JPRI Working Paper No. 81, October 2001
Arthritic Japan: The Slow Pace of Economic Reform
by Edward J. Lincoln

At the turn of the millennium, the Japanese economy remained mired in a pattern of stagnation that had continued since the early 1990s. As this disappointing pattern dragged on, some in Japan called for systemic reforms to restore the nation to economic health. Beginning in 1994, the Japanese government formally pursued an agenda of broad economic deregulation, a specific package of deregulation measures for financial markets, and administrative reform. The private sector has also carried out some restructuring in the face of substantial excess capacity in some industries. Viewed casually from the outside, one could easily get the impression that substantial-- and beneficial-- systemic change was well underway by 2001. Having recognized their problems, the Japanese appeared on the surface to be charging forward to embrace practical, market-oriented solutions. That interpretation received an additional shot in the arm by the surprise selection of Junichiro Koizumi as LDP leader and prime minister in the spring of 2001. Koizumi's mantra of reform has proved to be overwhelmingly popular with voters.

But appearances are deceiving. The central conclusion of my recently published study is that fundamental aspects of the economic system are not changing very much. Like a person with arthritis, the existing Japanese economic system has lost much of its nimbleness; its joints have become creaky and painful. Japan has been taking aspirin for its arthritis-- partially alleviating the pain on a temporary basis-- whereas something more radical, like hip replacement, is needed to restore some mobility for the long-term. So far this is not happening, not even under the charismatic Koizumi. As is the case with arthritis, surgery and more powerful medicines will not return Japan to its youth. Japan is a mature industrial economy with a shrinking working-age population, so even reform will not restore it to the high-growth pattern of the past. Nonetheless, more radical treatment would produce a better economic performance than in the 1990s.

To be sure, the formal policy of deregulation has been proceeding since 1994 and has increased competition in some markets. However, the nature of corporate governance, corporate finance, labor markets, and the role of government in the economy continue without much alteration. This conclusion may raise some protest among readers. In 1997, as reform was getting underway, Wall Street Journal editor Paul Gigot concluded that the Japanese economic system had failed, proving the superiority of American-style capitalism, and that Japan would now reform to become more like America ("The Great Japan Debate Is Over: Guess Who Won?," Wall Street Journal, January 31, 1997, p. A18). In 1999, then-Prime Minister Keizo Obuchi published an op-ed in the New York Times stating that his nation recognized the need for extensive reform and was pushing boldly ahead ("Japan's Quiet Reforms," New York Times, April 29, 1999, p. A29). A few observers believe that radical changes are underway that will propel the economy back onto a stronger growth path (see, for example, M. Diana Helwig, "Japan: A Rising Sun?" in Foreign Affairs, vol. 79, no. 4, July/August 2000). I believe a careful analysis reveals that such optimistic views are incorrect and thus provide misleading expectations for American businesses and policy makers.

The economic stagnation of the 1990s was largely macroeconomic in origin, stemming from the rise and collapse of real estate and stock prices. Such asset bubbles can occur-- and have occurred-- in any economy. However, the macroeconomic origin of the problems obscures the fact that structural problems and flaws in the existing system contributed to the creation of the asset bubble. Furthermore, the failure to reform throughout most of the 1990s complicated and delayed the recovery of the economy. Therefore, robust economic recovery depends on further systemic reform and not just macroeconomic fixes. Cyclical macroeconomic developments and simple downsizing in the corporate sector should produce an upturn in growth over the next few years. But for Japan to move to a sustained higher growth path and avoid renewed recession or financial crisis over the next decade requires more substantial reform. Given the grim demographics facing the nation-- a falling population and rapid rise of retirees relative to workers-- an acceleration of economic growth and productivity change is crucial. With reform Japan might manage a growth rate of two to two-and-a-half percent annually over the next decade; without reform annual growth of one percent or less will be Japan's fate.

