15 16 werner

Back to the Future

The Return of U.S.-Style Capitalism

Recession Ended MoF Dominance

In the late 1980s, the bright, powerful bureaucrats at the Ōkurashō had been considered a dream catch for any Japanese bride. The man who could introduce himself with a business card, or meishi, from the renowned Finance Ministry elicited deep bows and hushed exclamations of awe and respect, not only from potential in-laws but also from society at large. But times have changed for the MoF men. Scandals have rocked the ministry. In early 1998, public prosecutors for the first time actually raided the most powerful of Japan’s ministries. Frequent demonstrations have been held outside the ministry’s doors by citizens disgusted by the bureaucrats’ actions. Several senior bureaucrats have been arrested in the past few years, and several have committed suicide. In January 2001, the Ōkurashō was abolished. The remaining rump is a far cry from the powerful institution that it had been for over half a century.
As a result of the long recession and crisis of the 1990s, the princes of the Bank of Japan won their decades-old war with the Ministry of Finance once and for all. Since all traditional policies to revive the performance of the old system seemed to fail, the system itself was blamed. A number of commentators, initially from abroad, later homegrown, claimed that Japan’s troubles were due to the fact that Japan did not follow the free market model. To them it was no wonder Japan was in recession, what with powerful bureaucrats setting a plethora of regulations and maintaining a cartelized and closed domestic economy, companies ignoring the demands of shareholders for profitability, frozen labor market structures with lifetime employment, a corporate sector burdened with debt. To neoclassical economists, the real surprise was that the Japanese system had not collapsed earlier. As the symbol of the old economy, MoF was blamed for the lost decade, the escalating fiscal crisis, as well as the creation of the bubble. It was accused of incompetence and, worse, corruption.
As a result, MoF had no more standing to defend itself. It fell prey to politicians eager to gain credibility by bashing the best scapegoat about: the Ministry. By late 1996, MoF had lost the battle for regulation policy, having to concede a full-blown deregulation of the financial sector, known as the “Big Bang.” This abolished the license system, one of MoF’s main power bases. By early 1997, MoF had lost the battle again, this time for supervision over the banking system. It was decided that beginning in June 1998, this task would be handed over to an independent Financial Supervisory Authority. In a previously unthinkable move, MoF’s banking bureau and securities bureau were abolished. The new FSA began business with a vengeance in June 1998, closing two amakudari banks, LTCB and NCB. By late 1997, MoF had also lost the battle for political initiative, so that since then all decisions on fiscal and regulatory policy have been made by LDP politicians.
Most importantly, MoF had lost the battle for the key control lever, monetary policy and oversight of the Bank of Japan. In June 1997, a revised Bank of Japan Law was passed, which became effective in April 1998. This finally gave the Bank of Japan what it had been struggling to gain for half a century—independence from MoF, and, for good measure, from anyone else (more on this in chapter 18).
What if the Bank of Japan Is Right?

But we have found that the princes pursued goals much grander than just breaking up the ministry and becoming legally independent. Their goal has been the structural transformation of Japan’s economy. While it is one thing to criticize the way they may have pursued this goal, what if the ultimate goal, to change Japan’s economic structure, was not so bad after all, and perhaps in the long-term interest of Japan and the rest of the world? And if, as is quite possible, their particular monetary policies were the only way to implement this structural reform, then perhaps the central bankers have been doing the right thing all along. Certainly the press, especially the foreign press, though by the late 1990s increasingly aware of the use of monetary policy to implement structural change, seems to approve and expresses no surprise or shock that Hayami “fears that if he loosens policy too quickly, it would remove the pressure for reform.”1
Leading politicians have now also explicitly adopted the old structural reform agenda and seem sympathetic to the idea of creating hardships to facilitate the reform process. The politician whose script could have been written by the princes at the Bank of Japan is the declared reform prime minister, Junichiro Koizumi. At the Geneva summit in July 2001, when asked how he was going to balance cyclical and structural reform policies, Koizumi replied, “I say: ‘no growth without reform.’… Because we have decided ‘no growth without reform,’ we cannot postpone reform and take cyclical stimulation policies. Some say recovery comes first, without reforms. But if the economy recovers, the will to reform will disappear.… After the elections I will continue with the plan of ‘no growth without structural reform’“ (italics added).2 It is noticeable that Koizumi did not claim that structural reforms are necessary for a recovery, in terms of economic causation. He had decided to declare “no growth without reform,” which expresses the Bank of Japan’s motto of the 1990s well. It is indeed merely a restatement of a phrase in the Maekawa report, which said that Japan urgently needed “to make a historic transformation in its traditional policies on economic management and the nation’s lifestyle. There can be no further development for Japan without this transformation.”
Of course, it is clear that the bad performance of the economy during the 1990s is not a good reason to implement structural changes. During the 1990s, the Bank of Japan has argued that stimulatory monetary policies would be counterproductive to its long-term goal of structural change precisely because they would be effective in achieving their goal of creating a recovery. This, however, recognizes that the economy would respond to cyclical policies, and hence admits that the bad performance of the 1990s is not a reason to change Japan’s economic structure. In other words, by admitting that a short-term downturn may be necessary to implement structural changes, proponents of structural reform deprive themselves of their main argument for just why structural reform is necessary. The Bank of Japan effectively agrees with many of its critics that the economy, in an unreformed state, could have produced higher growth than has been the case for much of the 1990s. If this is the case, then why does the Bank of Japan want to change Japan’s economic structure?
Could the motivation of Maekawa’s ten-year plan justify the Bank of Japan’s actions? It argued that in a globalized and internationalized world economy, Japan could not continue its closed, export-oriented economy. It had to open up to the world. Equally importantly, it also argued that changing Japan’s economic structure would not only end trade friction, but also raise the standard of living and the quality of life in Japan and boost Japan’s economic growth rate. Was this claim just good salesmanship, to appease a conservative population that would resist change? Or is there some truth to it?
Pillars of Growth

