Japan Ignores Free-Market Lessons

Back in the 1980s, a lot of best-selling books were written about how the United States should emulate Japan. Pursuing free market economics based on individual entrepreneurs was passe, so it was often said by Ronald Reagan’s critics.

Instead, we should follow Japan’s lead and actively use government to pick winners and losers. Its all-powerful Ministry of International Trade and Industry (MITI) was the wave of the future, we were told over and over again.

This view of Japan’s invincibility reached its peak with the 1993 movie "Rising Sun," which made MITI look like a combination of the CIA, the Mafia and the world’s best investment bank all rolled into one. However, not much has been heard on this theme since, because Japan’s economy tanked just about the time "Rising Sun" appeared. It has been in the tank ever since.

For the first few years after Japan’s economy collapsed, it was assumed that it would quickly recover. But as year after year went by with no sign of the old Japanese powerhouse in sight, expectations of recovery have also collapsed.

Ironically, some economists now view Japan’s weakness as being as bad for the United States today as its assumed invincibility was in the 1980s.

The Japanese invincibility theory was always stupid, but mainly because it completely misunderstood the true basis of Japan’s economic strength. It had nothing whatsoever to with MITI and everything to do with the competitiveness of the Japanese economy. Gen. Douglas MacArthur deserves more credit for this than any Japanese government official.

MacArthur was appointed Supreme Commander in Japan after World War II. During that time, he virtually had dictatorial power, which he used to reform Japan’s economy and political system. In terms of the economy, his most important contribution was to reform Japan’s tax system. For the next 30 years, its taxes were considerably lower than in the United States and structured to encourage growth to a far greater extent.

Almost as important was MacArthur’s breakup of the corporate cartels that dominated Japan’s economy before the war. Known as zaibatsu, these oligopolies made it very hard for new businesses to develop and grow. By smashing the zaibatsu, MacArthur opened up the Japanese economy in a way that probably could not have happened without such outside intervention.

In his 1999 book Embracing Defeat, historian John Dower notes that many of Japan’s largest and most profitable companies in the postwar era probably never would have emerged under the prewar constraints. Harvard Business School Professor Michael Porter’s book, Can Japan Compete?, recently concluded that Japan succeeded in spite of MITI, not because of it.

Unfortunately, MacArthur failed to reform one key element of the prewar system-banking. In Japan, businesses were encouraged to get most of their financing from banks, and they were allowed to own equity in such businesses. In the United States, banks were prohibited from owning equity and businesses got most of their financing from bonds and stock. The result was a heavy concentration of business ownership in Japan, versus the much more decentralized ownership in America.

Eventually, Japanese businesses and banks became deeply interlocked. In the 1980s, liberals like former Labor Secretary Robert Reich saw this as a source of strength-Japanese businesses, he said, could manage for the long-term without pressure from shareholders for profits or fear of hostile takeovers. But the result was that Japanese businesses had no pressure to perform and eventually became complacent.

When the 1990-91 recession came along, American businesses restructured; Japanese companies just rode it out without making significant reforms. When the savings and loan problem hit the United States, banks were closed, assets sold and the issue put behind us.

When similar banking problems hit Japan, however, no similar liquidation occurred. Banks were reluctant to write off bad corporate loans because they also owned the companies.

Today, the Japanese banking system is paralyzed. It has so many bad loans on it books, it cannot make loans to new businesses or existing ones needing capital for expansion. The Japanese money supply is exploding, but none of the money is getting where it is needed. Yet, rather than bite the bullet and liquidate the bad loans, as we did with our S&L’s, the Japanese government just keeps hoping that the problem will take care of itself.

Even if Japan pulls out of the worst of its current difficulties, it is hard to see a return to high growth unless another MacArthur comes along.