Failure to change will yield a stumbling economy bedeviled by recession and financial crisis that will raise worrisome possibilities for Japanese society, the rest of the region, and the United States. Should the economy sink into recession and crisis-- a distinct possibility, with the economy clearly headed into at least a cyclic recession in 2001-- Japanese households will obviously suffer. But this also means that Japan will not contribute much to global growth by sucking in more imports and investment. Furthermore, the politics of a disgruntled population could easily produce a more nationalistic foreign policy stance.

Why the Response Has Been So Modest

During the past 130 years, since modernization began, the Japanese have been a pragmatic people, producing a dramatic and successful transformation of their nation into one of the leading industrial powers of the world. However, this background and the ability to respond to foreign trends should be kept in perspective. The Japanese economy has coped quite successfully in the past century with a constantly changing economic structure. Industries have emerged, grown, and died. A massive movement of people out of agriculture into modern industry occurred in the past century, and with it a wholesale relocation of population from rural to urban areas. The textile industry, once a dominant exporter, has shrunk to insignificance. Much of the current news in Japan relates to restructuring-- bloated corporations shedding capital and workers, banks recouping from disastrous amounts of non-performing loans, and new industries taking off. But structural change is quite different from systemic change, and the big question today is not restructuring, but systemic change. Are the basic rules and practices that constitute the architecture for economic behavior in Japan undergoing major reform? No. Is the economy moving toward greater reliance on freely operating markets for goods, services, labor, and corporate control? Not very much. Will the Japanese economic system continue to appear distinctive when compared to the United States or other advanced industrial economies? Yes.

A decade from now the Japanese economic model or system will not have converged with that of the U.S. or other industrial nations. Japan's economic system may be somewhat different a decade from now, but it will remain distinctively Japanese. Government will remain intrusive in a number of areas of the economy, driven by a continuing belief that its guidance remains necessary for prosperity and to ensure the competitiveness of Japanese firms vis &Mac246; vis their American and European competitors. Financial markets, labor markets, and corporate governance will experience some shifts, without matching American practices. Deregulation will unleash new competition in some markets, to the benefit of domestic consumers, but the tendency even in those markets to temper competition with informal cartels will remain strong.

The terms "American model" and "American standards" have become quite faddish in Japan. One could argue that Japan is actually not so different from European countries, but when people discuss reforms that move the Japanese economy toward a greater reliance on markets, it is the contemporary American system they usually have in mind as a model. I use the phrase "American model" rather loosely as shorthand for a system that relies heavily on markets for goods, services, and corporate control. Of course American institutions and behavior have also changed considerably in the past several decades, and continue to change. Economic regulation in the United States has lessened or been eliminated in some industries, including transportation and telecommunications, but the economy is hardly a completely unregulated laissez-faire model today. American venture capital, and equity markets in general, play a larger role today than they did three or four decades ago. Shareholders-- especially mutual funds and pension funds-- exercise strong roles in corporate governance, representing another change from the past. Government plays less of a role than in the past in overt economic regulation, but it retains a critical function through establishing ground rules for markets and monitoring them to combat fraudulent or other undesirable behavior. However, compared to Japan or most other advanced industrial nations, the contemporary American economic model relies more on markets with relatively freely determined interaction of demand and supply for exchanging goods, services, labor, corporate finance, and corporate control.

I believe that aside from being different from the American model at the present time, the Japanese economy will not come to resemble the more market-dominated American model over the next decade. That comforting notion, as expressed by Paul Gigot or former Prime Minister Obuchi, is a misinterpretation of what is occurring in Japan. Despite the evident need for systemic reform, a set of powerful interconnected factors insures that change will not produce a clone of the American economy. These five inhibiting factors are:

1. A belief in the value of the existing system, which has been shaken but hardly destroyed by the events of the 1990s because of the mild impact of the economic slowdown on the average individual;

2. The interconnected nature of the distinctive features of the existing system, meaning that tampering with a few pieces of the system is not sufficient to change the whole;

3. Strong vested interests in the current system that may include a majority of the population;

4. Conformity of the system with broader social norms and expectations, representing values that society is reluctant to lose (or at least that the government is reluctant to have the society lose); and

5. A weak process of deregulation and administrative reform, driven by the bureaucracy itself rather than broad political pressures from voters, coupled with a corporate restructuring that emphasizes downsizing more than reforming the nature of the corporation.