Japan’s postwar modification of the war economy was hooked on success. It needed continued high growth in order to remain viable as a system. As we saw, in Japan’s war economy the profit motive had been replaced by the goal of market share expansion. Shareholders received low dividends but were rewarded by rising share prices, reflecting the reinvested profits. So continued growth was necessary to keep shareholders content. The same applied to managers and employees. In the war economy system they were motivated by moving up the corporate ladder. Pay scales at large firms began modestly but rose quickly. To keep the promise of lifetime employment and ever-rising salaries, continued high growth was necessary. Finally, high and rising standards of living would appease the population, which had little political say in the system—and a lower quality of life than in Europe or America. In other words, the war economy needed high economic growth to satisfy all interest groups.
Growth, however, was ultimately based on exports. Although they accounted for less than 15 percent of GDP in the 1990s, their importance had been larger. Domestic demand had been suppressed and domestic prices kept artificially high to increase savings. The goods that were produced with the overinvestment had to be sold abroad.
Without continued growth, the system was unsustainable and would have to be modified at the very least. The ability to grow fast rested on two pillars. One was a world trade system (read that of the United States) that allowed Japan to eat into everybody else’s market share. In exchange for the strategic military benefits, the United States allowed the continuation of the war economy. The second pillar was the ability to constantly allocate new credit to productive sectors. MITI helped in their identification. Drawing on its advice, the BoJ princes allocated credit. Unproductive sectors could not obtain purchasing power. This way Japan quickly moved up the value-added ladder, from textiles to steel to automobiles to semiconductors and consumer electronics.
Crisis of the Miracle Model

Both pillars of growth started to crumble in the early 1970s. Beginning in the 1980s, when the costs of Japan’s export drive became too large for the United States to bear, all U.S. administrations have been demanding that Japan abandon its export orientation and open its markets. With the end of the Cold War, this policy change became much more urgent, as the political and strategic benefits of a strong Japan were also reassessed.
Japan could not ignore the foreign cry for change: Suffering from Japan’s trade surpluses, the world could close itself off from Japanese imports. For a long time this threat seemed only theoretical, with Japanese goods having become so dominant in many sectors that a boycott would be unthinkable. However, the creation of trade blocs and strong Asian competitors had changed the equation. Despite skepticism, Europe forged monetary union. North and South America are scheduled to be united in a single free trade zone in 2005, likely to be followed by monetary union some time later. Such large trade blocs could become autarkic, or at least independent from Japanese goods.
The second pillar of growth, the constant upgrading to higher-value-added activities, was also showing its age. In the past, all the new high-value-added areas, from automobiles in the 1970s to semiconductors in the 1980s, had been within the manufacturing sector. Now Japan had reached the top of the manufacturing value-added pyramid. Despite maximum rationalization and heavy investments, the incremental additional value produced by even the top-end manufacturers was leveling off. The growth potential of manufacturing was diminishing.
The main factor inputs that are used in an economy are land, labor, capital, and technology. The war economy system is probably the most efficient at mobilizing these inputs in the shortest possible time and ensuring that they are used for whatever activity is considered high priority. As more and more people joined the labor force, as more land was used productively, as capital investments were increased, and as new technologies continued to be introduced from abroad, economic growth remained high. However, in the 1970s, after decades of high growth, Japan was approaching full employment of these factor inputs.

Figure 15.1  Japanese Real GDP Growth

Source: Economic and Social Research Institute; Cabinet Office, Government of Japan
Worse, the quantity of inputs started declining. The workforce participation had reached a peak and, due to an aging society, was approaching the point where it would fall. Land is fixed, and it was hard to raise its productivity (although decentralization and regionalization would provide an answer). Capital investment had reached a level where any further increases led to diminishing returns. Technological inputs were much harder to come by now that Japan’s technology had caught up with that of the world leaders. Instead of copying or licensing, expensive and time-intensive research and development was now needed.
Japan was running out of inputs. Consequently, the war economy system could not deliver high growth anymore. Beginning in the 1970s, Japan’s economic growth rate dropped sharply: While growth averaged 8.7 percent in the 1950s and 10 percent in the 1960s, it only clocked up 6.0 percent in the 1970s.3 As can be seen in Figure 15.1, statistically, Japan’s growth rate has been on a sharp downward trend since. On the basis of the old reliance of input maximization in the manufacturing sector alone, economic growth would at best stagnate at the 1 percent level. The old high-growth system had turned into a slow-growth straitjacket.4
Not only the mechanics of the mobilized war economy system required continued high growth. Its rapidly aging society also made more than 1 percent growth necessary. The workforce will begin to contract soon, while the expenditure required for pensions and social welfare will soar. Since Japan had opted for a pay-as-you-go system whose excess revenues were squandered, this will place an enormous burden on a declining base of able-bodied workers.5 There is now more than one pensioner for every two welfare contributors. The number of pensioners is rising so fast that drastic cuts in pensions and hefty increases in the contributions would remain insufficient. One suggested solution is to transfer the public pension liabilities to a private system of defined contributions to equity investment funds. But the only way to feed its aging society is to increase Japan’s growth rate. If more wealth is generated, there is more to share with the elderly.
Raising Productivity

