Post-war Development of

the Japanese Economy

Development, Japanese/Asian Style
For Students in the EDP&M Program

April 2007

Shigeru T. Otsubo*
GSID, Nagoya University
(w/ inputs from Prof. A.Furukawa, Ritsumeikan Univ.)

For Students in the Economic Development Policy and Management Program

Prof. Shigeru T. OTSUBO
The purpose of this presentation is four-fold:
1) to introduce the macroeconomic development process of the postwar Japanese economy (the
so-called Miracle Recovery);
2) to explore the Japan-specific (mostly microeconomic) elements of a market system that
supported her rapid development;
3) to show the need for adjustments in the Japanese-style market system in the post-catch-up
era; and
4) to demonstrate the evolution and revolutions in economic systems underlying a development
process.

____________________________________
* The presenter wishes to acknowledge:
i) material inputs provided by Prof. Akira Furukawa, Ritsumeikan University, and
ii) valuable comments provided by Ms. Debra J. Saito, Economist, Federal Reserve
Bank of New York.

Objectives of This Presentation

The purpose of this presentation is four-fold:
1)

2)

3)
4)

to introduce the macroeconomic development process of the

postwar Japanese economy (the so-called Miracle
Recovery);
to explore the Japan-specific (mostly microeconomic)
elements of a market system that supported her rapid
development;
to show the need for adjustments in the Japanese-style
market system of the post-catch-up era; and
to demonstrate the evolution and revolutions in economic
systems underlying a development process.

To start with, macroeconomic factors that supported Japans strong post-war economic recovery such as high
investment ratios backed by savings mobilization, technology progress, flexible labor supply, and favorable
external conditions will be reviewed. Then, market practices of a long-term nature that were often referred to as
elements of the Japanese-style market system are surveyed. These elements include labor market practices,
keiretsu business relations, a main-bank system, and business-government relations that feature detailed
regulations and industrial policies. The long-run macroeconomic policies conducted by the Japanese government
including the medium-term economic plans will be introduced.
The post-WWII Japanese economic development was a process of catch-up to the other industrialized economies.
Economic policies and corporate strategies were geared to this utmost mandate in our mindsto catch-up. This
general goal was shared by all economic agents as a national consensus. Macroeconomic policies, particularly
monetary policies, were conducted in order to provide funds to strategic sectors for economic development. The
Japanese-style market system functioned fairly well in strengthening international competitiveness among the
tradable-goods-producing industries. Although the domestic markets were heavily protected in the early stages of
Japans post-war development, the potential threat of global competition provided sufficient incentives for
productivity growth as Japanese industries looked for export markets. On the other hand, investments in nontradable sectors were not sufficiently funded. As a result, development of non-tradable sectors lagged behind.
Elements of the Japanese post-war development system that were competition-restricting in nature functioned well
during her catch-up process.
When the catch-up process was over, however, those competition-restrictive elements became harmful. With the
energy crises of the 1970s, the Japanese economy went into an era of transition. In the 1980s, limited productive
investment opportunities in the domestic market coupled with loose monetary policy in the face of the yens rapid
appreciation fueled speculative investments in securities and property markets, creating a financial bubble. After
the bubble burst in the early 1990s, throughout the so-called lost decade, the Japanese economy has been coping
with the mounting needs of fundamental structural reforms.
Where is Japanese-Style Development heading now? Let us explore the evolution of Japans (socio-) economic
development system.

Contents
Part I:

Postwar Economic Reforms and Rehabilitation

Part II:

High Economic Growth Period

Part III:

SocioSocio-Economic Outcome of Rapid Growth

(1945 mid 1950s)

(mid 1950s early 1970s)
( 1970s )

Part IV: JapaneseJapanese-Style Market System for a Miracle Recovery

Part V:

The Evolution of the Japanese Development Model

End of the CatchingCatching-Up Process to the Bubble Economy
(1970s 1980s)
Lost Decade and Beyond
(1990s - )

Part VI:

Structural Reforms in The Japanese Development Model

Part VII: Aging Japan, Aging Asia

Part VIII: Revolutions and the Evolution of Economic Systems

(References)
On Development History, Japanese System
1.

Takafusa Nakamura and Konosuke Odaka, eds. Economic History of Japan 1914-1955 A Dual
Structure. Oxford Univ. Press, 1999.

2.

Takafusa Nakamura. The Postwar Japanese Economy Its Development and Structure, 1937-1994.
2nd ed. Univ. of Tokyo Press, 1995.

3.

Ian Inkster. Japanese Industrialization Historical and Cultural Perspectives. Routledge, 2001.

4.

Juro Teranishi. Evolution of the Economic System in Japan. Edward Elgar, 2005.

5.

Kozo Yamamura, ed. The Economic Emergence of Modern Japan. Cambridge Univ. Press, 1997.

6.

Hirohisa Kohama and Machiko Watanabe. Economic Development in Postwar Japan (in Japanese).
Nihon Hyoron Sha,1996.

7.

Yoshiro Miwa and J. Mark Ramseyer. The Fable of the Keiretsu -- Urban Legends of the Japanese
Economy. Univ. of Chicago Press, 2006

8.

Yukio Noguchi. Economics of the Bubble: What happened to the Japanese Economy (in Japanese).
Nikkei, 1992.

9.

Yukio Noguchi. The 1940 Regime: Goodbye War-time Economy (in Japanese). Toyo Keizai Shinpo
Sha, 1995.

10. Yukio Noguchi. Business-led Revolution in Japanese Economy: From Big Organization to Small
Organization (in Japanese). Nikkei, 2002.
On Industrial Policy
11. Mikio Sumiya, ed. A History of Japanese Trade and Industry Policy. Oxford Univ. Press,2000.
12. Chalmers Johnson. MITI and the Japanese Miracle The Growth of Industrial Policy 1925-1975.
Stanford Univ. Press, 1982.

Devastation during WWII

(1941-1945)
zHuman loss 1.85 million (2.8 million) deaths
zMaterial loss 25% of national wealth
zIndustrial production dropped to 1/10 of the
prewar level.
zHyper-inflation with commodity shortage

Devastation during WWII

Japan was devastated during World War II (1941-45). The human loss mounted to 1.85 million (about 4% of
the entire population) and 680 thousand injured or missing. The material loss mounted to about 25% of
national wealth excluding military stock (Economic Stabilization Board report of 1949). Another estimate of
the death toll was 2.8 million (Heibonsha Encyclopaedia, 1989).
Industrial production dropped just after the war to one-tenth of the pre-war level (24% of the pre-war level in
consumer products and only 8% in industrial input products). An increase in budgetary expenditure such as
veterans payment and compensation for the war damage, together with a commodity shortage, caused
hyper-inflation.

Successes and Failures in Japanese Economic Development

Phase
PhaseII(1945-1960s)
(1945-1960s)
Catching-up
Catching-upprocess
process
----Post-war
Post-war
democratization
democratization
----Common
Commongoal
goal
----Savings
shortage
Savings shortage&
&
directed
directedallocation
allocation
----Japanese-style
Japanese-style
Market
Marketsystem
system
--Employment
Employment
practices
practices
--Main
bank
Main banksystem
system
--Corporate
Corporategovernance
governance
--Govt
Govtintervention
intervention&
&
public
policies
public policies

Phase
PhaseII
II(1970s80s)
(1970s80s)
Failure
to
Failure toreform
reform&
&
bubble
economy
bubble economy

Phase
PhaseIII
III(1990s
(1990s--))
Long
Longstagnation
stagnation
&
beyond
& beyond

----Front-runner
Front-runner
necessity
necessityfor
for
competitive
competitivemarket
market
----Failure
to
transform
Failure to transform
the
thesystem
system
----Expansive
Expansivebehavior
behavior
by
businesses/banks
by businesses/banks
----Macroeconomic
Macroeconomic
policy
policyto
tocope
copewith
with
yens
appreciation
yens appreciation
----Bubble
Bubble

----Excess
Excesscapacity
capacity
----NPL
NPLand
andfinancial
financial
crisis
crisis
----Confidence
Confidencecrisis
crisis
----Deflation
Deflation
----Expansive
Expansivemacromacroeconomic
policy
economic policy
--Zero
Zerointerest
interest
--Budget
Budgetdeficit
deficit
----Structural
Structuralreform
reform
--Regulatory
Regulatory
--Financial,
Financial,etc.
etc.

Phases of the Postwar Japanese Development

Phase I: Postwar Reconstruction and Catch-up
Phase I of the economic development after WWII was from 1945 through the 1960s. A common purpose shared by
business, household and the government sectors was to catch up with North American and European industrial economies.
The collective and concerted actions coordinated by the government, often competition-restrictive, were effective in
achieving this goal.
A major obstacle on the macroeconomic front was the shortage of savings. The government created a system to mobilize
and direct funds to key industries for rapid economic development. On a microeconomic front, the so-called Japanesestyle market system was established, which emphasized building long-running relationships between economic agents.
Stable relationships were built on a foundation including (1) the long-term employment system, (2) corporate governance
built on cross-share holdings among businesses and with other financial institutions, and (3) the main-bank system. And
together with active public policies/guidance, they played an important role in Japans catching up with industrialized
economies.
Phase II: Era of Transition and the Bubble Economy
In phase II (early 1970slate 1980s), the Japanese economy caught up with other industrial economies in the world. The
clear, common goal had been achieved. Japanese business and household sectors should have changed their behavior
from the one based on collective actions to the more autonomous one of coping with their own risks under a more
competitive environment. However, we failed to change upon the celebrated success with our old system. Collective
business practices and government interventions largely remained. With a lack of innovative investment opportunities and
poor corporate governance, business firms and financial institutions rushed into speculation in financial and real estate
markets, creating the bubble economy. Expansive macroeconomic policies adopted in order to cope with yens rapid
appreciation in the middle of the 1980s also served to fuel the speculative bubble. Then, the bubble burst in the face of
restrictive monetary policies, first in the stock market in 1990, and then in the property market in 1991.
Phase III Lost Decade and Beyond
In phase III (the 1990s and on), the Japanese economy struggled with the aftermath of the burst bubble. Excessive
investment, excessive employment, and excessive lending and over-borrowing that had piled up during the bubble
development period had resulted in excess capacity and mounting non-performing loans. The necessary stock adjustment
of this excess, however, has been delayed in consideration of job security. This delay in adjustment resulted in longlasting stagnation, persistent deflation, and financial crises, in spite of massive expansion of government expenditures and
the money supply. This, in turn, created a public domestic debt overhang. In order for the Japanese economy to get out of
this trap, a comprehensive strategy and bold structural reforms are indispensable. The Japanese economy is in the middle
of a multi-pronged fight to (1) stop deflation, (2) reform the public sector and its budget, (3) resolve problems associated
with non-performing loans and stabilize the financial system, and (4) to stimulate business sector confidence through
regulatory reforms, tax reforms, and a conducive environment for technology development.
The Japanese society, facing a rapid aging of its now-declining population, is now also confronted with reform needs in its
social security system.

Part I: Postwar Economic Reforms

and Rehabilitation
(1945 mid 1950s)

1.1 Post-war Economic Reforms

Democratization of the Economy
Zaibatsu
Zaibatsu dissolution
dissolution
Dissolution
Dissolutionof
of
Zaibatsu
conglomerates;
Zaibatsu conglomerates;
Prevention
Preventionof
ofeconomic
economic
power
concentration
power concentration

Fair
Fair market
market rules
rules
Anti-trust
Anti-trustLaw;
Law;
Securities
Exchange
Securities Exchange
Law;
Law;etc.
etc.

Agrarian
Agrarian reform
reform Labor
Labor market
market reform
reform

Elimination
Eliminationof
of
tenant
system;
tenant system;
Growing
Growing##of
of
independent
farmers
independent farmers

Legalization
Legalizationof
oflabor
labor
movement;
movement;
Establishment
Establishmentof
of
labor
unions
labor unions

Postwar Reforms
The allied force (General Headquarters = GHQ) first tried to democratize Japan on both political and
economic fronts. The GHQ believed that a concentration of economic power in a limited number of
companies, financial institutions and landlords hands, coupled with the lack of democratic forces such
as labor unions, had been the hotbed of militarism in prewar Japan. Thus, the so-called economic
democratization reforms were carried out first.
1. Zaibatsu dissolution (1945): Zaibatsu were big conglomerates of major companies and banks, often
controlled by a share-holding company. The most powerful ones were Mitsui, Mitsubishi, Sumitomo, and
Yasuda. To eliminate concentration of economic power, zaibatsu were dissolved and share holding
companies were prohibited. Fair Trade Law and the Economic Power Excessive Concentration
Elimination Law was enacted in 1947.
2. Fair market rules (1947): American-style market rules were imported. The most important laws were the
Anti-trust Law and the Securities Exchange Law, enacted in order to secure market competition and
transparency.
3. Agricultural reform (1945): The government purchased land from absentee landlords and all the tenant
land in excess of one hectare, and sold them to tenant farmers at nominal prices. The percentage of tenant
land dropped from 46% to10%. The number of Independent farmers increased.
4. Labor market reform (1945): Through an enactment of the Labour Union Law (1945), Labour Relations
Adjustment Law, and Labour Standards Law (1947), the organization of labor unions was promoted and
their labor movements were legalized.
5. Education reform (1947): The compulsory education was extended from 6 to 9 years.

1-2 Economic Reconstruction and Re-industrialization

Economic reconstruction
Priority production strategy
Priority sectors:
Steel, coal mining, electricity,
shipbuilding, marine transportation,
railways, chemical, etc.

