “big country”, since the early 1970s.
* Japan’s domestic policy began to affect other countries & world market.
Also, Japanese companies had become large, strong, and (in several
sectors) major global competitors.
* They could cope with the foreign pressure to liberalize trade & capital flows,
* In many sectors, firms benefited from increased participation in the world economy.
* Large firms became more risk averse in a slower growth environment.
* Some industries & firms did much better than others, as the comparative advantage
evolved (changed) over time (growint industry vs. declining industry).
2. Success Undermines Institutions Designed for a Different
Era (cont.)
Bretton Woods fixed exchange rate system collapsed in 1973.
* Market-based flexible exchange rate system replaced government-based one.
* Short-term volatility in exchange rate substantially increased.
Japan’s experience in past two decades exceptional in three respects.
1.
2.
3.
Japan’s cumulative current account surplus had made Japan the world’s largest
creditor nation.
Japan’s productivity gains have occurred particularly in export-oriented industries.
- Substantial productivity gap emerged between tradable good sectors and nontradable (service) sectors, contributing to the Yen appreciation.
A huge gap between high prices in Japan and world prices, even in manufactured
products where trade barriers are low, not just in agricultural products where high
protection continues. (allow further appreciation of Yen).
* Reveal Japan’s unique (closed) distrubution & supplier-buyer networks.
2. Success Undermines Institutions Designed for a Different Era
(cont.)
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Yen appreciation has had two major impacts.

Shift in Japan’s comparative advantage more clear, losing comparative
advantage in standard, labor-intensive manufacturing.
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Bring in increase in volume of manufactured imports (less in value terms).
Accelerate outflow of FDI (to low wage countries in Asia).
However, proper adjustment in industrial structure delayed due to oil crisis (Yen
depreciated) and over-valued dollar in the early 1980s.
Huge foreign exchange losses on Japanese-held foreign assets.
Other major changes in Japanese economy

Rapidly aging population (demographic change).
3. How Have These Economic Institutions Responded?

The Permanent Employment System
A key condition for the system is that “demand for labor rises steadily.”
This system gets problematic when cyclical decline is steep & sustained, or firm loses
competitiveness over the long-run.
Firms have always recognized this, developing variety of safety valves under this system,
which include:
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Extensive overtime under normal conditions
Use of contract workers, part time workers, female workers (higher attrition rate)
As recession has persisted (& increasing number of workers become redundant), none
of the above measures sufficient.
3. How Have These Economic Institutions Responded? (cont.)
The Permanent Employment System (cont.)
The fundamental problem is that most manufacturing firms require fewer workers since the
mid 1970s, as the economy’s growth rate dropped by half.
Firms began cutting their labor force, including the substitution of part-time production
workers for full-time employees.
* Part time workers comprised 7.2% of the labor force in 1980, these numbers had
increased to 14.5% by 1993.
Even so, large Japanese firms face both excessive numbers of middle managers (45 to 50
yrs old) and excessive layer of white-collar workers.
While the permanent employment commitment maintained in principle (form),
actual practices arose in reduction in managerial workers and wage costs.
* Early retirement packages, transfer to subsidiaries & affiliated firms, etc.
3. How Have These Economic Institutions Responded? (cont.)
The Permanent Employment System (cont.)
The key challenge is reducing the layers of management and numbers of white-collar staff in
order to cut overhead costs. (Overhead costs ballooned while production costs were
being cut.) Firms realize they must re-engineer their white-collar operations.
Some argue that the permanent employment system will disintegrate
and that firms will abandon making new permanent employment commitments to
newly hired employees.
Author does not agree.
1.
2.
Firms face a prisoner’s dilemma; no single firm can abandon the system without
loss of reputation and difficulties in recruiting good new workers.
With permanent employment, firms will deal with long run shortages of qualified
labor (with longer-run reality of labor shortage).
3. How Have These Economic Institutions Responded? (cont.)
The Permanent Employment System (cont.)
Adjustment have been taking place in other aspects of the industrial relations
system, too.
Seniority wage increases have steadily become a smaller component (while
merit- or performance- based portion of wage increased).
The competition for promotion becoming more intense, as the pressure to reduce
employment increases.
* Promotion already based on performances (with seniority as basic criterion).
The enterprise union system will continue, with decreasing unionization rate.
3. How Have These Economic Institutions Responded? (cont.)
The Permanent Employment System (cont.)
The serious structural problem lies in labor intensive (small and medium)
manufacturing enterprises, which are competed out by imports and company
decisions to invest & produce abroad (in low-wage countries).
These employees do not have permanent employment contracts and many easily laid off,
ultimately increasing unemployment.
In the past, many of the laid-off manufacturing workers were absorbed in diverse personal
service businesses and in small family-owned businesses.
Q: Will labor market flexibility be sufficient to absorb several million newly laid-off
workers, much greater than unemployment in the past?
3. How Have These Economic Institutions Responded? (cont.)
The Permanent Employment System (cont.)
The most effective mechanism for labor re-allocation is steady & decent (about
3%) growth, which will create the jobs into which laid-off workers from
declining industries can be absorbed.
The adjustment process will be eased by the demographic reality of labor force decrease.
In the long-term, returning to the growth potential can resolve the unemployment problem.
Short-term problem (as of mid-1990s) is how to generate sufficient new jobs to absorb
those losing jobs in uncompetitive manufacturing sectors.
The transition will be a difficult process, requiring lots of government programs.
3. How Have These Economic Institutions Responded? (cont.)
The Main Bank System
It provided finances to large industrial corporations at a time when information was
scarce and poor, monitoring could be done more effectively by banks, and
rapidly growing firms had huge demand for external finance.