These five factors are mutually reinforcing, and together they will shape the nature of change. While they are not sufficient to totally block some modification of the system, they certainly reduce the pace of change and affect the outcomes. This has important consequences for both Japan and the United States. For Japan, if the restraining factors identified here are too powerful, then very little systemic change will occur, and the economy will perform poorly for many more years. Renewed recession, dangerously rising levels of government debt, and a failure to meet the financial needs of a burgeoning retired population, are clear possibilities. The Japanese public will be less well off than they could be. This outcome also matters to the United States and the rest of the world. With the Japanese economy just muddling through, it will not contribute much to regional or global growth, and U.S. officials will have to cope with the international consequences of recurring financial problems in Japan. Meanwhile, Japan is unlikely to adopt a more liberal stance on bilateral or multilateral trade negotiations as weakness at home results in a continued defensive trade posture. Even security policy could be affected, including both the specifics of the bilateral alliance and Japan's broader participation in regional or global security issues. Self-absorption with domestic economic problems will leave Japan in a marginal role in major power security discussions. In general, Japan's failure to produce more vigorous economic reform produces a series of challenges and problems for American policy.

The Role of Japan's Government

Over the past quarter century, nations all across the globe have been getting government out of the marketplace. The United States began a process of deregulation during the Carter administration in the 1970s, and the process continues today. In Britain, Prime Minister Margaret Thatcher presided over the privatization of nationalized industries during the 1980s. China has permitted private corporations and markets to operate. Experiments with Communism, socialism, and regulation undertaken in many countries in the name of fairness and promotion of economic growth failed to meet expectations, leading to this massive reversal in policy. Behind the reversal lay a strong intellectual movement based on theory and empirical research concerning the inefficiency and failures of government when it meddles excessively with markets.1

On the surface, Japan would appear to conform to this broad global trend, as deregulation, administrative reform, and industrial restructuring have been the hot topics for discussion during most of the past decade. The 1990s were certainly a troubling decade for Japanese society. After a half century of rapid economic growth and successful transformation to an advanced industrial nation, the economy stagnated and a mountain of bad debt weighed down the financial sector. Economic growth in the eight years from 1992 (when the slowdown began in earnest) through 1999 averaged a relatively weak annual rate of 1.0 percent. This general stagnation was also punctuated by the first real recessions since 1974, with negative growth in calendar 1998, two consecutive negative quarters in the second half of 1999, and now again in 2001, with the first two quarters of contraction. This economic performance was hardly the disaster that it might have seemed from the exaggerated adjectives often used by the media; Japan remains one of the most affluent nations of the world and unemployment remains modest. But stagnation and bad debts after such a long period of unusually successful economic performance left many Japanese dismayed and bewildered by their problems.

The proximate cause of this poor economic performance lay in the speculative asset price "bubble" in the stock market and real estate market during the second half of the 1980s. In five years both equity prices and urban real estate tripled in value. When a worried government finally raised interest rates to constrain this situation, the party came to an end. The collapse of asset prices from the beginning of the 1990s, wiping out all the price gains since 1985, had a serious negative impact on the economy, as it would on any economy. Banks were also left with massive amounts of non-performing loans secured by real estate collateral that was shrinking in value. Both poor macroeconomic performance and the bad debt problem were then exacerbated by poor decisions within the Japanese government. Fiscal stimulus was an on-again, off-again affair for much of the 1990s, while the bad debt problem was allowed to fester unchecked until near the end of the decade.

