Japan

Japan’s Economy in the Twentieth Century Overview By almost any definition, Japan’s economy turned in a remarkable performance starting in the last quarter of the nineteenth century and continuing through most of the twentieth. To cite just one statistic, annual output grew a massive 70-fold between 1885 and the end of 1999. The American economy, in comparison, expanded at less than half that rate. This absolute increase in the sheer size of economic production in Japan brought with it an immense multiplication of the standard measures for gauging economic welfare. For example, the average value of national income per person expanded by a factor of almost With its stellar performance by this and other yardsticks, Japan demonstrated to the world that it was not necessary to be European or North American to get rich. The more recent takeoff of economies in Asia and elsewhere in the developing world owes much to this example and to the lessons, learned and mis learned, from the Japanese experience. This chapter outlines the main trends of Japan’s economy over the twentieth century. Before proceeding, though, a word needs to be said about the data that were used to calculate the long-term trends discussed here. To construct more or less consistent information spanning a centuryplus, several shorter time series that had been compiled on different occasions had to be strung together. The need to convert monetary values into quantities that reflect general price changes introduced additional complications. Therefore, the analysis should carry a large, bold-faced warning: Read with caution. To say, for instance, that real gross national product per capita in 1885 was ¥188,000 in 1990 prices compared with a 1999 figure of ¥3,866,000 is, at best, a gross characterization—although not necessarily a mischaracterization. Fine distinctions are not warranted by the quality of the data. Pre-Meiji Foundations of the Modern Japanese Economy The rapid industrialization of Japan following the Meiji restoration in 1868 surprised most contemporary observers. Japan’s military defeat of China in 1895 and Russia 10 years later demonstrated a mastery of modern technology and industrial practice that could be brought to bear in a compelling fashion. According to figures compiled by growth economist Angus Maddison, Japan’s economic performance over the years 1870 to 1913 was exceeded by only seven countries out of the 29 examined. From 1950 to 1973, no other country did as well as Japan. Such an amazing track record raises the question of its foundations. What was happening inside Japan before its economic prowess startled the world? For the 250 years that ran from the beginning of the 1600s to the middle of the nineteenth century, Japan’s leaders cut the nation off from contact with other countries. The Tokugawa shoguns who ruled during this period from their capital in Edo—now Tokyo—prohibited the construction of oceangoing ships and severely punished unauthorized contact with foreigners. In 1600, the largely peasant Japanese economy was not that different from most of the rest of the world in terms of technology and living standards. In the intervening years, however, the industrial revolution in Great Britain and then in North America created technology, growth, wealth, and capabilities that far surpassed what was happening in the isolated islands of Japan. Despite the absence of the fruits of the industrial revolution that were transforming the West, Japan was not undeveloped. It boasted three of the largest cities in the world; Edo alone had more than 1,000,000 inhabitants. With this urbanization came the creation of craft industries and merchant classes that processed the food and other materials of the countryside and catered to society’s elites as well as to the tastes and the incomes of the masses. Sophisticated as well as popular arts flourished. Japan’s Economy in the Twentieth Century 3 When Japan began to open in the 1850s, the West was astounded by the creativity that had thrived there out of sight. Western artists and manufacturers quickly incorporated Japanese ideas into their own products. Although most Japanese production was in small craft shops that used little capital, several mining establishments employed more than 1,000 full-time laborers apiece. Spread around the country were 80 to 90 iron mines, each of which had around 300 workers. The growth of an iron industry promoted the beginnings of a factory system, with the attendant accumulation of capital and the organization of paid work. The production and marketing of products for urban centers and the taxes-in-kind imposed on feudal lords based on rice output led to the growth of sophisticated financial practices and markets. Osaka was the main financial center. A small group of bankers performed many of the functions of a central bank, acting as lenders of last resort, making loans to local governments, controlling the level of bank credits, and establishing a market between gold and bank money. A rice market in Osak a featured such modern activities as futures trading. The population was relatively well fed, housed, clothed and educated. About 40 percent to 50 percent of all males and about half as many females benefited from some formal schooling. Temple schools in rural areas spread literacy, with 30 percent to 40 percent of males able to read and write.4 According to World Bank estimates, that level of literacy in Japan in the middle of the nineteenth century was greater than what is found today in some 40 countries. One peculiar feature of the Tokugawa shogun ate was the practice known as alternate attendance. Feudal lords were required to spend every other year in Edo. When they returned to their lands, their families remained in the capital—essentially as hostages of the shogun. This policy was meant to restrict the ability of the lords to plan uprisings against the central authorities by keeping them under the direct gaze of the shogun when they were in Edo and by breaking up their periods away from the capital when they could engage in plotting. But it had unintended consequences that were important for long-term economic growth; the movement every year of several hundred feudal masters with up to several thousand retainers required roads, means of transportation, post houses, feeding and supplying people and animals, and considerable planning. When, in 1861, the emperor’s younger sister traveled from Kyoto to Edo to marry the shogun, some 25,000 court retainers accompanied the royal party. Planning for this movement took several months and involved thousands of porters, animal tenders, and other staff at each of the 69 posts along the Kiso road. It required administrative competence in the capital, but local initiative and energy made the whole thing work. Smaller versions of this once-in-a-millennium event took place almost on a daily basis. The movement of people from their native villages to metropolitan areas across the breadth of Japan educated generations of minor officials and peasants who otherwise would have known little more than the fields around their villages. At the same time that peasants were learning the ways of the big city, local methods, ideas, and arts

were being introduced to Edo. This two-way flow nurtured the notion of a greater Japan.Economic growth was slow but positive in the eighteenth century and the first half of the nineteenth. Living standards even in a poor district like the Morioka region examined by University of Washington professor Kozo Yamamura rose by roughly 0.5 percent a year from the early 1700s to the end of Tokugawa rule. Nutrition, clothing and housing improved steadily throughout the period. Thus, when the leaders of the Meiji restoration decided to seek Western technology and institutions and to adapt them to national purposes, Japan already had a society that worked—and worked well. Mr. Maddison has estimated that Japan’s 1820 per capita output was about $609 in 1985 purchasing power dollars, or roughly $750 at 1995 purchasing power parity prices. According to World Bank estimates, that level of economic output would have placed Japan ahead of about 15 countries in 1995, making it underdeveloped but not at the bottom of the economic league tables. In the words of Kazushi Ohkawa of Hitotsubashi University and Henry Rosovsky of Harvard University, Japan “was a vigorous, advanced, and effective traditional society. In many ways it was more advanced than many countries in Africa or Latin America today. … We tend to inevitably associate low income per capita with poor organization, corruption, lethargy, and undernourishment. And, this gives a false picture of Japan before the Restoration.”9 In short, Japan, on the eve of its coming out, was in a good position to absorb the lessons that the West had for it. Japan’s Economy in the Twentieth Century 5 The Growth of National Economic Output Phases of Development Although Japan began to move toward economic modernity in the last decades of the Tokugawa shogunate, this transition became a burning national priority only after the installation of the new regime in 1868. The years until 1885 or so were ones of change as such traditional institutions as clans, feudal domains, and state support for samurai were disestablished and new institutions were created. By 1885, the contours of the modern Japanese state and economy were evident. From that year through 1930, the growth of the economy was fairly steady, averaging 2.8 percent annually. However, since the population was increasing at a pace of slightly more than 1 percent a year, average individual welfare improved more slowly than the expansion of the overall economy. Real GNP per capita doubled over this period, rising by roughly 1.6 percent a year. The ups and downs in the pre-1940 economy were, to a degree, stimulated by events in the global economy. For instance, a doubling of growth from 2 percent to 4 percent between 1915 and the 1920s was fueled at least in part by a surge in European orders due to World War I and by the economic boom that followed. A decline from the 1920s to the early 1930s reflected the effects of the Great Depression on Japan. A subsequent spurt in the late 1930s was caused largely by stepped-up production in preparation for World War II. Despite the fluctuations in growth in the half century or so preceding World War II, the Japanese economy demonstrated considerable momentum after the Meiji restoration. Wartime destruction ended that phase of industrialization and growth. Total output failed to reach 1939’s level until 1955. However, after that point, Japan’s economy took off in an unprecedented fashion. Indeed, to borrow from the romantic poet, Samuel Taylor Coleridge (1772-1834), it was a “miracle of rare device.” It would not be an exaggeration to assert that the economy’s performance between 1956 and the early 1970s continues to color our views and understanding of Japan. The postwar period can be divided into several phases. The first one was the immediate aftermath of the surrender, when Japan struggled with shortages of virtually every kind. Not only had domestic production capacity been destroyed by the war, but Japan also lost many of its suppliers because they were either former colonies whose ties had been broken or other Asian nations that had suffered similar destruction.\ Inflation of more than 100 percent annually raged from 1946 through 1948. The following year, the occupation authorities implemented a stabilization program crafted by Joseph Dodge, a Detroit banker who had undertaken a similar job in war-torn Germany. The fiscal and monetary policies known as the Dodge line stabilized the economy and set the stage for a revival of investment and growth. The onset of the Korean War in 1950 generated large-scale orders from the American military for equipment that helped to revive the Japanese industrial sector and brought the economy out of a deep, stabilization- induced recession. From that base, the economy’s expansion became self-sustaining. As early as 1960, growth over the preceding 10 years was nearly 8 percent, although, admittedly, it was from a low postwar level. From the late 1950s to 1970, the rise in GDP accelerated to double- digit rates. In the Tokugawa era, output had doubled in 150 years; after the Meiji restoration, the same increase had taken 45 years. The twentieth-century doubling was accomplished between 1963 and 1970! Deceleration then set in. The economy’s expansion during the 1970s fell to 4 percent a year, where it remained until the 1990s. Since the end of its highspeed growth, Japan has marched toward a long-term growth rate of roughly 2 percent. Although there is nothing magical about that figure, it is the maximum sustained rate that rich countries have managed to attain in the past 25 years. The methods, institutions, habits, and psychology that were instrumental in producing the so-called miracle growth of the postwar era now must be adjusted to a new reality. The necessity to revise expectations and to recast standard operating procedures and assumptions is the problem facing the world’s second-biggest economy at the beginning of a new century as it attempts to deregulate and restructure business operations in response to permanently slower growth. Chasing the United States Not only did the economy’s surge transform the very nature of Japan’s global role, but it also produced a level of per capita income that is among the highest in the world today. One measure of the gain in personal welfare is obtained by dividing GNP by population. figure 2.1 shows real GNP per capita for Japan and the United States converted into 1990 dollars by using that year’s estimated purchasing power parity of Japan’s Economy in the Twentieth Century 7 ¥196=$1.00. Note that the vertical axis is a logarithmic scale such that each division is double the previous one and that the slopes of the curves indicate rates of growth. In 1890, the first year of comparable data, American output per capita was 3.7 times the Japanese figure. The United States was not quite the richest country in the world at the turn of the twentieth century but, according to Mr. Maddison, then at the University of Groningen, the Netherlands, it would be in just a few years.10 Despite steady growth in Japan, the relative situations of the two countries had not changed much by 1930 because the United States also was experiencing a vigorous expansion. Although the American economy continued to increase in size after 1945, the exceptional experience of Japan

pushed its average output closer to the U.S. figure. However, even in 1970, American per capita output still was 80 percent larger than Japan’s. Nevertheless, Japan’s faster growth gradually drew the two curves closer together, with the nearest approach reached in 1992, when the U.S. economy in per capita terms was only 24 percent bigger. The 1990s were not good to Japan, and outputs moved apart in the remaining years of the decade. The 1999 figure showed that, per person, America turned out some 40 percent more than Japan.