Economic success & the following slower growth weakened rationale of the system.
* Firms became large, more information available, and need much smaller
amount of external fund (facing slower growth with large internally reserved funds).
* Gradual liberalization of financial system led to increasing role of corporate
bond market.
: Previously, development of a corporate bond market had been prevented by MoF which
ensured leading roles to long-term credits banks and main banks in large firm finance.
* Once firms became large and creditworthy, bond issue (particularly, Euro bond) became
cheaper form of finance than bank loans.
* government bond issue & its transaction in secondary market provide the basis.
3. How Have These Economic Institutions Responded? (cont.)
The Main Bank System (cont.)
The benefits of the system were reduced and the costs increased.
* Companies need less external funds, increasingly meeting the needs through bond
market.
* As firms became strong & information more available, bank monitoring became
‘formality’.
* Bilateral bargaining power shifted from the main bank to the industrial corporation.
* Company main-bank relationship not terminated, but weakened.
The banks sought new customers (markets),
* Some in international financial market,
* Others in domestic market of medium/small firms (used to be served by local banks).
* Most banks moved into real estate projects (seemed safe), engendering speculative
land bubble. (As bubble bursts with sharp decline in real estate prices, the NPL of the
banks increased remarkably, suffering large losses).
* Similar problem (large loss) erupted as stock market plunged in the early 1990s.
3. How Have These Economic Institutions Responded? (cont.)
The Main Bank System (cont.)
Q: Will major banks continue to serve as main banks, when they lose their best
industrial clients to capital market?
Q: Will they establish the main bank relationship with other weaker borrowers?
Answer: The main bank system will not disappear, but become more complex.
* With strong firms not borrowing much from banks, traditional relationships will be
much looser but not disappear.
- Some firms within a group (keiretsu) will rely more on bank loans than capital
market funding, with the main bank relationship continuing.
* Banks will find new main-bank clients in smaller (growing) firms,
: The firms would benefit from the reputation of having a prestigious main bank and
the bank’s broader and deeper experiences (in a range of economic and operational
issues), and its range of financial services in addition to its loans.
3. How Have These Economic Institutions Responded? (cont.)
The Keiretsu system
Traditional keiretsu forms of relationships have come under pressure
from four major sources.

1.
2.
3.
4.
Rising labor costs
Decisions of manufacturing firms to move & produce abroad.
Increasing competition in domestic markets from new sources (domestic and
foreign)
The search for new technological partners
The effects of the pressure would vary according to the type of
keiretsu.
3. How Have These Economic Institutions Responded? (cont.)
The Various Forms of Keiretsu (cont.)
Distribution Keiretsu have been under pressure both from rising labor costs and
increasing competition.
* For many products, sole-distributorship retail stores, are too small to be efficient.
* Competition from discount stores, department stores, and new forms of sales outlets
makes it more difficult to sustain the price in sole distributor system.
* Japan is in the midst of a distribution revolution in which traditional patterns are being
undermined, and distribution channels widened (combined with surge of cheap imports).
Distribution Keiretsu will erode, but will not disappear entirely.
3. How Have These Economic Institutions Responded? (cont.)
The Various Forms of Keiretsu (cont.)
The strong market pressure is put on the vertical keiretsu.
* Components & parts produced in Japan by labor intensive methods are no longer competitive.
However, the supplyer-buyer relaitonships are difficult to terminate, because they
are long-term one, built upon mutual trust.
* They often embody non-economic elements which solidify such relations.
* Those assemblers terminating the relations will suffer reputation loss.
The vertical keiretsu will not disappear, rather being internationalized, with a
more complex sourcing strategy emerging.
1) Design-intensive, high-tech, high value added components continue to be produced in
Japan (for domestic & overseas Japanese assemblers).
2) Japanese producers of medium-tech components establish subsidiaries abroad.
3) Standard labor-intensive compenents produced abroad by local firms for local Japanese
assembler or for assembler in Japan (on a stable, long-term supplier relationship.)
3. How Have These Economic Institutions Responded? (cont.)
The Various Forms of Keiretsu (cont.)
The relationship among the Big Six financial keiretsu members are gradually
loosening.
* As each firm becomes very large, it has become increasingly autonomous with many
members turning to bonds rather than relying on their keiretsu main bank for finance.
Member firms seldom set up joint venture with each other to enter new line of business.
Often, alliance made to access complementary & synergistic technology, with non-keiretsu
firms.
However, the financial keiretsu will not disappear entirely, because some benefits of
membership will persist.
3. How Have These Economic Institutions Responded? (cont.)
The Various Forms of Keiretsu (cont.)
Enterprise keiretsu face the same pressures and challenges as the financial
keiretsu.
However, because they are based on internalization of economies external to
the individual firm, but to the group, they will persist.
When some firm within the keiretsu is making losses with poor prospects, it is not likely that
other members will provide help (eg. disappearance of keiretsu-dominated aluminum
industry when it became uncompetitive with oil crisis).
Conclusion
Japan’s postwar economy has gone through four phases:
1.
2.
3.
4.
Reconstruction (1945 – mid 1950s)
High growth (mid 1950s – 1974)
Good growth (1974 – 1991)
Maturity (1992 – present)
A number of economic institution developed & flourished in the high growth period.
Many institutions became of lesser benefit as growth moderated & Japan became an
economic & technological leader.
* Many features of the earlier economic institutions get counter-productive and inefficient
as Japan became a mature economy.
However, the basic structure of the institutions will remain, even as major elements
will erode & change in response to changing economic realities.