There were several ways Japan could break out of the slow-growth straitjacket. Japan’s economy had relied on maximizing inputs in order to maximize growth, but economic growth is not just the result of the quantity of inputs; it also involves the quality of their use—productivity. Since the war economy system is based mainly on the mobilization of factor inputs, the Japanese economy had hardly tapped productivity as a source of economic growth. Japanese exporters are famous for their efficiency and high-quality products. So it usually comes as a surprise to observers to learn that in international productivity comparisons, Japan ranks very low down the list, far behind other nations.6
Productivity is a function of the right incentives. And the best incentive tends to be competition. The export sector had always been exposed to the harshest competition that exists—the world markets. That is why Japanese exporters have been highly productive. But the majority of employment is accounted for by the domestic demand-oriented industries. The wartime system kept the domestic economy cartelized and closed. While competition for ranking existed, it was limited through the cartels. Thus productivity was not as high as it could have been, especially in the nonmanufacturing sector. Given its large share of the economy, this reduced Japan’s overall productivity.
This presented Japan with an opportunity. The solution to Japan’s problem of a declining growth rate was to increase productivity. If Japan managed to use its factor inputs more efficiently, it would be able to increase growth, even if their quantity was shrinking.
Productivity could be raised in several ways. One was to retool the economy by shifting from export orientation to an expansion of domestic demand, especially consumer-oriented industries. Another involved a move from an input-based manufacturing sector to an emphasis on high productivity and creative activities in nonmanufacturing, such as research and development, innovation, information-based activities, and the service sector in general. Such a shift would also be in line with the demographic trend—more pensioners mean greater demand for the domestic consumer, service, leisure, and welfare-related industries.
Thus Japan had to do what it had never done before in its modern history: turn services and domestic demand into the daily bread of economic growth. During the war, fast growth to maximize physical output was the priority. The service sector was not important and hence had not been afforded a prominent role. Quality of life was a luxury that could not be afforded. Hence investment in housing, public facilities, cities that are attractive to live in, a sustainable natural environment, short commuting times, and high pay in terms of real purchasing power were badly lacking. The system also did not allow much individual freedom, as that got in the way of the quick execution of collective goals. Open debate and the free expression of views was never a strength of the war economy system, whether at work or in public life. This muffled creativity in many areas.
The concern of the central bankers to raise Japanese productivity was probably genuine. Central bankers care about productivity, as it determines the maximum potential growth rate that an economy can achieve, given its factor inputs. They primarily control the nominal growth rate of an economy (via the quantity of credit creation). How much of that nominal growth will be real and how much will take the form of inflation is not clear. That depends on how much the economy is growing relative to its potential growth rate. Put simply, if nominal growth remains below the potential growth rate, then there are deflationary pressures instead of inflationary ones. Factories are idle and there is unemployment. In such a situation, it is possible to increase nominal growth (by increasing credit creation) without creating any inflation. If, however, the economy is growing faster than the potential growth rate, then prices will be pushed up and inflation ensues. This can be due either to too much credit creation relative to a given potential growth rate, or to a drop in the potential growth rate. So to keep inflation in check, central bankers take great interest in potential growth, and they generally support measures that can raise it.
When Maekawa and Mieno reflated the economy in the late 1970s, they probably noticed with concern that growth above 5 percent would result in inflation—much sooner than in the past. Japan’s potential growth rate had dropped. With shrinking factor inputs, it became apparent that the long-term potential growth rate would continue to fall until productivity rose. The princes apparently were convinced that they could raise productivity by abandoning the war economy, deregulating, liberalizing, breaking up the formal and informal cartels, and opening up Japan’s economy to the world. The structural reformers got what they wanted.
Endaka Accelerated Deregulation

The endaka (strong yen) that accompanied the tight money policy of the 1990s accelerated the shift of manufacturing bases into Asia and helped open up Japan’s domestic economy to imports. The unprecedented shift of factories out of the country has virtually created a second Japan outside its borders. In financial year 1995, Japan produced more abroad than it exported from its shores.

Figure 15.2  Import Share of Manufactured Goods

Source: Ministry of Finance
Simultaneously, the strong yen boosted imports. A large part, of course, consisted of reimports from Japanese factories that had been shifted abroad. However, imports from Europe and North America have also soared since the mid-1980s. Japan’s war economy was characterized by an unusually low share of manufactured goods among imports. The strong yen has changed that; Figure 15.2 shows that, driven by the strengthening yen, the share of manufacturing products among imports more than doubled from a low 26 percent in 1980 to 64 percent in 2000, a figure that is rapidly approaching the levels seen in Germany or the United States.
The relocation of factories offshore and the influx of manufactured goods, whether from Japanese overseas plants or foreign firms, forced change on the domestic economy. In order to compete with rising imports, firms had to lower prices, reduce inefficiencies, and increase productivity. To do that, employment practices had to change, staff were laid off, and consumer tastes had to be taken more seriously. New jobs had to be created at home in the new industries of the future. But thus far, domestic demand-oriented industries had been less efficient. With foreign products now gaining market share in Japan—from semiconductors to beer, from steel to cars—consumers would no longer be willing to pay high prices for the sake of strong exports.
How could the domestic and service-oriented sectors be made more efficient? The same way that in the past manufacturing exporters became efficient: through competition. With the manufacturing base shifting offshore, deregulation and greater import penetration became an important option to create new jobs. In turn, deregulation in one area created economic pressures for further deregulation in other areas. The effects of deregulation accumulated exponentially—painfully slowly in the beginning, but picking up speed sharply.
The Tide Turns to Transformation