It sometimes was said in the 1980s that Japan’s GNP per capita would overtake that of the United States before the end of the century. Rasher voices extended the prediction to GNP itself. A little arithmetic would have shown that neither possibility was likely over the forecast span of years. If, starting in 1992, Japan had maintained its 2 percent growth differential, it would have taken 11 more years for that country’s GNP per capita (measured by 1990 purchasing power parity) to catch up with the United States. In terms of the absolute size of the two economies, Japan’s 1992 GNP was only 40 percent as large as America’s. Again, with a 2-point expansion differential, convergence would have required another 46 years.11 In fact, the gap has swung in the other direction. By 1999, America’s economy was three times larger than Japan’s. Investment in Physical Capital It is a commonplace of development economics to note that nations grow through investment in physical and human capital, through increased efficiency, and through the absorption of more productive technologies, which generally occurs in conjunction with investment. In the latter part of the 1800s, a good deal of Japan’s productivity advances came from the internal diffusion of best practice, mainly in agriculture. As industry and finance developed and as personal incomes rose, retained earnings and individual savings became available to fund an increasing share of investment out of total output. The long-term trend of investment is captured in a data series on gross domestic fixed capital formation, which covers the entire century. This information includes government infrastructure investment, business investment, and residential housing investment. For purposes of describing the capital accumulation that made Japanese industry more productive, however, it is too inclusive. It is better to exclude residential investment. Mr. Maddison has produced standardized estimates of nonresidential investment and accumulated capital for the world’s major economies. However, his data do not include the government’s contribution to infraJapan’s structure, which represented the largest and most productive share of investment in Japan in the late 1800s. Both investment measures are plotted in figure 2.2 as ratios of GNP, all in 1990 prices. The pattern is similar in both curves. Investment started at low levels in the nineteenth century, rose gradually as a share of total output, and reached high points in 1920 and then again in the wartime buildup of the late 1930s. Mr. Maddison estimated that onequarter of the capital stock subsequently was destroyed in the war. Figure 2.2. Ratio of Investment to GNP, 1990 Prices, 1890-1999, Percent Sources: Nonresidential fixed investment: Angus Maddison, “Standardised Estimates of Fixed Capital Stock: A Six Country Comparison,” in Explaining the Economic Performance of Nations (Brookfield, Vermont: Edward Elgar Publishing Co., 1995); gross domestic fixed capital investment: Statistics Bureau, Management and Coordination Agency, Historical Statistics of Japan on CD-ROM, Japan Statistical Association, 1999, tbls. 13-03, 13-08, 13-11A It was in the postwar period that investment took off in Japan. Gross fixed capital formation soared to more than one-third of GNP in 1970.

Even the narrower measure shows that more than 20 percent of the nation’s product was plowed back into plant and equipment. With the slowdown in growth in the 1970s, the pace of capital accumulation slowed—but not by as much as might have been expected by the falling rate of GNP increase. The “bubble economy” of the late 1980s stimulated a resumption of high investment reminiscent of Japan’s economic glory days. Investment has several important effects. Since new technology typically is incorporated in new equipment, not only does investment expand productive capacity, but it also increases the productivity of capital itself as well as that of other inputs. Moreover, labor productivity rises as the capital stock increases relative to the number of employees—even without new technology. Investment, therefore, is the key ingredient for growth.

Japan’s Economy in the Twentieth Century 11 The capital intensity of the Japanese and the American economies is shown in figure 2.3. As one of the fastest-growing and richest economies of the late nineteenth and early twentieth centuries, the United States already had a large capital base relative to output in the 1890s. The Great Depression of the 1930s caused investment to collapse as depreciation eroded the value of the capital stock faster than the dwindling additions could increase it. During World War II, little nonmilitary investment was undertaken, and the capital stock continued to deteriorate. However ,sharp increases in productivity in the postwar period allowed the U.S. economy to prosper with a lower capital intensity of production than in the prewar period .Japan’s capital stock increased gradually relative to output from1890 to 1930, with only a shallow dip during the Great Depression, followed by a wartime surge. By 1960, the very high rate of investment caused the capital-to-output ratio to resume its prewar trend, but at an accelerated pace. In the 1970s, the capital intensity of production in Japan exceeded that in the United States. Moreover, the capital stock continued to expand faster than output itself. By 1995, the capital intensity of productionin Japan was 60 percent higher than in the United States. By then, the apparent excess of capital was an increasing problem for Japan. It was indicative of the economy’s low productivity and inadequate rates of return on investment. Investment in Human Capital Primary and Secondary Education A high priority of the government after the Meiji restoration was to promote universal education. The education law of 1872 established a three-tiered structure of primary schools, middle schools, and universities. Enrollment rates for 6 to 12 year olds increased gradually from the1875 level of 50 percent for boys and less than 20 percent for girls to near universality by 1905 (see table 2.1)In 1947, the educational system was changed to six years of elementary school, three years of lower secondary school, and three years of upper secondary school. Although the population was almost 100 percent literate and had basic mathematical abilities, advancement to upper secondary school was not automatic. In 1950, less than half the graduates o flower secondary schools continued their education. It was not until 1975that more than 90 percent of those completing their ninth year of schooling moved on to the next stage of education (see. 2.2).The relatively rapid spread of literacy and basic educational skills admirably suited the needs of an industrializing economy. Since most technology came from abroad, either embodied in investment goods or licensed directly from foreign firms, there was little need for an extensive university system to train engineers and scientists. Recent research on the impact of education on development emphasizes the importance of basic schooling, especially for women, rather than university training for an elite class.

Table 2.2. Advancement Rates From Lower and Upper Secondary

University Education As an economy matures, a greater share of the increase in productivity flows from technology that is not incorporated in machines but rather produced by targeted research and productivity-enhancing efforts. To make the transition to a phase that is more oriented to research and development, university and graduate education becomes more important.As shown in table 2-2, the advancement rate for males from upper secondary schools plate aued in the 1970s. Female advancement, however, continued to increase, partly because of the popularity of women’s junior colleges.

The proportion of 19 to 24 year olds enrolled in four-year colleges and universities accelerated from 1890 to 1980 and then leveled off for10 years, only to rise again in the 1990s (see figure 2.4). Increases in college and graduate school enrollments have been typical reactions to difficult employment markets in the United States. Perhaps the sharp fall in the availability of jobs for high school graduates in Japan had the same effect there. Enrollment in Japanese graduate schools was very low until the late1950s. Even between 1965 and 1980, only about 3 percent of the people who graduated from four-year colleges and universities continued with graduate education. In the 1990s, the rate almost doubled at the same time that the share of 19 to 24 year olds going to college also rose. By1998, the number of graduate students was twice as high as in 1990 and triple the 1980 level. The growth of undergraduate and graduate education in Japan over the past 20 years has helped to equip the country with a more flexible work force that has the capability to learn new skills on a continuing basis .Compared with the United States, however, Japan still has room for improvement. Approximately 50 percent more of the U.S. college-age cohort is enrolled in four-year educational institutions, and 23 percent of the undergraduate student body goes on to graduate studies —roughly four times the Japanese ratio. Enhancing the role of higher education remain son Japan’s agenda for the future. Trade and Exchange Rates Exports and Imports Japan depended on imports of raw matrials and machinery for its development. Imports from the West allowed the nation’s new businesses to access advanced technologies and products that were unavailable at home. At first, Japan paid for its purchases from abroad by exporting such traditional goods as silk and silk products. However, as industrialization occurred, it was able to sell overseas the output of its Japan’s Economy in the Twentieth Century 15new mills and factories, particularly non silk textiles. In a very real sense, exports played a critical role in Japan’s development since they earned the foreign exchange to pay for essential imports. Throughout the period before World War II, imports and exports alike were a large fraction of total economic production, much more than they would be in the postwar period. On a 10-year moving average basis, exports and imports as shares ofGNP rose steadily from the end of the nineteenth century, peaking at 20percent of national output in the 1920s and 1930s (see figure 2.5). The effects of the Great Depression, the widespread imposition of tariffs, and the onset of war combined to drive down trade in Japan, as they did in other countries as well. In 1945, Japanese industry was destitute and unable to produce for export. The American occupation authorities managed trade on an item byitem basis, making up differences in export earnings and import bill sthrough subsidies provided by the U.S. government.

Since many import items were deliberately subsidized to keep prices low, Japan’s trade deficit turned into a burden for

American taxpayers. Statistics of Japan on CD-ROM, Japan Statistical Association, 1999, tbls. 13-03, 13-04;955-99; Statistics Bureau, online at http://www.stat.go.jp/1.htm.Occupation economists saw a clear need to resume trade based on market principles, but rampant inflation complicated the calculation of an exchange rate. An exchange rate of ¥360=$1.00 was introduced in April1949, and inflation was tamed through the implementation of the Dodge line. Those developments positioned the Japanese economy to resume unsubsidized trade. However, trade never returned to its prewar levels. During the 15 years of maximum growth from 1955 to 1970, exports averaged less than 10.5 percent of GNP. The peak export year was 1981when sales abroad represented 13.6 percent of total output. In the 1990s,exports and imports both were equivalent to less than 10 percent of the economy .The notion that Japan’s economy is export-driven even today is hard to shake because of the visibility of Japanese products in the minds of consumers and the international fame of key exporters. The real importance of exports, as economists have noted ever since 1776 when Adam Smith developed the logic in The Wealth of Nations, is that they provide payment for imported goods and services. From the numbers, it is hard to understand why the idea of export-driven growth has received such prominent attention in economic histories of Japan. If anything, the discussion should be about importdriven growth, since the essential ingredients of life, economic development, and economic welfare were all supported by foreign goods and services. A simple measure of the direct contribution of a GDP component to the growth of GDP is the ratio of the change in that component to the change in GDP. This is done in table 2-3 for 10-year movements of consumption, investment, and exports. Japan clearly was consumption driven throughout the postwar period, with consumer spending accounting for one-half to two-thirds of the increase in output. Investment was the second-largest driver. Exports came in third, except for a few years when investment collapsed. The same exercise for the prewar period would demonstrate that consumption was even more important and exports less so than in recent decades.

Exchange Rates The yen-dollar exchange rate has varied from parity in 1875 to¥360=$1.00 in 1949 to ¥80 briefly in the spring of 1995. What accounts for these fluctuations? As a good first approximation, variations in the relative prices of so-called tradable goods explain most of the changes in the exchange rate. Such other influences as interest rates and capital flows account for the remaining movement. However, the difference between inflation rates in Japan and the United States is a good place to begin. The theory that relative prices drive exchange rates follows from the notion of the “law of one price.” That is, if a product is sold at different prices, it pays arbitrageurs to buy it at the lower price and resell it at the higher one, thereby driving the gap to zero. A technical issue in estimating the effects of relative inflation rates is the choice of a price index for tradable goods. Not all goods are traded, as demonstrated by the fact that only 10 percent of Japan’s output enters into export channels. Thus, a broad measure like the GNP price deflator would include too many items that are unaffected by the international law of one price. Surprisingly perhaps, export and import price indexes also are inappropriate. They respond to the exchange rate at the same time that they influence it. If they did not adjust to exchange rate changes, either it would be impossible to sell a product because its international price was too high, or the product would be so cheap that the seller would face excess demand and probably would have an inadequate profit margin. The price index chosen was the wholesale price index for Japan and the comparable producer price index for the United States. These indexes mainly reflect the prices of manufactured products and bulk commodities that potentially could enter into international trade. To estimate the effect of these price series on the exchange rate, a simple equation was constructed with the yen-dollar exchange rate as the dependent variable and the two price indexes as independent variables,18 Chapter 2all in natural logarithms. If the strict version of the law of one price holds such that purchasing power parity determines exchange rates, the Japanese price variable would have a coefficient of 1.0 and the U.S. price variable a coefficient of minus 1.0. In fact, the coefficients are 1.02 and minus 1.30, respectively. Actual and

predicted yen-dollar values are shown in two panels in figure 2.6 to separate the very different values of the prewar and

