By Benjamin Powell
Following the end of the Allied occupation of Japan, real increases in GNP averaged 9.6 percent from 1952 to 1971. From 1972 to 1991, growth remained strong but less dramatic, averaging 4 percent per year. The rest of the 1990s and early 2000s have been a different story. From 1991 to 2003, real economic growth averaged just 1.2 percent per year. Why was Japan able to grow so fast for so long, and why has the subsequent slowdown lasted more than a decade?
A number of factors contributed to Japan’s rapid economic growth, including its starting point. World War II ruined Japan’s economy, killing millions of its people and destroying about 40 percent of its capital stock. With so much of Japan’s capital stock gone, the rate of return on capital was high, and so people had a strong incentive to invest and accumulate more capital. Naturally, this increased growth rates. But this, by itself, cannot explain why Japan’s growth rate was high for so long; other countries with even less capital failed to attract more and grow.
Low levels of privilege seeking also helped Japan grow. Privilege seeking occurs when a special interest group tries to obtain special privileges from the government. Because the interest group’s gains are much less than the overall losses to society, lower economic growth rates occur. Mancur Olson’s book The Rise and Decline of Nations describes how a major conflict such as World War II breaks up entrenched interest groups in losing countries and how this improves growth rates. Groups need time to reorganize and begin to seek privileges, and meanwhile, the economy grows faster. As more and more groups successfully get their special privileges, growth rates slow. Olson attributes much of the postwar performance of Japan and other Axis powers to the breakup of interest groups.
Japan funded its investment and capital accumulation through high rates of domestic savings. Gross private savings rose from 16.5 percent of GNP between 1952 and 1954 to 31.9 percent in 1970 and 1971. Average domestic savings from 1960 through 1971 averaged 36.1 percent of national income. The United States, by comparison, averaged only 15.8 percent from 1961 to 1971. The Japanese government encouraged saving by not taxing away the incentive to save. The tax code allowed for a portion of savings to earn interest income tax free when in an employer-run savings plan. In addition, interest on the first thirteen thousand dollars in each postal savings account was tax free, and many people had multiple accounts.
But special tax treatment was not the only cause of high levels of savings and investment. The overall environment of universally low taxes and economic freedom created much of the incentive to invest. Taxes as a percentage of national income fell from 22.4 in 1951 to 18.9 in 1970. During the same period, that percentage in the United States rose from 28.5 to 31.3. Lower tax rates in Japan fueled investment because citizens had more money to invest and businesses had a greater incentive to exploit opportunities since they would reap the rewards.
Tax rates, regulations, inflation, and other measures must be examined collectively to determine the extent of government intervention in an economy. The best compilation of these measures can be found in the Economic Freedom of the World Annual Report (see economic freedom). In 1970, the earliest year for which a ranking is available, Japan was concluding its period of rapid growth and was the seventh-freest economy in the world.
Various observers, including Chalmers Johnson, Robert Wade, and economist Joseph Stiglitz, have attributed Japan’s growth to the policies of the Ministry of International Trade and Industry (MITI). All claim that MITI helped Japan achieve a high growth rate by selectively pursuing tariffs and other industrial policies to favor particular industries.
The idea that MITI’s industrial policy was a cause of Japan’s growth does not bear close scrutiny. Any industrial policy that promotes one industry is necessarily a policy against other industries. For industrial planning to succeed, it must identify, better than markets do, which industries should be favored. In a free market, competitive bidding dictates how capital and labor are allocated, and profits and losses reveal what adjustments should be made. Information about which industries should exist is revealed only through the market’s process (see information and prices). Industrial policy rigs the market to enlarge some industries at the expense of others, thus undermining the process that generates the relevant information. Industrial policy faces the same knowledge problem as socialist planning: neither central planners nor anyone else can know the optimal industrial structure before the market produces it. Attempts at industrial planning are likely to hinder development by promoting incorrect industries. MITI was no exception.
In the 1950s, MITI attempted to prevent a small firm from acquiring manufacturing rights from Western Electric to produce semiconductors. The firm persisted and was eventually allowed to acquire the technology. That firm, Sony, went on to become a highly successful consumer electronics company. MITI also attempted to prevent firms in the auto industry from entering the export market and tried to force ten firms in this industry to merge into two: Nissan and Toyota. These attempts failed, and automobile manufacturing went on to become one of Japan’s most successful industries.