Even though the problems of the 1990s can be traced directly to the rise and fall of asset prices, the problems lay deeper. Why did the speculative bubble occur? Why did the bad debt problem fester so long without any serious effort at resolution? Why didn't low interest rates in the 1990s encourage new business investment? Answers to these questions lay in structural flaws in the organization and operation of the economy rather than in just unfortunate but understandable speculative mistakes in asset markets. The existing Japanese economic system is a modification of capitalism involving, among other things, a strong indirect government intervention in markets that may have been well suited to the needs of a rapidly industrializing nation. But the problems of the 1990s demonstrated that this model did not suit the needs of an advanced industrial nation.

Poor economic performance in the 1990s therefore sparked a vigorous domestic debate over the need for government administrative reform, economic deregulation, new accounting rules, and other changes to spur more efficient corporate behavior. Beginning in 1993, all of these topics gained major attention in government and the private sector. Over the course of the rest of the decade, government moved forward with a plan for general economic deregulation, a "big bang" deregulation of the financial sector, and government administrative reform. Gradually, corporations also began to cope with their own problems-- bad debts, excess labor, and excess facilities. By 2000, talk of change was very much in the air.

Nonetheless, a number of important and interrelated factors impede the reform process, and the end result will be an economy that continues to differ in organization and behavior from that of the United States or most other industrial nations. The government will remain more intrusive in the economy than is the case in the United States or some other nations that have been deregulating. Mistrust of markets will continue, leading to constraints on the scope of their function. Corporate governance will not change to put shareholders in the driver's seat. And corporations will temper their drive for efficiency by other social considerations. Corporations might succeed in raising their return on investment relative to the dismal performance of the 1990s, but still remain less profitable than their Western counterparts.

All economies change over time. Economic institutions, the laws enabling those institutions, and regulations affecting economic behavior are all artificial constructs created by political systems and can be changed at any time. New technologies, experience gained concerning the success or failure of existing institutions and rules, shifts in macroeconomic variables (such as private sector savings and investment), as well as shifts in growing and shrinking sectors all produce changes in laws, regulations, institutions, and economic behavior. In this basic sense, Japan is no different from other countries. Many changes have occurred in the past 50 years, including creation of new industries and deregulation of some sectors.

In just the past decade the number of franchise outlets in Japan (an American corporate organizational innovation of the 1950s) has increased four-fold, with convenience stores and fast food outlets popping up like mushrooms.2 Franchised convenience stores have morphed into a distinctly Japanese format, providing a set of goods and services quite different from their American counterparts. Cellular telephones boomed in Japan after substantial deregulation occurred in 1994, with the number of cellular telephone subscribers rising explosively from 2.1 million to 60 million in the seven years from 1993 to 2000. Those rather dramatic changes in the context of a largely stagnant economy certainly suggest that economic vitality was not entirely lost. But such examples do not offset the harsh reality of a stagnant economy and the need for broader reform. The fact is, Japan does not have enough examples of such successes to drive the economy back to health and needs further systemic change to provide a more receptive environment for them.

The Japanese are well aware of trends in the rest of the world. They have been deeply interested in deregulation in the United States, as well as changes in other countries that have reduced the role of government in the economy. Much of the call for change at home has been driven by knowledge of these trends abroad. The ongoing revolution in information technology and its explosive deployment in the United States have attracted particular attention. The Japanese economy lags behind the United States in many aspects of information technology, but it is moving forward quite rapidly (and leads in some areas such as wireless communication). Japanese society is rich in technical expertise and generally has a pragmatic approach to new industries and technologies that will enable the economy to adjust reasonably quickly to the information revolution. (For example, the Japanese government is not phobic about internet access in the way the Chinese government is.) Concern over lagging behind the Americans provides a powerful incentive to both corporations and government to push development of this sector of the economy. Despite this, the record of the past decade is one of slow, mild reform efforts. And much of the systemic reform agenda is going nowhere.