postwar eras. The simple, relative-price explanation of the exchange rate does remarkably well over the entire 1892-1999 period. The bottom panel of figure 2.6 indicates that analysts did a pretty good job in 1948 in estimating an equilibrium exchange rate, given the inflation raging at the time and the absence of reliable trade data. The occupation economists working for Gen. Douglas Mac Arthur kept track of the individual exchange rates implicit in the negotiated prices of each trade deal. They also measured the rate of inflation to determine how fast relative prices were moving. Exchange rates for specific products varied from¥100=$1.00 for agar to ¥600=$1.00 for flat glass. In May 1948, Ralph Young, a Federal Reserve Board economist, suggested an exchange rate of ¥300=$1.00, which he thought would under value the yen to encourage exports. An October 1948 Ministry of Finance report recommended that exports be priced at ¥350=$1.00. Analysts running a price computing system proposed a rate of ¥450=$1.00 in February 1949. The final decision, announced in April 1949, was¥360=¥1.00. This rate was intended to be sufficiently undervalued to encourage exports, although importers found their bills rising by an average of 100 percent. The devaluation of Great Britain’s pound sterling in September 1949, which countries in the sterling area followed, erased the planned advantages of a cheaper yen.13According to the estimate shown in figure2.6, the yen seemed to be over valued for several years in the 1950s, but it then became under value das U.S. inflation rose faster than the increase in prices in Japan. The generally excessive strength of the dollar in the late 1960s and early1970s led to the replacement of the fixed exchange rate regime by a system of floating rates. The other period of an overly strong dollar in the first half of the 1980s also is obvious. On the same basis, it is possible to argue that the yen was over value din the 1990s. However, as noted, enough other forces act on exchange rates that conclusions based simply on relative prices are not fully warranted, although a currency’s broad movement certainly responds to the price differentials of tradable goods. Conclusion Japan faced enormous challenges in developing the modern, affluent ,and technologically advanced economy that it is today. It was the first nation to deliberately set out to change itself in fundamental ways for the Japan’s Economy in the Twentieth Century 21express purpose of modernizing the economy and society along Western lines. The risk-taking creativity of that endeavor left little untouched. Growth itself wrought continuing mutations and permutations in techniques, technologies, and relationships. In fact, breathtaking change has been an integral part of Japanese economic history. Ironically, the lingering effects of one particular phase of this history—the so-called miracle years—now bind Japanese psychology and policy to inappropriate routines that once had economic logic behind them but that now are unproductive. As Japan makes the transition to a permanently slower growth trajectory, a move that requires greater attention to the mundane objectives of rates of return and profitability, the nation once again is being forced to change. History leaves little doubt about Japan’s capacity to adapt to a new environment. Nevertheless, the legacy of the past can handicap the race to the future, however sure the eventual results may be. Problems and Prescriptions for the Japanese Economy: An Overview With the bursting of its asset and real estate market bubble in 1990 and1991, Japan’s economy entered into a long period of mediocre performance that by 2002 and early 2003 was accompanied by growing pessimism about Japan’s future among scholars, policymakers, and economic commentators, both inside and outside Japan. This pessimism was shared by the Japanese public. The growth rate had become negative again, banks were failing, and stock prices were plummeting to the level of a decade earlier. Deflation seemed to be worsening, while the unemployment rate was increasing to an unprecedented level. Monetary policy seemed impotent after the benchmark interest rate became zero. Fiscal policy seemed to be powerless as large government spending and tax cut packages failed to lift the economy long enough to generate a self-sustaining recovery. Moreover, Japan is in the midst of a profound transformation process—economic, demographic, social, and political —that will take s everal decades to complete. These fundamental forces are deeply intertwined with the cyclical and structural roots of Japan’s fourteen-year malaise .By mid-2004 there was growing optimism that the economy was finally emerging from its 13 years of poor performance to return to sustained growth, but also nagging doubts persisted that this recovery wasno more than a cyclical upturn. Earlier recovery attempts in 1996 and2000 had been followed by disappointing recessions. This proved to betrue once again, as a strong first quarter in 2004 was followed by threequarters of essentially flat growth. While

the economy will probablyrecover once again in 2005, it seems unlikely that the recovery will besufficiently strong or durable to get back onto the path of sustainedgrowth to achieve the economy’s full potential. Our deep concern is 1 2 Reviving Japan’s Economy that fundamental economic and institutional problems will remaininadequately address, possibly inducing another crisis (see Patrick,2004).Japan does have feasible, optimal economic policy solutions to themajor economic problems and issues that have undermined its fundamentaleconomic strengths since the early 1990s. Even if Japan has entereda period of improving economic conditions, and that is not to betaken for granted, it has not yet adopted the kinds of policies that would maximize its growth potential, improve its people’s quality of life, andcontribute to strengthening the global economy. The basic purpose ofthis book, and the two-year research project on which it is based, is todevelop and recommend policy solutions to return Japan to long-runsustainable economic growth. The following chapters, written by outstandingJapanese and American economists are forward-looking, butfounded on a careful analysis of Japan’s recent economic history.As general context for the following chapters, in this introductionwe outline the long-term economic transformation now underway andrelate the major economic problems in Japan’s 14 years of malaise tothat extended process. Subsequent chapters in the book cover the costsof the economic malaise, aggregate demand and macroeconomic policy,monetary policy, financial system difficulties, corporate restructuringand financing, and Japan’s new trade policy. Some of the analysesfound in subsequent chapters are incorporated into this overarchingdiscussion, which ends by summarizing a few of the major conclusionsreached by the authors.This collaborative project has involved deep and sustained interactionsamong the 15 well-known Japanese and American economistswho authored these 11 chapters. We share a high degree of agreementbut certainly not complete consensus on all the proposed policy solutionsto Japan’s economic problems, and there has been no effort toforce consensus. The authors are responsible for their own studies, and we bear sole responsibility for this chapter. 1 Japan’s Ongoing Fundamental Transformation While a great deal of analytical emphasis has appropriately focused onthe cyclical and structural difficulties of Japan’s malaise since 1990, it isimportant to recognize the more fundamental long-term forces at work.Three major economic transformations have been underway: the completionof the catch-up process of fast growth as Japan changed from an introductory Overview 3low income country to a mature economy with a high per capita GDPand standard of living; the ongoing demographic transition to long lifeexpectancy, low fertility, and an aging population; and the evolutionfrom a system of relational capitalism to market-based capitalism. (For an even longer-term history of the evolution of Japan’s economic system,see Teranishi 2005.)Japan’s extraordinarily successful postwar economic growth wasbased significantly on its ability to close the huge gap between the Japaneselevel of productivity and technology and the world’s productivityfrontier. This was achieved through the effective utilization of aninitially cheap, abundant and skilled labor force; entrepreneurial businessinvestment that applied newly available technologies; a rapidlyincreasing (and ultimately) very high saving rate that provided domestic financing for the burgeoning rate of business investment, the development of synergistic postwar economic institutions and supportive government economic policies. By the mid-1970s, Japan had caught upwith the West, becoming the world’s second largest economy with Europeanlevels of per capita GDP and a high standard of living. From1980 on, Japan became an increasingly large foreign investor, both directand portfolio, and by the 1990s by a wide margin had become theworld’s largest creditor nation. Japanese banks were the largest in theworld and had very high credit ratings, and Japanese institutions werebuying prime properties worldwide. Now, after more than a decadeof stagnation, there is a widespread sense in Japan that it has failedto make a transition from a super-effective manufacturing economy (exemplified by firms such as Toyota, Sony, and Nippon Steel) to ahigh-tech service-oriented economy (characterized by companies likeMicrosoft, Goldman Sachs and CNN). In the high growth, catch-up era, from the early 1950s to the mid1970s, Japan’s postwar economic system developed and flourished. Itwas founded, especially for big business, on the permanent employmentsystem of industrial relations, the bankbased system of corporatefinance, and the separation of shareholder ownership and managementcontrol. Large firms then and still now are controlled by entrenchedprofessional managers, trained and promoted from within to serve aschief executive officers and board members. Any weak firms and bankswere merged with healthy ones through backroom discussions andthe encouragement of regulators. Declining industries, such as coal,changed through a very gradual process; a few industries that were obviouslyuncompetitive, such as aluminum, shrank much more rapidly.4 Reviving Japan’s EconomyThe economic system was opaque and cozy, with power centered onbusiness leaders, central government officials, and Liberal DemocraticParty (LDP) leaders. The LDP was the sole governing party from its1955 inception until 1993, and since 1996 has continued to be the dominantleader in a series of coalition governments.In some respects, by the late 1980s Japan had become a victim of itsown economic success. The economy grew too large to be managedeffectively based on personal relationships. Japan was gradually movingtoward a more market-based, open economic system. For good domesticand foreign policy reasons, the government initially reduced itsearly postwar controls over prices, then foreign exchange rates, foreigncapital flows, and trade in manufactured goods. Piecemeal financial deregulation,a twenty-year process, began in the mid-1970s. Many governmententerprises were partially or totally privatized in the 1980s.Airlines are now 100% privately owned; railway companies are partialyprivate; and the formerly monopolistic domestic and internationaltelephone companies are substantially privatized and compete againstprivate communication companies. Other deregulation has taken place,though many regulations persist.In Japan, as in other countries, development and growth broughtmajor changes in the economic structure. Agriculture declined to minoreconomic significance (but remains politically potent); the share ofthe manufacturing sector rose sharply and then gradually declined;and the portion of the economy centered on business and personalservices naturally rose. With wages increasing continually and the yenappreciating, by the 1980s Japan no longer was a cheap-labor

economy;labor-intensive industries, facing the onslaught of cheap imports,increasingly invested abroad while declining at home. One of Japan’smajor anomalies is that the productivity gap between manufacturing,especially of exports, and services, mostly non-tradables, has remainedvery wide, and still is the most extreme of any major OECD economy.This wide gap suggests both a potential for better growth through moreeffective resource reallocation and the real difficulties of major structuraladjustment for low-productivity service industries, especially retailand wholesale trade, and construction.It is our view that Japan successfully overcame several economicchallenges in the past, but since the 1990s Japan has really stumbled.We should not forget how Japan overcame difficulties in the 1970s and1980s (for a comprehensive review of the Japanese economy before the bubbles burst in 1990 and 1991, see Ito 1992). The economic turmoil of Introductory Overview 5the 1970s brought on the first set of challenges, and the mid-1970s wasthe first inflection point for the Japanese economy. The yen had justbeen floated for the first time since World War II. Inflation reached 30%in 1973, due partly to monetary easing the year before but particularlydue to the quadrupling of oil prices. Strong tightening to halt inflationcaused negative growth in 1974 for the first time in the postwar period.Following the first oil crisis, business optimism and investment slowedmore than the gradual reduction in household saving rates. The energyresource constraint and increasingly obvious pollution problems put abrake on the overwhelmingly growth-oriented focus of corporate management and government policy. Deficit-financing government bonds were issued in increasingly largeamounts for the rest of the 1970s to help the economy regain its growthpath. Private sector aggregate demand was no longer excessive relativeto supply, and weakened sufficiently to require government macroeconomicstimulus. Credit rationing was no longer necessary, andcredit became easy; the Keynesian paradox of excess saving, initiallyperceived to be cyclical, became long-term and structural. Japan, as theworld’s second largest economy, has from the 1980s been unable to exportall of its excess domestic savings because the requisite concomitanthuge trade (and current account) surpluses were and are unacceptableto the United States and Europe. The second big challenge the Japanese economy faced was in themid-1980s, when yen appreciation brought about another big shock tothe Japanese economy. The first half of the 1980s were marked by dollarappreciation vis-à-vis all other currencies. Japanese exports soared andthe economy enjoyed rapid growth. By 1984 Japan’s current account inits balance of payments had turned to substantial surpluses, while thatof the United States had turned to large deficits. The Plaza Accord ofSeptember 1985 was supposed to correct exchange rate misalignmentsand restore equilibrium exchange rates for the major OECD countries.The yen appreciated from 260 per dollar in February 1985 to 240 justbefore the Plaza Accord in September, and to 200 in December 1985. Itthen kept appreciating, in part because of the collapse of oil prices, and reached a then record high of 150 yen per dollar by the fourth quarterof 1986.Given the severe appreciation in the yen’s value, fears arose about thecollapse of Japanese exports and the economy in general, but the economywas more resilient than expected. Monetary policy was greatlyeased from 1985, and the economy embarked on rapid growth based on6 Reviving Japan’s Economyprivate demand. Accordingly, the government was able to pursue fiscalconsolidation throughout the 1980s, and achieved a balanced, evensurplus, budget by the end of the decade. Japan recovered from the yenappreciation of 1985– 86, and from spillover effects from the Americanstock-price declines of late 1987 (Black Monday, October 19, and its aftermath).At the end of 1989, the Japanese economy was at the peak ofits asset-price and real estate bubbles. Land and stock prices had risenfour-fold in 6 years. No one would dare to forecast those gains wouldbe erased in the following 13 years.The bursting of the bubble and the ensuing stagnation of the 1990s through 2004 has been the third and biggest challenge faced by postwarJapan, and it has been much more protracted than necessary. Assetprice declines resulted in huge amounts of non-performing loans,giving rise to the banking crisis of 1997–98. After the basic interest rate became zero, monetary policy was a much less effective tool since 1995.Fiscal deficits and government debt have become so large that furtherfiscal stimulus has not seemed feasible to policymakers.Japan’s decades of success led to some fundamental assumptionsthat attained the status of myth before being seen as mistaken. The twomyths of the late 1980s were that land prices would never decline, sincethey never really had for the entire 40-year postwar period; and thatrapid GDP growth would continue indefinitely. The 1990–91 burstingof the twin bubbles shattered the land price myth, and raised doubtsabout maintaining an annual growth rate greater than 4%. Nonetheless,faith in naturally renewed growth led to mythical expectations duringthe 1990s that growth would be restored fairly soon and the economywould recover; thus it was felt that painful business and governmentstructural adjustments could be postponed until conditions improved,and that was how decision makers behaved through much of the 1990s.We are concerned that excessively optimistic perceptions are widelyvoiced once again in early 2005. 1.1 Demography Japan’s long-term demographic transformation is as profound as itseconomic one. Over the course of its modern economic development,Japan has transited from relatively high birth and death rates, low lifeexpectancy, a young population, and moderate population growth to anation of very low death rates, even lower birth rates, and the longestlife expectancy in the world. As a result, Japan has a rapidly aging popIntroductoryOverview 7 ulation. Since 1995 there has been an absolute decline in the workingagegroup (15–64), and by 2007 population size will peak. Populationstability occurs when the completed fertility rate is about 2.1; currentlyit is only 1.29. The Japanese level is comparable to Italy’s very low fertilityrate, both of which are among the lowest of OECD countries.In this volume Broda and Weinstein cogently point out how unrealisticis the common assumption that Japan’s low birth rates will persistindefinitely; that means that the Japanese eventually will disappear.Changes in demographic behavior are typically long run, but it is reasonableto assume that some decades hence, the ever-richer Japanesewill desire to have more children and the population will stabilize. Orperhaps Japan will decide to give up ethnic homogeneity and acceptlarge numbers of permanent immigrants, as Hashimoto and Higuchisuggest in their chapter. Demographic assumptions are important inanalyzing long-run issues of