While striking examples exist of companies succeeding despite MITI’s discouragement, evidence of successful promotion does not. Although some industries previously promoted by MITI are profitable today, that alone does not show them to be good investments. They might have evolved similarly without subsidy; and one cannot demonstrate that MITI’s favoring of particular industries was better for the economy than if industrial policy had not rigged the outcome. Rigging the market process allows some companies to bid away resources that would have gone to other industries if the market had operated unencumbered. The industries discouraged by industrial policy would have better corresponded to Japan’s comparative advantage because they would have obtained their resources through the competitive process without the distorting influence of government.
Despite MITI’s involvement, Japan’s institutional environment of relatively low government interference and high economic freedom allowed the nation to grow rapidly for a number of years. During the 1980s and 1990s, however, policies changed.
After the September 1985 Plaza Accord, in which leaders from the world’s five biggest economies made agreements on economic policy, the yen appreciated and economic growth fell from 4.4 percent in 1985 to 2.9 percent in 1986. Between January 1986 and February 1987, Japan’s government attempted to offset the stronger yen by easing monetary policy, reducing the discount rate from 5 percent to 2.5 percent. The stock of narrow money (M1) was expanded at an annual rate of 6.7 percent from 1986 to 1988, while broader monetary aggregates (M2) grew even faster, at an average annual rate over those two years of 10.1 percent. Following the stimulus, asset prices in the real estate and stock markets increased, creating a financial bubble. The government responded by tightening monetary policy, raising the discount rate five times—up to 6 percent by 1990—while reducing narrow money growth to 2.3 percent in 1989 and 4.3 percent in 1990. After the tightening, stock prices and real estate prices collapsed.
The Nikkei stock-market index fell by more than 60 percent—from a high of 40,000 at the end of 1989 to below 15,000 by 1992; in May 2005, it was at about 11,000. Real estate prices also plummeted during the recession—by 80 percent from 1991 to 1998. After the onset of the recession in 1991, with the exception of a couple years of stronger growth in the mid-1990s Japan’s economy has shown either slow growth or an actual contraction. Overall, real GDP grew only 1.17 percent per year from 1992 through 2003, with an even lower 0.75 percent growth rate since 1998. The unemployment rate rose from 2.1 percent in 1991 to 4.7 percent at the end of 2004. These numbers understate labor market inefficiencies because of the Japanese commitment to lifetime employment that has resulted in many unproductive workers remaining on payrolls essentially as “window sitters.”
Japan’s government has taken an active role in trying to get out of the depression. Unfortunately, its policies have further hampered economic recovery. Most of Japan’s policies have focused on the traditional Keynesian prescription of increased government spending to boost aggregate demand for goods and services. Since 1992, Japan’s government has tried ten different fiscal stimulus packages totaling more than 135 trillion yen. These packages have accounted for approximately 3 percent of the Japanese economy. None was able to cure the depression, but the spending programs have caused Japan’s official public debt to exceed 150 percent of GDP, up from 40 percent before 1992 and currently higher than that of any other developed nation. While there were some temporary income tax rate cuts and revenues were falling with decreased economic activity, there were also some tax rate increases such as the two-percentage-point 1997 consumption tax increase that raised it to 5 percent.
Monetarist policies that focus on increasing the money supply to stimulate the economy have also failed. From 1995 through 2003, while central bank discount rates were often pushed down below 1 percent, the stock of narrow money (M1) was increased at an annual rate of 9.8 percent; but growth remained low and sometimes even negative. Expanding the stock of narrow money failed to produce similar increases in broader measures of money. The broader money (M2) measure increased only 2.7 percent annually during this same time. Some economists have mistakenly called the situation a liquidity trap, that is, a situation in which monetary policy is impotent because investors expect that in the future interest rates can only rise from the current low levels. But the lack of credit expansion is not due to investors’ expectations of future interest rate increases. Rather, it results from the enormous amount of bad debt in the banking system. Banks have used increases in the money supply to improve their balance sheets instead of issuing more loans.