One reason why the organization and behavior of the Japanese economy differs from that of the United States or other industrial nations is that over the past half-century it adopted neither the American pattern of extensive use of independent regulatory agencies, nor the European pattern of nationalized industries and extensive welfare. What Japan did adopt was:

1. Reliance on banking (rather than stock or bond markets) to move funds between savers and investors, including as a corollary broad collections of firms (horizontal keiretsu) centered on the major banks from which they borrowed;

2. A system of corporate governance that downgraded the role of shareholders in favor of banks and other "stakeholders;"

3. Long-term contracting in the corporate sector (known as vertical keiretsu);

4. Reduced price competition in the marketplace; and

5. A heavy dose of indirect government interference in the operation of the economy (often called industrial policy).

When this system was working well-- as it did during the first four decades after the Second World War-- people felt strongly that they had created a kinder and gentler version of capitalism than that advocated by neoclassical economists or practiced in the United States. Economic growth was high, unemployment was low, and rapid gains in personal income were broadly distributed throughout the society.

The nature of this system and its performance over the past half century also provide two powerful factors that obstruct reform. First, Japanese have been proud of their system for the past several decades. Why tamper with something that provided high growth, rising incomes, and low unemployment? The economic malaise of the 1990s certainly shook their belief in the efficacy of the system but hardly destroyed it. Many Japanese also see other benefits that they believe flow from their system-- relatively low income disparities between rich and poor (compared to the United States) and lower crime rates than in other countries. Some Japanese believe that the system is truly broken and must be radically reformed, but most seem to be far less certain that the system is broken and are reluctant to abandon a model they firmly believed to be superior to their perception of American capitalism.

Second, Japan's distinctive economic system involves a set of interlocking features, and changing or tinkering with any one feature of the system without simultaneously addressing most or all of the others will likely not be successful. At best, the piecemeal approach takes time as alteration of one feature of the economy creates incompatibilities elsewhere leading to further changes. At worst, the incompatibility that results from tinkering with one piece of the economy causes the proposed changes to be watered down or the resulting effect of the change to be minimized.

The Argument for Change

The main source of pressure for reform in the 1990s was, of course, the collapse of the asset bubble and the ensuing economic stagnation and non-performing loan problems. But an argument for change based on other factors can also be made. First, economic evidence demonstrates major areas of inefficiency or misallocation of resources in the economy relative to other industrial nations. While continued growth might be possible without fixing these problems, their negative impact has tended to grow over time, and by the end of the 1990s, some aspects of inefficiency were quite startling. Why, for example, does Japan have the highest ratio of investment to GDP among OECD nations (including the highest level of public works investment relative to GDP) while sustaining a virtually stagnant economy?

Second, the existing system contains some inherent weaknesses or flaws. Indeed, some of these flaws provide at least part of the explanation for the emergence of the speculative bubble of the 1980s and the poor policy and business response to its collapse in the 1990s. For example, the non-transparent relations between banks and their borrowers, or between government officials and the private sector, provided ample room for bad decisions and incestuous relationships to go largely undetected until they had resulted in major damage to the economy.

Third, the growing globalization of economic activity renders increasingly doubtful the advisability or capability of maintaining an economic system so different from that of other nations. The rising presence of foreign investors in Japanese financial markets, for example, pushed the discussion of raising returns on equity and other changes in corporate behavior.

All these factors fed into discussion and pressure for reform over the 1990s, but none of them was sufficiently powerful to produce radical change.Public dissatisfaction stemming from poor macroeconomic performance was modest because that performance was far from a disaster-- GDP did grow, albeit slowly, for the decade as a whole. The average person was better off at the end of the decade than at the beginning, making it more difficult to convince him or her to abandon the system for something unknown. Furthermore, while sustained economic recovery will require systemic reform, short-run cyclical recovery (as occurred in 1995-96 or in the first half of 2000) masked this need. To be sure, the financial sector experienced a debilitating bad debt problem and still teeters on the brink of disaster. But the fact remains that the average household was somewhat better off at the end of the decade than at the beginning.