fiscal sustainability, namely how much goverment revenues will have to be raised as a share of GDP to meetsocial security commitments to the elderly.High or low dependency rates—the number of children and elderlyas a percentage of the workingage population—provide information on growth prospects and the needs for government expenditures (includingincome transfers), but depending on the characteristics of thesocial security system these dependency rates do not necessarily implyfiscal and economic problems. However, the current Japanese social securitysystem, designed as a pay-as-you-go program, is already in deeptrouble. Too many of the young are not paying in premiums, and corporationsare exiting the corporate part of the social security system whenpossible. Clearly the institutional arrangements and the implementationof policies have to be improved, an issue we stress even though ittranscends the topics of this book. 1.2 Transformation Policy Choices One key issue for Japan’s long-term economic performance is the degree and nature of the factors determining potential growth: changes inlabor supply, capital investment per worker, and technological change(total factor productivity increase). Another key issue is what portionof GDP society decides to have the government spend on its people—elderly, young, and those of working age. The ratio can be high as inScandinavia, quite high as in many European countries, or more modestas in Japan and the United States. A third issue is how to pursue8 Reviving Japan’s Economypolicies that assure labor, capital, and other resources are fully and efficiently utilized.What proportion of GDP will the Japanese be willing to transfer totheir elderly in the form of public pensions and health care? Should Japanmaintain high ethnic homogeneity, or should it encourage substantialpermanent immigration? Should it provide incentives to increasefertility, including more adequate support structures for working mothersand their children? How much should politically-important buteconomically-inefficient sectors and activities be subsidized, and howcan such programs be made more efficient given appropriate transferprograms? As economists, we are good at making recommendationson efficiency issues, but are hesitant to make recommendations aboutthese important social choices. While beyond the scope of this study, social and political changes area major component of the transformation process. We note several importanttrends. Today’s young Japanese grew up in relative comfort, incontrast to their grandparents’ experiences in a war-ravaged 1940s Japanand their parents’ experience in the 1950s and 1960s. In contemporaryJapan young adults are considerably better educated, have moreinternatonal awareness and experience, and aspire to realize their owncareer goals. Today’s young adults have a wide range of interests andlifestyle opportunities, although they have been constrained by theirpoor employment situation. We do not know what figures most importantlyin their life-cycle decisions, but the fact is that they are post poning marriage: half the Japanese women and men aged 30 are notmarried.Given that the current young adult generation is affluent and behavesquite differently than previous generations, Japan’s economicstructure, as well as its social structure, may well change in the future.The saving rate may drop in addition to a natural decline due to anaging society, and employment practices may change as more youngpeople, voluntarily and involuntarily, find only temporary, part-timejobs as their first professional positions. Hashimoto and Higuchi findthis trend very unsatisfactory for effective career development, as discussedin chapter 10. The postwar Japanese family model—analogous to the Americanmodel of the 1950s—of the husband working permanently for a largeorganization and the wife at home raising their two or three childrenwas always an inaccurate stereotype. Most Japanese men have alwaysworked for small- or medium-sized enterprises and changed jobs fromIntroductory Overview 9time to time; some two-fifths of married women re-enter the workforce, usually part-time, once their children start school. However, Japanis the only advanced country that has had a significant drop in thefemale labor force participation rate for the childbearing and childcaringage group. It is debatable whether this is a voluntary choice orinvoluntary. 1.3 Political Change In the 1990s there was a significant change in the political environment.The Liberal Democratic Party (LDP), always a collection of factions, beganto split. In the July 1993 elections, the LDP lost its majority in theLower House. LDP splinter groups formed coalitions with other partiesto obtain a majority in the Diet, and in August Morihiro Hosokawabecame the first non-LDP prime minister since 1955. However, thatcoalition collapsed after 20 months. The LDP first managed to form acoalition with the Socialist Party (now the Social Democrat Party of Japan)yielding the prime ministership to its leader, Tomiichi Murayama.Since January 1996 the LDP has formed coalitions with several smallerparties, including now the New Komei Party, and regained the primeministership.The major opposition party in the 1950s through 1970s, the SocialistParty [later renamed the Social Democrat Party (SDP)] participated inthe coalition government in the early 1990s, but later essentially disappeared.By 2003, the Democratic Party of Japan (DPJ) had emerged as arival to the LDP. The DPJ is an amalgam of members of most pre-1993opposition parties (other than the SDP and Communists), newly electedmembers, and those LDP splinter groups that did not rejoin the LDP.In the November 2003 House of Representative election and the July2004 House of Councilors election, the DPJ actually gained more votesin total than the LDP, but these victories did not convert to control ofeither house. For both houses, most members are elected by districts,the rest proportionally. For the lower house since 1994 the districts aresingle-seat (replacing multi-member districts); for the upper, they areprefectual.While many commentators observe that Japan is approaching a“two-party system” like the United States, one conspicuous differenceis that currently the small, but well organized New Komei Party holdsbalancing power in the Diet. Prime Minister Junichiro Koizumi’s termas LDP president and hence as prime minister ends in September 2006.10 Reviving Japan’s Economy His successor is far from certain. The possibility of further party memberrealignments based more on common policy positions than on historyis real. 1.4 International Context Japan’s demographic and political transformation is not unique, andnot isolated. The world has changed dramatically as well. The cold warconfrontation between the United States and the former Soviet Unionended in the late 1980s, and the United States has emerged as the solemilitary hegemon. The September 11, 2001 terrorist attacks on NewYork and Washington

fundamentally altered American foreign policy,with repercussions for all countries.The world trading system has been strengthened by the creationin 1995 of the World Trade Organization (WTO) out of its forerunner,the General Agreement on Trade and Tariffs (GATT), despite its remaininglimitations. Global financial markets have become increasingly important:huge short-term and long-term capital flows, exchange ratemovements, and expectations about interest rates, now strongly affectthe economic policies of all major nations. The creation of the systemof arbitration panels under the WTO has significantly decreased thechance of unilateral actions in bilateral trade disputes. Some prominenttrade disputes between Japan and the United States, such as the Fujiversus Kodak film case, were settled under the WTO panel in favor ofJapan. In addition to these global multinational approaches, regional approachesto trade have proliferated. One of the most important of theseis the North American Free Trade Agreement among the United States,Canada, and Mexico. Moreover the Free Trade Agreement of the Americas(FTAA) is being negotiated. The FTAA will cover the entire westernhemisphere from Canada to Argentina. An even more importantregionl trading group is the European Union; with its 2004 expansionfrom 15 to 25 members, most of Europe and much of its periphery arenow one market.In East Asia, while Japan remains the largest and by far the mosttechnologically sophisticated economy, the big change is the economicrise of China. The Chinese economy has grown at almost 10 percent annuallyover the past two decades, just like Japan in the 1950s and 1960s.China has joined the WTO, and has become a major factor in regionaland global trade. Given its still low level of income and its still hugeIntroductory Overview 11numbers of rural workers, China has the potential to continue to growrapidly for another two decades. China provides Japanese companieswith both great economic challenges and opportunities. As the Japaneseexperience over the past two decades well demonstrates, a rapidlygrowing large economy is better for the world economy than a slowlygrowing one.The prospects of North Korean nuclear capability have added a newsecurity dimension to regional cooperation. If anything, the North Koreanissue has strengthened the security alliance between Japan and theUnited States. At the same time, the six-party talks under Chinese leadershipare a new approach to regional security cooperation. However,each country—North Korea, China, the United States, Japan, SouthKorea, and Russia—has its own interests and anxieties. With a strongeconomy, many South Koreans now have little sense of military threatfrom North Korea and are increasingly sympathetic to their North Koreanbrethren, as reflected in the last presidential election. We live in anuncertain world and, as various pundits have articulated, the future ofEast Asia is more uncertain than its past. 2 Economic Malaise Since 1990 The Japanese economy has performed poorly over the 14 years since1991. It has suffered the malaise of inadequate growth, a soaring unemploymentrate and deepening under-employment, bank failures, slowand inadequate corporate restructuring, sub-optimal resource allocation,and slow, protracted institutional and structural reforms. Despiteimmense macroeconomic stimulus, policies of forbearance, relationship-based inertia and policy mistakes have contributed to the lengthypersistence of this poor performance. Termed by many as stagnation,though certainly not collapse, the “lost decade” became a popular nicknamefor this stalled period of economic growth. We prefer to termthe 1990s as a decade of underperformance and malaise, since in factmany institutional and other changes took place. (There are many studiesof the Japanese economy in the 1990s; see for example, Blomstromet al, 2003; Cargill et al 1997, 2001; Katz 1998, 2003; Lincoln 1999; OECD,2004; Porter et al, 2000; Posen 1998; and Saxonhouse and Stern, 2003.)Indeed, the succession of recoveries and recessions in the first five yearsof the 21st century undermine predominant focus on the 1990s; we nowhave to think of Japan’s underperformance extending at least 15 yearsrather than 10.12 Reviving Japan’s EconomyWhile certainly influenced by the specifics of Japan’s long-run transformationprocess, all the problems recounted above have been madesubstantially worse by poor economic performance since 1991. A varietyof forces have been at work to undermine Japan’s economy. Thebursting of the huge real estate and stock market bubbles in 1990–91resulted in severe balance sheet and non-performing loan problems forbanks, other financial institutions, and corporations. Given the excessof borrowing and irrational exuberance over real estate and stocks inthe 1980s, the collapse of asset markets was inevitable, but major policy mistakes were made in handling the bursting of the bubbles. An increasinglyhuge non-performing loan problem was hidden for too long,and has been addressed in wrong ways; a new financial regime, basedon an arm’s length relationship between the regulator and the regulated,has been very slow to emerge. In 1995 the Ministry of Financedeclared that none of Japan’s 20 major banks would fail, but HokkaidoTakushoku Bank suddenly failed in November 1997. Subsequently, theMinistry of Finance's regulatory functions were separated out into thenew, cabinet-level Financial Supervisory Agency (FSA). Several morebig banks failed, and others merged. Japan will soon have three majorbanking groups representing most banking sector assets, in addition tothe still huge postal savings system.Japan has been caught in the combination of these inadequacies andof the long-run fundamental transformation discussed above. Whilethe economy cyclically rebounded between the early 2002 trough andthe first quarter of 2004, the subsequent abruptly stalled economicerformance for the rest of 2004 is indicative of the reality that majoreconomic problems persist. As discussed below, aggregate demandremains inadequate; deflation has yet to end; land prices continue todecline; corporate, financial institution, and public sector restructuringis far from completed; and unemployment, under-employment, andmisallocated labor and capital are particularly serious.It is clear that solid aggregate demand and good, sustained growthwill contribute significantly to the solution of Japan’s economic problems.Growth reduces adjustment costs, undergirds financial restructuring,and enhances the effectiveness and efficiency of markets forgoods, services, labor, land, and capital. However, growth alone is notenough. Supply-side improvements— efficiency-enhancing deregulationand restructuring—must go hand in hand with development andmaintenance of inadequate aggregate demand, in both the near-termand the longer-run. Corporate restructuring destroys jobs in the shortIntroductoryOverview 13 run while creating them in the long-run. This means social safety netsneed to be better designed and deployed.Japan’s macroeconomic difficulties have been deeply intertwined with the weakening of the Japanese financial system. In 1990 Japan’sbanks and life insurance companies were considered to be not only thelargest but the strongest in the world. Today, these financial institutions

