Werner japan ch 1 and 2

Japanese Lesson
New Era Dawning in Japan
Fundamental changes in Japan's economic, social, and political system have happened only twice in modern Japanese history: during the Meiji period, in the late nineteenth century, and during war and defeat sixty years ago. In both cases, crises triggered the change. The threat of colonization by foreign countries propelled the Meiji reforms. The Great Depression, the Pacific War, and consequent defeat were the triggers for the second major mutation. The postwar miracle of high growth was, despite all its achievements, largely a quantitative change, one that took place within the unchanged economic and political institutions that had earlier been put into place. Today, Japan is once again at a crossroads. The crisis of the 1990s has spelled the end of the "Japanese-style" economic system as we know it. Japan is now in the process of switching to a fundamentally different form of economic organization, namely, a U.S.-style free market economy.
Back to the Future-Forward to the Past
The irony is that this system is not new for Japan. Few people are aware of the fact that free markets were almost the norm in Japan before the war. In the 1920s, the famous postwar Japanese system did not exist. Then, Japan's economy in many ways looked like a carbon copy of today's U.S. economy-with fierce competition, aggressive hiring and firing, takeover battles between large companies, few bureaucratic controls, strong shareholders that demanded high dividends, and corporate funding from the markets, not banks. Yet throughout the postwar era, Japan's economy has been the opposite: highly regulated, with cartels limiting competition, bank financing and cross shareholdings reducing shareholder power, no takeovers, and a frozen labor market with lifetime employment and seniority pay. The peculiar nature of this postwar economic system has puzzled observers for decades. Leading economic theories indicate that only free markets can lead to success. But Japan rose within decades from developed-country status to become the second largest economy in the world without relying only on the "invisible hand" of free markets. Many theories have been advanced to explain this enigma.
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War Economy
What changed Japan was an event that is often neglected in research on Japan, one that took place between the prewar era and the postwar era: the war itself. The Japanese economic system was created largely during World War II. Its true nature is that of an output-maximizing mobilized war economy. Japanese corporations have been on a war footing since the early 1940s. In the early postwar era, the United States was keen to demonstrate to the world that post-occupation Japan had been reshaped in its image. In reality, with the beginning of the Cold War, the United States decided to maintain Japan's war footing and keep its wartime bureaucratic elite in power. While Germany's minister of the war economy, Albert Speer, remained in Spandau Prison as a war criminal, his Japanese wartime colleague became prime minister and, together with his brother, governed Japan for twelve crucial years. During this period, from the late fifties to the early seventies, the wartime bureaucratic elite, still at the control levers, managed to complete the system of the "total economy" that had delivered rapid resource mobilization during the war years. Capable of servicing a far larger market than the restricted domestic economy, it had to expand overseas. The United States, interested in strengthening Japan, allowed this to happen. It was the system of a mobilized war economy that spearheaded Japan's postwar conquest of world markets. The main reason why the extraordinary nature of Japan's system has remained unknown for so long is the ahistoric and usually counterfactual approach of many current economic theories. History provides the data set for the scientific economist to study. Ignoring history means neglecting the facts. Big business and politicians also had a role to play in Japan's miracle model, but in the end the economy was controlled not by the triangle of business, politicians, and bureaucrats but by the much narrower triangle of the Ministry of Finance (MoF), the Ministry of International Trade and Industry (MITI), and the Bank of Japan (BoJ). Among these three institutions, the Bank of Japan has had the lowest profile. There was a reason why it was so self-effacing. Although its technical know ledge of the most powerful control tool ensured that in practice the central bank ruled Japan, it was legally subordinate to MoE Therefore it has always pretended to have very little power. This book tells the story of the true extent of the use and misuse of its power.
Government Intervention Can Create Fast Growth
Economic success and free market economics are virtually synonymous in the eyes of many opinion makers today. This is why developing countries are persuaded to adopt the mantra of the World Bank and the IMF-liberalization, privatization, and deregulation-to achieve economic development. When the Iron Curtain fell and many communist countries adopted market-oriented economic systems, some ob
JAPANESE LESSON 3
servers even argued that the "end of history" had arrived: The struggle between rival economic systems was over, and the free market system had won. However, Japan did not use free markets to become the second largest economy in the world. This means that there is a rival capitalist economic system, based on the very visible hand of planners, that has outperformed other systems in terms of economic growth rates over a sustained period of time. The Japanese experience also teaches that government intervention has been misunderstood so far, for it did not take the form of meddling micromanagement, as in a planned economy. Instead, Japan's wartime government officials primarily intervened visibly by conscious institutional design that was aimed at creating the right incentive structures for fast growth. Successful government intervention is about organizational design, not picking winners. 1
Institutional Design
Influenced by German thinkers, the war economy leaders encouraged the creation of large-scale firms. They realized that among the three stakeholders involved in large companies-management, shareholders, and employees-shareholders' aims were least in line with the planners' overall goal of fast growth. So shareholders were eliminated, managers elevated, and employees motivated through company unions and job security. Management, freed by cross shareholdings from dividend-oriented shareholders, did not payout profits but reinvested them. This allowed them to grow their companies and expand market share. It biased Japan's economy toward high growth. At home, the ensuing cutthroat competition for market share had to be contained by the formation of cartels. This did not mean that competition ended; companies continued to compete to keep up their rankings within the cartel. Most importantly, there were no cartels restricting competition abroad. The world's open doors and free markets meant that Japan's growth machines wreaked havoc. In the 1960s and 1970s, one leading U.S. industry after another was eliminated. Europeans, less dogmatic about free trade, simply restricted Japanese entry. The Japanese complied-managed trade was what they were used to-and trade friction never became a major issue with Europe.