The USs strategy changes to allow re-industrialization

Joseph Dodges stabilization policy in 1949
-- Macroeconomic tightening
-- Balanced budget on a consolidated basis
-- Forced rationalization in private businesses
-- Unification of yen exchange rate to 360JPY/1USD

Favorable international conditions

-- Sustained world economic growth
-- International trade and investment development

Severe
recession

Cold War
Korean War

Priority Production Strategy

In 1946, high inflation persisted despite a contingent measure restricting surplus purchasing power. To
rapidly reconstruct the economy despite shortages of commodities and investment funds, the government
in 1947 implemented a strategy to concentrate resources in priority industrial sectors such as steel, coal
mining, electricity, shipbuilding, marine and railway transportation, and chemical fertilizer. Industrial
production rapidly recovered from 31% of the pre-war level in January 1947 to 80% of that level, in April
1949.
Change in the US Strategy toward Japanese Recovery
In the early stage of recovery, the GHQs stance was to prevent Japan from regaining military power. As
such, a full recovery of heavy industries was not necessarily permitted in the beginning. However, as the
Cold War worsened, the US attitude gradually changed to allow Japan to re-industrialize and to become an
independent economy. In 1949, a series of severe belt-tightening policies was conducted by Joseph Dodge,
a US banker who came to Japan as an economic adviser to the GHQ. Policies included enforcement of a
balanced budget, and reduction of both price subsidies and inflation, i.e. stabilization. As a result, the
economy fell into a serious slump. In 1949, a fixed exchange rate of 360 yen per US dollar was introduced
in order to spur Japans international trade. This exchange rate was broadly perceived as overvalued given
the weak competitiveness of Japans business sector then.
In 1949, a major reform in the tax system was also carried out following recommendations made by a
team of experts headed by Carl Shoup. This reform focused mostly on direct taxes such as personal
income tax.
This tight policy package strengthened the business environment and in retrospect, provided the basis for
economic development. However in the short run, it pushed the Japanese economy into a severe recession.
Favorable External Conditions
The Korean War, which broke out in 1950, resulted in high military demand and triggered rapid
reconstruction of the Japanese economy. By 1952, Japan restored the real GDP level to a level
comparable with that of 1935. After the Korean War ended (1950-53), the Japanese economy fully
benefited from the sustained development of the world economy.

1.3 From rehabilitation to enhancing

competitiveness
z

Introduction of new technology to fill the gap

Steel (strip mills); shipbuilding (electric
welding); chemical fertilizers; synthetic
fiber; consumer electric appliances, etc.
First machine is imported and the second
machine is produced domestically
Improved Engineering

Rural-urban transfer of young workforce

Shudan Shushoku
z Industrial Policy
Business Rationalization Promotion Act
(1952)
Government-owned financial institutions
JDB, ExIm Bank, Small Business Credit
Corporation
Establishment of long-term credit banks

Domestic Factors
Domestic factors that enabled high growth included a high investment ratio supported by savings mobilization,
migration of the younger-generation workforce from the rural area to cities by collective employment (Shudan
Shushoku, 1954-1975), and high productivity growth brought about by the introduction of foreign technology and
improved engineering. Shudan Shushoku increased workforce of 15-24 years of age in Tokyo by 1 million during
1955-1965.
Industrial Development and Governments Industrial Policy
An expansion of business investment in the early 1950s shows that Japanese businesses shifted from phases of
rehabilitation to one of strengthening international competitiveness through rationalization of production. Foreign
technology was actively absorbed in key industries such as strip mills in steelmaking, electric welding in
shipbuilding, and other technologies for chemical fertilizers and heavy electric machinery. New industries such as
the automobile, synthetic fibre and consumer electric machinery also started to bring in new technology that
promoted autonomous growth.
Government policies supported business development. The Business Rationalization Promotion Act of 1952
provided a special depreciation scheme for modernizing equipment in key industries. Government created financial
institutions such as the Japan Development Bank, the ExIm Bank, and the Medium and Small Business Credit
Corporation. The long-term credit bank system was introduced in order to provide public funds and long-term loans
to the business sector.
Return to the International Community
In 1951, the San Francisco Peace Treaty was co-signed with the major allied-force countries, and Japan regained
independence. Japan joined the United Nations in 1956. Japan also joined the International Monetary Fund and the
International Bank of Reconstruction and Development (the World Bank) in 1953, and the General Agreement on
Tariffs and Trade in 1955. In the case of the IMF, first Japan joined as an Article 14 country that allowed restrictive
foreign exchange transactions for balance of payment purposes, and later became an Article 8 country in 1964. In
GATT, Japan initially joined as an Article 12 country with possible trade restrictions for balance of payment
purposes. The Japanese economy was under BOP constraints up until the mid 1960s.

1-4 Coping with Savings Shortage

Investment ratio

Household savings ratio

1951
1953
1955
1957
1959
1961
1963
1965
1967
1969

50 %
40
30
20
10
0

50 %
40
30
20
10
0

Source SNA
Investment ratio = (private and
public investment) / GDP
Household savings ratio = (household savings) / (household
disposable income)
Prior to 1955, the older SNA
level was adjusted using 1955-60
average difference between the
two series

Policy
Policy measures
measuresto
to cope
copewith
with savings
savings shortage
shortage
Targeted
Targetedpolicy
policyto
toallocate
allocatefunds
fundsto
tokey
keysectors
sectors
----Relying
on
financial
intermediaries
for
capital
Relying on financial intermediaries for capitalsupply
supply
----FILP
and
public
financial
institutions
FILP and public financial institutions
----BOJ
BOJmonetary
monetaryexpansion
expansionthrough
throughwindow
windowguidance
guidance
over-lending,
over-borrowing
over-lending, over-borrowing
Fund Shortage and Increased Role of Banking (indirect finance)
During the reconstruction phase of the postwar Japanese development, the biggest macroeconomic challenge was a
shortage of funds for investment or a shortage of savings. In the early 1950s, the household saving rate was around
10% according to the System of National Account (SNA) data. The figure was slightly higher in household surveys
(than in employee households). Like many other developing economies, Japan faced the risk of falling into the
savings shortage trap where a shortage of savings leads to a shortage of industrial funds, which in turn leads to a
limited production capacity, to stagnant income, and finally comes back to aggravate the savings shortage.
In order to cope with this shortage, Japanese government adopted targeted policies and directed funds to key
industries for dynamic economic growth, rather than relying on a market-oriented allocation of the limited funds.
First, the government relied on financial intermediary institutions to supply industrial funds, rather than
relying on capital markets. To this end, three big long-term credit banks were established (along with large
commercial banks) in order to provide long-term credit to these key industrial sectors. (Refer to the slide for
the Main-bank System on page 36.)
Second, the government introduced the fiscal investment and loan program (FILP) in order to channel public
funds to key industries through newly established public financial institutions such as the Japan Development
Bank and small business loan corporations. The major sources of funds were postal savings and, at the initial
stage, collateral funds established with earnings from the sales of products supplied by the US government as
commodity aid.
Third, the Bank of Japan (BOJ) supplied high-powered money to the private sector by providing loans to
private financial institutions through window guidance. Commercial banks borrowed money from the BOJ
and actively lent to business sectors, resulting in low capital ratios (over-lending). Business sectors
borrowed heavily from financial institutions, again resulting in low capital ratios (over-borrowing).
Then, the social system was formed/geared for increased savings: long working days, a six-day work week, and poor
social security provision.

10

1-5 Growth without Inflation; Mobilization of Funds

Avoidance of inflation in spite of monetary expansion
Low interest rates and credit rationing
Regulation -- Extraordinary Interest Control Law (1948)
Window guidance -- official discount rate kept low
Interbank call market higher call rates - incentives for
small/regional banks to provide funds for larger banks
100 billion yen

Interest rates
and BOJ loans

Call rate (right)

BOJ loan (left)

Source: Tomita p.110

Discount rate (right)

1956 1957 1958 1959 1960 1961 1962 1963 1964

Growth without Inflation

This type of monetary expansion could normally lead to rapid inflation. However in Japan, overall inflationary pressure
did not emerge. This was the case as the long-term credits provided were immediately used for real business investment,
leading to an expansion of production capacity in a very short period.
Over-lending, or a persistently low capital adequacy ratio, ought to increase bankruptcy risks of financial institutions.
However, the government policy protected the banking sector from bankruptcy and from cut-throat competition. Banks
that faced financial difficulty were merged with healthier banks before their collapse. This policy scheme was often
labeled as a convoy system, with the Ministry of Finance acting as commander-in-chief. As such, from the 1950s to
the early 1990s, no major bankruptcies in the banking sector occurred in the Japanese economy.

Artificially Low Interest Rates and Concentration of Funds

Interest rates were controlled at levels lower than potential market rates (open financial markets were underdeveloped).
The Extraordinary Interest Rate Control Law, enacted in 1948 to control increases in interest rates during the post-war
hyper-inflation, survived 40 years and kept deposit and loan rates at low levels. Together with this interest rate
regulation, the official discount rate (the rate of BOJ loans to commercial banks) was also kept at a lower level.
Artificially low interest rates amidst a shortage of savings naturally bring about excess demand for loans, that in turn
calls for credit rationing. Window guidance was adopted to compel commercial banks to provide funds to key
industrial sectors, and to restrict an extension of the loan supply when monetary policy had to be tightened.
The only liberalized financial market was the inter-bank call loan market where financial institutions dealt short-term
money with each other in order to cover temporary shortages of funds. The call rate was regularly higher than the
official discount rate, and therefore regional banks and other small-size financial institutions had incentives to provide
their surplus deposit to the call market rather than supplying loans to local and small businesses at less favorable terms.

11

Part II: High Economic Growth Period

(mid 1950s early 1970s)

12

2-1 Entering Virtuous Cycle

Period of rapid growth (1955--1970)

Average real
growth rate
4.9

Source: National Accounts

2001-2005

1.5 1.0 1.4

1996-2000

3.3

1981-85

1976-80

1971-75

1966-70

1961-65

1956-60

4.5 4.4

1991-95

11.1

1986-90

8.8 9.2

Dual structure -- lower productivity and poorer working conditions

in small businesses, consumption-goods and service sectors
National consensus -- trickle-down strategy
Rapid-Growth Period and the Dual Structure
The Japanese economy eventually entered an economic growth process with positively reinforcing feedback:
demand expansionproduction expansionincreases in incomeconsumption expansionfurther income
expansionincreases in savings-investment growth and an expansion of production capacity. The rapid
growth period from the late 1950s to1960s was thus created. From 1955 to 1972, the Japanese real GDP
grew by an annual average rate of 9.3%.
This virtuous cycle particularly benefited big businesses in heavy industries such as metal, chemicals, energy
and machinery. Scarce funds were preferentially allocated to industries with a lower capital cost. On the
other hand, although lower prices of capital goods as a result of the massive investment in machinery
industries partly facilitated investments, small businesses and consumer-goods and services sectors suffered
from shortages of investment funds.
This scheme was often criticized as having overly-favored key industries and big businesses. However, this
strategy was generally accepted by most Japanese as a trickle-down approach to raise incomes and living
standards in Japan. In forming this consensus, governments medium-term economic plans, particularly the
National Income Doubling Plan of 1960, contributed significantly.
Although it was generally a big success, this approach also created the problems associated with dual
structure. A world of difference in productivity, wages and in other working conditions emerged between
the favored industries and those that were not. There was a big gap in competitiveness between heavy
industries and big businesses on one hand, and consumer-goods and service-related sectors on the other. The
cause of poor performance in the latter sectors was twofold: a shortage of investments and a lack of market
competition. Even today, this continues to be a major challenge to the Japanese economy in the process of
major structural reforms.

13

2-2 Demand and supply side factors for rapid growth

z

Demand side
Shortage of production capacity investment
demand
New consumer durables consumer demand
Increased Quality and undervalued exchange rate
export expansion
Supply side
Innovation seeds from overseas
Growth of working-age population and its migration
Increase in household savings
Rise in education attainment to enhance human
capacity

National Income Doubling Plan (1961-70): great success

Demand- and Supply-Side Factors for this Rapid Growth

Demand-side factors:
-- Due to rapid growth and the emergence of new products, the expansion of production capacity was always
lagging behind that of demand. There was massive demand for fixed investment, and investment called for
further investment.
-- Household consumption started to drive the economy as consumer durables rapidly spread into households.
First wave: monochrome TVs, washing machines, and refrigerators. Second wave: colour TVs, airconditioners, and automobiles.
-- Demand for Japanese exports grew thanks to higher international competitiveness due to gains in product
quality, and to the undervalued exchange rate.
Supply-side factors:
-- There were ample applicable seeds of product/business innovation that Japan gained from overseas due to
the technological gap with industrial economies.
-- The growth rate of the working-age population was high. There was a massive migration of younggeneration workers from rural to urban areas.
-- The household savings ratio rose to finance investment growth.
-- Higher education attainment supported rapid growth in human capital.
In 1960, the Cabinet of Prime Minister Hayato Ikeda adopted the National Income Doubling Plan and
projected an annual growth rate of 7.2% between 1960 and 1970, aiming for a doubling of real GDP in this
decade. The Japanese economy had in fact grown at a much faster pace.

14

2-3 Rapid growth as a catching-up process

Catching-up process

Goal of development

Consensus formation

Advantage of latecomers
-- introduction of technology and process innovation
-- lower business risks
-- incentive for innovation and quality control through
competition in foreign market

Advantage in Catching-up as a Latecomer

The fact that the Japanese economy was in the process of catching-up with industrialized economies was a
big factor that enabled sustained rapid growth. This catching-up process came with the following
latecomers advantages.
First of all, it facilitated technological progress. The import of foreign technology was given high priority in the
allotment of foreign currency (limited foreign reserves). Manufacturing technicians and workers had sufficient
technical skills and knowledge for them to utilize, emulate, and improve imported technologies (improved
engineering). Manufacturing companies also had both the willingness and the ability to absorb such technical
progress (Ohkawa and Rosovsky:1973, Chapter 9).
Secondly, foreign business was a good reference for the future development of Japanese business and
consumer demand, so Japanese companies could effectively avoid market risks associated with new business
operations.
Thirdly, for manufacturing companies, sales success in the markets of advanced economies was a powerful
demonstration of their products quality and competitiveness in the domestic market. Thus, they made massive
efforts to export their products, which resulted in productivity enhancement, new technology development,
quality control, and strengthening of non-price competitiveness that often offset increases in labor costs.

15

2-4 Industrial Development and Market Opening

Protection of infant industries
through foreign currency quota

Current account balance (% of GDP)

1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980

3
2
1
0
-1
-2
-3

Govt. service

Distribution/
service

Utility/T&T/
finance

Construction
Misc.
Machinery
Material
Agriculture, etc.

1955
1960
1965
1970
1975
1980
1985
1990
1994
2000
(estimate)Manufac.

Ceiling of the balance

of payment

Protection of infant industries through foreign currency quota

Export of Labor-Intensive Products
Since the end of World War II, Japanese tradable industries were highly protected from international
competition. Imports, foreign exchange transactions and inward foreign direct investment were all tightly
regulated. Trade barriers took the form of foreign exchange quotas as well as tariffs and other non-tariff
barriers.
The trade structure then was to export labor-intensive manufacturing products in order to earn foreign
currency revenue (foreign exchange) and then to import capital- and technology-intensive manufacturing
products and raw materials.
Balance of Payments Constraint
Until the first half of the 1960s, a major constraint to Japanese economic growth was the ceiling on the
balance of payment. An expansion of the Japanese economy triggered an import boost and thus created and
widened the trade deficit. The BOJ had to then tighten monetary policy in order to protect the value of the
Japanese yen (the yen was at a fixed exchange rate). Monetary tightening, executed in the forms of a
reduction in the loan supply to private financial institutions and an increase in the official discount rate, first
effectively reduced banking credit extended to the business sector that highly relied upon bank loans, which
put a brake on fixed investment, and thereby decelerated growth, thus leading to an improvement in external
balance. Once the monetary policy was loosened, the Japanese economy rushed into the next expansion
phase with a quick recovery in credit supply and investment.