are still huge, but recognized as the weakest of any advanced industrialnation. Bank lending to business has declined steadily. Banks holda large amount of government bonds and equities, but have failed to develop fee businesses sufficiently. Their balance sheets are still greatlyat risk from securities market fluctuations. Japan’s government is anexceptionally large financial intermediary, crowding out private-sectorinstitutions, rather than complementing them by serving areas characterizedby market failures. Government financial institutions, witha huge share of household deposits and life insurance policies held inthe postal savings system, account for some 40% of all loans, and areespecially important mortgage lenders to households and to smallerbusiness enterprises. As Japan’s private sector financial system hasbeen fundamentally deregulated and liberalized, many governmentfinancial institutions have been rendered weak and redundant as theireconomic rationale has evaporated.While moving ahead slowly and cautiously on domestic structuralreform, the Japanese government has embarked on a bold new foreigntrade policy, initiating negotiations for bilateral (and perhaps eventuallyregional) free trade areas (FTAs) or more comprehensive, regionaltrading agreements. These new policies and the issues they raise arediscussed by Urata in chapter 11. Whether this new approach is an appropriatetrade strategy, and whether it will be complementary to, orcompetitive with, Japan's global commitments and objectives underthe WTO remains to be seen; certainly it is parallel to the earlier NorthAmerican and European Union regional trade policy commitments.The major stumbling block for Japanese trade policy continues to bethe still-high degree of protection provided small and very inefficient,but politically powerful, agricultural, forestry, and fishery interests. 2.1 The Costs of Japan’s Long Malaise The costs of Japan’s poor economic performance and slowness toadjust since 1991 are not hidden but are not necessarily obvious. Despitewidespread fears and even dire predictions, the economy did not14 Reviving Japan’s Economycollapse. While there certainly have been crises for individual companiesand even some government institutions, no systemic crisis hasoccurred. The closest call was in the banking and financial systems betweenSeptember 1997 and March 1998, but a fullfledged crisis, such asa widespread bank run, was averted. Nonetheless, we can conceive ofpossible adverse scenarios in which large unexpected shocks could createconditions that might precipitate a collapse, such as another majorTokyo earthquake, hyperinflation, or war. Probably the greatest cost of the economic malaise has been the GDPforegone due to below-potential growth for so many years. Japan’sGDP could be on the order of 25% higher today if the economy hadachieved its growth potential. Its high standard of living could be significantlyhigher.In human terms, Japan’s most serious problem is a combination of unemployment,under-employment, and misallocated labor. The recent reductionin the reported unemployment rate from the 5.5% peak in 2002to 4.5% in January 2005 is an improvement, but it masks major declines inthe quality of jobs and in the withdrawal of persons of working age (15–64) from the labor force. As Hashimoto and Higuchi emphasize in chapter10, between 1997 and 2003 the labor force participation rate droppedto its lowest level ever. During this period, employment declined by 2.4million persons: 1.2 million withdrew or never entered the labor force,and 1.2 million became unemployed. Worse, from 1997 full-time regularemployment until the beginning of 2005 continually decreased, whilepart-time and temporary employment has risen steadily and now comprisesmore than a quarter of total employment. Compared to fulltimemale employees, the hourly wages of part-time male workers are only51%, full-time female workers only 66%, and parttime female workersonly 44%. Large department stores now rely predominantly on parttimeworkers. More broadly, firms with more than 1000 employees arereplacing retiring full-time workers with part-timers; whereas part-timeemployees comprised 3.9% of their workers 1995, this ratio increasedto 8.6% in 2002, and is even higher today. The Japanese economy hasbeen experiencing de facto wage reduction, reflecting weak labor demandand slow productivity growth. This wage reduction is good in thesense that the unemployment rate is less high than otherwise, but badin the sense that the full potential of the work force is not being realizedbecause of inadequate demand for labor.In longer-term perspective, the weak labor market has harmed theyoung—those aged 15 to 24 years—disproportionately. The unemployIntroductoryOverview 15ment rate for 20–24 year olds not in school in 2002 was 9.3%, but in 1990this rate was only 3.8%; for those aged 15–19 years, the correspondingfigures are 12.8% in 2002 versus 6.6% in 1990. The “idle labor” rate,meauring those neither in school nor in the labor force, for those aged20–24 years was 17.0% in 2002, up from 11.3% in 1990; for those aged15–19 years, 24.3% in 2002, up from 14.6% in 1990. Equally serioushas been the increase in young part-time workers. In 2003, male parttimersaged 20–24 comprised 28.3% of their employed age group, upfrom 14.9% in 1990 and even lower levels from earlier periods. Some35.2% of female workers aged 20–24 were part-timers in 2003, up from18.4% in 1990 and lower ratios earlier. 54.5% of these young parttimeworkers are female.Some of these young people have voluntarily chosen alternativelifestyles made possible by high wages in an affluent society. The estimatesof the non-accelerating inflation rate of unemployment (NAIRU)has risen from its exceptionally low earlier levels, but at about 3.5%it remains significantly below the actual unemployment rate. Surveydata indicate most young people would prefer full-time regular jobs.The significant rise in the proportion of part-time workers, a categoryespecially comprised of young people, reflects the still weak demandfor labor. In the longer run, this underemployment means that youngworkers are not obtaining the benefits of skill development throughon-the-job training. This is a major hidden cost of Japan’s mediocreeconomic performance since 1991 (in addition to the Hashimoto andHiguchi chapter, see Sato and Sato, 1997). 3 Aggregate Demand and Macroeconomic Policy All the studies contained in this book make it clear that Japan’s mostimportant economic policy objective is to achieve good, sustained, fullemployment growth. This theme runs throughout this chapter as well.Certainly, while some of Japan’s slower growth has been due to changeson the supply side, a main thesis of this book is that Japan’s poormacroeconomic performance has been largely due to inadequate aggregatedemand necessary to maintain full utilization of labor and otherresources (see, for example, Amyx, 2004; Ihori and Sato, 2002; Mikitaniand Posen, 2000; Posen, 1998).Japan’s macroeconomic policy since 1991 has been one of xtraordinarystimulus, but even this has been insufficient in what have becomeeven more extraordinary circumstances. The government has run16 Reviving Japan’s Economybudget deficits of

close to 6–8% annually since 1997. Gross governmentdebt now exceeds 161% of GDP though importantly, as Broda and Weinsteinstress in chapter 2, the net debt actually is much lower because thegovernment both owns substantial financial assets and on a consolidatedbasis owns a significant proportion of its own debt. Nonetheless, both gross and net debt levels will continue to rise for some time. TheBank of Japan has reduced interest rates as much as possible, with thebenchmark overnight bank call rate, analogous to the American federalfunds rate, at zero. Yet these macroeconomic policies have not beensufficient to prevent deflation, albeit mild, since the mid-1990s. Evenmore importantly, between 1992 and 2003 Japan’s GDP averaged only1.2% annual growth, substantially below its potential. During that timethere were three recessions followed by inadequate recoveries, includingslightly negative growth (technical recession) for the middle twoquarters of 2004, and only a slightly positive fourth quarter (thoughJapan’s quarterly GDP data are weak, and subsequent adjustments sosubstantial, that they are only rough indicators).While it is true macroeconomic stimulus prevented a full-fledged financialcrisis and collapse into a 1930s-style depression, that is no greatachievement. Other rich, advanced nations have gone through difficulteconomic times in the last half-century, but relative to its potential nonehas done so poorly for so long as Japan. The lack of a successful macroeconomicpolicy has harmed all parts of the economy, and continuesto do so. The Japanese economy was particularly hurt by two major macroeconomicpolicy mistakes involving premature tightening. The first, inearly 1997, raised the consumption tax and other taxes while cuttinggovernment expenditures, a fiscal tightening swing of some 2% of GDP.The second misstep occurred in August 2000 when the Bank of Japanraised interest rates in the midst of deflation, ending monetary ease;while the size of the rate increase was small, that action had a hugeadverse effect on expectations.Expanding aggregate demand continues to be essential. Only thiswill narrow the supply-demand gap, restore true full employment, andfoster more positive expectations about Japan’s economic future, thekey to ending deflation. Growth, as must be repeatedly stressed, is necessaryboth to affect the short-term contractionary effects of industrialrestructuring and to provide the foundation for restructuring still weakbanks, life insurance companies, and other financial institutions.Introductory Overview 17Although some policy analysts have continued to propose an evenmore aggressive shortterm cyclical fiscal stimulus in order to revitalizethe economy and ensure sustained recovery and growth, many observersconsider increased government spending economically veryinefficient, with too many wasteful pork-barrel public works projects.Building bridges, tunnels, dams, and reclaimed land in sparsely populatedareas with little future demand for these services is worse than taxcuts, because the infrastructure investment not only results in constructiondebt but requires maintenance costs and labor misallocation foryears to come. Overspending on public works, partly due to collusionin bidding, is widespread in Japan; most voters, even in areas where theproposed infrastructure is located, have become skeptical of the valueof public works. There has been little domestic call for fiscal stimulusthrough public works and, indeed, the share of GDP devoted to publicinfrastructure investment has declined steadily since the mid-1990s.Fiscal stimulus proposals through tax cuts have gone nowhere becauseof deep Japanese anxiety about the persistent huge governmentbudget deficits and the high gross government debt-to-GDP ratio. Thespecter of a fiscal crisis sooner or later looms large in the media and thepublic consciousness, but apparently not in the presumably more sophisticatedfinancial markets, where long-term interest rates on 20 yeargovernment bonds remain very low, around 2% or less. A key policy dilemma is how to increase aggregate demand whilecurbing government budget deficits and the high government debtto-GDP ratio. Essentially this task is a matter of timing between thenear-term versus the long-term. Over the longer term Japanese savingrates will continue to decline and private business investment and personalconsumption demand will rise sufficiently to end the output gap,restoring normal aggregate demand and full employment growth withoutrequiring huge budget deficits. Eventually as well, further neartermincreases in the government debt ratio will end and then decrease.These problems are manageable, both in the near- and long-term. A keyfiscal issue is whether in the long run the Japanese government will beable to achieve fiscal sustainability, namely to finance increasing expendituresas a proportion of GDP for the rising elderly share of the populationwhile providing government services to the rest of its citizens aswell. The economic issue is how much government tax revenues willhave to increase as a share of GDP to meet societal commitments; orhow much these existing commitments will have to be cut in order to18 Reviving Japan’s Economymaintain incentives for firms and workers to stay in Japan; or how toalter income distribution.In one of the most important and controversial studies in this volume,Broda and Weinstein in chapter 2 present a careful empirical analysisthat argues Japan does not face a future fiscal crisis. They found that thepotential tax burden of long-term fiscal sustainability is much less direthan the Japanese government currently projects. Broda and Weinsteinestimate that, in due course, government revenues as a share of GDPwill have to increase only modestly unless Japan decides to increasewelfare levels to the equivalent of current European levels Broda and Weinstein base their analysis on several key points. First,net government debt, not gross, is the correct measure of the government’sfinancial position. It is necessary to subtract the Japanese government’sfinancial assets from its liabilities, and Japanese governmentinstitutions hold more than half the outstanding gross governmentdebt. For example, the government holds some $840 billion in foreignexchange reserves, which represents about 18% of GDP; these reservesare financed by government borrowing; and are basically a wash onthe balance sheet of the government special accounts. Broda and Weinsteinestimate that the government’s net debt as of March 2002 was 64%of GDP. They then use a more comprehensive public sector definitionof the net debt, consolidating the central bank’s assets and liabilities(which reduces the net debt ratio to 46%) and the government’s unstatedliabilities (based on the estimates of Doi and Hoshi, 2003) to arriveat a net public sector debt of 62%, which they use as their baselineestimate for long-term sustainability. They argue there is no need toreduce this level; net debt can rise as rapidly as nominal GDP withoutcausing problems.In order to have government expenditures for all Japanese, old andyoung, increase at the same rate as GDP growth, Broda and Weinsteinestimate that in the long run government revenues will have to be only34.6% of GDP, almost the same ratio as in 1990 before tax cuts were enacted.The OECD estimates that the average ratio of Japanese governmentrevenues to GDP for 1980–2000 was 30.9%, and forecasts the ratiofor 2004 to be 29.8%.The Broda and Weinstein estimate of fiscal sustainability is basedon reasonable assumptions. These include the population projectionsmade in an IMF study that fertility rates will eventually rise, that populationdecline will