In April 1995, thanks to the double crisis of economic slump and historic yen strength, the reformers at the BoJ, in MITI, and among the politicians managed to break the bureaucratic resistance against deregulation. The shock of the yen at ¥80/$ convinced even die-hard conservatives that Japan had no choice but to deregulate. Thus only weeks after the historic high of the yen, a far-reaching deregulation package was announced, consisting of a catalog of one thousand deregulation items. A “Deregulation White Paper” followed later in the year. Moreover, in 1996 and 1997, the reformers had won enough political support to push for their biggest challenge to the old war economy establishment: a full-scale deregulation of the financial sector. The Big Bang started in April 1998 with the deregulation of the foreign exchange law. That, indeed, symbolizes the end of the war economy, because, as we saw, it was the foreign exchange laws that began the introduction of the war economy in the 1930s.
Previously, only licensed foreign exchange banks could deal in foreign currencies. Now foreign exchange transactions can be undertaken by anybody. Capital can flow freely into or out of the country. The liberalization of stockbroking commissions, the blurring of the distinctions between different types of financial institutions, and the opening up of the financial sector to players from outside as well as other fields inside Japan (such as retailer Ito-Yokado) bring fierce competition with global leaders onto the home turf. All the barriers against foreign firms had come down; the doors to the domestic financial sector and hence to the entire economy are now open to the world. Hence foreign firms took large stakes in leading Japanese firms—unthinkable a decade earlier. For example, Merrill Lynch took over the bankrupt Yamaichi Securities, the Travelers Group bought a quarter of Nikko Securities, and the U.S. fund Ripplewood bought once-mighty Long-Term Credit Bank.
Japan is shifting its economic system to U.S.-style markets, and that also means that the center of the economy is being moved from banks to stock markets. To entice depositors to pull their money out of the safe bank and postal savings deposits and into the risky equity market, reformers have withdrawn the blanket guarantee on all bank deposits and propose to privatize or abolish the postal savings system, while creating tax incentives for stock investments.
From Collectivism to Individualism

Since mid-1994, probably for the first time ever in Japanese history, the service sector employed more people than the manufacturing sector. Meanwhile, firms, forced to boost productivity, have switched from the lockstep seniority system to merit-based pay that could have large rewards for creative individuals. They have adopted flexible year-round hiring. As the educational system shifts gear from being one aimed at producing human inputs into hardware production by focusing on rote memorization to becoming one that encourages individuality and creativity, the social landscape will change as well.
In 1960, there were over one thousand legal cartels, granted exemption from the Anti-Monopoly Law. By 1998, deregulation had reduced the number to almost zero.7 In addition to the official cartels, there were a number of special laws that had created barriers to entry in many industries. However, many of these have now been revised. The revision of the large-scale retail law boosted the number of consumer-oriented large-scale shops that are discounting heavily. In 1993, the telecommunications sector was deregulated, which created a significant boom in mobile phones and boosted employment in the information services sector dramatically. In 1996, the Electric Enterprise Law was changed to allow firms other than utilities to generate electricity. Other examples include the deregulation of the gasoline retailing law. Public prosecutors have also become tough on corporate racketeers, construction dangō (informal collusive agreements), and other practices that the war system had brought with it.8 The Fair Trade Commission has been strengthened and made more meaningfully independent. Having previously acted in the interest of the monopolists, it seems now to be seeking to restrict their influence. Japan’s new product liability law of 1995 for the first time explicitly favors consumers. In case of dispute, the burden of proof has now been placed on the manufacturer.
Political System Change

The systemic change did not stop at the economic system. The numerous scandals that followed the bursting of the bubble also brought down the 1955 system of stable one-party rule by the LDP. In the old system, politicians did not compete by proposing different policies. Policy was made by the bureaucrats, and the politicians merely focused on appeasing local constituencies with public works projects. Since the Japanese electoral law had given the rural vote a much bigger weight—up to three times that of the city vote—this meant that politicians had to please rural constituencies in particular. That gave the agricultural lobby its power over government policies. The 1993 Hosokawa administration changed the electoral system and thus politics, which is now catering more to city dwellers. Imports of agricultural products rose. The rice market was forced open in 1993, thanks to the government’s reduction in official rice supply stocks to the lowest level on record in the postwar era. This allowed bad weather to create a rice shortage, and public opinion was influenced favorably toward the liberalization of rice imports.9
Politicians, with their power bases increasingly in the cities and not the rural farms, found that voters liked the idea of a higher quality of life and standard of living. Thus politicians of almost all parties have since the mid-1990s been competing to present themselves as radical reformers. They have started to take power away from bureaucrats and increasingly make the key decisions. In October 1997, for the first time in postwar history, all policy initiatives to stimulate the economy originated from politicians, not bureaucrats.
The arrival of the Koizumi administration was a reminder of the popularity of the earlier reformer government under Hosokawa. By now, however, the consensus toward a deep structural transformation of Japan had become deeply engrained. Koizumi’s popularity was also a much more important factor for him in retaining his position: For the first time a prime minister was in power due more to his general popularity with the voters than his support among the LDP factions.
The Ten Years That Changed Japan