16

2-5 Market Opening in the 1960s

Market opening on a scheduled, step-by-step basis

Foreign trade
1960: Trade Liberalization Program
Positive list
Negative list
Foreign currency quota
Automatic approval
Import liberalization ratio
1959 1966
34% 93%

Foreign
exchange
1960
Restoring yens
convertibility
1964
Accepting
IMF Code
Article 8

Inward FDI
1967~1970
Basic Program for
Capital Account
Liberalization
1970
Majority foreign
ownership was
allowed in
80% of
industries

Market Opening during the 1960s

During the 1950s, as Japanese exports increased, industrialized countries gradually stepped up the pressure
on the Japanese government to open its market. In the 1960s, the Japanese government initiated the process
of market opening in a strategic (scheduled, step-by-step) manner.
Trade liberalization was conducted by changing the foreign currency quota for the import of restricted
commodities (FA, fund allocation) to an automatic approval (AA). In 1960 the government adopted a
comprehensive plan to liberalize foreign trade that changed a ground rule from restriction as a rule,
openness as an exception to the contrary. The ratio of liberalized import lines rose from 34% in 1959 to
93% in 1966.
With regard to foreign exchange transactions, the yen regained convertibility in 1960. In 1964, Japan
accepted the IMF Code Article 8 that ruled out foreign exchange restrictions for the purpose of balance of
payments stability.
As to capital flows, the law on foreign capital of 1950 stipulated that inward FDI should be allowed only if it
contributed to an improvement in balance of payments. In reality, the majority of inward FDI applications
were not approved as they were perceived to bear risks of harming the Japanese business sector. In 1967, a
basic program for capital liberalization was adopted. This program was implemented by 1970, again in a
step-by-step manner. By 1970, majority foreign ownership was allowed in 80% of Japanese industries.

17

2-6 Changes in Japans Comparative Advantage

Changes in trade structure
and positive adjustments

Export-led growth?
Contribution to GDP growth

Export structure

1950

% point

Business investment

60

70

80

90

-1

95

Export

Other manufac.
Motor vehicle

Machinery

Other material
Metal
Textile
Food

1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980

-2

Source: SNA
1953-55: older SNA

Changing Comparative Advantage

As wages went up in the Japanese labor market, labor-intensive manufacturing products such as textile
products gradually lost their price competitiveness. On the other hand, price increases in capital-intensive
and technology-intensive products were mostly avoided as wage increases in these sectors were largely
offset by healthy productivity gains. Their prices relative to those of foreign products showed a declining
trend, thanks in part to yens fixed exchange rate. Thus, the structure of comparative advantage in Japanese
manufacturing sector had completely shifted. Capital- and technology-intensive products were also products
that faced elastic demand (high income elasticity). As a result, the structure of Japanese exports changed
dramatically.
Given this rapid shift in comparative advantage, industries such as textiles, coal mining, shipbuilding, and
after the first oil crisis, aluminum, exited or slimmed down substantially. Positive adjustments were made in
expanding industries. The chemicals industry, originally concentrated on production of fertilizers, shifted its
focus to basic chemicals, and then to fine chemicals. Cement and other related industries moved to
production of synthetic materials such as fine ceramics. Textile industries turned themselves into
multinational fashion industries.
Export as an Engine for Growth?
Looking at the developments in GDP components, exports or external demand had not necessarily played a
major role quantitatively in Japans economic growth, at least until the first half of the 1960s. On the macro
front, business investment had been the major engine for Japans growth. The contribution of export
expansion trade (export) as an engine for growth was made through its microeconomic effects instead,
by stimulating innovation and productivity growth in Japans manufacturing sector.

18

2-7 Balanced Budget and Issuance of Govt Bond

Balanced budget
1947: Budget Law -- Prohibiting deficit financing bonds
1949: Attainment of balanced budget on consolidated basis

1965 recession
Perception of the end of
investment-led growth
Issuance of deficit
covering bond
1966~
Construction bond

50
40
30
20
10
0

FY

Central govt bond issuance

(% of total revenue, general account)

1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998

Bond issuance

Balanced Budget to Bond Financing

The hyper-inflation after the war was partly attributable to the Japanese governments massive budget deficit
and its direct financing by the BOJ. In order to control inflation and to prepare for a self-reliant economic
reconstruction, the 1947 Budget Law prohibited the issuance of bonds to finance the current deficitthe socalled deficit financing (covering) bonds. Initially, there were loopholes in budgeting due to the existence
of special accounts. Since the FY1949 budget, Japans national budget was balanced on a consolidated basis
(that is, including special accounts). Until the first half of 1960s, the budget was kept neutral to the
macroeconomy.
The recession in 1965 turned out to be the first post-war economic slump against which monetary loosening
was not effective. A serious question was raised regarding whether the post-war rapid growth process driven
by business investment had ended. Pessimistic views predicted persistent shortages of final demand unless it
was supported by government demand. In 1965, due to a shortage of tax revenue, the government was forced
to issue deficit financing bonds, enacting an extraordinary law to allow it. Since then, in order to fill gaps in
final demand while conforming to the Budget Law, the Japanese government has continued to issue bonds
under the name of construction bonds, to finance development of social overhead capital. The size of bond
financing (deficit financing by bonds) continued to be small until the mid-1970s.

19

2-8 Role of Economic Planning

14 economic plans officially adopted
Economic
Economic plans
plans in
in aa free
free market
market economy
economy
Indicative-type
Indicative-typerather
ratherthan
thanCommand-type
Command-type
Sharing
of
information
between
Sharing of information betweenthe
thegovernment
governmentand
and
the
public
(business
and
household
sectors)
the public (business and household sectors)
----Medium-run
development
Medium-run developmentscenario
scenariothe
thegovernment
governmentassumes,
assumes,
including
target
economic
growth
rate
and
other
including target economic growth rate and other
indicators
indicators
----Medium-run
Medium-runeconomic
economicpolicy
policystance
stanceand
andpolicy
policypriority,
priority,
including
allocation
of
funds
for
investment
including allocation of funds for investmentin
in
social
overhead
capital
social overhead capital
----Economic
Economicbehavior
behaviorof
ofhousehold
householdand
andbusiness
businesssectors
sectors
that
the
government
deems
desirable
that the government deems desirable
Economic Plans
To what extent did the governments economic plans contribute to the success in Japans post-war
development?
The Japanese government first adopted the Economic Self-Reliance Five-Year Plan in 1955. Then economic
plans of five- to ten-year duration were created in sequence. The Doubling National Income Plan adopted in
1960 with the target year of 1970 was often regarded as the most successful plan. The plan that aimed at
doubling national income in real terms in ten years was executed successfully by building confidence within
Japanese business and household sectors, thereby attaining such rapid economic growth.
Up to the present day, there have been 14 officially adopted economic plans. Although their planning periods
were five to ten years, all of them were replaced by revised plans before the end of the original plan period.
This was partly because of deviations of actual economic conditions from the assumed economic framework
during the plan period, and partly because new administrations preferred to adopt their own new plans when
they took office. Even before the enactment of the first official plan, there were discussions among government
sections, businesses, consumers and academia that contributed to the national consensus building on
development strategies.

Nature of Economic Plans in a Market Economy

Economic plans in the market economy were geared to communicate governments views on the future of
Japanese economy to the public, and to form a national consensus. Japanese economic plans usually consisted
of the following ingredients: i) medium-term development scenario that the government assumes, including an
economic framework such as targeted rates of economic growth and inflation; ii) medium-run economic policy
goals and policy priority, including allocation of investments in social overhead capital in the plan period; and
iii) private sectors actions that the government considered desirable. As such, these plans were of an
indicative-type rather than those of command-type widely seen in central planning economies. Acceptance
of those suggested actions was optional rather than compulsory.

20

Examples of Adopted Economic Plans

Name

Plan
period

Major purposes

Growth target
/actual growth

1.Economic SelfReliance Plan

1956
~1960

Economic self-reliance
Full employment

4.9%
8.8%

3.Doubling National
Income Plan

1961
~1970

High growth
Higher living standard

7.8%
10.0%

5.Economic and Social 1967

Development Plan ~1971

Balanced and fulfilled

economy/society

8.2%
9.8%

7.Economic and Social 1973

Basic Plan
~1977

Peoples welfare
International relations

9.4%
3.5%

8.Economic Plan for 1976

Stable development
nd
2 Half of the 1970s ~1980 Fulfilled peoples living

6%+
4.5%

Economic Plans that Played a Significant Role

During the rapid growth period, economic plans generally contributed to a consensus formation. The typical
case was the Doubling National Income Plan. Subsequent plans such as the Economic and Social
Development Plan (19671971) and the New Economic and Social Development Plan (19701975)
addressed problems that emerged as a result of this rapid growth, such as pollution, income inequality, and
rapid urbanization and concentration. These plans shed light on the importance of balanced economic
development.
Although the plan was very short-lived due to the dramatic changes caused by the first oil crisis, the
Economic and Social Basic Plan (19731977) focused on peoples well-being and international aspects of
development. With the energy crisis, pessimistic views on Japans growth potential prevailed. The
Economic Plan for the Second Half of the 1970s (19761980), by (1) advocating potential annual growth
rates of 5 to 6%, (2) emphasizing the needs of structural reforms and (3) adopting energy-saving initiatives
in order to regain growth potential, contributed to Japans overcoming of the oil crisis.
Compared to these plans, subsequent plans were less effective in setting/forming national consensus. In a
post catch-up era, government plans should be limited to governments own reform agenda such as
regulatory and budgetary reforms.

21

Part III:
Socio-Economic Outcome
of Rapid Growth
( 1970s )

22

3-1 Socio-Economic Transformation

Employment share
1955
Primary industry
41.3%
Secondary industry
24.9%
Tertiary industry
33.8%
z
z

1970
19.7%
35.3%
45.0%

Labor market labor surplus to labor shortage

Wage increase productivity-differential inflation
Infrastructure
Tokaido bullet train; Meishin super highway
Physical transportation modes motorization
Negative side
Underdevelopment of social overhead capital
(infrastructure) for better living
Overpopulation in urban areas and depopulation
in rural areas
Environmental degradation
Public pension system extended to self-employed

Socio-Economic Transformation
During the rapid growth period, Japanese society underwent various changes. From 1955 to 1970, the share of
primary industry in total nominal GDP decreased from 19.2% to 5.9%, while that of secondary industry
increased from 33.8% to 43.1%. In terms of employment share, primary industry declined from 41.3% to 19.7%,
secondary industry from 24.9% to 35.3%, and the tertiary sector from 33.8% to 45.0%. Changing conditions in
the labor market, from excess supply to labor shortage at around 1960, resulted in wage increases even in the
less productive sectors and smaller companies. A shrinking wage gap in spite of the persistent gap in labour
productivity caused the so-called productivity-growth-differential inflation. The consumer price index
constantly increased from the beginning of the 1960s, while wholesale prices were relatively stable.
Regarding peoples livelihood, a spread of consumer durables caused substantial changes in consumers lives
(consumption revolution). A sense of middle class was shared by a large part of Japanese society.
Economic infrastructure was actively developed as seen in the opening of the Tokaido bullet train between
Tokyo and Osaka in 1964, and a super highway between Komaki (near Nagoya) and Nishinomiya (near Kobe)
in 1965. Motorization proceeded with increases in auto sales and highway construction.
On the downside of the rapid growth, some significant distortions developed. Most notably were (1) a delay in
development of living-related infrastructure, (2) urban overpopulation and rural depopulation as a result of labor
movement from rural to urban areas, and (3) environmental degradation. With the advent of four major
pollution-related diseases, the government took anti-pollution measures such as the enactment of the Basic Law
for Anti-pollution Measures in 1967 and the establishment of the Environmental Agency in 1971.
As for social insurance, the National Pension System started. The coverage of public pension and health
insurance was widened to all people including self-employed and unemployed by the late 1960s.

23

3-2 Positive Outcomes of the Rapid Growth

Longevity

Female

80

Female
2006

2000

1965

1960

Total
1955

Manufacturing

100
90
80
70
60
50
40

Male

1995
2000
2005

1985
1990

1970
1975
1980

1960
1965

1947
1950
1955

40

1995

50

1990

50
40
30
20
10
0

1985

60

1980

Male 60

1975

70

Percentage of students who

enter colleges/universities

1970

90

2004

1995

1985

1975

1965

1955

1,000500-999
300-499
200-299
100-199
50-99
30-49
20-29

Wage gap by size of company

The rapid growth raised the income level and peoples living standards. For example:
Lifespan lengthened
Thanks to increases in income, education on nutrition, vaccination and other medical care improvements, peoples
health condition dramatically improved. Average life span of the Japanese was lengthened from 60 years for males
and 63 years for females to 71 and 77, respectively, between 1950 and 1975. It continued to lengthen after the end
of the rapid growth, and now stands at 78 for males and 85 for females.
Education attainment improved
Higher education had become far more accessible to ordinary people. The percentage of young people who enter
universities/colleges (including junior colleges) jumped up from 10% (male: 15%, female 5%) in 1960 to 38%
(male: 43%, female 32%) in 1975. University enrollment ratio stagnated from 1975 to 1990, but it started to rise
again in the 1990s, this time mainly due to a significant increase in female students enrollment. Now the gender
gap in university enrollment has almost disappeared.
Income gap narrowed
After WWII ended, Japans economic development strategy initially focused on recovery of key industries and of
large size enterprises.
Small businesses and non-manufacturing sectors were left behind in terms of productivity, wages and working
conditions. The productivity gap continued to widen during the rapid growth period. Nevertheless, overall labor
shortages as a result of the rapid growth eventually pushed up the wage levels even at small and non-manufacturing
companies. The wage gap by company size narrowed sharply from 1955 to 1965, but that trend reversed afterwards.