level off by 2060 and that the share of elderly wllIntroductory Overview 19then remain constant. The fiscal costs of paying benefits to the elderlyduring the period of demographic transition will be spread over 100years, meaning that several Japanese generations will share these costs.This assumption implies that the ratio of net (and gross) governmentdebt will continue rising for some years before beginning to decline,but this increase is manageable. Broda and Weinstein note that whilethe share of expenditures on the elderly will increase as they becomea larger part of the population, total government expenditures on childrenwill decrease as their numbers decline. They also estimate sustainabletax rates under alternative, more stringent assumptions.These relatively optimistic projections are indeed good news. A fiscalcrisis will not occur so long as people and institutions continue tobelieve that Japan can restore fiscal balance in the long run. Tax revenueswill have to rise, but only moderately, as a share of GDP. Normalgrowth will help to increase tax revenues from their current cyclicaldownturn, but tax rates will have to increase somewhat, though not agreat deal unless Japan moves to a European-style welfare state or decidesto finance the transition process for the elderly in a much shortertime frame.Broda and Weinstein also make the important point that inflation hasonly a temporary effect upon reducing government debt, everythingelse remaining equal. Inflation does not solve the long-run governmentdebt problem since it only reduces the value of accumulated past governmentdebt, not the government’s future liabilities embedded in itscommitments to all Japanese, but especially to the elderly. Moreover,although an inflationary doubling of the price level would halve thegovernment’s gross debt, because so much debt is held by the governmentitself, the net reduction would be relatively small.While fiscal stimulus may be desirable in the short-run, it is difficultto cut taxes now while planning to raise them later. The political realityis that the LDP coalition government, which seems likely to remain inpower until 2007, has rejected any additional fiscal stimulus measures.Instead it has consistently attempted to keep the annual budget deficitto GDP level more or less constant, and has announced a medium-termgoal of achieving a primary budget balance by 2012. Broda and Weinsteinassert that this goal is too extreme a tightening path, especiallyif the economy grows below potential. As with all long-term policypronouncements, this may well be altered by changing events or newanalyses.20 Reviving Japan’s Economy 4 Monetary Policy This volume includes two important complementary chapters on monetarypolicy. Inadequate monetary policy is one of the most importantfactors in understanding the Japanese economy’s malaise in the 1990sand early 2000s. The Bank of Japan was consistently behind the curvefrom 1993 to 2000, and made a key policy error in August 2000 by tighteningmoney while deflation persisted. Harrigan and Kuttner in chapter3 convincingly argue that the Bank of Japan could have done better, ifonly it had known what the United States Federal Reserve would havedone in a similar situation, as did indeed begin to occur in America inthe early 2000s. Ito and Mishkin in chapter 4 provide a comprehensiveset of policies for ending Japan's sustained deflation (see also Cargill etal, 1997 and 2000; OECD, 2004; and Mikitani and Posen, 2000).As the Japanese economy fell into mild deflation in the mid-1990s, theneed for more effective monetary policy increased. Most mainstreameconomists believe that inflation and deflation are monetary phenomenain the long-run, and that a central bank can influence the course ofthe inflation rate, not by fine-tuning, but by achieving a medium-runaverage. From this general viewpoint, the Bank of Japan’s failures toprevent deflation from setting in and then allowing it to remain for aprolonged period represent mismanaged monetary policy. Specifically,the timing of adopting the zero interest rate policy (ZIRP) was late;additional actions while ZIRP was in place were taken too late, onlysending tentative and at times inconsistent messages; and prematuretightening in the midst of ongoing deflation was a major mistake. Evenwith a zero interest rate, a central bank should influence expectationsby promising a credible course of monetary policy and target inflationrates.Harrigan and Kuttner compare the macroeconomic situations andmonetary policy responses to the ending of asset price bubbles in Japanin 1991 and in the United States in 2000. Growth acceleration and stockprice increases prior to the burst bubbles were similar in both countries.Japanese fiscal balances improved during the boom years, but deterioratedin the down years, and the United States showed a similarpattern with even less favorable fiscal consequences. One substantialdifference is that Japan has been running current account surpluses inits balance of payments while the United States has been running increasinglylarge current account deficits in the years following the peakof its bubble.Introductory Overview 21Harrigan and Kuttner argue that monetary easing by the Bank of Japanafter the bubble’s peak was slower than in the United States whenmeasured by the respective actual interest rates adjusted for the inflation.Japan’s delay in cutting the interest rate in the early post-bubblestages very likely contributed to the start of the long stagnation. Onemitigating factor is that in 1991 and 1992 actual disinflation exceededexpectations, so that failing to cut the interest rate more aggressivelymay be somewhat excused. However, this excuse does not hold after1993. In particular, the Bank of Japan’s decision to keep the call rateunchanged at 2.25% in 1994 and in the first quarter of 1995 actuallycontributed to a further decline in economic activity by slightly tighteningmonetary policy in real terms. If in 1991–94 the Bank of Japan hadacted like the Federal Reserve in 2001–04, disinflation may not have setin as rapidly as it did, and more aggressive interest rate cuts in 1994 and1995 might have even prevented the eventual deflation that occurredand still persists.Harrigan and Kuttner apply an econometric model of a central banksetting the interest rate in reaction to the gap GDP and the expectedinflation rate, the so-called Taylor equation. Then they fit the Japanesedata with the estimated American coefficients to determine what wouldhave happened if the Bank of Japan had acted like the Federal Reserve.They find that the interest rate would have been reduced to zero bymid-1993, and remained there at least through 1995. They also criticallyreview the Bank of Japan’s monetary policy from 1995 to 2003 and findits response to deflation has been misguided, notably the rate hike inAugust 2000, or long overdue, as evinced by the quantitative easingbeginning only in March 2001.There is no question the Bank of Japan’s very easy monetary policycurrently in place should continue until sustained growth is restoredand deflation ends. Once sustained good economic performance isachieved, the appropriate monetary policy—when and how to exit thecurrent policy of quantitative easing and zero overnight call market interestrates—is addressed in the chapter 4. Ito and Mishkin argue forprice-level targeting to catch up with the hypothetical trend line of 1%core CPI increases extending from the 1997 level. (Given the upwardbias of the CPI, a 1% rise in fact maintains price stability.) This policyis history-dependent: the longer deflation continues, the higher theaverage inflation rate will need to be during the catch-

up period. Bycommitting to such a strategy, inflationary expectations will becomehigher as deflation persists (since the requisite “catch-up” will become22 Reviving Japan’s Economygreater). This aspect of price-level targeting is particularly attractive ina period of deflation. Once the price level catches up with the targetedtrend line, Ito and Mishkin propose that the Bank of Japan shift to regularinflation-rate targeting, for the sake of simpler communication tothe public.The effective coordination of fiscal policy and monetary policy is akey for success in maximizing policy efforts. In the early years followingthe Bank of Japan’s independence in 1998, especially under GovernorMasaru Hayami, relations between the Bank of Japan and its formermaster, the Ministry of Finance, were not smooth (see Ito, 2004). Bank ofJapan executives resisted suggestions from the Ministry of Finance toease monetary policy more aggressively as a threat to its independence,arguing instead that the Ministry’s fiscal policies should be more expansive.However, the Ministry of Finance’s monetary policy suggestionsturned out to be correct, and resisting them was a costly mistake. SinceApril 2003, under Governor Toshihiko Fukui, the relationship has improved.When the same message is sent both from the government andthe Bank of Japan, and when fiscal policy and monetary policy actionsare presented as a coordinated package, the effects on the economy willbe maximized. 5 Financial System DifficultiesJapan’s macroeconomic difficulties have exacerbated the prolongedand profound weakening of it’s financial system, and this problem isanalyzed in three related chapters: Hoshi and Kashyap consider thebanking system, Fukao examines the life insurance industry, and Doifocuses on the government financial institutions. What once was consideredto be an extraordinarily large, strong and effective financial systemhas become one of the weakest among advanced industrial nations.Virtually every Japanese financial institution has been overwhelmed bythe major declines in stock and real estate prices, non-performing loans,very low interest rate spreads for banks, negative carry for life insurancecompanies, persistent if mild deflation, and the consequences ofmanagement mistakes.In chapter 5 Hoshi and Kashyap stress that, despite huge write-offsof non-performing loans and improvements in the last few years, thecapital position of almost all Japanese banks remains extraordinarilyweak. Through mergers and failures the reduction from 20 big banks in1990 to 8 in 2004 has created even larger but not stronger banks. MergIntroductoryOverview 23ers have not yet resulted in substantial cost cutting or in the developmentof new, more effective business models. Moreover, bank lendingpolicies have worsened asset quality. While total bank loans have decreasedsignificantly, loans to very weak, large borrowers (called “zombiefirms”) have been maintained and in some cases even increased.Hoshi and Kashyap emphasize that under Minister Heizo Takenakasupervisory and regulatory reforms by the Financial Services Agency(FSA) to restructure bank balance sheets and identify and deal withnon-performing loans have been a substantial improvement over thepast, but should be further strengthened and pursued even more vigorously.Nonetheless, these are only the first steps to restoring competitivenessand strength to Japanese banks. Hoshi and Kashyap stressthe reality that many banks remain undercapitalized and need to berecapitalized. Several ways to capitalize banks have been proposed andimplemented. The government can inject capital into weak but solventbanks that are essential to the financial system’s stability or in regionalbanks to support the local economy, as has been done in the past. Ifinjected as shares, the government can sell these in the market, ratherthan having the bank pay the capital back to the government, in orderto maintain capital.Japan’s banking system continues to be plagued by overbanking,resulting in very thin lending spreads and low profitability. As Hoshiand Kashyap make clear in their policy recommendations, even endingdeflation and restoring good economic growth will not be sufficient tocreate a competitive banking system within a reasonable time period.Moreover, once the economy returns to normal and interest rates rise,Japanese banks will suffer losses on their immense government bondportfolios; it is not certain that gains in their stock holdings will be sufficientto cover these losses. The major Japanese banks need both to improvetheir information technology infrastructure and to develop new,fee-based sources of income, still extraordinarily low by internationalcomparison. The traditional bank model of accepting deposits and lendingthese funds is no longer profitable since large, sound firms can raisefunds and borrow through the capital market. Japan’s banks are slowto adapt to a new deregulated environment by changing their businessmodel, and this needs to change (see Hoshi and Kashyap, 2001; Hoshiand Patrick, 2000; and Ishigaki and Hiro, 1998).Bank restructuring has progressed more slowly for regional and localbanking institutions, especially second-tier banks and credit associations,many of which continue to have severe nonperforming loan24 Reviving Japan’s Economyproblems. The June 2004 legislation providing 2 trillion yen (about $18billion) of government funds to facilitate bank rescues and mergers byinjecting needed capital without declaring them insolvent signals thatthe Financial Services Agency is finally prepared to tackle regional bankbalance sheet problems. How strongly and effectively this agency willmove, and how the politically powerful local banking institutions willrespond, remains a serious concern.In Japan the government is an exceptionally large financial intermediary.The post office system, through postal savings accounts, holdssome 30% of total household deposits and 37% of the life insurance industry’sgross assets, both far larger amounts than held by any privatefinancial institution. Some of these funds are invested in governmentbonds, but a significant portion, together with government-controlledmonies, are transferred to a host of government financial institutionsand special public corporations through the Ministry of Finance’sFiscal Investment and Loan Program (FILP) and other channels whichhave recently been put in place by FILP reforms introduced in April2001. Nonetheless, these financial flows, and government financialinstitutions and special public corporation activities, have been veryopaque.In chapter 6 Doi provides the first careful, detailed English-languageanalysis of government financial institutions and special public corporations,each of which is a major source both of the burgeoning governmentdebt and increases in government financial claims on the privatesector. However, these entities have huge non-performing loans (on theorder of 36 trillion yen) which are yet to be addressed. Doi focuses on 10major government financial institutions and special public corporation, which together make about 20% of total loans to the private sector andan even larger share for small business and for household mortgages.As the economy has matured and the financial system has been fundamentallyderegulated and liberalized, Doi stresses that many governmentfinancial institutions have become weak and redundant, andtheir economic rationales have evaporated. Government financial institutionsdistort markets by competing unfairly with the private sector.They are inefficient because their activities are explicitly or implicitlyguaranteed by the government; this soft budget constraint means thatdeficits

