JPRI Critique Vol. V No. 7 (August 1998)
The Mirage of Japanese Financial Reform
by Akio Mikuni
The core of Japan's economic problem lies with long-established economic policies dating to the war years and even earlier that aimed at the maximization of savings. A policy of savings maximization is another way of saying a policy of current-account-surplus maximization.
These savings were allocated not on the basis of the free play of market forces but rather to those industries that were either politically powerful or deemed essential by Japan's economic mandarins. The savings financed capital expenditures far in excess of those required by the domestic economy. This capital spending made many Japanese companies in a wide range of industries into world leaders at least when measured by technology, costs, or market share, but not necessarily by profitability. The beneficiaries of the Japanese system in the great corporations did not need to consider the profitability of their investments because they were engaged only in the expansion of production. Their solvency was the responsibility of their banks and ultimately of the government because the government insured the solvency of the banks.
The final guarantee of the solvency of Japanese industry, however, lay with Japanese households whose savings financed the economy. The strength of that guarantee thus directly correlated with the extent of their savings. Hence the entire economic policy apparatus aimed at maximizing those savings.
Those savings overwhelmingly took the form of bank deposits. Under an unwritten social contract, households put their savings into banks or the post office and accepted very low interest rates in return for at least an implicit guarantee that the principal would be safe. Since deposits were effectively guaranteed, losses incurred by the banks and the industries who used those deposits to finance their activities could not be written off directly. The only way for the economy as a whole to write off losses, except via the use of tax money, was through general inflation, but that in turn reduced the actual purchasing power of the deposits. In the 1990s, the Japanese authorities found that they could no longer engineer inflation, since Japan's position as the world's leading creditor nation made that impossible.
The implicit guarantee given to all deposits was only the first of the policy tools aimed at maximizing savings. Of equal importance is the tax system. Discussion of structural measures to encourage demand in Japan is simply empty talk in the absence of an overhaul of the tax code that would discourage saving and encourage consumption. By failing to do this, and by failing to dismantle its mercantilist system--and what, after all, is a policy of savings maximization other than mercantilism under another name--Japan now runs the danger of seeing the actual destruction of much of what it has achieved.
Why Is There No Change?
The Japanese system continues to work so well in extracting savings that savings are running far ahead of domestic investment requirements. This excess flows out of the country, where it finances Japanese exports that are not politically welcomed by its trading partners. The day will surely come when some combination of a stronger yen, severe trade frictions, and recessions in the economies of Japan's trading partners will force a reduction in Japanese exports. And when that day comes, Japan's low level of domestic consumption will be woefully insufficient to support the entire production apparatus built in this country. The politically engineered suppression of purchasing power of the Japanese economy will then pull Japan down into a recessionary abyss far deeper than anything seen since 1945.
Japan's policy elite has condemned the Japanese population to a standard of living far below that which they are capable of earning for themselves and actually deserve. This is, of course, the price of a mercantilist economy. Japan's industries may be at the cutting edge of late 20th century technology, but socially Japan is still mired in feudalistic thinking and social structures. No social revolution has occurred to create full-fledged Japanese citizens, a democratic political system, or a market economy. The policy elite will thwart any serious change as long as it can maintain its instruments of control over the economy, suppress consumption, maximize savings, and rely upon external rather than internally generated demand to keep the Japanese industrial machine going. Thus publicly voiced concerns over a weak yen/dollar exchange rate are little more than crocodile tears. The entire thrust of policy is to keep the exchange rate of the yen as weak as possible despite Japan's ever-rising current account surpluses and continual accumulation of claims on other countries.
Of course there are plenty of reasons by which market observers and participants justify to themselves today's weak yen regime. The U.S. Treasury is thought to want it. The United States offers more profitable investment opportunities. Dollar interest rates are higher.
But what all this reasoning ignores is just how dependent the United States is on a continued flow of funds from the rest of the world, most particularly from Japan. The funds keep flowing because of a set of politically determined policies in Japan that have brought about a recession. In a manner of speaking, Japan is deliberately depriving itself so that the United States can enjoy cheap access to foreign credit.
It is important to understand that while the government may have given up its policy of supporting asset prices at astronomical levels, asset prices have not yet fallen to market-clearing levels. Excess production capacity is not being shut down. Inventories have not been reduced. And as a result, of course, profits continue to be anemic. In such an environment, lower interest rates do not bring about any increase in borrowing and do not stimulate economic activity. Today they only produce aggressive purchases of dollars for yen--not, however, because domestic investors are borrowing low interest yen to buy higher interest dollars, but because the worldwide flight from Japanese banks has forced these banks to fund their dollar assets by purchasing dollar liabilities with yen. So while the Bank of Japan's balance sheet may be exploding, that is not translating into any commensurate increase in loan volume by Japanese banks.