24

3-3 Negative Outcomes of the Rapid Growth

(1) Overpopulation and Depopulation
thousand
Movement from
rural to urban

Movement inside urban

from one prefecture
to another

Movement from
urban to rural

Net inflow of population

to Metropolitan Tokyo Movement inside rural
from one prefecture
to another

Dark Side of the Rapid Growth

The rapid economic growth also brought about significant problems in society, such as (1) over-population
in metropolitan areas and depopulation in rural areas; (2) weakening of social cohesion such as regional
community and family relationships; and (3) environmental disruption such as air and water pollution, noise,
increase in waste, and land subsidence. Here (1) and (3) will be discussed.
Over-Population and Depopulation
The rapid growth period was also a rapid population movement period. The substantial shift of the industry
structure from agriculture to manufacturing and services drove farmers to urban areas to seek job
opportunities and urban life. Agricultural employment halved from 13.3 million (33% of total employment)
in 1960 to 6.7 million (2.6%) in 1975. It has continued to decline and as of 2005 only 2.9 million (4.7%) are
engaged in agriculture, a majority of whom engage in other jobs and farm only part-time. In particular, to
fulfill the labor demand expansion in manufacturing, sons and daughters of farmers were systematically sent
to big cities in large numbers.
Over-population in the metropolitan areas unavoidably caused the congestion phenomena, such as traffic
jams, poor housing conditions, a shortage of urban infrastructure, terrible commutes, and environmental
pollution. Depopulation in the rural areas resulted in more reliance on food imports, further budget
dependence of the local government on the central government, and a higher risk of natural disaster due to
devastated fields and forests.
The rural-to-urban migration calmed after the economic growth rate slowed, but the inflow of population
into the Tokyo metropolitan area has been consistent.

25

3-3 Negative Outcome of the Rapid Growth

(2) Environmental degradation
Atmospheric polution

0.07
0.06
0.05
0.04
0.03
0.02
0.01
0

SO2(ppm)

2004

2000

1995

1990

1985

1980

1975

1970

1965

NO2(ppm)

Source: Ministry of Environment

Environmental Degradation
The development strategy that put emphasis on industrial growth caused serious environmental degradation
in many parts of Japan.
Atmospheric pollution
Metropolitan and industrial areas faced serious problems associated with air pollution, beginning in the
1950s. Smoke covered the cities and the number of asthmatic patients increased in major industrial cities.
The government enacted a law to control air pollution in 1962 that mainly focused on smoke emission from
coal fuel. However, it did not address the emerging industrial use of petroleum fuel that caused sulfa-oxide
emission or the increasing emissions from automobiles. In 1968 this law was revised as the Air Pollution
Prevention Law. It regulated SOx emission from factory chimneys. Factories were forced to build very high
chimneys of 100 to 150 meters. Although this law was effective in reducing SOx exposure around the
factory chimneys, it also created air pollution in a wider area. In 1970, the law was substantially amended in
order to allow prefectural governments to (1) set stricter standards than those set by the central government,
(2) introduce direct punishment against violators, and (3) widen the coverage of regulation from specific
regions to nationwide.
Now the level of SOx emission has decreased to 1/10 of the level in 1965. However, NOx emission that
mainly comes from automobiles is still at a high level.

26

Water pollution

100

% of attaining environmental standard

80

Rivers

60
40

Lakes
2004

2000

1995

1990

1985

1980

1975

20
Source: Ministry of Environment

Water pollution
Water pollution was also a serious environmental problem. The water quality generally deteriorated in lakes,
rivers, seas, and underground water. Emissions of harmful substances from factories caused very serious
human diseases that often were fatal. The most prominent example was the Minamata disease, caused by
Methylmercury contained in drained water from chemical factories that killed and disabled many people in
Kumamoto in the 1950s and Niigata in the 1960s. Accumulated slime created by water drained from
pulp/paper factories and contaminated rivers and coastal waters.
Not only industrial but also household emissions aggravated the situation of water pollution.
Although two laws were enacted in 1958 in order to protect water quality from factory emissions, they were
largely ineffective. In 1970, a far more potent Water Pollution Prevention Law that introduced a strict
liability principle to water pollution was enacted. Thanks to this law and technological developments, the
quality of water has been improving since then.

27

3,000
2,500
2,000
1,500
1,000
500
0
2005

2000

1995

1990

1985

1980

1975

1970

Number of patients
100,000
Atmospheric pollution
90,000
80,000
related disease (left)
70,000
60,000 Minamata
50,000
disease
40,000
(right)
30,000
20,000
10,000
0
Source: Ministry of Environment

Diseases Caused by Environmental Degradation

Environmental pollution caused serious diseases in various regions in Japan. Even confined to officially
recognized cases, the estimated number of patients of diseases related to air pollution such as asthma in
Yokkaichi City, Mie, surpassed 100 thousand in 1988.
A symbol of Japans pollution disease, Minamata disease. The number of officially recognized Minamata
patients reached 1,924 in 1984. There was a far larger number of patients requesting official recognition. In
March 1978, the number of recognized patients was 1,348, while 5,385 patients were filing for recognition.

28

3-4 Gaps between Manufacturing

and Non-Manufacturing Sectors
Manufacturing sector -- productivity growth
Non-manufacturing sector -- stagnant productivity
-- preferential financial and foreign exchange allocation
-- difference in market competitiveness
Manufacturing

Non-manufacturing

Catch-up process
Japanese-style market system
International competition
Regulation and protection

Manufacturing vs. Non-Manufacturing Sectors

During the catch-up period, Japans tradable sector built a strong comparative advantage in manufacturing, taking
advantage of (1) the Japan-specific employment practices, (2) joint development of parts/components through a
supplier network called keiretsu, (2) the long-term management strategy supported by the mainbank system, (4)
the corporate governance structure, and (5) the effective protection from foreign capital through cross share-holdings.
This successful system of development unavoidably restricted market competition by effectively preventing entries
and even exits. In the tradable sector, however, tough international competition effectively offset the disadvantages
associated with this weaker domestic competition. As tariff barriers and quantitative restrictions effectively
protected the domestic market until the late 1950s, actual or potential pressures of international competition mainly
came from export markets. Even in the domestic economy, the markets of the tradable sectors were very competitive
during the industrialization period (Aoki and Okuno: 1996, p.13). Although the elements of competition were not
provided through a typical neoclassical market mechanism consisting of many mutually unidentified participants,
competition among visible participants whose names and faces are known to each other was often tougher than that
with many invisible participants.
In contrast to the success in the tradable sector, the non-tradable non-manufacturing sectors of the Japanese
economy lagged behind as they were effectively isolated from global competition. Moreover, the governments
market interventions, excessive regulations, fiscal and financial subsidies, and protection of domestic markets from
imported services and foreign direct investments, hindered sound competition in these sectors. Thus, productivity
growth was not seen in non-tradable non-manufacturing sectors.

29

Relatively low productivity growth in the

non-tradable sector and resultant mild inflation
BOJs accommodative monetary policies effectively stimulated
corporate profits, investment, employment, and consumption

15
10

% Annual average inflation rates

WPI

CPI

5
0

19
5
1 9 1- 5
5 5
1 9 6- 6
6 0
1 9 1- 6
6 5
1 9 6- 7
7 0
1 9 1- 7
7 5
1 9 6- 8
8 0
1 9 1- 8
8 5
1 9 6- 9
9 0
1 9 1- 9
96 5
-9
9

-5

Stable WPI with CPI Inflation during High Growth Period

Certain non-tradable sectors grew, nonetheless, thanks to diversified demand structure. Relatively
vibrant non-tradable sectors were distributions (retail/wholesale trade), leisure services, business
services, and housing and urban development.
Productivity growth in non-tradable sectors was generally slow, particularly relative to that in the
tradable sector. As a result, mild inflation in consumer prices emerged. As labor union movements
became coordinated across sectors, wages in less productive non-tradable sectors tended to increase
with increases in wages in tradable manufacturing sectors. It imposed a higher unit labor cost in
non-tradable sectors and these increased costs were passed to their product prices as those markets
were heavily protected. Thus, while manufacturing producers prices did not show any rising trend
(only cyclical fluctuations), consumer prices consistently rose at a rate of about five percent per
year.
Mechanism of Economy-wide Growth
The BOJ provided ample money in order to support rapid growth in the Japanese economy starting
in the 1950s. Beginning in 1965, the government began to issue bonds every year, sold to the
syndicates of private financial institutions. Under tight financial market regulation, the bond interest
rates were set substantially lower than long-term market rates. Therefore bonds were not attractive
instruments for the financial sector. The BOJ ended up purchasing them from the financial sector
within one year of issuance. Thus a very accommodative monetary policy was created.
This accommodative monetary policy and resultant mild inflation assured profits for manufacturing
companies and thus attracted new investment while enabling job creation in non-manufacturing
sectors that supported the expansion in manufacturing sectors. In this way, strong economy-wide
macroeconomic growth was preserved.

30

Annual growth of total factor productivity

1955-70

1970-80

1980-95

Manufacturing
6.0
Light manufacturing 2.7
Materials
9.2
Machinery
11.9

2.1
1.7
-1.9
7.6

2.3
0.2
0.6
5.5

Non-manufacturing
4.2
Construction
2.7
Finance/utility/T&T 6.4
Distribution & service 3.3

0.3
-2.9
1.8
-0.1

0.3
0.3
0.7
0.2

SectorPeriod

1955-70 1970-80 1980-95

annual rate

Manufactur
Production growth
T FP gro w th
Contribution of capital
Contribution of labor
Nonmanufacturing
Production growth
T FP gro w th
Contribution of capital
Contribution of labor
Light manufacturing
Production growth
T FP gro w th
Contribution of capital
Contribution of labor
Materials
Production growth
T FP gro w th
Contribution of capital
Contribution of labor
Machinery
Production growth
T FP gro w th
Contribution of capital
Contribution of labor
Construction
Production growth
T FP gro w th
Contribution of capital
Contribution of labor
Finance/Utility/transport/Telecom
Production growth
T FP gro w th
Contribution of capital
Contribution of labor
Distribution/Service
Production growth
T FP gro w th
Contribution of capital
Contribution of labor

14.2
6 .0
6.0
2.2

4.4
2 .1
2.8
-0.5

3.5
2 .3
1.6
-0.4

10.9
4 .2
4.6
2.1

5.0
0 .3
3.7
1.0

3.6
0 .3
2.6
0.7

8.5
2 .7
4.6
1.2

3.8
1 .7
2.8
-0.8

0.6
0 .2
1.3
-0.9

19.6
9 .2
7.2
3.2

2.8
- 1 .9
4.7
-0.1

2.7
0 .6
1.8
0.3

21.7
1 1 .9
6.2
3.6

9.6
7 .6
2.6
-0.7

6.6
5 .5
1.9
-0.8

11.7
2 .7
5.9
3.2

2.9
- 2 .9
4.3
1.4

2.5
0 .3
2.1
0.1

12.4
6 .4
3.3
2.7

4.9
1 .8
2.2
0.9

3.9
0 .7
2.3
0.9

9.9
3 .3
5.0
1.6

6.1
- 0 .1
5.2
0.9

3.8
0 .2
2.8
0.8

31

Part IV:
Japanese-Style Market System
For a
Miracle Recovery

32

4-1 Elements of Japanese-Style Market System

Employment
Employment system
system
Main-bank
Main-bank system
system
Corporate
Corporate management
management
Cross
Cross share-holding
share-holding
Parts
Parts supplier
supplier Keiretsu
Keiretsu
Industrial
Industrial policy/regulation
policy/regulation

Long-term relations
Organizational trade
Stability-oriented

The
The 1940

1940 Regime
Regime
originated
originated just
just
before
before WWII
WWII
Adjusted
Adjustedby
bythemselves
themselves
after
the
after thewar
war

Interventionist
government

Elements of Japanese-Style Market System

In the development of Japanese industries, certain institutional schemes and business practices played an
important role. Typical elements of the Japanese-style economic system and business practices included longterm employment and related labor market practices, such as in-house training, the dominant role played by the
banking sector in corporate finance (via direct financing), corporate governance controlled by managers
supported by a main-bank system, cross share-holdings among companies, and a close relationship between
government and business with regulations and other kinds of market intervention such as guidance.
Origins for the System
These elements of Japanese-style market system are often believed to be deep-rooted in Japans traditional culture.
Others think that this framework was designed after WWII for a quick recovery from the devastation of the war.
In fact, many of the elements of the Japanese economic system originated from just before WWII, when there
were national mobilization policies in preparation for the war. The system survived the war and was built into the
Japanese economy with substantial adjustments after the war.
System with Long-Term Relationships
Whether the Japanese-style market economy was a rational system or not continues to be debated. It was
characterized by its long-term nature. That is, it included stable long-term engagements of economic agents, often
implicit both in intra- and inter-company relations. Some elements of the system were exclusively Japanese, while
other aspects were commonly shared with other market economies.
Although the long-term relationships embedded in the Japanese-style market system contributed positively to her
economic development, it was exclusionary (anti-competitive) in its nature. New and potential entrants to markets,
particularly foreign businesses (and foreign governments), continue to criticize this exclusivity.
In Need of Change after the Catch-Up Process
The Japanese system apparently worked effectively during its catch-up phases of development. However, after
having caught up, it is now believed that new progress must come from autonomous risk-taking behavior by
businesses and individuals. In this regard, the Japanese-style system of development based on consensus and
cooperation that once functioned so successfully has become an obstacle. The system was (and still is) in need of
change.