are inevitably covered by government subsidies. The potentialliabilities of the government are open-ended, as there are no clear bankruptcystatutes for the government financial institutions or the specialpublic corporations.Introductory Overview 25Doi identifies the specific set of problems for each major governmentfinancial institution or special public corporation and proposes appropriate required to raise funds by selling their bonds in themarket, as has only just begun, in order to impose market discipline.However, so far the spreads show the market views these bonds as havingat least an implicit government guarantee. Doi also recommendsthat some institutions be closed and that the others be transformedinto state-owned companies with limited liability and a hard budgetconstraint.Reforming the postal system through privatization has long been amajor priority for Prime Minister Junichiro Koizumi, despite oppositionfrom many of his fellow LDP politicians who benefit from the localpower of the special postmasters in some 24,000 post offices. The Koizumigovernment now has underway proposals for major privatizationof the postal system over a long-term (17-year) period (see Cargill andYashiro, 2003). How this will play out politically and economically isnot at all clear. Assuming some bill will be passed, what will be the specificdetails of privatization embodied in the legislation? How effectivewill they be? How will the post-Koizumi government actually implementor alter any policies enacted by the Koizumi administration. Inour view, this will continue to be a contentious yet important issue forseveral more years. Nonetheless the major economic issues are clear.Japan’s postal system has three business lines: mail delivery service,postal savings accounts, and postal life insurance. Each function is agiant in its respective industry, so simple privatization will create hugeinstitutions with strong market power, in conflict with a good solutionin terms of competition policy. Moreover, as Doi points out, crosssubsidiesare a source of unfair competition. However, separating eachbusiness line into regional divisions could reduce the value of the servicesprovided to households.The incumbent provider of postal delivery services, the Ministry ofPublic Management, Home Affairs, Posts and Telecommunications,argues that mail service should be universal, and that private-sectorentrants should be required to provide universal service. This stancewould make new-entry prohibitively expensive. Package deliveries arecompetitive markets, as several private-sector delivery services and thepostal system compete with each other. Private companies argue thatthe postal system has an unfair advantage because it does not pay taxeson their real estate holding or profits.26 Reviving Japan’s EconomyThe postal savigs and postal life insurance systems compete directlyand powerfully with private financial institutions. In an effortto deregulate and privatize postal financial services, there are severalabsolutely necessary requirements, and others that are more controversial.The first requirement in reforming the postal saving system is thatit should have to pay the same deposit insurance premium as banks.This change would achieve a level playing field and eliminate the government’scurrent free guarantee of deposits. The postal savings systemmay be effective in collecting deposits, but it has little expertise in theportfolio management of these funds; it has no capability to make efficient,informed loan decisions. However, the Ministry of Finance wantsthe postal system to expand into lending operations. Doi proposes thatthe system be transformed into a narrow bank, that accepts savings depositsbut only holds government bonds as assets. This would obviateany increases in banking services in an already over-crowded financialsystem, and eliminate the need to develop expertise in providing lendingservices. It also eliminates the threat of market power, while providingdepositors with safe assets and the government with continuedready access to household savings.In his chapter on the life insurance industry, Fukao incorporates ananalysis of the government postal life insurance system (Kampo), whichcontrols more assets than the five largest private companies combined.Kampo receives substantial government subsidies, explicit and implicit,including tax exemption, government guarantees, and cross-sellingwith deposits. These subsidies should be addressed first. How to privatizepostal life insurance while ending its excessive market power isone of the key challenges of any privatization program.Fukao paints a stark picture of the life insurance industry from the1990s to the present. The private-sector now comprises some 40 companiesof which many are new entrants, both Japanese and foreign firms,following reduced entry restrictions in the 1990s. Seven traditionalcompanies failed in the 1990s due to weak management of interest raterisks, excessive exposure to stock market declines, perverse incentives,and lax regulatory supervision; in fact, though not reported at the time,these firms were deeply insolvent when they went bankrupt and weresold off.Fukao focuses on the 10 major companies that together now have adominant market share of the life insurance industry. The fundamentalproblem for all these firms is negative carry, the fact that the guaranteedrates of return on policies sold prior to the mid-1990s are substanIntroductoryOverview 27tially above the current rates of return on company assets in Japan’slow interest-rate environment. As a consequence, these life insurancecompanies are suffering losses and depletion of their capital. Fukaoshows that the adjusted solvency ratios are substantially weaker thanreported, and several companies are in considerable difficulty. If negativecarry persists, more firms may go bankrupt or be forced to reducethe guaranteed rates to policyholders, the latter of which is now allowedbut will have adversely affect their reputations in increasinglycompetitive markets.Fukao also analyzes the problems of this industry’s poor asset-liabilitymanagement, weak corporate governance, weak regulatory supervision,double-gearing between life insurance companies and banks,and the market distortions generated by Kampo. He proposes a rangeof policies to restore the industry’s strength, including more effectivesupervision and regulation, ending the inclusion of deferred tax assetsin the measurement of their capital, and the prohibition of doublegearing.Chapters 5–7 make clear how significant the remaining problems offinancial system reform are, and propose what should be done. Structuralreform of Japan’s banks, life insurance companies, and especiallyits government financial institutions is essential to overcome distortionsin resource allocation and economic activities. 6 Corporate Restructuring and Financing All sectors, companies, and households have suffered through Japan’s long period of economic malaise. Credit is the life blood of all businesses,and the banking system’s profound weaknesses have had greatadverse spill-over effects on all economic activity, as Iwaisako discussesin his chapter analyzing business investment and restructuring. Wellfunctioning, competitive banking and financial systems are essential toallocate resources more efficiently so as to increase GDP.Although corporate restructuring has made some progress, much remainsto be done before Japan can become a normal, efficient economybased on competitive markets unimpeded by large amounts of

nonperformingassets. The average return on equity remains low in internationalcomparison, and the gap between strong and weak firms in allsize categories has widened. In addition to the highly publicized casesof very large, inefficient, heavily indebted zombie firms subsisting oncredit rollover and new injections from main banks, many small- and28 Reviving Japan’s Economymedium-sized enterprises remain weak due to a combination of stillhugedebt burdens and lost competitiveness in a changing domesticand global business environment. The government made progress onthis front by creating the Industrial Revitalization Corporation Japan inApril 2003, a semi-public arm of corporate restructuring. Together withthe main banks, it takes stakes in and restructures the overly-indebtedcompanies. Firms with good cash flow have focused primarily on payingdown debt to restore balance sheets. However, too many firms haveyet to develop, much less implement, more effective business models.Restructuring inefficient government special corporations and agenciesso far has been quite slow. These problems will endure even after theprivate-sector economy returns to a stable equilibrium growth path.Iwaisako notes that business investment has slowed to about 15%of GDP, but is still higher than in the United States and certainly highrelative to the GDP growth rate. The slowdown in business investmentwas due primarily to lack of business demand and the need to restorebalance sheet equilibrium by paying down debt, despite a brief creditcrunch in late 1997 and early 1998. Iwaisako identifies as a major problemthe slowdown in productivity growth, due in part to the slowdownin the reallocation of capital and labor across industries. He identifiesthe misallocation of bank credit as a serious problem. Because banksare weak and insiders in the non-performing loan problems, they havecontinued lending to weak borrowers, termed evergreening. Bankshave not been able to engage in their earlier monitoring and restructuringroles as outside, objective arbiters.New private financial institutions engaged in business restructuringhave developed only since the late 1990s. Not surprisingly, restructuringbrings to the fore conflicts between conventional business practicesbased o management control and the painful requirements of restructuringand of new corporate governance modes. Most restructuring has desirable. Government policies have been supportive, especially inlegal and institutional changes to make management decision choices,corporate governance, and capital markets more effective.Yet government policies to deal with the asset management difficultiesof large, virtually insolvent Japanese companies have beenad hoc and partial. This is in stark contrast to countries such as Korea, inwhich a government asset management company was established andrequired to purchase bad bank loans, with the government temporarilytaking over majority ownership of the banks. The Japanese governmentIntroductory Overview 29established the Reconstruction and Collection Corporation in the mid-1990s, but it has served mainly to take over nonperforming loans offinancial institutions in difficulty, and has not concentrated much onthe restructuring of the corporate borrowers. The Industrial RevitalizationCorporation Japan is more active in restructuring large companiesbut inevitably will have a relatively limited direct role since it has onlya five year charter.Iwaisako considers two important cases of government interventionin restructuring corporate debt. One is the nationalization of the Long-Term Credit Bank, the terms of its eventual sale to Ripplewood, and itsre-establishment as Shinsei Bank. He notes that the government andbusiness community were implicitly expecting Shinsei to play accordingto the existing game, in effect to keep lending to existing borrowersregardless of quality, not to exercise the put option on non-performingloans they had taken on, and in general not to rock the boat. InsteadShinsei behaved as a rational economic actor. This incurred the wrathof traditionalists, but was ultimately a successful strategy. The secondcase was the placing of the excessively diversified, heavily indebtedKanebo into the Industrial Revitalization Corporation Japan process inmid-2004. Management was changed, equity was written off as were aconsiderable portion of the bank loans, the successful cosmetics divisionis being sold, and the non-profitable divisions are being restructured,sold or closed.Iwaisako draws several conclusions. Restructuring often needs athird, outside, party that is not involved in embedded and tangledlong-term relationships among the company, its main banks, and otherinterested players. Government intervention should be limited in ordernot to crowd out private market restructuring efforts; it is desirableonly when there are obvious market failures, as generous governmentbail-outs come at the expense of taxpayers and healthy competitors.He judges the Industrial Revitalization Corporation Japan to have beensuccessful. However, Iwaisako is more skeptical of the increasinglyextensive restructuring activities of the Development Bank of Japan,which is more vulnerable to political pressure and because its objectiveto ensure its own survival may be more important than efficientresource allocation.Efficient corporate restructuring usually involves downsizing, includingreducing the numbers of employees. In Japan, job cuts havebeen mostly through natural attrition and, in extreme cases, early retirementbuy-outs. As Hashimoto and Higuchi discuss in chapter 10,30 Reviving Japan’s Economylabor market adjustments inevitably are specific, depending on age,skill, gender, and geographical location. They propose programs to enhancelabor mobility, including training programs to ensure the smoothtransition of workers to new employers rather than trying to protect existingjobs. They also emphasize the importance of good GDP growth toreduce unemployment, increase labor force participation rates throughnew employment, and make the reallocation of labor easier.Most Japanese orporate finance has continued to be provided bybanks and, especially for small- and medium-sized enterprises, governmentfinancial institutions. The government’s Big Bang policies of thelate 1990s have accelerated the development of capital markets. Nonetheless,the Tokyo capital market is still relatively costly, and the legalframework does not adhere to international best practices. Its rules andregulations are not foreignerfriendly; prospectuses and balance sheetshave to be written in Japanese. Stock transactions and registrations arenow electronically based, registration of ownership can be done withthe stock depository, and changes in ownership are much easier thanbefore. Further development of the Tokyo capital market is necessary.In chapter 9 Fujii analyzes the development of Japan’s corporatebond market since the late 1990s, which is important because bond issuancewill become a significant source of business finance, as it is inother advanced countries. She uses her own survey of participants inthe Tokyo capital market, and analyzes market effectiveness throughbond pricing models. Respondents identified taxation issues and lackof human capital (professional expertise) as major problems.Prior to deregulation culminating in the Big Bang financial reforms,regulations restricted corporate bond issues to only a few top-classcompanies. Now government restrictions on corporate bond issuanceare minimal, and previously high issuance costs have been reducedsubstantially. However, a market has not yet developed for high yield,below investment-grade, bonds. Nor has an appropriately priced middle-market evolved