Maekawa’s ten-year plan effectively called for Japan’s economy to revert to the freer markets that existed in Japan in the 1920s and to turn the producer economy back into a consumer economy. Thanks to the policies taken by the princes, all the main goals had been achieved by the end of the 1990s. Foremost among them, the Ōkurashō had been considerably weakened and the BoJ had become independent in 1998. With this, bureaucratic resistance to deregulation had been broken. But this was not all. The plan to change Japan had set in motion economic forces that continue to work today. The bubble accomplished three things: First, it taught Japanese consumers that spending money could be enjoyable. During the late 1980s, conspicuous consumption appeared for the first time in postwar Japan. Though centered on the rich speculators, it took away the social stigma that conspicuous consumption had had for decades. The second result of the bubble was to send a wave of Japanese foreign investment abroad, partly to shift factories offshore. Third, the bubble set the stage for the recession, which continued the reeducation: It taught consumers newly acquainted with the joys of shopping to demand value for money. Thanks to the deflation of the 1990s, “price destruction” appeared for the first time and discounting spread widely. The recession also initiated deep structural changes in the economy, as companies were forced to lay off workers, unemployment was pushed up, and Japan’s traditional lifetime and seniority-based employment system was eroded.
Striking at the Core of the War Economy System

As we saw in the early chapters, when the war economy system was established, the reduced influence of individual shareholders through diluting cross shareholdings put managers in charge and allowed them to pursue growth irrespective of dividend payments. Firms could afford to maintain cross shareholdings even if stock prices fell, because Japan was using German-style book value ac- counting. Without pressure from shareholders, firms could plan for the long term and grow fast. Book value accounting had the additional benefit that it shielded companies from unnecessary volatility due to stock market movements. This contributed to overall economic stability.
This system of capitalism without capitalists had become increasingly embattled during the 1990s. The collapse of share prices and the credit crunch forced many companies to sell off cross shareholdings that had been created during the war and in the postwar era. That meant the return of shareholder power. At the same time, with Japanese equity prices on a falling trend in the 1990s, and with the Nikkei 225 index having closed at a twenty-year low on the last day of 2002, foreign investors have seized the opportuntity to buy the ownership of Japanese companies—something that had not been possible in earlier decades. In March 1999, the share of stocks listed on the Tokyo Stock Exchange that were owned by foreigners reached a postwar record high of 14.1 percent. By March 2001, this had risen to 18.3 percent, a long way above the 2.8 percent foreign ownership recorded in 1978.10 The protective structural barriers against foreign takeovers built up in the early postwar years were increasingly crumbling. Foreign institutional investors now demand higher dividends and better returns on assets than the old-style Japanese corporation was willing to deliver.
The Return of the Capitalists

Battered by criticism, the Ministry of Finance also agreed to adopt a radical change in Japan’s accounting standards. Fiscal year 2001 was the first in Japanese history that company books were calculated according to market value accounting. MoF, by this time keen to please critics inside and outside Japan, was persuaded to adopt “international best practice” by dropping book value accounting in favor of U.S.-style marking to market. It did not bother MoF that the majority of industrialized countries have not yet adopted this accounting standard, which is first and foremost a U.S. standard.
The change to market value accounting may sound like a fairly innocuous move by gray accountants. But with this seemingly harmless change in accounting rules, the bookkeepers made significant progress where decades of colorful U.S. trade negotiators had failed. The change sharply accelerated the transformation away from the war economy corporate governance structure and toward shareholder capitalism. Since companies and banks were made to suffer for owning underperforming shares, they had a strong incentive to dissolve their cross shareholdings. Thus they have been dumping their previously stable stock holdings in fire sale operations that peaked especially around book closing, such as in March 2001 and September 2001—each time exerting strong downward pressure on the stock market. Plans were announced to legally require banks to reduce their stock holdings further over several years. This completes the unraveling of cross shareholdings that has been taking place throughout the 1990s. By 2005 the corporate governance landscape will be reshaped—the main bank system is becoming history. Cross shareholdings will have become the exception, not the rule. As a result, accountability to shareholders is beginning to become a reality for the first time since the 1920s. Corporate management is becoming increasingly profit-oriented, and companies are run for the benefit of shareholders, not managers and employees. Capitalism for capitalists has returned to Japan.
Change Is on My Mind