The High Price of Success
The war economy system was highly successful in achieving its goal of rapid economic growth. But there was a price to pay. Worker benefits were usurped by the small minority employed by the large firms. About two-thirds of all employees still work for small firms, where they never enjoyed the lifetime employment, housing and welfare support, and big expense accounts that large firms offered. A number of mechanisms forced the majority of the workforce to underconsume and save much of their hard-earned income. These included tax incentives, high costs
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for necessities such as food and education, high and rising land prices, and a patchy pension system. In the race for a higher ranking in the world, goals such as quality oflife and the environment, as well as individual freedom and choice, were judged lower priorities. Living conditions in Japan are still relatively poor-or at least not commensurate with the country's status as the world's number two economic power. Houses are small, commuting in crowded trains often takes two hours or more, and leisure time is limited. Concentration in a few urban areas and conformity even of leisure patterns limit the quality of holidays. At the same time, the Japanese system delivered great income and wealth equality and hence social cohesion, stability, and peace. Japan's low crime rate is still the envy of the world. Many developing countries would accept such a price for success. The implication for them, as well as for economies changing from a noncapitalist system to a capitalist one, is that they can potentially do much better by adopting the Japanese mobilized economy model than by simply introducing free markets and waiting for the invisible hand to deliver growth. Which economic and social system is preferable-free markets or the mobilized economy-is a political decision. It should be treated as such. The implication for Japan is that its system is not immutable. It does not go back over two thousand years. The postwar system of the war economy was introduced barely sixty years ago. This proves that Japan is capable of dramatic change. All we need is a crisis-a shock that is large enough to trigger the change.
Hitler's Control Tool
While most of the intervention in Japan's economy took an indirect, market-oriented form, there was a control tool that was used for powerful direct intervention. However, it works in such a subtle way that today many economists would still dispute its presence. The tool is money. The wartime bureaucrats understood what money is, where it comes from, and how it could be used to control every aspect of the economy. In Europe, the evolution of monetary economics was hampered by the backwardness of its economic system. While the Chinese emperors had already invented paper money and used it to totally control their empire in the tenth century A.D., European rulers still believed that only precious metals could be money. As a result, they were not in charge of the money supply, and hence also not in control of their countries. Gold proved cumbersome to deal with, so it was deposited with goldsmiths, who became the first bankers. A mistaken understanding of their activity led generations of politicians and economists astray as they ignored the farreaching implications ofthe fact that banks create money and decide who gets it.2 This also explains why the levers that have been manipulating the Japanese economy remain largely unknown. The war bureaucrats, on the other hand, understood the role of banks and recognized that money is the lifeblood of an economy.
JAPANESE LESSON 5
Influenced by the methods of Hitler's central banker, Hjalmar Schacht, the leaders of the Japanese war economy turned credit creation into their most powerful mechanism for total control. They used the banking system purposely and skillfully to allocate resources to targeted industries.
Window Guidance
The credit controls used by the war bureaucrats survived virtually unchanged into the postwar era. They took the form of the extralegal and secretive "window guidance" operated by the Bank of Japan. This "guidance" consisted of direct credit allocation quotas strictly enforced by the central bank. It was at the core of Japan's postwar economic success. It also explains the success of Korea and Taiwan, where the Japanese installed the same during the war, and where the postwar leaders continued to use it. In the 1950s and 1960s, window guidance controls became instrumental in the emerging struggle for supremacy between the powerful Ministry of Finance and the legally subordinated Bank of Japan. While the ministry won the first political battle and avoided a change in the Bank of Japan Law (which had been introduced in 1942, largely as a translation of Hitler's Reichsbank Law of 1939), the Bank of Japan remained solely in charge of window guidance. It lulled the ministry into a false sense of security by allowing it control over interest rates and downplaying the importance of quantitative credit policies. A string of Bank of Japan studies, supported by conventional neoclassical economics (which at best sees no role for credit policy and at worst simply assumes money does not exist), "proved" that credit controls were ineffective. Thus the Bank of Japan announced that they were abolished. Memories of the powerful nature of the controls faded over the years. By the 1970s, few observers were aware of the factthat while the Finance Ministry might reign, it was the Bank of Japan that ruled.
Test Run: The First Bubble
In the 1970s,.the Bank of Japan flexed its credit control muscles to test the limits of its autonomy over running the economy. Using window guidance, it ordered the banks to expand credit to speculative real estate borrowers. As a result, land prices soared and Japan found itself in the midst of the first postwar bubble economy. The recession that inevitably followed shook the established elite, foremost the Ministry of Finance. The role of window guidance credit controls remained little known, so virtually no blame fell on the Bank of Japan. This experience laid the groundwork for the events of the 1980s and 1990s. It emboldened the central bank to develop its own plans for a new economic, social, and political system for Japan to replace the war economy. The new system was modeled on U.S.-style free markets. The Bank of Japan preferred to move "back to the future" of Japan's free market past, where shareholders were in charge, not
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other stakeholders, such as employees. Equally importantly, a free market system often leaves the central bank as the uncontested authority over the economy. Of course, to introduce such deep structural changes, the entire war economy system had to be dismantled. That amounted to a revolution. And revolutions happen only in times of crisis.
Buying up the World
From around 1986 until 1990, Japanese money flooded the world. From real estate in New York, Hawaii, and Australia to corporate takeovers in the United States, Europe, and Asia, Japanese money seemed to buy up the planet. The scale of overseas investments was unprecedented and its sheer size left the experts without explanations. Japan was not just using up the dollars it had earned through its sizable exports and trade surpluses; in 1987, Japanese net long-term foreign investment was almost twice as large as the record-high current account surplus. Foreign investment of that scale defied traditional economic models. Japanese money flows remained a mystery. The plot thickened in 1991, when Japan suddenly turned from being the biggest net capital exporter ever to a net importer of capital. What was the cause of these events?