33

Development
Developmentof
ofJapanese-style
Japanese-styleMarket
MarketSystem
SystemThe
The1940
1940Regime
Regime

The
The 1940
1940 Regime
Regime

[Yukio
[YukioNoguchi
Noguchi(2002)]
(2002)]

Main-bank
Main-banksystem
system
1941:
1941:syndicate
syndicateloan
loangroup
groupw/
w/the
theleadership
leadershipof
ofIBJ
IBJ
1942:
examination
departments
in
commercial
banks
1942: examination departments in commercial banks

Corporate
Corporategovernance
governance1939:
1939:dividend
dividendregulation
regulation

Employment
practice

1937:
intra-firm
labor
Employment practice 1937: intra-firm laborunions;
unions;
1939:
wage
increase
regulation
(annual
wage
1939: wage increase regulation (annual wagehike)
hike)

Parts
supplier
keiretsu

established
during
war-time
Parts supplier keiretsu established during war-time

Industrial
Industrialpolicy
policy1941:
1941:regulation
regulationof
ofindustries
industries

Taxation
relying
on
income
tax

1940:
Taxation relying on income tax 1940:withholding
withholdingtax
tax

34

Corporate governance built on cross share-holdings

Substitute
Substitutefor
for
Zaibatsu
Zaibatsu
Prevention
Preventionof
of
M&As
M&As

---- Autonomy
Autonomy of
of corporate
corporate managers
managers
---- Long-term
Long-term management
management perspective
perspective
---- Low
Low capital
capital cost
cost of
of equity
equity finance
finance

Shares issued by business companies

Ratio of shares held by stable holders
of which held by financial institutions
Shares issued by banks
Ratio of shares held by stable holders
of which held by business companies

1987

1995

1999

29.7%
22.0%

28.7%
20.1%

27.9%
12.9%

55.7%
34.4%

53.3%
32.9%

45.6%
28.5%

Source: NLI Research Institute (adjusted series for changes in disclosure rules)

Cross Share-Holdings
A separation of ownership and management of corporate entities was originally established in the United
States. Japan, too, had separation of management from ownership, but in a Japanese style. A large portion of
corporate equities was (and still is) held by other corporate firms including financial institutions, often
known as stable shareholders. This took the form of cross share-holding among firms. Those (cross)
shareholders were believed to be stable owners as they do not usually sell off the shares, try to take over the
firms, or intervene in the management.
Cross holdings of corporate shares originated after WWII, partly as a substitute for pre-war Zaibatsu
conglomerates that were forcefully dissolved, and partly as a preventive measure against M&As by foreign
multinationals.
Thanks to this common practice, Japanese businesses had been relatively free from the threats of adversarial
takeovers and from interventions by shareholders. In addition, as the stable corporate shareholders did not
usually request high dividend payouts, the capital cost of equity finance had been extremely low. As such,
corporate profits were mostly re-invested in new equipment, and this in turn raised the value of the firms and
created massive capital gains for these shareholders.
This tendency toward low dividends was formed during WWII, when high dividends to capital investment
were deemed inappropriate (Noguchi,1995). In 1939, dividend regulation was introduced. When inward
foreign direct investment was liberalized in the 1960s, this system was effectively utilized in order to protect
Japanese firms from takeover bids by foreign multinationals.
Thanks to this practice of stable shareholdings, corporate managers had the luxury of pursuing their longterm goals. As the mandate of management was not dominated by short-term profits, Japanese firms were
able to invest in equipment, research and development, and human resource development.
Downside
The downside was the possible moral hazard in management as managers were not subject to monitoring by
participants in capital markets.

35

Corporate finance relying on banking sector

z

Functions of the main-bank system

Saving of costs associated with
asymmetry of information
Screening and monitoring
Signaling to other financial institutions
Corporate governance

Insurance to corporate management

risks
Information exchange

Main-Bank System
The Japanese corporate sector relied heavily on loans extended by financial institutions. Even today, when
corporate financing through the capital market (i.e., direct financing) is growing, a substantial portion of
business debt stock is still in the form of bank loans (i.e., indirect finance). (According to the Bank of
Japans flow of funds account, in 1997, non-financial corporations aggregate outstanding loans amounted to
525 trillion yen, in which 407 trillion yen (77.5%) consisted of private bank loans as compared to corporate
shares of 291 trillion yen and other securities of 83 trillion yen.)
Most firms have their main banks. A main bank for a firm is defined as the bank that has the largest share in
total bank loans extended to that firm. Moreover, main banks often arrange bond and equity finance for the
firms, and regularly monitor their corporate management and business plans/projects.
Functions of Main Banks
From a microeconomic point of view, the regular collection of borrowers information by main banks was
good therapy for the problem of information asymmetry between lenders and borrowers (i.e., the
monitoring function of main banks). This saved the cost of information collection and the risks associated
with lending for non-main banks. In case management performance of a borrower firm temporarily
worsened and the risk of bankruptcy arose, its main bank was expected to step in and rescue the firm with
contingent loans and/or a loan rescheduling. A main bank dispatched top managers and extended advice for
its rehabilitation (the insurance function). When a decision was made by a main bank to finance a firms
project(s), other banks were pleased to provide additional loans as the main bank guaranteed the profitability
of the project(s). In case of difficulties, the main bank was expected to assume the burden of a corporate
bailout (the signaling function). The main-bank system had played a role of corporate governance in the
Japanese post-war system of development. In post-war Japan, where shareholders and capital markets did
not assume the monitoring role due to the existence of stable shareholders created by cross share-holdings,
main banks took that role.

36

Financing Sources of
industrial investment

1935
1940
1950

1960
1964

Bond
Equity

Bank loan

Before
Beforethe
thewar:
war:
Equity
finance
Equity finance
dominant
dominant

Own fund

During
Duringthe
thewar:
war:
Banking
was
Banking was
promoted
promoted

tight regulation
tight
regulation
Convoysystem
system
Convoy

1955

After
Afterthe
thewar:
war:
Bank
finance
Bank finance
Main-bank
Main-banksystem
system

Equity Financing to Bank Financing under the Convoy System

As a matter of fact, before World War II, corporate firms relied more on capital markets for their financing
of investment. Commercial banks then often lacked the capacity to evaluate borrowers repayment
capabilities and associated risks. As the war became imminent, the government tried to provide a larger
portion of available funds to military-related industries by seeking more direct control over fund flows. The
authorities denounced stock markets for their speculative and disorderly nature, and encouraged markets of
financial intermediation by banks. The authorities believed that financial intermediation by banks was much
more controllable. Therefore, the seed of the main-bank system was formed in WWII, when the Japanese
government took steps to make banks the key financiers of the economy. In 1942, examination departments
were introduced into commercial banks by government regulation and began their regular monitoring of
borrowers. This scheme was thought to be the origin of the main-bank system established after the war
(Noguchi, 1995). The main-bank system facilitated Japans economic growth by allocating funds to growing
industries. Tight regulation of the financial sector by the Ministry of Finance, or the so-called convoy
system, kept this sector orderly and preserved a stable main-bank scheme. The main-bank scheme helped
businesses to develop long-term plans by regularly providing loans and serving as a lender-of-last-resort in
case of financial difficulties. Thus, the main-bank scheme played an important role in Japans corporate
governance as it kept corporate management prudent and long-term oriented.
Downside
The downside was that this scheme unavoidably weakened competition among financial institutions in terms
of their fighting for corporate customers/borrowers. Main banks also often influenced borrowers finance
decisions and hindered the sound development of capital markets in Japan.

37

Labor market practices based on long-term employment

z

Japanese-style employment practices

Long-term or life-time employment
Wage increases and promotions based on
seniority
On-the-job training (OJT)
Intra-company labor unions

Rationality of long-term employment

Accumulation of company-specific skills and
technology
Smooth transfer of skills from one employee to
another
Smooth introduction of new technology
Saving of workers transition costs of changing jobs
Less need to monitor workers

Japanese-Style Employment Practices

The Japanese labor market had been characterized by its so-called Japanese-style employment practices.
These practices consist of long-term employment (or lifetime employment), a seniority-based wage system,
promotions in internal labor markets, intra-firm labor unions, and long-run on-the-job training (OJT). Intrafirm labor markets were formed with equal opportunity given to all newly-recruited workers, with a slow
promotion process (in selecting winners), and with active visible competition among the participants. This
kept young workers motivated.
Reflecting these employment practices, labor adjustments were performed mainly through
lengthening/shortening working hours, wage adjustments, and intra-firm job transfer, rather than through
layoffs. This prevented the rate of unemployment from rising even during recessions. Labor unions were
organized as intra-firm organizations. The union membership was usually extended to both white- and bluecollar workers.
Development of These Practices
Before WWII, Japans labor market was more like that written in an economics textbook. Although some big
businesses had introduced long-term employment practices for their core white-collar workforce, manual
workers (blue-collars) were most likely hired in spot markets. In 1937, in order to secure labor-employer
cooperation in serving the nation, intra-firm unions encompassing both white-collar and manual workers
were organized. These practices survived throughout the post-war development period as they had systemic
advantages, such as a high level of worker morale, cooperative behavior among workers, firms positive
attitudes toward long-term human resource investment and OJT, and employees positive attitudes toward
technological innovation.
Advantages
From microeconomic viewpoints, these practices were effective means to (1) overcome difficulties
associated with asymmetry of information regarding employees abilities and work ethics, (2) promote
workers faith toward their companies through reputation and hostage mechanisms, (3) settle conflicts of
interest in intra-firm negotiations, and (4) facilitate transfer of skills among workers.

38

Part V:
The Evolution of the
Japanese Development Model
***
End of Catching-Up Process
Bubble Economy
(1970s 1980s)
**
Lost Decade and Beyond
(1990s - )

39

5-1 Failure to Adjust to Post-Catch-Up Era

The end of the catch-up process
Survival of the Japanese-style economic system and practices
Strengthened by the success in overcoming the oil crises
Implicit goals shared by
all segments during
the catch-up period

To attain success
-- consensus formation
-- coordinated actions

Japanese-Style
Market System
-- long-term relations
-- information sharing
Post-catch-up period
Common goal disappeared

Autonomous action
Top management forced to
steer the ship

End of Catch-Up Process

The catch-up process seemed to have reached its successful conclusion by the end of the 1960s, at least as indicated
by the level of per capita GDP (PPP). However, the economic system that brought about the successful catching-up
did not itself evolve, or adjust to the new needs in the post catch-up era. The traditional process of consensus
formation played a significant role again at the time when Japan faced the first oil crisis of 1973-74. In order to cope
with the quadruple price increase of imported oil and the resultant stagflation, economic agents implicitly agreed, as
directed by the government, to accept tough industrial and employment adjustments and not to rely on
accommodative macroeconomic policies for recovery. Eventually, the Japanese economy overcame high energy
prices by energy-efficient manufacturing processes and products, and this, in turn, strengthened the international
competitiveness of Japanese products. The Japanese economy weathered the second oil crisis of 1979, again without
significant inflation or commodity shortages. In retrospect, however, this resulted in a survival of the modality of
consensus formation, collective actions, and government leadership that was no longer suitable in the post catch-up
era.
After the catch-up process was over, exogenously given goals for business and technology development no longer
existed. Companies had to create their own goals and management strategies suited for their new targets. The
elaboration of explicit goals and strategies by top management had become indispensable.

40

Manufacturing: adjustments to changing environment

-- persistent appreciation of yen
-- industrialization of Asian economies

Long-term
Long-term
employment
employment
----survived,
survived,taking
taking
advantage
of
advantage ofOJT
OJT
(after
(afterbubble
bubbleburst)
burst)
----increased
share
increased share
of
ofpart-time
part-timeor
or
temp
workers
temp workers

Parts-supplier
Parts-supplier
keiretsu
keiretsu
----survived,
survived,taking
taking
advantage
advantageof
of
information
informationsharing
sharing
----strengthened
strengthened
bargaining
bargainingpower
power
of
ofsuppliers
suppliers
(after
(afterbubble
bubbleburst)
burst)
----transforming
transforminginto
into
aamore
market-oriented
more market-oriented
network
network

Main-bank
Main-bank system
system
----lowering
loweringof
ofbig
big
Businesses
reliance
Businesses reliance
on
onbank
bankloans
loans
(after
(afterbubble
bubbleburst)
burst)
----consolidation
consolidation
in
inthe
thebanking
banking
sector
sectoritself
itself

Manufacturing (Tradable) Sectors in Transformation

The manufacturing sector, confronted with stiff global competition in the face of the rise in Asian nations and the yens
appreciation since the 1970s, constantly sought to maximize the rate productivity increase. This sector thus chose to
preserve the effective parts of the existing system and to transform other elements. In other words, they were keeping what
worked, and changing what didnt.
Labor Market
Many of the long-term employment practices survived because they are effective human resource management practices.
The manufacturing sector tended to rely heavily on company-specific technology, and therefore more long-term, on-the-job
skill development continued to be an effective option. After the burst of the bubble, however, the share of part-time and/or
temp workers has been increasing with deregulations in Japans labor market.
Keiretsu
The parts supplier keiretsu network system substantially changed due largely to the strengthened ability of parts suppliers
to develop new products. With advantageous information sharing, the keiretsu scheme survived. However, the nature of
subcontractors dependency on their parent companies had largely changed. In many industries, final-assembly producers
were no longer capable of designing new products without cooperation from parts suppliers. Backed by technological
advantages, many suppliers could abandon their former customers if the terms of the transaction seemed disadvantageous
to them and if they could find other partners. Parts suppliers competitiveness was fostered by stiff competition with other
suppliers in the same keiretsu network and by potential competitive pressure exerted by suppliers outside the keiretsu. This
has been a typical form of visible competition in the Japanese-style market system. Visible face-to-face competition was
often tougher than textbook-style competition among anonymous players. This induced massive efforts to raise
productivity, and to shorten delivery time. With the advent of more independent suppliers, parent companies started to
source their parts from firms outside keiretsu if it was more cost efficient. Thus the parts supplier keiretsu transformed
itself into a more open, market-oriented system.
Main-Bank System
By the 1970s, major manufacturing companies were no longer dependent on specific financial institutions for their
investment funds. In the 1980s, capital market instruments (equity finance, CP, etc.) had regained strength in corporate
finance in Japan. Financial institutions often lost their best customers and frantically sought new borrowers. They found
new customers typically among construction, real estate and non-bank financial sectors. Although the business activities of
these new customers involved substantial risks, banks tended to lack information to evaluate these risks properly. As a
result, those new loans were backed by real estate collateral. Market values of real estate collateral were based on a very
optimistic future assessment, and this, in turn, fueled the bubble formation.

41

Non-manufacturing: delay in adjustments

-- weaker market competition
-- lack of global competition
--public regulations

High costs imposed on

-- consumers
-- tradable sector businesses
-- business startups
-- inward FDI

Changes in Environment
-- globalization
-- developments of IT
-- FDI

Necessity of
-- creativity
-- risk-taking

Delay in Adjustments in Non-Manufacturing (Non-Tradable) Sectors

In addition to the lack of international competition, a slower pace of economic growth after the end of the
catch-up process limited the space for market competition in the non-manufacturing (non-tradable) sectors.
The traditional Japanese market system and public regulations continued to restrict competition and
protected matured or declining sectors.
The lack of competition led to lower productivity in these sectors, which in turn imposed high costs on
consumers and growing manufacturing industries.
Owing to the globalization of economic activities and rapid development of information technology, the
Japanese economy had entered an era of a diverse, knowledge economy. Here, even the competitiveness of
the nontradable sectors is determined by creative ideas and risk-taking innovative behavior.