Before countries change, mind-sets must change. There can be no doubt that the new consensus against the postwar system emerged as a result of the recession. There may be a way to quantify this. Considering the four Nikkei newspapers in Japan and counting the number of articles in a year that were devoted to three key topics of structural change, we find evidence of such change.11 Figure 15.3 shows that articles on amakudari (bureaucrats parachuting into private-sector positions and hence informally controlling the industries they have previously supervised) began to soar from 1992 onward. The foreign-domestic price differential (Figure 15.4), a reflection of Japan’s closed, export-oriented economic structure, became a buzzword from 1992. Discussions of deregulation (Figure 15.5), with several thousand articles written in a year, really took off in 1992. One may wonder what happened in that year. The simple answer is that 1992 was the year when the recession started. As a result, the old economic structure was criticized and a fundamental rethinking began.12
The postbubble recession of the 1990s succeeded in shifting the consensus from being in favor of the wartime economic system, as was still the case in the mid-1980s, to its diametric opposite. Today, most intellectuals in Japan have come to agree with the slogan of Prime Minister Koizumi, who started his reform-oriented administration in 2001: no economic recovery without structural change. It has become a consensus in Japan that the old system does not work anymore and has to be scrapped.
Observers even began to wake up to the wartime roots of the postwar system—and that seemed to further condemn it. An editorial in the widely read Yomiuri newspaper suddenly thundered in mid-2000, “In the ten years since the collapse of the bubble economy, the government has tried every financial and fiscal policy possible. But the economic slump is still continuing because the government has never attempted to revamp the fatigued economic and social systems of the wartime regime.”13 The ten-year slump seemed evidence enough to most observers that the postwar system did not work anymore.
There can be little doubt that later historians will conclude that the slump of the 1990s marks a historic turning point in Japan’s economic, social, and political system. Believing that the system itself was to blame, policymakers scrapped the structure that had created the postwar miracle economy. They abandoned the war economy system. Japan is now well advanced on the path to implementing U.S.-style capitalism. It appears as if the Bank of Japan has done the right thing, after all.

Figure 15.3  Articles with Keyword “Amakudari” in the Nikkei Newspapers

Source: Nihon Keizai Shinbun

Figure 15.4  Articles with Keyword “Foreign-Domestic Price Differential” in the Nikkei Newspapers

Source: Nihon Keizai Shinbun

Figure 15.5  Articles with Keyword “Deregulation” in the Nikkei Newspapers

Source: Nihon Keizai Shinbun
Shareholder Capitalism or Welfare Capitalism?

Even if we ignore the inappropriate way in which the central bank facilitated these structural changes, there are two reasons why its actions were not justified. First, there was an alternative for Japan to introducing U.S.-style capitalism. The problem of falling factor inputs and low productivity that Japan experienced beginning in the 1970s did not mean that the old system had to be abandoned. It could simply have been adjusted. All that was needed was to use the key control tool, credit creation, to supply the nonmanufacturing and service sectors, especially high-value-added activities such as education, research and development, information services, software development, and telecommunications, as well as welfare-enhancing projects such as housing and public facilities and environmental projects and industries, with new purchasing power. Incentive structures could have been redesigned to allow for a greater degree of individual freedom and public debate. Purchasing power allocated to low-productivity activities, such as the traditional distribution system, sunset manufacturing industries, and the like could be slowly phased out, thus producing a natural shrinkage of these sectors and efforts to restructure or relocate offshore.
With such credit policies, the emphasis of Japan’s economic system would quickly change. The structure of the miracle economy, based on capitalism without capitalists and competition for size, not profits, could be maintained. As long as the key control tool, credit creation, was under democratic supervision, Japan’s economy could then continue to deliver high economic growth while at the same time enhancing the standard of living and quality of life of its population, continuing an egalitarian ownership and safeguard its achievements in terms of social justice. The war economy system has helped Japan avoid the disadvantages and significant human costs of free-market-style capitalism, namely, great income and wealth inequalities, high unemployment, high crime rates, and social injustice of many kinds. These advantages could be maintained if the system as such was kept but updated to suit the times.
Such a transformation of a war economy system into a successfully modified and modernized structure has a historical precedent. In the early postwar decades, Germany underwent a similar structural break when, under Ludwig Erhard, it made the conscious decision to preserve the advantages of the economic system established in the 1930s but improve it by shifting its goal further away from output maximization to raising the standard of living of the population.
German Model

The result was a combination of the collectivist war economy and the U.S.-style free markets. Worker protection and participation in corporate management remained high, ensuring that the profits produced were divided fairly between the three stakeholder groups, shareholders, managers and employees. The financial system remained centered on banks, thus allowing allocation of newly created credit directly to productive corporations. Speculative loans to the real estate sector were kept low by regulatory control that implied low loan valuation ratios of real estate-related lending. At the same time, entrepreneurs were rewarded far more than the war economy system allowed. Thanks to the corporatist structure, worker representation ensured that a reasonable share of corporate profits would go to workers and employees, not just fat-cat capitalists. As a result, the income structure remained far more egalitarian than in the United States. Most of all, resources were allocated toward raising living conditions.
The Germans called this hybrid economic system the soziale Marktwirtschaft, or social market economy.14 The postwar transformation succeeded beyond expectations, as the high growth rates of postwar Germany, also dubbed a “miracle economy,” attest. Taking purchasing power, size of houses, distance to work, working hours, cost and quality of education, and other such issues into account, there can be little doubt that the quality of life and standard of living of the average German is among the highest of the industrialized countries, exceeding that of the average American.
Japan could have opted for going the German way in the 1990s. But there was another way to enhance productivity: entirely abandon the war economic system. By freeing the domestic economy from regulations and cartels, by abandoning the seniority pay system, and most of all by making the shareholder the ultimate lord over the firm again, entrepreneurs could be given incentives to start up new, creative firms in the new service industries. Productivity could be boosted by reversing the half century of war economy and reverting to the free-for-all style of capitalism that existed in the 1920s. But in that case, all advantages of the egalitarian “Third Way” system would be lost, and Japan would also import the disadvantages of unmitigated capitalism that its leaders sought to avoid in the 1930s.
No Public Debate: The Princes Decide for You