Credit Bubble and Bust
During much of the late 1980s, Japan created too much money, and some of it spilled over abroad. Bank credit creation expanded at a rate of about 15 percent, while national income grew by only about 6 percent. The newly created money was not used productively. It went into speculative purchases of land and stocks. Enormous amounts of new purchasing power pushed asset prices to dizzying heights. In 1989, the little plot of land surrounding the Imperial Palace in Tokyo had the same market value as the entire state of California. It was a bubble. In the long run, credit creation that is not used productively cannot be paid back. The excess credit creation beyond the needs of the economy had to turn into bad debts. This is what happened from 1990 onward. Bank loan growth slowed. As asset prices fell, speculators were bankrupted and banks were left holding the bag. About ¥100 trillion worth of loans, a fifth of Japan's GDP, turned into bad debts in the 1990s. Banks were paralyzed and stopped lending. The credit crunch boosted unemployment. The economy moved into the worst recession since the Great Depression. Who was to blame? Most observers believed the Ministry of Finance was in charge. The ministry also thought so. But all its attempts to create a recovery were to no avail. Despite record low interest rates and unprecedented spending packages, the economy failed to recover. Most observers concluded that the system did not seem to work anymore. The long recession of the 1990s took the shine away from Japan's postwar miracle and destroyed the consensus that had maintained the war economy.
JAPANESE LESSON 7
But the system was not the reason why the economy went from boom to bust. Nor could lowering interest rates or fiscal policy help. There was a simple policy that could easily have created a recovery as early as 1993 or 1994. Since banks were not creating enough money, prices were falling, demand shrinking, unemployment rising. The economy simply needed more money. Nothing could have been easier than that-the Bank of Japan could just have switched on the printing presses.
The Battle ofthe Yen
So just how much money did the Bank of Japan print in the 1990s? Very little. While the Ministry of Finance desperately tried to create a recovery, the Bank of Japan didn't seem in a hurry. Although it lowered interest rates, as ordered by the ministry, it simultaneously reduced the amount of money in circulation. Zero interest rates don't help if the majority of firms (small firms) can't borrow money at any rate. When the ministry increased fiscal spending, the central bank failed to fund it with new money creation. So it was funded by bond issuance to private investors, which merely crowded out private demand. In early 1995, when in desperation the ministry tried to boost exports through a weaker yen and thus ordered record amounts of foreign exchange intervention, the central bank quietly sterilized all intervention. The yen remained strong. In March 1995, the central bank oversterilized and so sent the yen to its postwar high of¥79.75. This delivered another severe blow to the economy and the ministry. No doubt, the recession of the 1990s was the result of the central bank's policies. It could fine-tune it through the quantity of credit. An analysis of its actions indicates that it chose to prolong it. Meanwhile, the central bank launched a frontal assault on the power base of the ministry. For the first time since the 1960s, it reignited a public debate about the Bank of Japan Law and lobbied politicians for its cause. Its goal was to become legally independent. Since the ministry was blamed for the recession, the central bank won the battle. The ministry was defeated and stripped of all key power levers. The central bank is now independent and unaccountable. In Asia, defeated enemies often are at least allowed to save face. No such mercy for the ministry: To add insult to injury, it was stripped of its grand old name. In January 2001 the Okurasho ceased to exist.
The Strange Policies of the Central Bankers
Why did the Bank of Japan prolong the recession of the 1990s? Aconc1usive answer can be found only when another puzzle is solved. The events of the 1990s are rooted in the bubble of the 1980s. How did the bubble, the greatest resource misallocation in peacetime history, come about in the first place? We know that it was due to excessive credit creation by banks. But why did the banks lend so much? We know that from about 1940 until the end of the 1970s, bank lending was
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determined by Bank of Japan window guidance. However, according to official statements by the Bank of Japan, these credit controls had been abolished and were not in use during the crucial 1980s. This is the accepted view to date. Is it true? The evidence is that window guidance continued. It is the smoking gun. Who pulled the trigger? What were the moti vations of the decision makers? The answer will provide clues to why the Bank of Japan prolonged the recession of the 1990s. Japan's remarkable story is not without parallel. In the early 1990s, the central banks of Korea, Thailand, and Indonesia embarked on the same policies as the Bank of Japan in the 1980s. Using the extralegal "guidance" of bank lending pioneered by the Reichsbank in Germany, they forced their banks to lend excessively to real estate speculators. The bubble was further inflated by central bank policies to maintain an overvalued fixed exchange rate and higher domestic than foreign interest rates. Speculators were given every incentive to borrow from abroad. Record amounts of U.S. dollars flooded the Asian region, further fuelling the asset bubble and rendering the situation more precarious. In 1997, investors pulled out. Simultaneously, the central banks forced the commercial banks to restrict credit creation. The bubbles burst. Instead of quickly floating their currencies, the central banks ensured that their substantial foreign exchange reserves were wasted in a futile attempt to defend the overvalued exchange rates. By late 1997, all three countries were insolvent. As central banks reduced credit creation further, the crisis turned into recession. Why did they all take these same, disastrous policies?
The Second Economic Miracle Ahead
By the 1970s, more voices argued that Japan's wartime system would not deliver high growth anymore. The old system had maximized output by increasing inputs, such as land, labor, capital, and technology. But by the 1970s, Japan was running out of inputs, and hence the potential growth rate was declining. A similar story was told about other Asian countries in the 1990s. One proposed solution was to boost productivity by introducing U.S.-style capitalism. Almost sixty years after its introduction and extremely successful performance, the Japanese war economy structure was scrapped. The historic deregulation, legal changes, and market-oriented reforms of the 1990s eroded its foundations. Market forces are now pushing ever faster toward the goal of U.S.-style markets. New industries were born of deregulation. The domestic economy has become more productive and is now able to deliver up to 4 percent noninflationary growth. For an advanced economy such as Japan's, this is nothing short of a second economic miracle. So is all fine and well with Japan and its Asian neighbors? We will know only once we have answered all the puzzling questions.