42

5-2 Japanese (poor) corporate governance

that caused the bubble
Corporate managers interested
in expansion of the company and stable
relations with stakeholders;
overlooked profitability and risks
Banksstruggled for new customers;
lacked risk assessment of borrowers
Capital market lost corporate
monitoring function; equity finance

Race for size expansion

Neglecting risks & profits

Employment
practice
Consensus
for job
security

Moral hazard

Call for
intl policy
coordination
Yens
appreciation

Economic stimulus
by BOJ and govt

The bubble economy

Into the Bubble Economy
In the second half of the 1980s, Japan developed a bubble economy. Major factors that drove the
Japanese into the speculative boom were competition among firms seeking an expansion of their
company size, competition in the banking sector to expand the loan supply and other investments without
due consideration of credit risks, and economic stimulus measures taken by the Bank of Japan and the
government in the face of the Yens rapid appreciation after the Plaza Accord. Many factors were
attributable to the Japanese-style market system. The lack of sound corporate governance both in nonfinancial and financial entities, and the social consensus demanding job security as a result of the
ingrained long-term employment practices can also both be blamed.

43

Asset prices

16
14
12
10
8
6
4
2
0
-2

Land price

1986

1987

1988

1989

1990

1991

1992

1993

19
8
19 4.0
8 1
19 5.0
86 1
19 .0
8 1
19 7.0
88 1
19 .0
8 1
19 9.0
90 1
19 .0
9 1
19 1.0
92 1
19 .0
9 1
19 3.0
94 1
.0
1

Stock
price
(right)

45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0

Nikkei average

1985

Land price

30 increase (left)
25
20
15
10
5
0
-5
-10
-15

Monetary aggregates

123
45
678
9
10
11
1212
34
567
89
10
11
1212
34
567
89
10
11
1212
345
678
9
10
11
121
234
567
89
10
11
1212
345
678
9
10
11
1212
345
678
9
10
11
1212
345
678
9
10
11
1212
345
67
89
10
11
12

5-3 Emergence of
the bubble

end June, end December

Social pressure to maintain job security
Japans labor market practice (long-term employment) had led to a strong national consensus demanding job security and
no firings or lay-offs. Under the practice of long-term employment and seniority-based internal promotion, companies were
compelled to try to ever expand their size in order to offer a sufficient number of posts in their company hierarchy.
The government was expected to avoid recession to keep unemployment low. However, in September 1985, there was the
signing of the so-called Plaza Accord which triggered a rapid appreciation of the yen. The yens rapid appreciation was a
threat to the Japanese economy that relied so heavily on exports to the US market. In order to avoid an economic slump, the
government took fiscal stimulus measures, and the Bank of Japan took an extremely accommodative monetary policy. This
stimulating policy stance was maintained even after the real estate and stock market booms began to emerge; this flooding
of money supply thereby further fueled the bubble economy.
Emergence of the bubble
The two-digit rate of expansion of monetary aggregates fueled asset market inflation. Land prices rose by 50% on average
nationwide during the second half of the 1980s. In Tokyo and other metropolitan business districts, land prices even tripled,
peaking in early 1991. Stock prices in terms of the Nikkei average quadrupled to peak values at the end of 1989.
As Japanese became more and more optimistic regarding the future course of the economy, massive funds were poured into
domestic and overseas business projects. The resultant build-up of excesses, such as excess capacity, excess employment,
excess liability and excess loan supply, necessitated a long process of stock adjustments once the bubble economy collapsed
in the early 1990s.
Financial institutions that were insensitive to risks
Japans financial institutions were not sensitive enough to credit and other risks, as they had been protected by the convoy
system led by the Ministry of Finance. They found new customers in construction, real estate, and non-bank financial
sectors, and provided loans to them with real estate collateral. This created a typical spiral increase in real estate values and
loan supply.

44

Accommodative macroeconomic policy

Macroeconomic
Policy that fueled
speculative bubble
-- Reaction to yens
appreciation
-- Black Monday

Real
GDP growth (left)

-1

-2

Growth of

export (left)

-2
-3

-4
-6

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
1985

1987

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
1985

1986

Q1 Q2
Q3 Q4

1987

Fiscal package

Discount
rate

Bottom

6
5
4
3
2
1
0

1986

Peak

-- Low interest rates

remained until 1989
-- Fiscal stimulus
in 1987

45

5-4 Burst Bubble and the Lost Decade

1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

10 %
GDP growth rate
6.8 5.3 5.2
8
3.4 Nominal growth
6
Real growth
4
2.9
2.6
2.6
1.9 1.4
1.0
1.8 2.3
1.1
2
0.4
0.2
0.1
0
-0.2
-2
-1.8
-4

Source: ESRI, Cabinet Office, "Annual Report on National Accounts

Note: data after 1995 is based on chain-linking method, 2000 price.

Average annual
growth rate
195660
8.8%
196165
9.2%
196670 11.1%
197175
4.5%
197680
4.4%
198185
3.3%
198690
4.9%
199195
1.5%
19962000 1.0%
200105
1.4%

Note: data before 1980 are based on

the 1968-based SNA.

Low rate of economic growth persisted after the bubble burst

After the collapse of the bubble economy in early 1991, the Japanese economy rapidly fell into recession.
It technically bottomed out in late 1993, but the recovery process was slow and fragile, with an average
annual growth rate of only one percent plus throughout the 1990s and the early part of the 2000s.
Changes in employment practices
During this post-bubble period, the Japanese economy experienced negative growth in real terms in two
different years. The unemployment rate that used to be only one to two percent until the early 1980s
steadily rose to 5% in 2000. The share of non-regular employees, such as part-time workers, fixed-term
workers, and temp workers sent out by temp agencies, had drastically increased, signifying a departure
from the long-term employment practice.
End of the convoy system
Corporate profits stagnated. As a result of the accumulation of non-performing loans and the plunge in the
market values of equities, some major financial institutions (e.g. Hokkaido Takushoku Bank, Yamaichi
Securities, both in 1997) went bankrupt for the first time in the history of post WWII development of the
Japanese economy. This signified the end of the convoy system.
Persistent deflation
The Japanese economy experienced persistent deflation starting in the middle of the 1990s (which has in
fact just recently ended). This, too, was a phenomenon never before experienced in the post-war
development of Japan.
Lost Decade
Thus, the Japanese economy suffered significant stagnation, and the decade after the bursting of the bubble
is now called the lost decade in post-war Japanese development history. It was only after 2002 that the
economy entered a steady, albeit weak, recovery phase.

46

5-5 Adjustment process after the bubble burst

Real GDP development in
economies with 'bubble' experience
200

1985=100
USA

180
160

Source: OECD
"Economic Outlook 74
(Dec. 2003)

Japan

140
Sweden

120
100

UK
Finland
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

80

Comparative analyses of post-bubble developments

Speculative bubble formation and bursting occurred between the late 1980s and the early 1990s not only
in Japan but also in the US and Scandinavian economies, and to a lesser degree, in the UK economy. In
those countries, after the collapse, painful adjustments of excess capacity and redundancy were carried
out often with rather drastic financial stabilization measures including temporary nationalization of major
banks. Their real GDP shrank and unemployment rates jumped up during transition. Sweden and Finland
went through a severe transition phase.
In contrast, in Japan a top priority was to maintain employment, and therefore drastic measures were
avoided. Companies tried to hoard their employees. The government pumped massive amounts of money
into the economy through public works and tax cuts. The Bank of Japan poured literally unlimited
liquidity into the economy. Faced with failing borrowers and an accumulation of non-performing loans,
banks, at least initially, continued to supply additional loans in order to let borrowers survive. They
propped up their sick and hobbling customers, but with further burdening debt.
As such, in spite of the burst of probably the largest bubble among the aforementioned countries, the
Japanese economy maintained slightly positive rates of growth in the first half of the 1990s. However,
this strategy of preserving employment prolonged the following adjustment process and increased the
total adjustment costs. With the bankruptcies of some major financial institutions in late 1997, the
stagnancy of the Japanese economy continued into the 21st century.

47

5-6 Deterioration of the government fiscal balance

General government budget

balance % of GDP

1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

Cyclical balance
4
0.3 2.1
2
0.8
Projected
0
-2
-4
-4.2
Structural balance
-6
-4.7
-5.1
-5.2
-5.9
-8
-7.5 -7.9
Budget balance
-10

SourceOECD Economic Outlook 79(June 2006

Macroeconomic policy
Policy options that Japanese had after the bubble burst were (i) traditional macroeconomic stimulus
measures (fiscal and monetary), (ii) financial measures to restore the financial intermediary system, and
(iii) structural measures to speed the disposal of excesses built up during the bubble period and to develop
new business sectors. In fact, the chosen policy mix was traditional macroeconomic stimuli, partly coupled
with financial rehabilitation measures. The necessity of structural reforms was not fully recognized at least
until the latter half of the 1990s.
Discretionary fiscal policy and structural budget deficit
Japan adopted a discretionary fiscal policy, which is the utilization of measures like tax reduction and
public investment, to stabilize the economy. The subsequent build-up of budget deficits shows the extent of
this massive budgetary support for the ailing economy. The budget deficit can be broken down into two
parts. One is the cyclical deficit that reflects the functioning of the automatic stabilizer such as tax revenues
and unemployment benefits. The other part represents structural deficit. This latter part comes from
intentional fiscal policies such as tax cuts and expenditure programs, and from institutional factors such as
subsidies, education expenses, and social security and taxation systems.
Since the bubble burst, the majority of Japans general government budget deficit has been structural,
which has expanded rapidly due to repeated economic stimulus measures taken in the 1990s.

48

Budget balance% of GDP

UK
France
Japan
Government debt % of GDP

Japan

160
140
120
100
80
60
40
20
0

Italy
France

USA
Germany

2005

2004

2003

UK
2002

1990

Source: OECD Economic Outlook 78

Dec. 2005
Note: General government budget

2001

1990 1995 1999 2000 2001 2002 2003 2004 2005 180

2000

Italy

Germany

1999

USA

1995

6
4
2
0
-2
-4
-6
-8
-10
-12
-14

Japanese budget balance in comparison to the other industrial economies

In the 1990s, most industrialized economies consolidated their budgets, and some even attained
budget surplus. Japan, on the contrary, experienced a sharp deterioration of the budget balance,
from a surplus in 1990, to a massive deficit of more than 7% of GDP by the turn of the century.
As the social security account has maintained a surplus of about 2% of GDP during this period,
the central and local governments have been in fact running a deficit worth about 9% of GDP.
Budget deficit has been largely financed by issuance of government bonds and by other kinds of
borrowings. As a result, the outstanding government debt has reached 160% of GDP. Japan is
now the country with the worlds largest government debt.

49

5-7 Non-performing loans of financial institutions

15
10

Annual disposal

5
0

(trillion yen)

50
40
30
20
13. 110
0

42 34. 8
26. 2
17. 5

Nonperforming
loans

Nonperforming

1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

Nonperforming
loan annual
disposal

Nonperforming loans and disposal

End of FY

Source: Financial Service Agency

Note: end of fiscal year

Non-performing loans
During the bubble period, financial institutions poured money into the real estate sector (more than 100 trillion
yen), taking real estate itself as collateral for loans. When the bubble burst, the construction and real estate
sectors failed to make a profit and quickly became unable to pay their debts. With plunging real estate prices, the
liquidation of real estate collateral proved insufficient to cover loans. Thus, non-performing loans quickly
accumulated on a massive scale.
Disposal of non-performing loans
The disposal of NPLs started in 1992. At the time of the adoption of the comprehensive economic package in the
summer of 1992, Japan already recognized the gravity of its NPL problem, based on observation of other
countries earlier problems with NPLs. The package that the Japanese government enacted aimed at disposal of
NPLs and recovery of the real estate market and asset prices. The package contained measures such as
liquidation (sales) of real estate collateral, preferential tax treatment on NPL disposal, disclosures of NPLs by the
lending institutions, and resolution of non-bank financial institutions such as housing loan companies. Some
economists and politicians, learning from experiences of other countries, were aware at that time that an injection
of public money would be necessary to dispose of NPLs in the banking sector, however, the general public was
in no mood to support this recapitalization as the public believed that the banking sector itself was the major
cause of the speculative bubble. Only after a series of bankruptcies at major financial institutions took place in
1997 and 1998 was public money injected into financial institutions, which enabled banks to finally dispose of
NPLs to a large degree. The recovery of a sound financial system was a key factor in bringing the economy back
in 2002 to the steady (although still weak) growth path.

50

Part VI:
Structural Reforms
in
The Japanese Development Model

51

6-1 Japanese System in Transformation

Employment
Employment system
system
Main-bank
Main-bank system
system
Corporate
Corporate management
management
Cross
Cross share
share holding
holding
Parts
Parts supplier
supplier Keiretsu
Keiretsu
Industrial
Industrial policy/regulation
policy/regulation

Major
Major challenge
challenge

IT

ITand
andglobalization
globalization
Mega
-competition
Mega-competition
Aging
Agingof
oflabor
laborforce
force
Change
of
values
Change of values

Structural
reform
Marketization,
Marketization,competition,
competition,choice,
choice,diversity,
diversity,own
ownrisk
risk
Cohabitation
and
competition
of
systems
Cohabitation and competition of systems
based
basedon
oncomparative
comparativeadvantage
advantage

Rationale of the system

The Japanese-style market system consisted of (i) an employment system utilizing long-term employment,
seniority-based wage structure, on-the-job training and intra-firm labor unions, (ii) a main-bank system,
(iii) corporate management by managers promoted from employees, (iv) corporate groups united by cross
share-holding, (v) a long-standing trade relationship between parts suppliers and assembly producers or
between manufacturers and distributors, the so-called keiretsu, and (vi) long-term relationships between
the government and business sectors through industrial policy and public regulations.
It was believed that the aforementioned deep, longstanding relationships would mitigate the problem of
asymmetric information, such as agency problems between employers and employees, and between
bankers and borrowers. It also brought about a long-term perspective in corporate management and
facilitated long-term strategic investment. However, in the post catch-up era, this same system appears to
have helped bring about problems such as the bubble economy of the late 1980s and the persistent low
growth throughout the 1990s and beyond, even to present day.
Changing environment and challenges to the system
The major challenges to the Japanese-style market system are: (i) changes in the industrial structure and
business environment, brought about by an advancement of information and telecommunication
technology, which calls for more flexible and timely management and transactions; (ii) the ongoing
process of globalization and mega-competition; (iii) the aging of the population and workforce; and (iv)
changes in peoples values. These evolving factors have undermined the effectiveness of the traditional
system, and call for a systemic change for further economic development.
Structural reforms and a system evolving for the future
Japans ongoing structural reform combines a transformation of the economy into a more market-oriented
system with less government interventions/guidance, while still utilizing the advantages of the traditional
Japanese system. Key words for this reform have been marketization, choice, competition, diversity,
and own risk. There is still great potential for taking further advantage of information sharing. The
government, redefined from its earlier role, needs to create institutions to coordinate with this evolving
system and ensure it fully integrates into this new paradigm. In reality, the pace of change differs and there
is not a complete and total break with the past. Various systems, some of which are more market-oriented
and others which rely more on institutional trade relations, will continue to co-exist with dynamic
competition among them.