The same holds true for other problems or flaws in the Japanese economy-- they represent problems or distortions sufficient to provoke concern, discussion, and some tinkering but are not (yet) disasters sufficient to yield extensive reform. Many of the inefficiencies in the economy, for example, are more evident to outside analysts than to the Japanese themselves, and none has been sufficiently debilitating to foster political revolt and extensive economic reform. By the end of the 1990s, "global standards" became a faddish term, but often with little operational content and normally offset by an underlying desire to maintain past practices. The combination of all these forces was certainly producing something new; no one can doubt the atmosphere of change in Japan. But the force of these factors still does not appear to be pushing the country toward major systemic reform.

Further Obstacles

I want to focus on two factors obstructing reform that are often ignored by straight economic analysis: vested interests and the conformity of the existing economic system with social values. Many groups in Japan have benefited from the existing configuration of the economic system and are very reluctant to embrace change. Farmers and those living in rural areas more generally, workers with lifetime employee guarantees, bureaucrats, construction firms and their employees, workers in small firms, and homeowners all benefit from the current system. Although each of these groups is a minority in the society, and feels particularly protective about only those parts of the system that benefit itself, in total they represent a majority of the population. The extensive nature of vested interests provides much of the explanation for why the democratic political process has not driven economic reform more vigorously.

Second, the economic system conforms to broad Japanese social values. Japanese society differs in many respects from that in the United States or the West more generally-- a statement that seems obvious but that economists and some political scientists resist. Explaining differences as a result of "culture" either amounts to a tautology or gives comfort to the tenets of nihonjinron, the so-called science of what makes Japanese unique.Nonetheless, at any point in time, visible differences exist between Japan and other countries (such as the United States) in the array of values, expectations, preferences, rituals, and routines for acceptable or desired social behavior. For those who object to identifying these differences as an outcome of "culture," one can point to the government policies that have emphasized (through the school system and other mechanisms) maintenance of these differences, and that it appealed to these kinds of differences in selling the public on the value of the various economic institutions that evolved in the 1940s and 1950s. It would be surprising if those differences did not have an impact on economic institutions and behavior.

In broad terms, the differences that have been bound up in the economic system include a strong group orientation, a sense of hierarchy, a reliance on personal relationships, avoidance of uncertainty, an emphasis on façades, and a preference for indirectness. These features of society are compatible with-- and have helped shape-- all of the distinctive features of the economic system. Group orientation, for example, feeds into the notion of a corporation as an organic whole rather than just a collection of assets put together for the sake of shareholder profits, as well as into the preference for career job security. Avoidance of uncertainty feeds into the heavy reliance on banks rather than bond and stock markets as a vehicle for household saving. Reliance on personal relationships leads toward the vertical keiretsu relationships, and so forth.

Change in social behavioral norms certainly occurs over time, and Japanese society today is rather different in some respects from 50 years ago. But these changes generally occur slowly. As long as Japanese social behavior is visibly different from that in the United States, convergence with an American economic model is unlikely. Equally important, so long as the government can appeal to the notion that Japanese should not, or should not want to, behave like Americans, it gains support for maintenance of these economic institutions and behavior patterns. Alteration of the existing overarching architecture of the economy is certainly possible, but whatever those changes might be, they must also be broadly consistent with social expectations.

A Flawed and Weak Process of Reform

One reason why the process of reform has been slow and the outcome very modest is that at the governmental level, deregulation and administrative reform have been squarely in the hands of the bureaucracy itself. Unlike the United States or other countries where political dissatisfaction led to electoral outcomes that brought deregulation and a reduction in the economic role of government, in Japan the bureaucrats themselves have been granted the mandate for change. As one would expect, this is a rather weak means to achieve real reform. Deregulation has involved a bean-counting game, with bureaucrats emphasizing the number of regulations that have been eliminated or altered. Little attention has been paid to reshaping the overall regulatory framework for particular industries. Meanwhile, administrative reform yielded a major reshuffling of the bureaucracy-- moving pieces of various ministries around within the ministerial structure-- without addressing the larger issue of the role of government in the economy. And while touting deregulation and administrative reform, the government's involvement in the economy has actually expanded, and its industrial policy schemes to promote various industries continue unabated.