2
The Total War Economy
The Future Is in the Past
The defeat of 1945 is often regarded as a watershed that heralded the beginning of a new Japan. The dark past was left behind and a fresh start was made with new institutions and economic structures, set up from scratch under the guiding hand of the U.S. occupation. The pictures of burned-down cities, destroyed factories, and ruined bridges sometimes give the impression that a new era started in the ashes of August 1945. The U.S. occupation, officially in charge until 1952-longer than in Germany-implemented the U.S. program of reeducation and democratization of the Japanese people. It provided Japan with a new constitution, political parties, free elections also for women, and a market-oriented capitalist economic system. MacArthur's reforms allowed labor unions, broke up the zaibatsu, and introduced sweeping land reforms. Many books and especially popular accounts of Japan therefore start their analysis in 1945, and Japanese history is usually divided into the neat segments of postwar and prewar. Not all scholars look at it this way, as the division into postwar and prewar periods leaves out the most important period in Japanese history this century-wartime. I For it is during the war that virtually all of the characteristics of the Japanese social, economic, and even political system ofthe postwar era, all that we call "typically Japanese," were formed. Postwar sales drives and inroads into world markets by Japanese companies have often been likened to military campaigns. The employees of Japanese companies call themselves senshi (soldiers), and their well-known lifestyle is comparable to that of troops in an army. However, the characterization of Japan's postwar economic system as a war economy is not meant metaphorically; it is literally true. Japan's postwar economy is a fully mobilized war economy, with production shifted from weapons to consumer products.
Guess the Free Market Economy
The reader is asked to guess which country is described by the following facts. It is a country characterized by virtually unmitigated capitalism. The stock market is the main source of external funding for companies in this country. Shareholders
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are all-powerful and demand high dividends. This forces management to be oriented toward short-term profits. Most managers are appointed from the outside, not from the ranks of the company. Fierce takeover battles and corporate buyouts keep management on their toes. If they don't perform, they could be out of a job in no time. The labor market in this country is characterized by hiring and firing and a high rate of job switching by employees. Income and wealth differentials are large. A whole class of rich capitalist families lives off their dividend income. The overall savings rate is low and consumption constitutes the biggest part of GDP-about 80 percent. There are few government regulations, and government officials exert little direct influence over the economy. Indeed, bureaucrats have to do as politicians tell them. There are fierce disputes over policy issues and public interest in politics is high, at times even passionate. It would be natural to identify the country in question as the present-day United States; the description fits that country fairly well. However, the country referred to is Japan-the Japan of the early 1920s. Many observers believe that the typical, "Japanese-style" economic system has been around since before this century and has its roots in age-old Japanese culture. But scholars have by now established as fact that, to the contrary, the Japanese-style economic system that we know hardly existed in the 1920s.
Japan in the 1920s: Hotbed of Free Market Capitalism
In the 1920s, in many ways Japan was a different country from the one we have known since the postwar era. Its economic system was not pure free market capitalism, but it was much closer to this ideal than it has been ever since.2 Neither lifetime employment, a seniority-based wage and bonus system, nor company unions were widespread. Firms had few scruples about rapid hiring and firing. Neither did employees have any qualms about quitting to seek greener pastures: Japanese employees changed jobs as much as U.S. employees do now (a figure three times as high as in the Japan of the 1980s). Unions were organized by trade, not by company, thus providing employees with a better voice to call for pay raisessomething that became effectively impossible with the company union system of the postwar era. Influential labor unions organized many seriously disruptive strikes in the 1920s, something unheard of in postwar Japan. The unemployment rate was not 2 percent, as during much of the postwar era, but in the double digits. Firms were not majority-owned by other companies, as in the postwar system of cross shareholding. In the 1920s, there were real capitalists, individuals and families, holding substantial portions of stock. Individual share ownership accounted for the large majority of all shareholdings, while by the early 1990s it had fallen to less than 15 percent. 3 It was natural that the shareholders would be directly represented on the company board and have their voices heard in the determination of company policy. Before the war, the majority of directors on the boards of large
THE TOTAL WAR ECONOMY 11
companies were outside appointees, put in place by the shareholders. By contrast, in 1990, over 90 percent of directors on the boards of large firms were internal appointees, raised from the management of the firm.4 Back in the 1920s or 1930s, shareholders were powerful because companies obtained between 30 and 50 percent of their external funding from the stock market. In the postwar era, such as the 1960s and 1970s, fund-raising from the stock market accounted for merely 5 to 10 percent of total external fund-raising.5 The shareholders in the 1920s used their influence to demand high dividends. This required the firms to payout as much of the profits as possible.6
Going for Profits, Not Market Share
In the 1920s and early 1930s, more than two-thirds of profits among leading Japanese companies were paid out as dividends, a sizable 6 percent were paid out as directors' bonuses, and only 25 percent were kept as reserves.7 By contrast, in the period from 1966 to 1970,43 percent of profits were paid out as dividends, only 2 percent as directors' bonuses, and a massive 55 percent was reinvested.8 In other words, before the war the distribution of profits was heavily skewed in favor of the capitalist owners. Dividends reflected the fortune of the firm and thus fluctuated with it (unlike the low, virtually fixed dividends of the postwar era). If management did not implement the owners' orders, they would quickly be sacked and replaced by a new team. This was quite in contrast to postwar Japan, where annual general meetings were rubber-stamp affairs that approved management in a matter of minutes, without discussions or questions being raised (a reason why the sokaiya racketeers could make a living simply by threatening to ask questions at shareholders' meetings).9 Today's salarimen consider the firm "their own," not the property of shareholders, and feel justified to run it as they see fit, without explanations to shareholders. While in postwar Japan income and wealth were highly equalized, in the 1920s there were significant disparities, with many affluent owners of real estate and stocks who lived off dividends and rents. An important part of this capitalist class were the families that owned the main zaibatsu through their control of the holding companies that concentrated shares. But there were others. Only ten of the sixty largest mining and manufacturing firms were related to the zaibatsu.10 The majority of firms were non-zaibatsu, and they had diffused share ownership. The zaibatsu firms were keen to expand their influence, however. They aggressively bought up other firms in stock acquisitions and takeovers-a practice unheard of in most of the postwar era. Often rival zaibatsu would engage each other in hostile takeover battles. In the 1930s, the Mitsui group bought Meiji Sugar from the Mitsubishi group and two Toyo Sugar factories from the Suzuki group. Oji Paper took over management of Fuji Paper, although it was part of the competing Mitsui zaibatsu. The contrast between prewar and postwar Japan is also reflected in savings
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rates and the consumption share of GDP. While consumption today makes up less than 60 percent of GDP, in the 1920s it accounted for about 80 percent-as much as in the United States today. Likewise, the percentage of income that is saved, currently running at about 20 percent, was only about 5 percent before the war. Strong consumption sucked in many imports of final consumption goods, which was not the case in the postwar decades. The reform bureaucrats of the 1930s criticized Japan for looking just like "the stereotyped view of American firms in the present time."l1 Had U.S. trade negotiators been transported from the 1980s to the 1920s, they would not have demanded that Japan change to become more like the United States, for it resembled modernday U.S.-style capitalism.