52

6-2 Weakening of main-bank functions

z

Environmental
change

Banking loan share between 198590

among companies expanding loans

Financial liberalization
Strengthening of
corporate financial
Companies whose
basis
bank
loans

Growing diversity
increased
among banks
z

Share of mainbank loans

Up
Unch. Down

Mainbanks changed

Companies whose
bank loans largely

increased

Weakening of
main-bank function

Weakening corporate
governance and
screening/monitoring
during the bubble
period
Weakening of the
insurance function in
the 1990s

Real
estate

companies
0%

20%

40%

60%

80%

100%

Economic white paper 1996

53

6-3 Declining cross share-holdings

z
z

Lack of corporate discipline during the bubble

Weak capital market governance due to
cross share-holding
Weak discipline imposed by capital market

Rapid weakening of cross share-holding

1987
1987
Shares
issued
by
business
corporations
Shares issued by business corporations
ratio
29.7%
ratioof
ofstable
stableholders
holders
29.7%
((ofofwhich
)
held
by
FIs
22.0%
which) held by FIs
22.0%
Shares
issued
by
banks
Shares issued by banks
ratio
55.7%
ratioof
ofstable
stableholders
holders
55.7%
((ofofwhich
)
held
by
companies
34.4%
which) held by companies 34.4%

1995
1995

1999
1999

28.7%
28.7%
20.1%
20.1%

27.9%
27.9%
12.9%
12.9%

53.3%
53.3%
32.9%
32.9%

45.6%
45.6%
28.5%
28.5%

Nissei Research Institute (adjusted for change in disclosure rules)

54

6-4 Weakening of
Japanese-style employment practices
Aging of workers leading to higher wage cost
Development of external labor market
Dependence on part-time and other irregular workers
Development of temp services

Lowering of growth of corporate size

Changes in industry structure, globalization and IT
Manufacturing industries: skill transfer through OJT,
process innovation, and team work
Knowledge based industries: higher speed and risk of
innovation, leading to more flexible recruitment from
external labor market and ability-based wage
determination

Disadvantages of the Japanese-Style Labor Market System in the Post Catch-Up Era
There are issues both embedded inside and lurking outside the Japanese-style employment system that spell trouble
for Japans future labor situation: (i) differentiation between regular employees and spot or part-time employees,
i.e., a problem in terms of distinct benefits, as part-time workers are not privy to retirement packages and they may
face future earnings shortages; (ii) potential undermining of the system due to changes in consciousness or values
of younger-generation workers; (iii) the absolute necessity of a company to continuously grow, in order to be able
to maintain the Japanese-style employment scheme, particularly the seniority-based promotion system; and (iv)
rigidity of personnel (human resources) and resultant inflexibility in adapting new business opportunities and
introducing new technology.
The inability to downsize due to Japans aversion to layoffs has made technological advances not only unnecessary
but also unwelcome, and this has become increasingly debilitating as the share of knowledge-based industry, such
as IT and life-science industries, has expanded rather quickly. In the traditional manufacturing sector, companyspecific technology is highly important, and technology transfer through on-the-job training and process
innovation had built Japans competitive edge. In the knowledge-based sectors, however, competitiveness is
determined by technology, and the frontrunner is on the cutting edge. As companies are compelled to employ
professionally-skilled workers directly from an external labor market, compensation must be based on the abilities
and skills of individual workers. The seniority-based wage system becomes an obstacle that chokes away
companies growth potential. To facilitate the quick restructuring of companies and branches, it is imperative that
organizations be as flexible as possible.
Anecdotally, there have been many occasions when Japanese-style employment practices have been revised.
However on a macro level, the old system still dominates. Schemes such as the seniority-based wage systems and
corporate pension schemes still contribute to the long-term employment system. A likely scenario in the future
would be that, while traditional employment practices will survive among many manufacturing companies where
company-specific technology, long-term job training, and skill transfer are crucial, more flexible systems will
come to prevail among IT and service industries. Thus both the traditional and new employment systems will
coexist according to industry needs.

55

Survey year
Japan:
UK:
Germany
USA

Comparison of wage profile

production workers in manufacturing

1994
1991
1972
1969

160

Japan

140

UK

120
Wage index

West Germany
100

USA

80
60
40

Wage index: 25-29-year-olds=100

20

Age groups
Economic Whitepaper 1996

Wage profile to change

Seniority-based compensation has been seen as a strong incentive to stay in the same company in
Japan. A cross-country comparison of wage profiles by age groups shows that Japans relative
(indexed) wage level is a little lower than those in other countries at younger age groups, while it
is significantly higher from the 30s through the 50s. If the wage profile in the majority of
countries reflects labor productivity by age, then Japans wage level has been kept artificially
lower than that warranted by productivity when workers are young, then artificially higher when
the workers become older. However, Japans wage profile has been changing in the 21st century,
albeit at a slow pace.

USA

(25-34=1)

Japan

(25-29=1)

56

6-5 Regulatory Reform

(1) Coverage of regulation
Excessive
Excessive regulation
regulation
Weakening
Weakeningof
ofthe
thesense
senseof
ofrisk
risk
Reduced
business
opportunities
Reduced business opportunities
Inadequate
Inadequatebusiness
businessadjustments
adjustments
Number of regulations
11,402 11,581
12,000
10,278
11,000 10,054

Service
Electricity/Gas supply
Transport/Telecom
Real estate
Finance/Securities
Wholesale/Retail
Manufactur
Construction
Mining
Agriculture/Forestry/Fishery
Total

55.6
100.0
97.3
7.5
100.0
0.0
23.4

0%

USA
USA
1977
1977 17%
17%
1988
6.6%
1988 6.6%

10,000
9,000

Percentage of industries under

government regulation in 1990

1985

1988

1993

1999

100.0
100.0
87.1
41.8
20% 40% 60% 80% 100%

JAPAN
JAPAN
1965
1965 47.8%
47.8%
1990
41.8%
1990 41.8%

Economic White Paper 1995

Regulatory Reform
Excessive government regulation on businesses and financial institutions tended to weaken their
sense of risk or discouraged risk-taking behavior, dulled the threat of competition, and delayed
their adjusting to changes in the business environment.
Economic regulations and social regulations have numbered more than 10,000 for many years,
according to data produced by the Management and Coordination Agency. At the turn of the
century, that number was actually increasing. But that is not necessarily to say that Japan was
going in the wrong direction. In fact, as regulatory reform proceeds, regulation tends to be
unbundled into several regulations, particularly in the case of partial deregulation. In Japans
financial sectors, ambiguous regulations were changed to more specific regulations, and in the
process, the number of regulations increased.
An estimate using input-output table data showed that in 1990, 42% of Japans production was
under some kind of regulation (permission, approval, registration, etc.). Apparently, this figure
overstated the amount of regulation because of limitations in data collection (if any part of an
industry was under regulation, then the entire industry was counted as regulated). Still, a
comparison with US regulatory reform revealed that Japan had not yet achieved substantial
reform (as of 1990). In the US, the percentage of regulated industries (on an output basis)
declined significantly during the Ford, Carter, and Reagan administrations regulatory reform
period.
Despite a long period of renewed regulatory reform that started after the bubble burst, no
significant drop in regulation was observed in Japan until the late 1990s.

57

(2) Costs Associated with Regulation

Price differential
High-cost
High-coststructure
structure

Slow
Slowadjustment
adjustmentto
to
Changes
in
environment
Changes in environment

Lack
Lackof
ofinnovation
innovationand
and
new
business
opportunity
new business opportunity

Consumer price level

NY 100 vs. Tokyo 141 (1998)
High-cost pressure on
tradable industries
Manufacturing: Developed
various new products
Non-manufacturing: almost
no new services developed

Price Gaps between Home and Abroad =

Price Gaps between (unregulated) Tradable and (regulated) Non-Tradable Sectors
+

Price Gaps in Tradables Created by Border Protections (tariffs, etc.)

The costs associated with regulation

1) Regulation brings about a high-cost structure. This leads to price differentials between
regulated and not-as-regulated markets, and in Japans case, the price differential was between
Japanese and overseas markets. In 1998, consumer prices (in aggregate) were 41% higher in
Tokyo than in New York City (data source: Economic Planning Agency). A high-cost structure
imposes a cost burden on tradable sectors and weakens their international competitiveness.
2) Regulation weakens regulated industries incentives to adjust to changes in the economic
environment. Tightly regulated industries tend to perform worse when the economic environment
worsens.
3) Regulation restricts opportunities and weakens business capacity for innovation. The Japanese
manufacturing sector has developed and commercialized various new products, such as the fax,
VCR, and lap-top computer. The non-manufacturing sector, on the other hand, has merely
imported new services developed in foreign countries (with an exception of rental video shops).

58

(3) Economic effects of the 1990s regulatory reform

Annual average)
Demand expansion
Consumer surplus expansion
Sector Period
Telecom 96-97
Cable TV 96-97

Effect
6.86
0.30

Sector Period
Telecom 96-97
Share brokerage 96-97

Effect
7.10
0.26

96-97
96-97

0.24
3.12

Car exam 96-97

Airline 96-97

0.49
0.24

Farmland 96-97
Electricity 96-97
Temporary
personnel svcs. 96-97
Airline 96-97

0.68
0.32
0.03
0.17

Satellite TV

Retail

Total

11.85 tril. yen

CBond

96-97
Oil products 96-97
Electricity 96-97
Gas supply 96-97
Total

0.08
1.78
1.07
0.05

11.33 tril. yen

Economic Planning Agency (1999)

Total includes items other than those listed

59

(4) History of Japans regulatory reform up to the 1990s

1980s
z
z

Late 1970s -- aimed at lowering paperwork costs

1981 -- Administrative Reform Committee, proposed
privatization of NTTPC and JNR
z The first half of 1980s -- US-Japan financial sector
consultation, start of financial liberalization
z 1989 -- US-Japan Structural Impediment Initiative,
discussed regulatory reform, business practices, etc.

1990s
z

1993 -- Hiraiwa Report proposed liberalization as a

rule
z 1995 -- Regulatory Reform 3-Year Plan
z 1998 -- Economic Strategy Committee

History of Japans regulatory reform up to the 1990s

Japans regulatory reform process started at the end of the 1970s, mainly aiming to recreate a compact
government and to reduce red-tape costs. In 1981, the Second Temporary Council of Research on Public
Administration System (Daini-Rincho) was established. It emphasized private sector vitality, international
harmonization and peoples welfare, and advised various administrative reforms. Among others, it advocated
privatizationor at least partial privatizationof three public corporations (NTTPCa telecom companyin
1985, Japan National Railway in 1987, and Japan Tobacco Monopoly in 1985).
In the early 1980s, Japans trade surplus ballooned and international calls strengthened for Japans market
opening and regulatory reforms. The Japanese government tried to shift export-led growth to domestic-demandled growth on both macroeconomic and microeconomic fronts.
Interest rate liberalization began in the second half of the 1970s, induced by an expansion of national bond
issuance and by the globalization of financial services. In 1984 the Joint US-Japan Ad Hoc Group on Yen/Dollar
Exchange Rate, Financial and Capital Market Issues started and promoted financial sector regulatory reform. In
1989, Japan and the US initiated the Structural Impediment Initiative (SII), under which they discussed Japans
market opening from the context of changes in regulation and business practices.
After the bubble burst, when the economy was stagnating and the yen was appreciating, regulatory reform came
to be seen as the key to revitalize the economy, by (1) overcoming business and household sectors lack of
confidence, (2) lowering high business costs, and (3) enhancing business opportunity in the domestic market.
In 1993, an advisory group to the government of Japan released the so-called Hiraiwa Report, advocating that
economic regulation should be liberalized as a rule, while social regulation should be minimized under the
principle of self responsibility. In March 1995, the government adopted a comprehensive action plan for
regulatory reform (which was subsequently revised in 1998). It addressed 1,091 lines of regulations and set a
concrete time schedule to dismantle them.

60

() Characteristics of regulatory reform process in Japan

up to the 1990s as compared to that in the US and UK

Japan has tended to avoid trial and error process

Even in the US, the airline case was exceptional
Privatization in UK lacked competition scheme
Price cap system in UK
Bottom-up in the US, top-down in Japan/UK
Japans regulatory body was also an administrator
of industrial policies
US, UK: independent regulatory commission
Checks and balances with industrial policy
administration, competition offices and local
government

Empirical analyses had not been utilized

EPA team conducted CGE-model-based analyses in late 1990s

Characteristics of Japans regulatory reform (up to the 1990s)
-- Because the Japanese government tended to avoid the trial and error correction process, it took a long
time to consider new schemes and persuade all stakeholders. However, in the case of network industry
reforms where innovation proceeded rapidly, reform delay could turn out to be a fatal mistake. The
UKs privatization process of its national public utilities was a good example of the trial-and-error way
from which Japan can learn. Also, the UKs setting of the price-cap scheme was a typical trial-and-error
process.
-- In the US, deregulation processes were often triggered by new entrants taking advantage of legal or
administrative loopholes, without prior consent by incumbents and regulatory authorities. A typical case
was MCIs entry in the long-distance telecommunications market. In Japan, such loopholes were hard to
find and businesses tend to avoid a struggle with regulatory agencies, with notable exceptions of doorto-door parcel delivery service and lower pricing by a few taxi cab companies.
-- In the US and UK, semi-independent regulatory commissions carry out actual regulatory
administration, while separate government organizations cover industrial policies and regulatory design.
The judicial sector, antitrust authorities, andin the USstate governments were also involved. In
Japan, both regulatory administration and industrial design, among other things, were directed by a
single government agency, the Ministry of International Trade and Industry (MITI). And while a
separate authority, the Fair Trade Commission, was in charge of governing competition, it did not exert
visible influence. A concentration of both planning and execution (and monitoring) functions caused
conflicts of interest and made the process non-transparent.
-- In Japans regulatory reform process, empirical/scientific assessments of existing regulation and their
reform have seldom been utilized. In the late 1990s, some cost-benefit analyses and CGE-model-based
analyses were beginning to be carried out.