In the private sector, structural change has been driven by stark necessity. Banks were burdened by massive amounts of bad debt, life insurance companies failed to earn promised returns for their policy holders, foreign financial institutions injected new patterns of behavior in the market, and many non-financial corporations experienced financial losses and increasingly stiff global competition. Back in the 1980s, the high-flying economy caused some outside observers to believe that Japanese firms could defy normal economic rules-- since they aggressively expanded market share without regard to profits. However, in any economic system the bottom line matters. Japanese firms could get away with low profits for years, but a firm hemorrhaging money eventually either restructures or goes out of business. By the late 1990s, parts of the private sector faced this dire constraint and some restructuring was moving forward. But the resulting restructuring has focused on the immediate causes of poor financial performance without much alteration to fundamental aspects of corporate governance. Cutting employment through attrition and early retirements, for example, does not alter the underlying practice of lifetime employment. Nor have firms exhibited much alteration in the relationship between managers and shareholders. This approach should not come as a surprise. The kind of financial pressures faced by Japanese firms necessarily led to restructuring in order to cut costs. But these pressures do not lead logically to fundamental reform of corporate governance. What is occurring is more of a one-time slimming of bloated corporate structure, a delayed but normal response to stagnation and recession.

Thus, neither government nor the private sector is embracing fundamental reform as enthusiastically as commonly portrayed in the international press. Unless or until the Japanese public exerts its democratic voice, more radical changes are unlikely. Optimists can point to the increasing integration of Japanese financial markets with the outside world, brought about by the recent inroads of American financial institutions in Japan. Bringing with them Western assumptions about corporate governance, these institutions are not shy about pressing firms in which they invest for changes in corporate behavior. Nonetheless, it remains unlikely that foreign financial institutions will be sufficiently powerful within the domestic Japanese market to bring about major changes in corporate governance.

Japan-U.S. Relations

What does the weak process of economic reform means for bilateral relations? American government and corporate planning should start by recognizing that reform is not proceeding vigorously, that the organization of Japan's economy will remain distinctive, and that economic performance is likely to be disappointing. While economic adversity in Japan may actually create some opportunities for foreign firms, for the U.S. government the implications are more sobering.

To begin with, is there anything the U.S. government can do to nudge Japan toward reform and a return to economic health? It is clearly in America's interest that Japan should have a healthy, growing economy, and bilateral discussion of how to achieve this should certainly be on the U.S. government's agenda. But because Japan is a very large economy and a large net creditor, opportunities to apply any leverage to nudge Japan in desired directions are few. Discussion and advice are always desirable and should be pursued, but there is no guarantee that advice will be acted upon. No American official should enter into this process with unrealistic expectations about what U.S. government policy can do to help fix the Japanese economic system.

On systemic economic reform issues, American trade policy may play a useful if very modest role. Deregulation is central to many trade issues, and as foreign firms play a larger role in the Japanese economy as a result of negotiations that make the market more open, they can have an impact on promoting system reform from within. Foreign financial institutions, for example, have brought with them important financial innovations that help change broader corporate behavior. Even this possibility, however, should be kept in perspective. Foreign financial institutions play a larger role than they used to, but they are not sufficiently important to bring major change in either the nature of financial markets or broader corporate behavior on their own. They will have an impact at the margin, but not much more. Still, the prospect of a rising presence of financial institutions and other foreign firms helping the reform process along should lead the U.S. government to continue pursuing an active trade agenda with Japan.