I fear that no economic turnaround in Japan is possible until asset prices fall to a level where market players find it profitable to purchase them. Further, unemployment will have to accelerate until it forces the creation of an efficient labor market. Interest rates and the yen will have to rise to the point where unprofitable companies are forced to close their doors. The profitability of those left standing will have to recover sharply.
These events are not compatible with continued bureaucratic control of the economy. Japan's economic mandarins will not voluntarily give up their control; it will only be forced upon them by economic distress that will make today's bad economic news seem like a prelude. Such distress could, however, ultimately be constructive.
There remains, it is true, a very slight chance of reform prior to financial catastrophe stemming from Japan's inconsequential political leadership. Part of Japan's legislature is now elected via a single-seat system, which could theoretically provide one party with a landslide victory. Under the old proportional representation system, together with pork-barrel political machines, vested interests were bought off by public construction works, subsidies, and public employment in return for votes. This has become too expensive given Japan's enormous fiscal deficits.
Policy elites continue to be confident that Japan's journalists will protect them from the scrutiny of policy analysis. Japan's establishment media still operate to a very large extent under the wartime system, reporting what the elite deems will serve the national interest. Japanese newspapers do not discuss competing policy visions during campaign periods, meaning that vote-buying machines can work without being disturbed by the genuine cut and thrust of policy debate.
Assuming Japan does get that debate--a dubious assumption--and assuming it leads to an electoral takeover by the current opposition, it may be helpful at this point to ask what this new government would need to do in order to restart the Japanese economy.
A New Program
First, in order to maximize consumption and minimize savings--thereby reducing the current account surplus--the consumption tax must be eliminated. Interest income should be taxed as ordinary income. Both mortgage interest payments and property taxes should be deductible from taxable income.
To end the socialization of risk, to establish a clear link between risk and reward, today's almost completely intermediated financial system should be replaced with disintermediated securities markets as the primary source of corporate finance. Properly functioning securities markets would force elimination of the great drag on the Japanese economy--unprofitable production capacity. City banks must not be allowed to interfere with the necessary purging. They will have to be prohibited from supporting large companies: in other words, their role as "main banks" must end.
The government's attempts to control all financial risk should be abandoned. The government has a huge war chest that it uses for this purpose. It is the Trust Fund Bureau of the Ministry of Finance, funded with postal savings, postal insurance, and government pension funds. The bureau should be shut down. The government should tap personal savings through private intermediaries at market-driven rates of interest rather than unloading Japanese Government Bonds on the Trust Fund Bureau.
The Temporary Interest Rate Adjustment Law, which exempts financial institutions from anti-trust requirements and permits administered, cartelized interest rates on both lending and deposits, should be repealed so that interest rates are determined by market forces.
The core of the Ministry of Finance's licensing system should be changed. This system, by which the ministry licenses financial institutions to do business, gives the ministry immense power over credit allocation, leaving banks as little more than deposit gatherers. Both the risks and rewards of credit allocation should rest entirely with bankers, who would thus be forced finally to understand real credit analysis.
With the flow of funds in the economy finally freed from government control, the next most important reform must be the creation of a genuine labor market. Japan still has essentially a one-window market. It opens for young people on finishing their education and then promptly closes. Company employees are expected to work for 30 years, or most of their productive lives, for a single employer, during which time wages rise according to seniority but not their contributions. Japanese workers are underpaid during their younger years; as they age, the situation is reversed. This system can only work when bureaucracies and companies can promise incoming recruits that their jobs will be safe for 30 years. Only companies protected by the government and the main-bank system can make this promise, and bankruptcies of protected entities such as Yamaichi constituted serious breaches of the social contract. Meanwhile, smaller firms, whose viability is not protected, cannot compete for high-quality white-collar and engineering recruits.
Finally, reform depends on building an infrastructure of accountability. It is no longer possible for the Japanese government to compensate everyone, to allocate losses and burdens while fulfilling all of the implied social contracts. For loss-allocation to be carried out in a manner that is perceived as just and fair, Japan needs transparent, impartial accounting standards and universally followed judicial procedures. The number of accountants and lawyers in Japan is minuscule in proportion to the size of the economy. This must change and measures instituted to build the accounting and legal infrastructures necessary in a mature economy governed by market forces.
AKIO MIKUNI is President of Mikuni & Co., Ltd., Tokyo, Japan's
leading independent, investor-supported bond-rating agency. A graduate of the
School of Law, University of Tokyo, Mikuni was an executive of Nomura Securities
Co. from 1963 to 1975. See also his JPRI Working Paper 44 (April 1998), "Why Japan Can't Reform Its Economy."