61

6-6 PM Koizumis economic reform measures

(2001 2006)
Change
Changein
inpolicy
policyformation
formationstyle
style
----Strengthening
the
role
of
Cabinet
Strengthening the role of Cabinetfor
forpolicy
policyformation
formation
----Weakening
the
influence
of
the
MOF
Weakening the influence of the MOF
----Weakening
Weakeningthe
thevoice
voiceof
ofthe
theLiberal
LiberalDemocratic
DemocraticParty
Party

Settlement
Settlementof
ofthe
theBubble
Bubbleeconomy
economyaftermath
aftermath
----Banking
reform,
esp.
disposal
of
NPLs
Banking reform, esp. disposal of NPLs
----Budget
Budgetconsolidation,
consolidation,esp.
esp.reduction
reductionin
inpublic
publicworks
works
Measures
Measuresto
tocope
copewith
withdepopulation
depopulationand
andaging
aging
----Reform
Reformof
ofsocial
socialsecurity,
security,health
healthand
anddisability
disabilityinsurance
insurance
The Koizumi Cabinet reforms
Former Prime Minister Junichiro Koizumi conducted a series of major reforms of the Japanese economy
between April 2001 and September 2006. Some were successfully carried out while others met with only
nominal success. The continuing agenda of his reform initiatives was then inherited by the next cabinet of
PM Shinzo Abe. Koizumis reform efforts can be classified into three categories: (i) reform of the policy
formation process itself; (ii) cleaning up the aftermath of the bubble economy of the late 1980s and
subsequent long-term slump; and (iii) forward-looking reform of the Japanese economic and social
structures and institutions.
Transformation of policy formation process
Japans policy formation process inside the Administration used to be rather ambiguous and lacked clear
leadership. Policy proposals were regularly originated from the ministries in charge, through massive
negotiations with other ministries and particularly with the powerful Ministry of Finance. Then they were
intensively discussed within the leading Liberal Democratic Party through a complicated procedure, and
finally they had to be approved by the General Affairs Committee of the LDP with the consensus of all the
membersand all of this before the bills could be submitted to the Diet. The ruling party LDPs leadership
was broken into factions which controlled various political campaigns financing and recommended
candidates for ministers in the Cabinet to the PM. Therefore, the decision-making relied heavily on the
balance of power among these LDP factions.
PM Koizumi substantially altered this regime through his initiatives to increase prime ministerial
leadership. He did this by strengthening the power of the cabinet, via (1) establishing the Council on
Economic and Fiscal Policy to be chaired by himself, the PM, (2) expanding cabinet staff, (3) weakening
the MOF in policy formation, and (4) strengthening control over LDP factions.
Clearing the bubble aftermath
The bubble economy of the late 1980s and subsequent extended slump left the Japanese economy with
major problems, and the Koizumi Administration confronted the long-lasting remnants of the burst bubble.
First, the government aggressively pursued the disposal of accumulated non-performing loans, more or less
getting rid of them. Second, the Koizumi administration attacked the massive budget deficit, halving the
primary deficit from the 2002 peak level. However, the stock of the general governments debt continues
to be large relative to the size of the economy (in excess of 160% of GDP).
(continue to the next page)

62

Delegation
Delegationof
ofauthority
authorityfrom
frompublic
publicsector
sectorto
toprivate
privatesector
sector
----Privatization
of
the
postal
service/postal
savings
Privatization of the postal service/postal savings
----Reform
Reformof
ofstate-owned
state-ownedfinancial
financialinstitutions
institutions
----Privatization
of
public
highway
corporations
Privatization of public highway corporations
----Marketization
Marketizationtest
testof
ofpublic
publicbusinesses
businesses
----Regulatory
reform,
esp.
creation
Regulatory reform, esp. creationof
ofspecial
specialzones
zones
Delegation
Delegationof
ofauthority
authorityfrom
fromcentral
centralto
tolocal
localgovernment
government
----Trinity
reform
of
function,
revenue,
Trinity reform of function, revenue,
and
andintra-govt
intra-govttransfers
transfers
----Promotion
of
merger
of
municipalities
Promotion of merger of municipalities
Private
Privatesector
sectorreform
reform
----Strengthening
Strengtheningof
ofthe
theFair
FairTrade
TradeLaw
Lawto
tobar
barcollusion
collusion
----Regulatory
reform,
esp.
creation
of
special
zones
Regulatory reform, esp. creation of special zones
----Corporate
Corporategovernance
governancereform,
reform,facilitating
facilitatingM&A
M&A

Reforms to cope with rapid aging and depopulation

Japan is now one of the most rapidly aging economies in the world, where the age-dependency ratio has been
rapidly increasing. Japans population hit its peak in 2004 (at 127.8 million) and started to decline in 2005 for
the first time in its history. The population share of the ages 65 or over, that stood at 17.3% at the turn of the
century, is expected to climb up to 22.5% in 2010, 27.8% in 2020, and 35.7% in 2050.
The social security reform has been conducted, including public pension, health insurance and nursery care
insurance. However, as the speed of aging has been very rapid, further reforms are needed.
Initiatives to shift authority from the public sector to the private sector
Another major Koizumi reform initiative was to shift functions and resources from the public sector to the
private sector. Some major privatization programs were conducted, however as seen in the Postal reform
which is to be completed in 2018, they were often nominal and subject to future political environments.
Initiatives to shift authority from the central government to local governments
Another major category of reform was decentralization, i.e. a shift of authorities/functions and budgetary
resources from the central government to local governments. The trinity reform of (1) shifting
functions/authorities to the local government, (2) shifting the tax base from the central to local governments,
and (3) reducing transfer taxes and categorical grants to local governments was designed in order to weaken
central government leadership and strengthen local autonomy. As this set of reforms is still underway, strong
leadership is necessary to attain the initial objectives.

63

6-7 Structural Reform: Agenda for Sustainable Growth

Self-reliance
of Individuals

Expansion of Corporate
Activity and Investment
Job choice society
Employment practices

Human capital investment

Corporate governance
Corporate accounts disclosure

Corporate pension (401k type)

Portfolio investment diversification

Corporate restructuring
FDI into Japan

IT revolution

Regulatory reform Entrepreneurship promotion

Personal income taxation
Corporate taxation
Financial system reform
Social security
SME policy

Education reform

Public investment reform

Labor market liberalization

Information network
Budget consolidation
Administrative reform
FILP reform
Local govt autonomy
Electronic government

Compact and
Efficient Government

Building Institutions of Coordination:

From Interventionist Government to Coordinator Government
The necessity for basic structural reform, or marketization, extends to a wide range of the
Japanese economy. Three sectors of the economy have their own reform agenda: i) business and
financial sectors must reform themselves to enhance business and investment opportunity; ii)
individuals or the household sector must accept the discipline of self-reliance; and iii) the
government sector must transform itself into a compact and efficient government
respecting/utilizing market forces and utilizing decentralization in a strategic manner.
Changes in business and the government sectors must be compatible with (and accompanied by)
those in the household sector. Self-reliance of individuals involves shifts in lifestyle, from the
traditional reliance on the business community to self-decision-making and risk-taking in
choosing jobs and careers that require investments in the individual, by the individual. Selfresponsibility should be nurtured in the business sector, as opposed to relying on protection
through regulation. The banking sector should stand on its own without the MOF-led convoy
system.
Generally speaking, in the business sector, various reforms have already been started to get out of
the long stagnation of the 1990s. As for the government sector, some reform initiatives have
started in the areas connected to business, such as regulatory reforms and partial tax reforms.
However, for public sector-specific reform areas such as administrative reform and government
decentralization, the process has been much delayed. Budgetary reform had just begun under the
Koizumi administration. As for the household sector, it will take a long time for the majority of
people to change their lifestyle and way of thinking.
As the majority of the reform efforts and new initiatives should be happening in the cross-sections
of the three sectors, the building of institutions of coordination or, in other words, nurturing the
social capital of intra- and inter-sector networks is imperative. The role of the government
should be redefined in precisely this context. That is, a change from interventionist government
to coordinator government is now most urgently called for.

64

The Evolution of a Development Paradigm:

A Simplified Review
NIE

1989-

Governance
After WWII
1960s (early 1970s)

1980s

End of the 20th C.

& Beyond

ISI

SAP

PRSP

New Political
Economy of
Development

???
-2015

MDGs

BHN

Social Capital

Role of Government
1985-

Globalization

The New Institutional Economics (NIE) that international development finance institutions started to utilize
in the 1990s has two major principles: 1) institutions define economic performance, and 2) institutions can
be analyzed by microeconomics (of incentive structure). Therefore, it is in a way a fusion of traditional
institutional economics and neo-classical economics. (Neo-classical economics is the one that provided the
basis for structural adjustments in the 1980s.)
This new economics of institutions is essentially about: 1) reducing transaction costs and 2) facilitating
information flows. Roles of the public sector are captured in the treatment of ownership by the government
and coordination that reduces transaction costs and ensures proper information flow (North). Herein lie the
roots of the good governance arguments. The NIE also defines the timeframe of the economics of
institutions (Williamson). While governance as a play of the game (improving management) has a time
period of 1 to 10 years, governance as rules of the game (fixing the institutional environment) has a time
frequency of 10 to 100 years.
These theories are all relevant when we talk about institutions of coordination. Public-Private
Partnerships (PPP) and the power structure of related institutions such as decision-making bodies,
regulatory bodies, and partners should be developed in an adaptive manner and given a sufficient amount
of time.

65

Part VII:
Aging Japan, Aging Asia

66

7-1 Aging Japan

Unavoidable depopulation and aging

Population in Japan
Higher

million

Lower case

2050

2040

2030

2020

2010

2000

1990

1980

Medium case

1970

1960

1950

Birth rate
Until early 1970s
Around 2.2
2000 1.36
2005 1.26
Medium case
Same level as now
2030 1.24
2055 1.26
Lower case
Drop until 2020s
2030 1.04
2055 1.06

million
140
130
120
110
100
90
80
70
60
50

(SourceNational Institute of Population and Social Security Research estimate (Dec.2006

Depopulation and rapid aging

According to the 50-year projection created by the National Institute of Population and Social
Security Research released in December 2006, in the standard case, Japans population begins to
decrease after its peak of 127.8 million in 2005, and falls to 90 million by 2055. This scenario
assumes the birth rate (average number of babies born per female) to be virtually unchanged from
the current level of 1.25. In a more pessimistic case, assuming a further drop in the birth rate to
nearly one, the population would be 85 million in 2055.
At the same time, the aging of the population is set to further accelerate. According to the
standard scenario, people 65 years and older, now 20% of total population, would reach 40% in
2055, and those under 15 years old, now 14%, would be a mere 8%.
The government of Japan is deeply concerned with this depopulation phenomenon, as it would
create a shortage in the labor force and place a heavier burden regarding social security
contributions on the working generation. Therefore, various measures have been taken to
encourage couples to have more children. So far, the effect seems to be limited and the trends of
depopulation and aging appear unstoppable.

67

Cases of economic development under depopulation

Nation
Time

Western
Europe

Japan

Late 14th c.

17301800

Decline 7080 mil.

4050 mil

0.3%

Famine
Late marriage
Less birth
0.2%

0.4%

0.3%

Reason Black death

GDP
GDP
Per capita

32 mil.
30 mil.

Impact Labor
scarcity

Agricultural
technology

Ireland

Hungary

Late 19th c.

1980

2 mil. In 10
years

0.3% decline
annually

Famine
Immigration

Lower birth
rate

0.7%

0.6%

1.6%

0.9%

Change to

Marketization
livestock farming Investment

Source: Economic planning Agency (2000)

Will depopulation bring about economic decline?

It is generally believed that, with depopulation, an economy decelerates or shrinks. However, during
the 2nd millennium, a few cases were seen in which economies grew despite population decline.
In Japan in the 18th century, the population decreased due partly to famine in Tohoku and epidemic
diseases at an initial stage of urbanization, and partly as a result of late marriages and a smaller
number of babies born to couples in large cities. However, thanks to agricultural technological
progress and development of new fields, farm production increased.
In Ireland in the 19th century, depopulation set in as a result of famine and outgoing immigration.
Labor scarcity encouraged an industrial transformation from labor-intensive agriculture to landintensive livestock farming, bringing about higher productivity.
In Hungary, the population has been both decreasing and aging since the 1980s, due to a lower birth
rate, but thanks to catching up technologically and the introduction of the market economy, the
growth rate has been on the positive side.
In Western Europe in the 14th and 15th centuries, the black death wiped out nearly half of the
population. The resultant farm labor shortage widened the per capita farmland, and per capita output
increased significantly.
Lessons from these cases
These examples suggest that a society under the process of depopulation does not necessarily have to
experience economic and social decline. If the social system is reformed, industry structure
transformed, new technology introduced, and thus productivity heightened, economic development
can be attainable even in this challenging environment.

68

1995

1990

1985

1980

1975

40
35
30
25
20
15
10
5
0
-5
-10
1970

(% of GDP)

East Asia's Saving, Investment,

and CAB

Gross national savings, incl. NCTR

Gross domestic investment (% of GDP)
CAB (GNS-GDI)
Gross domestic savings

East Asias saving ratio (GDS) increased from 22% to 32% in the
1970s, and reached 37% before the AFC, facilitating a healthy
increase in the investment ratio
The CA deficit also expanded in the 1990s until the AFC came
about. And then ?

69

Is Doomsday Imminent ?
Age Dependency Ratio
(dependents to working-age population, %)
100
90
80
70
60
50

Higih Income Cos.

Low & Middle Income Cos.

2050

2040

2030

2020

2010

2000

1990

1980

1970

1960

40

Japan
East Asia & Pacific LMICs

Determinants of the private saving ratio:

Income (level), rates of return, uncertainty, domestic/foreign borrowing constraints, financial depth,
fiscal policy, pension system, income/wealth distribution, and demographics

70

Part VIII:
Revolutions and the Evolution
of Economic Systems

71

Revolutions and the Evolution of Economic Systems

(based on Yukio Noguchi, IT makes smallsmall-scalescale-organization economy advantageous
advantageous Nikkei, April 5, 2002)

Private ownership of
the means of production
Capitalism

Primitive Market Economy

Industrial Revolution

Imperialism
Monopoly Capitalism

IT-driven Market Economy

The US economy after the IT revolution

IT Revolution

?
Socialist Revolution

Japan under the

1940-system

Industrialized China

Larger-scale-organization oriented

Smaller-scale-organization oriented

China under Mao Zedong

(Maoist China)

Linux

USSR
Socialism

Utopian Socialism
State ownership of
the means of production

72

 Japans Development Experience

Thank You !

73