The Crisis That Changed Japan
Japanese-style capitalism does not go back to Japan's mystical past and peculiar Asian values. Compared to the well-known postwar version, it barely existed in embryonic form in the prewar era. But when and how was Japan so fundamentally transformed from a fairly free market economy to the highly regulated postwar system? The answer must be found in the event that happened between the prewar and postwar eras: the war itself. History teaches that no country changes fundamentally without a crisis. The 1930s and early 1940s were such a period. Until the early 1930s the paradigm that had prevailed outside communist countries was that of liberal free market capitalism without much government interference. In Japan there had been a strong tradition of government intervention, but by the early 1920s the arguments of free market capitalism had become influential. There was also considerable external pressure from the United States for Japan to liberalize. 12 However, in the 1930s, the intellectual tide in Japan was changing back to the idea of government intervention, because the free market system did not seem to deliver: The fallout from the New York stock market crash of 1929 was borderless. Worldwide, distressed banks withdrew their loans, bankrupting large proportions of the corporate sector and choking off demand, which led to deflation and large-scale unemployment. 13 This cast doubt on the capitalist paradigm. Quite apparently, free markets, left to their own devices, could also produce major economic disasters. As economies shrank (13 percent in the United States, 23 percent in the United Kingdom,14 12 percent in Germany, and 9.6 percent in Japan),15 poverty became widespread. 16 The scale of deprivation is hard to imagine today. Starvation and selling of children into prostitution occurred in the United States, Germany, and Japan. A countrywide survey conducted by the military in Japan in the early 1930s found that a high percentage of young men were physically unfit for military service due to malnutrition, disease, and job-induced disabilities. Meanwhile, the capitalist "fat cats" continued to live in style. The Japanese elite saw that both military capability and the workforce would be severely affected if nothing was done.
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Not fully comprehending the causes of the Great Depression, more and more thinkers and policymakers concluded that the capitalist system itself was at fault. Sitting idly on one's hands, as free market orthodoxy prescribed, was getting increasingly risky. It was the stuff revolutions were made of. The Bolshevik takeover of 1917, facilitated by dire economic straits and public discontent, was still fresh in everybody's memory.
Internal and External Threats
In Japan, the ruling elite and the bureaucracy became more worried about the possibility of a communist revolution. At the same time, a crisis loomed outside Japan's borders: As the Great Depression spread, countries engaged in competitive devaluation and trade wars to increase demand and income at home. As a result, prices were driven down further, heightening deflation. So more and more countries began to close themselves off from free trade, introducing quotas and tariffs. This was potentially disastrous, for, as a country with hardly any raw material resources, Japan had trade as its lifeblood. If it was not self-sufficient in food, it could survive only if it imported raw materials, processed them, and sold the value-added products abroad. Japan's economy was crucially dependent on energy imports, mainly of coal and oil. These came largely across the Pacific from the United States. However, the United States had begun to turn protectionist and was fending off Japanese exports. It also increasingly disapproved of Japan's colonial ambitions in Asia.
The Quest for Autarky
Japan ignored U.S. critique. After all, the United Kingdom and the United States had so far been the colonial aggressors in Asia (together with France and Holland). Japan's leaders, especially in the army, had examined closely how Germany was starved of raw material and food imports during the trade blockade of World War I. They concluded that as long as Japan was dependent on imports from the white man, it was not free. With the internal threats of recession, unemployment, and communist takeover and the external threat of being cut off from world trade, the military concluded that Japan could survive in such a hostile world only if it was strong and free from blackmail. That meant a strong and autarkic economy. 17 Externally, the military began to implement the dream of "Asia for the Asians." When they advanced beyond Manchuria into China in their quest for autarky, indications that the United States might play the trade boycott card merely confirmed their suspicions, and they accelerated the implementation of their plans. Internally, they worked on dismantling the system of classical laissez-faire economics, which Japan had tried but found wanting. It was time to try something else. Military thinkers and reform-minded bureaucrats in Japan noticed that economists in Germany were offering a different prescription. Under the Nazi adminis
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tration their counsel bore fruit. Indeed, to quote British economist Joan Robinson, "Hitler had already found how to cure unemployment before Keynes had finished explaining why it occurred.,,18 Moreover, Japanese bureaucrats noticed that one major country had escaped the Great Depression altogether: the Soviet Union. In the 1930s, it embarked on a frantic government-led industrialization drive that was admired in many capitalist countries.