Japan’s government has tried to circumvent banks’ unwillingness to lend. The Fiscal Investment and Loan Program (FILP), an off-budget branch of the Japanese government, lends directly to borrowers. FILP receives most of its money from the post office savings system, which had 254.9 trillion yen in funds at year-end 2000—around 35 percent of total household deposits. FILP and the postal savings system have been disconnected since reform in April 2001, but until that point, FILP had played a role in prolonging the recession. FILP allocated funds to borrowers through the Ministry of Finance Trust Fund Bureau. Politicians in the Liberal Democratic Party (LDP) run most of the government agencies in the bureau, and the Economist Intelligence Unit reports that “FILP money is channeled towards traditional supporters of the LDP, such as those in the construction industry, and without proper consideration of the costs and benefits of specific projects” (2001, p. 30). In one instance, a $5.3 billion loan was channeled into building a high-tech bridge-tunnel spanning Tokyo Bay that will, by the government’s own estimates, suffer losses until the year 2038. Thus, government direct lending does not aid economy recovery because funds are allocated to the most politically connected businessmen rather than according to consumer preferences. This leads to a higher cost of borrowing for those seeking private funds, further distorting the economy. Japan’s fiscal condition also worsened because the loans are often highly risky. Once FILP and other “off-budget” debts are included, Japan’s debt at year-end 2004 is estimated to exceed well over 200 percent of GDP.
The policy remedies that Japan’s government has tried have all focused on increasing aggregate demand. The real problem with the Japanese economy, however, is a mismatch between the structure of production and consumers’ specific demands. The structure of production was distorted away from consumer preferences when the post–Plaza Accord monetary expansion artificially depressed interest rates, thus signaling investors to undertake capital-intensive and long-time-horizon projects. When the monetary expansion stopped in the early 1990s, the boom collapsed. The Japanese government’s interventions in the economy have hampered the market’s correction process by maintaining the existing structure of production against consumer wishes, thus delaying economic recovery.
Much of the government spending has been on public works benefiting the construction industry—a large, politically powerful segment of the Japanese economy. The Liberal Democratic Party, which has been dominant in Japan since 1955, has cultivated the construction companies’ support through years of expensive public works programs. Almost half of the April 1998 and one-third of the November 1998 fiscal stimulus packages were spent on public works. Overall, between 1991 and 2000, the construction industry received more than fifty-nine trillion yen in orders from the government, accounting for 30 percent of all construction business. From 2001 to 2004 government has fallen to “only” 25 percent of the industry’s total business. The Economist Intelligence Unit’s profile notes that “generous Public works programmes have allowed many unviable construction companies to remain in business” (EIU 2001, p. 40). By keeping otherwise unviable construction companies in business, the government has hindered the market’s adjustment process by maintaining a capital structure that does not reflect consumers’ desires.
The government has used bailout funds and nationalization to help the banking industry. In late 1998, it set up a $514 billion bailout fund, with $214 billion designated to buy stock in troubled banks and $154 billion to nationalize, restructure, and liquidate failed banks. But nationalization and bailout funds serve only to prop up unsound financial institutions, delaying needed restructuring that would allow them to function as financial intermediaries again. The market deals with unsound banks by allowing bank failures, mergers, acquisitions, and restructuring. Some market corrections have taken place, but most bank mergers have occurred among smaller regional banks without access to bailout funds. Until the government stops intervening with bailout funds and nationalization, the process of larger bank failures and mergers will be delayed, and the time that the banks cannot function as efficient financial intermediaries will be extended.
The government has attempted to prevent the liquidation of the boom’s bad investments by creating a twenty-trillion-yen credit guarantee fund to ease credit availability for companies. The Economist Intelligence Unit’s profile states: “Funds disbursed under the programme are often going to companies that are not creditworthy and that would otherwise go bankrupt” (EIU 2001, p. 29). For the economy to recover, these companies must go bankrupt so that their capital and labor can be reallocated to other industries that better satisfy consumer preferences.
The repeated fiscal stimulus packages, the large amount of money controlled by the postal savings system and allocated through FILP, and the efforts to prevent bank and business failures have all prevented the market recovery process from working in Japan. These repeated government interventions have maintained the existing structure of production, delaying its alignment to the particular demands of consumers.
In the past half century Japan has experienced both high growth and prolonged stagnation. During the period of rapid growth, despite the existence of MITI, low taxes and low levels of government intervention were the main policies driving that growth. During the prolonged stagnation of the 1990s, economic growth suffered because the opposite was true.
Critical Accounts of State Industrial Planning
Favorable Accounts of Industrial Planning
Articles on Japan’s Recession