More broadly, economic reform decisions will be made by the Japanese on their own and U.S. government input will have relatively little influence. Americans are constantly asked by Japan for advice about what the country should do, and supplying gaiatsu (foreign pressure) has been a staple of bilateral relations since the time of Commodore Perry. In some cases, there may be opportunities to supply gaiatsu through government or even non-government channels that feed into existing domestic pressures for change. But most of Japan's economic problems are internal and will be worked out largely internally without reliance on American or other foreign input. Japan may seek advice and then ignore it. It may even choose to avoid bilateral arrangements in which the U.S. government can apply pressure; gaiatsu has become a pejorative term for many younger Japanese government officials who resent American interference in what they deem to be domestic issues. There is no harm in seeking ways to advise Japan on what to do, but American government policy must recognize that its influence will be small.

Even though gaiatsu may have little impact in general, times of approaching crisis (as when the Japanese banking industry was sliding toward wholesale collapse in 1998) justify strong pressure because of the potential international consequences of major economic crisis in Japan. Strong public statements by senior American officials at least have a high visibility in the Japanese media, providing some input in policy making. When necessary, public diplomatic pressure should be applied. American government officials should monitor Japanese developments closely to provide forewarning of approaching problems.

Even with American advice and occasional strong pressure, my conclusion is that Japan is unlikely to do more than muddle through. Sufficient reform will probably occur to prevent a serious collapse of the economy, but a weak growth rate of zero to one percent, with recurring financial problems, is the most probable outcome. In this scenario, the Japanese polity will remain self-absorbed with its domestic economic dilemmas for some time to come. Rather than thinking expansively or taking leadership on a global stage, Japanese political and bureaucratic leaders will focus heavily on domestic problems, and their behavior on international issues will reflect their domestic orientation. On economic issues, for example, the Japanese government will not be a progressive force within the WTO, and will work to undercut market-oriented policy proposals at the IMF. In addition, the nation's relatively weak economic performance and its image of bungling reforms undercut Japanese leaders' sense of confidence on the global stage, as well as the willingness of other nations to consider seriously international policy proposals coming from Japan. Even if American pressure were to lead to formal relaxation of the strict constraints on Japanese participation in peace-keeping operations (to include, for example, armed participation in collective security actions like the Gulf War), Japan's lack of self-confidence and its domestic self-absorption are likely to render it a relatively passive actor in multilateral deliberations during security crises and a reluctant participant in the wake of decisions made by others.

Continued weak economic performance could also affect the bilateral security relationship. A government concerned about the size of its rising debt levels will be less willing to increase budget expenditures related to American military bases. Furthermore, a Japan that feels uncertain about its own economic performance could possibly adopt a more nationalistic approach to the rest of the world. Unable or unwilling to hew more closely to an American-style market-based economic model, Japanese leaders might feel the time had come to distance themselves in other ways as well, pursuing a more independent or Asia-centric diplomatic and defense posture. If limited reform yields only a stumbling economy and financial crises increase resentment of a more successful American economy, Japan is likely to experience an increase in nationalistic attitudes and a desire for greater distance from the United States.

Could all of these predictions turn out to be wrong? One certainly hopes so. But the probability is small that accelerated and more thorough economic reform will revitalize the Japanese economy and yield a more confident global player. In fact, the downside risk-- in which failure to reform creates worse problems-- is much higher. While one can hope for a more optimistic outcome and direct American policy toward encouraging Japan to move in that direction, the presumption should be that Japan's performance will be disappointing.


1. For a comprehensive survey of the intellectual and policy trends that have reduced the economic role of government, see the study by Daniel Yergin and Joseph Stanislaw, The Commanding Heights: The Battle Between Government and the Marketplace That Is Remaking the Modern World (Simon and Schuster, 1998).

2. "Furanchyaizu no Mirai" (The Future of Franchizing), Nikkei Bijinesu, Issue 992, May 24, 1999, p. 23.

EDWARD J. LINCOLN is a Senior Fellow at the Brookings Institution and author of Japan's Unequal Trade (Brookings, 1990), Troubled Times: U.S.-Japan Trade Relations in the 1990s (Brookings, 1999), and many other books. This paper is based on the first chapter of his new book, Arthritic Japan: The Slow Pace of Economic Reform, published by the Brookings Institution in August, 2001.

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