Given the significance of the decision whether to reform and improve the war economy system or abandon it entirely and introduce free markets, a widespread public debate would have been crucial. Of course, the cost of changing over from one system to another would have to be added into the calculation, tilting it in favor of going the German way. Ideally, the population would be asked and a decision would be reached in a democratic fashion, based on fair and objective information. In reality, there was no public debate. Very few people were even aware of the issues that were at stake.
The early postwar leaders knew that they were running a war economy, but they chose not to talk for political reasons. The Cold War propaganda message was that postwar Japan had adopted a U.S.-style political and economic system. Unwilling to tell the truth, the leaders, including the Showa emperor himself, took their intimate knowledge about the origin of Japan’s miracle economy with them to the grave. A generation of bureaucrats and politicians reigned in the 1980s and 1990s who did not even understand the true character and purpose of their own country’s economy. Likewise, leading thinkers in the United States have little knowledge about the character of Japan’s war economy, its advantages and possibilities. Ironically, a whole generation of Japan’s elite had been sent to the United States to receive Ph.D.’s and MB As in U.S.-style economics in the postwar era. They arrived back in Japan trained in the theories of the free markets. Yet they had never, received any formal training in the principles of their own economy. In the postwar years—partly due to the need to cover up its roots—there had not been a proper theory of how the Japanese war economy system worked and what its advantages were.
Since neoclassical economics assumes that there is only one type of economic system, namely, unmitigated free markets, where shareholders and central bankers rule supreme, the young, bright Japanese elite quickly came to regurgitate the arguments of U.S. economists. When U.S. commentators were demanding that Japan change its system, neither economists and business leaders nor bureaucrats and politicians in Japan were able to counter U.S. arguments. Many older Japanese leaders instinctively felt that the Japanese system had served the people well and so should not be hastily abandoned. However, they failed to provide a convincing rationale for their arguments. U.S. leaders, drawing on decades of research into the free market theory, had an easy time winning the public debate. Thus there has never been a debate about whether Japan’s productivity should be enhanced by reforming the old system or by abandoning it. Those in charge of window guidance never gave such a debate a chance.
Reform Costs Excessive

When considering the option of modifying the Japanese system and entirely scrapping it by means of a long and deep recession, any cost-benefit analysis would have to conclude that it does not make sense to purposely prolong a recession, even if structural benefits emerge in the long run. To use a simple analogy: Cyclical policies aim at economic growth, hence at boosting the size of the national income pie. Structural policies aim at efficiency, which is the ease with which a given pie is cut up and allocated. While structural reform may indeed succeed in marginally increasing the efficiency of the economy, as measured by certain indicators, it seems clear that the enormous economic and social costs of the ten-year recession have greatly outstripped the potential benefits. To prolong the recession for the sake of implementing structural change is akin to shrinking a cake to a tiny size in order to be able to cut it up more easily.
Forward to the Past

Many observers are still convinced that the reform plans of Junichiro Koizumi, who became prime minister in April 2001, would be positive for Japan. Among them he gave prominence to his demands that various publicly owned companies, most notably the post office, ought to be privatized. This is indeed the most concrete reform plan, and one that Koizumi has proposed throughout his career. Yet it is difficult to see how such a reform will affect economic growth. Ownership of the public entities has not changed in the postwar era or even over the past century. Yet economic growth has changed. Japan moved into recession in the 1990s, although there was no increase in ownership of public corporations. Over the long run, if anything, one may detect a positive correlation between growth and the existence of these public institutions—their creation provided some of the infrastructure for Japan’s phenomenal economic growth.
What, then, is the attraction of privatization? It is often argued that privatization increases efficiency, as market forces will make those firms more productive and profit-oriented. Yet Japan’s public-sector employment as a share of total employment remains modest by international comparison. Moreover, the quality and reliability of public services must rank among the top in the world.
It is true that selling the public utilities to private investors is likely to boost the profit orientation of these entities. But is this necessarily a good thing? Private-sector firms look after the interests of their owners. To avoid this is precisely why public-sector institutions were created: They are supposed to work in the interest of the public. It is well known that markets cannot effectively manage goods from which everyone can easily benefit, namely, such public goods as the environment, education, and public infrastructure (such as parks, roads, and postal services). Private owners would not invest as much as is socially efficient. This market failure is why public goods usually are kept in the hands of the government. This is also true for industries with a natural monopoly that can only sustain a small number of firms. Leaving their operation in the hands of the private sector would lead to monopolies that disadvantage consumers by pushing up prices and reducing the amount and quality of services.
Japan introduced a publicly owned postal service because it is beneficial for society if the post office services all regions, even remote ones, at the same price. To boost profits, a privatized postal service will no doubt close a large number of offices. Prices of all postal services are likely to rise, while many unprofitable but convenient services are likely to be canceled. Transaction costs for the general public will increase. What is efficient for the new private owners will in part be inefficient for the public. As a result, privatization will most likely shift money from the pockets of ordinary citizens into those of the new shareholders.
The same applies to education, which is the foundation of economic development in any country. To boost Japan’s long-term growth rate and benefit the majority of the public, Japan created public schools and universities, which have very low fees. The highest overall level of education can be achieved in an open, merit-based educational system that offers equal opportunities for everyone, no matter how wealthy one’s parents are. This has been one of the pillars of the successful egalitarian, classless societies that boast high standards of living, such as Sweden, Germany, Japan, and other Asian countries.
Koizumi is now proposing to move Japan more in the direction of Britain, where the educational system has not adequately dealt with the bias against the less well off and where the privatization of public corporations has not visibly worked in the interest of consumers and the general public.15
A lingering worry is that public institutions do not motivate their staff properly, which privatization could change. Indeed, if there is underperformance, something should be done about it. But the performance of staff can be increased by implementing the right incentive structures without changing ownership. Apart from the ownership, the differences between public and private bureaucracies are in any case small: large firms are in their structure similar to civil service bureaucracies.
The End Does Not Justify the Means