Reform Bureaucrats Pushed for a New System
In Japan, the move away from the free market economy was spearheaded by the military and the "reform bureaucrats" who had entered the ministries during times of high unemployment and had often witnessed starvation in the countryside. They were sympathetic to the critique by Japanese thinkers, such as Kamekichi Takahashi, and German economists, who censured the free market system for allowing rich shareholders to pursue profits while unemployment was endemic.19 The capitalist shareholders often squeezed firms just to raise their dividends. As funds were drained, firms had little to reinvest. Managers were thus often unable to act in the interest of longer-term profitability and survival. Meanwhile, large-scale stockowners often engaged in speculation, driving up share prices and then dumping the stocks for the capital gain, rendering the stock market little more than a rigged casino. To the military, the equation was simple: To be strong, Japan's economy needed to grow fast. To increase growth, all resources had to be mobilized, ending the waste of unemployment. The reform bureaucrats also did not want to wait for Adam Smith's "invisible hand." They felt it had to be their quite visible hands that would strengthen Japan's economy. They urged government controls-thus they were often also called "control bureaucrats." Their desire for controls did not imply micromanagement as in a Soviet-style planned economy. Their ideas were strongly influenced by anticapitalist and especially national socialist thought from Germany, which placed emphasis on government intervention in the form of redesigning the incentive structures.20 Thus it happened that by the early 1930s Japan had already started to embark on a mobilized war economy. The reformers met resistance on the way, so what we describe as the mobilized war economy was completed only toward the end of the war or even, in many ways, during the early postwar period.21 When hostilities with China turned into full-scale war in 1937, the military pushed through major changes under the cover of emergency war legislation, which gave the reform bureaucrats the mandate to establish a mobilized economy with strong government intervention. A new economic, industrial, social, and political structure began to emerge. When the hostilities turned into world war, even stronger legislation was used to completely reshape the Japanese economic, social, and political system. The redesigned institutional setup was to ensure that managers and employees would work toward greater output, not for the sake of short-term profits. It was a transformation that created the postwar Japanese miracle economy.
THE TOTAL WAR ECONOMY 15
The Militarization of Japan
In 1936, the Hirota cabinet agreed to put the economy on a quasi-war footing. The first step was to boost the budget for military expenditure. As companies in the munitions sector watched the formation of the 1937 budget, they realized that substantial amounts of raw material imports were required to increase military production. A speculative import boom of raw materials ensued, throwing the balance of payments into sizable deficit. The 1932 foreign exchange control laws were used to restrict imports. They had represented the first set of reforms that would eventually create a controlled war economy.22 The 1937 promilitary cabinet of Konoe (the grandfather of 1993 prime minister Hosokawa) promulgated three wartime control laws. The Export-Import Commodities Emergency Measures Law ordered priority allocation of critical materials to the munitions industry. The Emergency Capital Allocation Law controlled the establishment of companies, capital increases, dividend payments, bond flotations, and borrowing of funds. It was used to channel money to the munitions industry according to priority. The Munitions Industrial Mobilization Law furnished bureaucrats with further powers of control. In April 1938, the sweeping National General Mobilization Law was put to the Diet. It allowed the mobilization of all physical things in the country, and it stated that "the Government may in time of war (including incidents that are to be treated as war) draft Imperial subjects and employ them in mobilization work as stipulated by Imperial Decree whenever necessary." It was pushed through by Konoe against vigorous resistance from politicians and business leaders, who realized it was a carte blanche-it did not specify the particulars of controls.23 The principle of a general law that leaves the details to be filled in later by ministerial ordinances gave all authority to the government bureaucracy that could freely wield it as it saw fit. The law gave the government the power to determine prices, establish controls over production, distribution, consumption, movement of goods, and foreign trade and to set up control agencies to implement the decrees.24
System for Maximum Production
With such legal powers in their hands and with the approach of Japan's entry into World War II, the Konoe cabinet in 1940 proclaimed the New Economic Order, composed of a New Financial System, a New Fiscal Policy, and a New Labor System. Overall coordination lay in the hands of the Cabinet Planning Board, set up in October 1937. It was designed as the economic general staff of the militarized economy. Its job was to set up a new economic system that would deliver maximum economic growth and to direct resources toward the priority industries. The aim of the structural transformation was to develop an institutional framework that changed incentives such that everybody would be striving toward the goal of maximum output growth. Economic growth is achieved when some re
16 CHAPTER 2
sources are saved and invested. The more is invested, the faster the economy will grow and the greater national income will become. A farmer starting out with nothing but a bag of rice seeds faces the choice between saving and consuming. If he maximizes current consumption, he can have a feast this year, but will starve the next. The more he saves and replants (invests), the greater the crop in the future, as each plant delivers more than one hundred grains of rice. The more he consumes, the less is left for replanting. Firms are the farmers of the economy. They face the decision whether to save and reinvest their profits or to pay them out to the shareholders as dividends. The smaller the dividends and the more money reinvested, the faster the company will grow. To create an economy that grows rapidly, the institutions of the economy must be shaped such that individuals will save and firms will retain earnings and reinvest.
Separation of Ownership from Control
There are three parties involved in the organization offirms: the owners, the managers, and the employees. In small, family-owned firms, all three roles may be played by the same person. This is what classical and neoclassical economics assumes, for its models consist of many small firms, run and owned by one individual. However, the rise of the large-scale corporation has driven a wedge between the three functions. Usually, large firms cannot be funded, hence owned, by one individual; they cannot be managed by one individual, and they employ a large number of workers. So the rise of the large corporation produced a separation of ownership from control and the detachment of employees from the goals of the firms. Each group has different aims and incentives. In a one-man firm, all the incentives of the three different functions coincide and the firm is pulling in the same direction. However, in large firms, as the three groups become separate units, each is striving for what is best from their viewpoint and the firm begins to pull in different directions. The final outcome may not be what produces fastest economic growth. It may also not be what is best for society and the country.
