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The unfinished business of recovery

Japan can't afford to be complacent over growth and reform

by Takashi Kitazume

Japan needs to keep up the momentum of economic reforms and accelerate them in the face of long-term challenges such as an aging population and increased global competition, scholars from U.S. business schools said at a recent symposium in Tokyo.

Some of the scholars expressed concern that Japan could become complacent with the level of its recovery in recent years — aided much by the China boom — and delay necessary reforms.

The scholars were speaking on the theme, “Sustainability of the Japanese Economy” at the June 3 symposium, organized by Keizai Koho Center at Keidanren Kaikan. The event followed a weeklong program marked by the scholars’ exchanges with Japanese scholars, businessmen, and government officials.

Andrew Bernard, professor of international economics with the Tuck School of Business at Dartmouth College, said Japan is in “desperate need” of growth as it faces a range of problems, including an aging population, the changing structure of the workforce and rising global competition.

The nation’s sluggish growth for more than a decade has resulted in severe fiscal difficulties for the government, he added.

According to Bernard, the solution to these problems is quite simple: faster productivity growth that will make up for declining labor input.

However, there is no single answer to the question of how to achieve greater productivity, he said. “The solution will come from the accumulation of lots of small positive changes.”

“Japan has put into place a solid framework (for reform), but must continue on the path of the last few years,” Bernard told the audience.

“The fear of change is still strong among corporations, the government and workers,” he said, warning that the nation’s improved economic performance in recent years may reduce the appetite for necessary reforms.

To accelerate competition in every aspect of the market, Bernard said, Japan should encourage foreign firms to enter the market directly as well as through merger and acquisition, which he said would provide a “kick” for Japanese firms.

Meanwhile, barriers must be reduced for the creation of new domestic firms, he said, noting that unlike in the United States, no new banks are emerging in Japan except for a few Internet-based banks.

Japan should not be afraid to let firms and industries fail, Bernard said.

“Prevention of failure is the enemy of productivity growth” because failures will free up resources for the more productive sectors of the economy, he said.

Resources will be limited as the nation is confronted with the decline in working population and massive government debts. “Human resources will be scarce in the future, so they must be used preciously,” he said.

Similarly, limited as they are, government resources must be carefully allocated “to provide broad-based benefits to workers and companies” rather than to particular interest groups or sectors, he added.

Bernard also saw the need to support broad-based skill and knowledge acquisition by workers, and increased flexibility in the labor market. “Firms should not be afraid to lose workers . . . because they should be good enough to attract the best workers from other companies. That kind of competition is extremely important,” he said.

A worse outcome

Benjamin Hermalin, professor of banking and finance at the Walter A. Haas School of Business at the University of California, Berkeley, warned that reform on only some dimensions might end up having a worse outcome than doing nothing.

“To have good reform, sometimes you have to change everything at once. You can’t do it in piecemeal fashion,” he said.

Implementing reform in one segment of a system but not in the others can be likened to, for example, Japan implementing a law to change the electric voltage into the European standard without changing the electric plugs, Hermalin said. Such so-called “reform” will end up leaving Japanese consumers unable to use electric appliances for a while.

Such halfhearted reforms could actually be put in place if there is a lack of political will to pursue reform in all dimensions, he warned, noting at the same time that in Japan, some reforms are politically easier to enact than others.

Reforms can also be blocked or slowed in some aspects by vested interests within organizations, he said.

Business management that refrains from pursuing certain reforms in corporate governance may not be a bad thing in itself, but discussions with Japanese scholars and business leaders suggest that some company management teams have their own motives in resisting changes, which may not be congruent with what’s best for their firms, he noted.

Hermalin said reforms should remove — not add — restrictions on business activities. However, liberalization would be valuable only if the market is allowed to work, he added.

Echoing the view of his co-panelist, Hermalin said companies must be permitted to fail under the dictates of market forces, noting that protection from failure would mean the firms can abuse the freedom gained through liberalization.

He compared the examples of the U.S. savings and loan crisis of the late 1980s and Japan’s banking sector woes after the bursting of its asset-inflated bubble boom in the early 1990s — although he recognized that the magnitude of the problem was far bigger in Japan’s case.

While the U.S. authorities let the savings and loan institutions fail and stood back as their shareholders lost their equity, Japan had allowed unviable banks to hobble along and protected shareholders at the expense of the capital market and the nation’s economic growth, he argued.

Japan should not have dragged out the pain of the banking sector’s failures, he said. “We need to let people fail . . . and get market forces to help guide the country forward.”

Hermalin warned that prescriptions for reform that were successful in the U.S. may not necessarily be effective for Japan today. It would not be wise to simply copy somebody else’s mechanism, he said.

He recalled how in the late 1980s the mantra at U.S. business schools was that American firms should “copy the Japanese system wholeheartedly.”

“Such a view fell out of favor when the bubble burst in Japan and the U.S. economy grew dramatically” in the 1990s, he said.

“But relative success over a relatively short period does not necessarily tell us which system is right,” he added.

Similarly, he noted, a prescription for one company will not necessarily be right for another.

The China question

Bernard of the Tuck School of Business observed how during his visit he heard Japanese businessmen talk more about the risk of doing business with China than about opportunity in China.

While the notion of China as an economic threat has largely receded in Japan in recent years, the massive anti-Japanese demonstrations in Chinese cities in April and chilly political ties between the two countries have prompted many Japanese firms to have a second look at their plans for doing business in China.

However, Japanese firms will have to continue to accept China as an essential part of their worldwide operations, he pointed out.

“U.S. firms have fully embraced the idea that China and India are part of their global strategy,” he said. “They know they have to think about it. . . . They have to reorganize not just what they make and where they make them, but how their processes are defined. Japan will have to do that as well.”

Japan’s geographical closeness to China gives it an advantage over other industrial countries, although this proximity also brings economic as well as political costs and risks, he noted.

Bernard acknowledged that dealing with China poses many risks, adding that Japan should consider China neither as a threat nor a savior.

Also recognizing the risks involved in dealing with China, Hermalin urged Japan to start looking to India — an economy with a similarly huge potential.

Hermalin said that India has many of the positive characteristics of China: an immense domestic market, abundant supply of skilled workers as well as cheap labor.

In addition, India has many advantages over China for Japan, including having more English speakers, the country being less of a geopolitical rival for Tokyo, and fewer country-specific risks, he noted.

And the prospect of foreign firms shifting their investments to rival India may make China more friendly toward potential investors, he added.