for more risky bank loans. Fujii concludes that corporatebond market pricing is working reasonably well because pricesand their credit-default swaps are consistent based on monthly data.Estimates of changes in the implied ratings by credit rating agenciesand their actual bond ratings move together quite closely. Nonetheless,liquidity remains low.Fujii recommends that Japan’s government encourage the privatemarket by leaving it alone, while making appropriate changes in thetax code to ensure that tax treatment is equal and neutral. Market parIntroductoryOverview 31ticipants, Japanese and foreign, have to develop and apply increasinglysophisticated financial technology, rather than relying on governmentpolicy prescriptions. She recommends that the government stay awayfrom attempting to regulate high-risk markets, such as venture capital,distressed assets, and high-yield bonds. Of course there are areaswhere the government regulators should take useful initiatives, such asproviding a more efficient settlement system and specific measures toreduce barriers that raise administrative costs. 7 Japan’s New Trade Policy Japan’s foreign economic policy has long been founded on its comprehensivesecurity, political, and economic alliance with the United States;its commitment to an open, globally multilateral trading system underthe first General Agreement on Trade and Tariffs and how its successorthe World Trade Organization; and the market-based system of globalfinancial and direct investment flows (see Lincoln, 1999). Japan andthe United States have provided learning experiences and models foreach other, as exemplified in this volume by the Harrigan and Kuttnerchapter on lessons for American macroeconomic policies taken fromJapan’s experience with deflation. These approaches and commitmentshave not changed. However, a new strategic dimension has emergedin response to the increasing reliance on regional trading arrangementsby the United States and the European Union, and due to China’s riseas an economic power. Japan also has embarked on a new trade policy,one of bilateral cooperation under free trade agreements or, more comprehensively,economic partnership agreements.Traditionally, Asian countries have not formed significant preferentialtrading arrangements. The ASEAN Free Trade Area is a regional tradeagreement, but the lowering of tariffs among its 10 Southeast Asianmembers has been slow. Japan, Korea, and China were the only threeoutliers, as they had not joined any regional preferential agreements.Japan’s first free trade agreement, with Singapore, became effective in2002. Korea concluded its first negotiated free trade agreement, withChile, in 2004. Now there are frenzied free trade negotiations amongall the Asian nations. China has just signed a free trade agreement withASEAN. Thailand is negotiating more than a dozen free trade agreements.The United States has negotiated a free trade agreement withSingapore and Australia. Japan signed one with Mexico in 2004, and isnegotiating separately with the Philippines, Thailand, Malaysia, and32 Reviving Japan’s EconomyKorea, as well as with ASEAN as a group. How these will shape tradingarrangements in Asia remains to be seen.In chapter 11 Urata explains Japan’s trade policy motivations andstrategy, and strongly recommends that Japan pursue free trade agreementsin a manner complementary to the World Trade Organization.One reason is defensive. In the worst case scenario, Japan maybecome isolated from a world characterized by three dominant freetrade zones—the greatly expanded European Union; the North AmericanFree Trade Agreement (NAFTA) governing Canada, Mexico andthe United States, the proposed Free Trade Area of the Americas andongoing American bilateral free trade negotiations; and an expandedASEAN Free Trade Area with an increasingly powerful China. Anothermotivation arises from Japan’s increasing policy focus on East Asia,the world’s most rapidly growing economic region. The 1997–98 currency,financial, and economic crisis greatly increased East Asian interestin greater regional economic cooperation. Urata argues that freetrade agreements will both expand Japan’s market access in trade andinvestment and contribute to Asian economic growth. Japan’s policyapproach is more comprehensive than liberalizing trade barriers; itfocuses on investment, movements of skilled workers, and facilitationand cooperation in a range of areas. In this respect, Japan aims tosupport the global system by addressing and testing solutions to arange of international economic issues not currently covered by theWorld Trade Organization. At its best, in Urata’s view, an effectivepolicy of free trade agreements can be a catalyst for Japan’s economicrevitalization.Urata recognizes that the strongest Japanese opponents to this newfree trade policy are the powerful domestic protectionist forces andlobbies, particularly in agriculture, fisheries, and other labor-intensivesectors which are Japan’s most economically inefficient industries. Theconflicts between these sectors and other business and industrial interestshave become increasingly open and pronounced, in part due to thenegotiation realities of free trade agreements. For some, the free tradeapproach reflects foreign pressure (gaiatsu) to force changes that areoverdue on these domestic issues. Japan needs a fundamental reform inits approach to these inefficient sectors, perhaps by shifting to a systemof guaranteed income subsidies for existing farmers combined with freeimports and acceptance of world prices that will benefit consumer welfare.Even without dramatic policy solutions, these sectors will graduallyweaken due to a lack of interest among young people in workingIntroductory Overview 33in them, and domestic policies will have to move toward a more efficientresource allocation. The question is how soon and how efficientlythese changes will occur. Until Japanese policymakers can overcomethe domestic protectionist forces, it will be very difficult to pursue andimplement a comprehensive free trade strategy because Japan’s tradingpartners will insist on access to these protected markets.8 Major Policy RecommendationsComprehensive and detailed policy recommendations are made by thechapters' authors, founded on their careful analysis. We do not attemptto summarize their recommendations here, but offer a few broad neartermand medium to long-term policy recommendations based on theanalyses provided in this volume.Japan’s highest priority in the near-term is to end deflation and putits economy back on a good, sustainable growth track, still far frombeing achieved as of the beginning of 2005. Since a substantial outputgap still exists, growing above its long term potential for a few yearswill not cause substantial inflation. Growth should be supported bymonetary and fiscal policy to ensure adequate aggregate demand. Untilthe price-level target described by Ito and Mishkin is achieved, continuingthe zero interest rate policy and quantitative easing is appropriate.The Bank of Japan should learn from the United States Federal ReserveBoard in carefully avoiding deflation as well as inflation, as suggestedby Harrigan and Kuttner. Once sustained growth is achieved, the fiscalsituation can be dealt with in the medium- and longer-run, as Brodaand Weinstein show.Restoring health to banks and insurance companies is another keytask to getting the economy back on track. Hoshi and Kashyap, andFukao, in their respective studies, emphasize the importance of rigoroussupervision and regulation, together with rigorous implementationby the

Financial Services Agency to restore financial institution balancesheets and to create the right incentives. Regional and local bankinginstitutions in particular need to reduce their still-high non-performingloans, which entail substantial restructuring, merger and consolidation.Solvency margin regulations and rules for life insurance companieshave to be tightened, as Fukao strongly asserts.We do not endorse the “cleansing view” that recessions effectivelyand naturally improve resource allocations and bring about adequatestructural reform, and indeed Japan’s past 14 years of malaise34 Reviving Japan’s Economyindicate that is not the result. As the economy recovers, reforming andrestructuring policies and efforts should be strengthened for all financialinstitutions and businesses, private and governmental. The full and effectiveutilization of labor in appropriate jobs, as detailed by Hashimotoand Higuchi, and the effective reallocation of capital as emphasizedby Iwaisako, is the way to enhance productivity improvements andachieve better growth in both the near and medium terms. In particularthe creation of better job opportunities for younger Japanese workers isessential to maintaining a highly skilled labor force. In addition, existingmarket and social norms have meant that in Japan female labor is notallocated well. Institutional support for child-bearing and childcaringwomen is essential to take advantage of their potential productivities,and appropriate policies could increase the incentives to have children,thereby raising the fertility rate. Better-functioning capital markets, especiallythe further development of the corporate bond market, willcontribute to the more effective allocation of resources, as Fujii argues.In the medium to longer-term, once deflation is over and sustainedgrowth is achieved, the Bank of Japan should adopt some form of inflationtargeting, preferably explicit, as is proposed by Ito and Mishkin.Then it will be possible to reduce, even eliminate, government budgetdeficits, and stabilize the government gross and net debt ratios relativeto gross domestic product. As Broda and Weinstein show, fiscalsustainability can be achieved without huge increases in taxes so longas the transition costs are financed over a sufficiently long time period.Structural reforms of the government financial institutions and specialpublic corporations, and of local government institutions, as Doi forcefullyargues, are essential in order to allocate resources more efficientlyand to reduce the government’s contingent liabilities inherent in theexisting soft budget system. For social and political reasons, reforminggovernment institutions cannot be accomplished quickly, but the processhas to begin and be strengthened now. The Japanese government’sfiscal difficulties provide policymakers an incentive to make the difficultdecisions the governmental reforms necessarily entail.Two aspects of Japan’s relations with other countries, particularlythose in Asia, are especially significant in the medium to longer term.One is the development of free trade agreements and, more precisely,economic partnership agreements to liberalize trade and investmentflows, as Urata argues. The deepening of Japan’s economic integrationwith its neighbors has significant political and security implicationsthat probably exceed these economic benefits. The other aspect is forIntroductory Overview 35Japanese to decide what is the appropriate role of foreign workers intheir economy. In an immediate context, in free trade agreement discussionswith Japan, the demands of Thailand and the Philippines forliberalized worker visas are stimulating Japanese debate over these issues,with a generally positive view. But in the longer-run with Japan’saging and declining population looming, the issue of how and to whatdegree to allow and even encourage foreign-worker immigration mustbe squarely faced.We are confident that in due course the Japanese economy can andwill rise again. The nation’s economic and social fundamentals are stillstrong. As the government and private sectors accept and implement thepolicy recommendations contained in this volume, the economy will dobetter on both the demand and supply sides. While Japan’s near-termgrowth potential is quite high because of under-utilized labor and otherresources, even in the longer-run it is not only quite likely but probablethat the Japanese will achieve per capita GDP growth rates at least asgood as is the average for the other G7 countries. Japan will continue tobe a major global economic player and technology leader, far ahead ofthe rest of Asia and second only to the United States. And the standardof living and economic well-being of Japan will continue to improve, afundamental objective of this and indeed all economic analysis.