Shareholders Versus Growth
The goal of the shareholders is profit maximization. If they are mainly interested in high dividend payments, companies may be starved of funds to reinvest and hence may grow more slowly. This tends to create surplus funds that a small class of rich owners spend on more trivial pursuits than productive investment. Income inequality rises, speculation and production of wasteful goods increases. Economic growth slows. For the super-rich, consumption is a small percentage of their total income and wealth.25 With high income and wealth inequality, consumption will be weaker than in an economy with an egalitarian distribution. If employees are not motivated to work hard, and if they squeeze higher wages
THE TOTAL WAR ECONOMY 17
and shorter working hours out of firms, it will also dampen profits and-if an economy-wide phenomenon-lower overall economic growth. So the reform bureaucrats concluded that giving too much power to either shareholders or employees was bad for growth. They found the story different for managers. Managers receive not only higher pay but also greater prestige and power over corporate resources (including expense budgets) if they move up the hierarchy. Since the hierarchy is pyramidshaped, with fewer people at the top, more at the bottom, more managers will be able to rise up the ranks if the firm grows. So the pursuit of their own goals leads managers to strive for faster growth of the firm. While the aims of shareholders and workers are not directly in line with fast overall economic growth, the goals of the managers are.26
Capitalism Without Capitalists
The New Economic System aimed at setting the firm "free from control of stockholders pursuing profit making.'>27 Disempowering shareholders and workers while empowering managers would boost growth, the war planners concluded in the 1930s. The managers of large-scale firms were their allies, shareholders and unruly unionized workers their enemy.28 Workers, though, could be won over if treated the right way. To curb worker discontent and communist agitators, employees had to identify closely with the firm-for instance, by having a greater say in company matters and through indoctrination with an ideology of the "firm as family." However, shareholders would be difficult to reconcile with the overall goal of fast growth. Among the three interest groups, they were least crucial for growth. The reformers concluded that in a modern economy dominated by large-scale corporations, capitalism would work better without capitalists, and instead with powerful managers.
Managerial Capitalism and the Firm as Family
Given such analysis, the reformers had their work cut out for them. Managers were elevated. This came naturally, since in large-scale organizations they are essentially private-sector bureaucrats. Modern bureaucracy is modeled on the Prussian bureaucracy, which in turn was designed on the basis of the Prussian army. Naturally, the military looked at managers as private-sector soldiers, and as controls strengthened, they were fully integrated into the military chain of command. In the end it extended down to the worker, who was a corporate soldier. The doctrine of the firm as an "organic organization" binding employers and employees together and serving for the public benefit was officially implemented in 1938, with the establishment of Industrial Patriotic Societies in all companies. Joint meetings with management and employees were organized where workers could raise their concerns and participate in management decisions. At the same
18 CHAPTER 2
time, trade unions were abolished and all union activity channeled to the company level. This ensured that concessions to workers would not become too large to endanger fast growth of the firm. Meanwhile, the role of stockholders was cut down to size. The New Labor System proclaimed in 1940 that the firm was not the property of the shareholders, but a communal organization composed of those who worked there. Army Ministry bureaucrats argued, "It is necessary to transform stocks to interest-bearing securities, and the character of stockholders to recipients of such interest .... In management it is essential to consider first and foremost the people who work for the firm. In one way or another, management, technology and labor all depend on the overall manipulation of people. This aspect of management is invariably more important than capital itself.,,29 New laws set limits on dividend growth. Beginning in April 1939, firms with dividend rates of 10 percent or more-about two-thirds of large firms at the time-required a permit from the Ministry of Finance to increase their dividend rate. This made stock investments less attractive. Moreover, since the assassination of Mitsui chief Dan Takuma, the zaibatsu families had increasingly been selling their shares to the public. This was not only in response to pressure from the military and bureaucrats, but also to mitigate the anti-zaibatsu feelings among the public. It was soon found that iffirms within a group issued shares and simply swapped them among each other, the influence of outside stockholders could be reduced without diluting group ties. Thus cross shareholdings rose in the 1930s, among the zaibatsu firms reaching as high as 40 percent of all outstanding stock during wartime.3o This increased the independence of managers, as the new shareholders were other managers with the same growth orientation.
The New Labor System: Creation of Japan as We Know It
Yet by 1943, the control bureaucrats and military felt that profit orientation of firms was still dominant and growth orientation insufficient. They found that managers were still afraid of shareholders. Although dividends had been reduced, shareholders could still threaten managers during general meetings. Thus as part of the 1943 Measures to Strengthen the Domestic System, the corporate law was changed and a new Munitions Corporation Law was promulgated in October of that year. It eliminated shareholders' influence on firm management. Instead, the authorities designated one manager as the responsible person for production in every firm. He was given the power to run the firm as he saw fit to achieve the twin goals of quantity and quality. He could not be sacked by stockholders and was dispensed from the necessity to obtain stockholder permission for his actions.3! He was only to be held accountable by the planning bureaucrats for the fulfillment of quantitative production objectives. The planners' powers were also strengthened, when in November 1943 the Cabinet Planning Board was united
THE TOTAL WAR ECONOMY 19
with the Ministry of Commerce and Industry to form the powerful Munitions Ministry.32 In March 1944, the annual share dividend was decreased to 5 percent. Any residual influence by shareholders over profit allocation, fund-raising matters, and the appointment of managers was eliminated. They had been reduced to fixedincome investors without a vote. The bulk of profits were divided among reinvestment, salaries for managers and employees, and special bonuses for workers to reward specific productivity improvements.33 Since managers had been given great powers, they had to be prevented from boosting their own bonuses too much. So managers and employees received salaries according to the number of years they had served in the firm-seniority pay. Promotion was to be decided on relative merit. If a firm grew fast, the less able manager could be promoted also. In return, employees and managers had to vow loyalty to the firm. They were effectively prevented from quitting, because other firms, organized on the same principles of seniority and lifetime employment, would not hire them. Welfare schemes for managers and employees were introduced that were the most advanced in Asia. The National Health Insurance Law of 1938 and the Personnel Health Insurance Law of 1939 provided virtually complete health coverage to employees. The 1942 Workmen's Annuity and Insurance Law for the first time required the payment of annuities in case of old age, disability, or death. In 1944 it was broadened to include other personnel and women.34
Creation of the Main Bank System
Large-scale firms were the bureaucrats' friends. So several "national policy firms" were set up, which evolved into giant conglomerates. Most of them were stock companies, but the majority of the stocks were held by the government and shareholder influence was limited. The government chose the top managers, and bureaucrats oversaw company policy. The number of these firms jumped from 27 in 1937 to 154 in June 1941.35 In 1944, key producers of military supplies were designated as "munitions companies." In 1945, over six hundred firms received necessary funds to fulfill their production quota via one or two banks that had been allocated to them by the Ministry ofFinance.36 This main bank was the designated "Financial Institution Authorized to Finance Munitions Companies," ordered to ensure a steady flow of bank loans to the firm as it required-a compulsory lending system. The "main bank" relationships lasted until today. Banks were compensated against losses for risky lending, either through the government loan guarantee program or by being bailed out by the government if they got into trouble. In March 1945, the system was further expanded. Soon more than two thousand firms, including many companies not involved with munitions, had each been assigned a bank charged with tending to their financing needs. The allocation of bank credit thus shifted drastically from other sectors to priority manu
20 CHAPTER 2
facturingY And bank credit accounted for almost 100 percent of corporate fundraising by the end of the war. Funding through the stock market had ceased.
The Origin of Japan's High Savings Rate
As more and more purchasing power was given to the military producers who then made claims on the limited resources, fewer goods and services were available for private consumption. If consumers were to spend as much as they had in the 1920s, they would compete with the military and bid up prices. Inflation would be the result, and that would threaten labor disputes and worker unrest, as it did in 1937 and earlier. The solution was. to get the population to withhold their purchasing power by saving. This would prevent inflation. The first step was to encourage voluntary savings. In April 1938, a National Savings Promotion Campaign was launched that aimed at boosting the savings rate to 30 percent of GNP. Savings Promotion Committees and cooperatives mushroomed throughout government offices and private firms and among ordinary workers and neighborhoods throughout the country. An agency for the promotion of savings was established at the Bank of Japan (where it is still in operation today). Most of the savings took the form of deposits with the postal savings system or with banks. The result was underconsumption and a transfer of purchasing power from the household sector to the corporate sector.
Creation of the Trade and Business Associations
In the New Economic Order the visible hands of the mobilization planners directed resources from the top down by formulating quantitative output targets, which were then divided into the various industries and passed on to the control organizations that had been created in each industry. They exist until this day as the ubiquitous industry or trade associations. Thanks to the associations, the bureaucrats could delegate the task of implementation and monitoring of their orders to the private sector. It was the control associations, not bureaucrats, that divided overall quotas into orders for individual firms and ensured compliance. Human resources were allocated similarly, achieving a historic transfer of labor from agriculture and nonpriority firms to munitions companies. To organize industry more efficiently, firms and factories were amalgamated into fewer, larger units that could enjoy economies of scale. The economic structure became highly concentrated. At the same time, the large firms found it efficient to subcontract production of certain components to smaller firms, who were dependent on them-virtual external subsidiaries.
The New Japan
The changes implemented between 1937 and 1945 reshaped the function of the firm. Under the slogan "Public interest above individual interest," the New Eco
THE TOTAL WAR ECONOMY 21
nomic Order successfully transformed firms from private profit-seeking undertakings to quasi-public ones focusing on growth, not profits. The market mechanism of the prewar period was substituted by a system of planning and government guidance that used private property and rank competition as an incentive device. Import penetration was successfully reduced.38 Resources had been shifted from nonessential industries to the heavy machinery and manufacturing industries crucial for munitions. Textiles halved from 29.3 percent of total production in 1937 to 14.7 percent in 1941, while the machinery production share more than doubled from 14.4 percent to 30.2 percent.39 Private-sector savings rose from only 9.1 percent in the 1920s to 54.8 percent of GNP from 1941 to 1944.40 Real GDP grew by 25 percent during the war years (from 1940 to 1944).41 Munitions production grew 197 percent between 1941 and 1944.42 Labor was fully mobilized and shifted from agriculture to industry in a transformation that irreversibly rendered Japan an industrialized nation.43 Unemployment had been eliminated. The planners of the war economy achieved the goal of maximizing output from the available resources.
Introduction of One-Party Rule
On the political front, the military and reform bureaucrats felt that a system had to be created that would keep meddling politicians at bay. For this purpose, political parties were simply abolished and all politicians united in a one-party system, as pioneered by the Soviet Union. The single party was called the Imperial Rule Assistance Association. The police force was reorganized in an attempt to increase surveillance of individuals. A system of neighborhood police checkpoints was developed, which put up police microstations in virtually every corner of the country and enlisted senior citizens in each neighborhood as police informers (the system is intact today). Japan also became the most advanced social welfare state in Asia. Schooling was transformed, agriculture revamped. The changes were long lasting.44
Japan's System: An Economy at War
By the time Japan surrendered in 1945, most key features ofthe postwar economic structure had been established and Japan had been transformed from the free market capitalism of the 1920s to the controlled, "Japanese-style" capitalism of the postwar era. The labor structure among large firms changed to low job mobility and high loyalty to the firm, lifetime employment, seniority system, company unions, and bonus pay. The corporate organization clearly separated ownership from control, allowed few outside board directors, left shareholders weak, and thus made low dividends and a growth orientation possible. A "dual" structure was created, characterized by a few large firms with many small subcontractors linked in business groups. Funding shifted to borrowing from banks. The role of the bureaucracy became more interventionist and "administrative guidance" was cru
22 CHAPTER 2
cial. Politicians did not make policies, and their influence was kept in check by the one-party system. The war mobilization changed what previously was a largely agrarian society into an industrial workforce trained to serve according to military work schedules. The sudden emergence of the war economy system in the short time from 1937 to 1945 should surprise economists and historians. First, the system itself is surprisingly consistent, logically coherent, and highly efficient. Taking one individual component alone, it would not work. Implemented in its entirety, as happened in the postwar era, it beat the free market system of other countries hands down and created the postwar Japanese "economic miracle." How could the wartime planners so quickly design such a consistent and efficient system? They had gained invaluable experience in implementing and running this system when they were experimenting with its prototype in Manchuria, which had been under direct army rule since 1931. The same bureaucrats then moved back to Japan to implement it there. The Manchurian planners did not have to invent it from scratch, either; they took most of their ideas from European thinkers and economists, with the biggest input coming from Germany.45