We have examined the case that, perhaps, the Bank of Japan’s means to achieve its end could be justified by the positive nature of that end. However, this argument does not hold. There is therefore no good economic rationale for pursuing the types of policies that the Bank of Japan has pursued over the past decades. This leaves us with the fact that the decision on structural reform is ultimately a political one. Irrespective of the ultimate goal, the question here is whether the implementation of a long-term structural change agenda that affects income and wealth distribution, social and economic institutions, and society in general is really the task of unelected central bankers. Nothing in the Bank of Japan Law, old or new, has ever awarded the central bank such a mandate. In Posen’s words: “No Japanese citizen elected the BoJ to pursue this policy of promoting restructuring, and in fact no elected official delegated this task to the BoJ or put the goal of ‘encouraging creative destruction’ into its mandate.”16 To create public consensus on the “need” for structural reform by purposely creating a recession must constitute an abuse of power.17
Reflation

Another Miracle in the Making

Investment Implications: Positive Outlook on Japan

Having analyzed the events of the past, and having criticized where critique is due, this chapter is addressed to investors and businesspeople who are interested in identifying the implications of our findings for investment strategy. The conclusion first: Contrary to popular opinion, Japan’s recession is not the result of deep problems with its system. It has been artificially created by the Bank of Japan to implement its structural change agenda. This also means that whenever the princes at the central bank decide to reflate, a recovery could be far stronger than many observers would expect. Moreover, in terms of sectoral investment allocation, the structural reform agenda implies that the ongoing changes in Japan are significant, they are likely to continue and they offer historic business opportunities for overseas companies. The upshot is that Japan must not be written off. To the contrary, it presents an unusually attractive prospect. The second largest economy of the world, so far largely closed to foreign businesses, is now significantly opening up. Moreover, the recession has reduced prices in Japan, rendered rents and real estate affordable by international comparison, and has artificially damaged the health of Japanese competitors. Not to take advantage of such a rare opportunity would be a grave mistake from the viewpoint of overseas businesses and investors.
From the time of the Mongols’ attempt to invade Japan in the thirteenth century through Perry’s Black Ships to the Plaza Agreement, there has never been a shortage of people ready to write Japan off. If history is any guide at all, the major lesson is that it does not pay to underestimate the potential of Japan to adapt to, confront, and overcome new challenges. The recession and the yen strength provided the crisis mood that forged the consensus for deep changes and the incentives for corporate Japan to restructure. The structural changes have boosted productivity and hence raised Japan’s potential growth rate. Four percent growth without inflation has become possible again.
Don’t Trust the Consensus

In early 2002, ten years after the downturn began, Japan’s economy was still mired in recession. Most economic indicators suggested a crisis similar to that of 1998. The Nikkei 225 equity index fell to an eighteen-year low. Just as in 1998, there were fears of a systemic banking crisis. Announcement of layoffs further depressed sentiment. After more than a decade of declining share prices, many investors were willing to write Japan off for good.
However, if we reflect back to the situation in 1998, when pessimism was most widespread and most economists were forecasting that Japan’s GDP would shrink in 1999, in actual fact what followed was a stock market rise of more than 50 percent, and real GDP growth of 1.4 percent. Then, when forecasters had revised their forecasts up, growth slumped again in 2000 and the stock market fell, sending the Nikkei 225 below 10,000 in September 2001. Again, the consensus became staunchly pessimistic.
Most analyses and economic models are based on interest rates as the main explanatory variable. As we have seen, that can produce highly misleading results. In 1991, for instance, many investors and advisers were convinced that the Japanese economy would remain robust and the stock market would recover quickly. Almost all securities houses recommended that their investors buy Japanese stocks, and especially real estate and banking shares. The Bank of Japan had just begun to lower interest rates—and according to mainstream theory that had to stimulate the economy and boost stocks. But it didn’t happen. Japan’s economy slumped by historic proportions.1
Similarly, interest rates have been giving misleading signals about the U.S. economy. In 1991, for example, most economists were extremely pessimistic about U.S. growth. This pessimism continued throughout 1992 and 1993, when real GDP growth was forecast at between zero and 1 percent. The leading financial newspapers painted a negative picture of the U.S. economy, with liberal use of adjectives such as sluggish, disappointing, and stagnant. Many well-known economists were forecasting that the economy would actually slump back into outright recession.2 The negative majority view even made political history: The prevailing pessimism over the U.S. economy is generally considered an important reason why in November 1992 George Bush lost his bid for reelection and Clinton could move into the White House.
But while the Wall Street experts were forecasting a long, drawn-out recession, the opposite occurred. With hindsight, we know that after the sharp recession in 1991 (with −1.2 percent real GDP growth), the U.S. economy embarked on one of its strongest and longest periods of growth in postwar history—real GDP growth between 3 and 4 percent in 1992 and the following years. Since interest rates rose gradually during the 1990s, standard models have continuously underestimated the strength of U.S. growth. What actually drove growth was steadily rising credit creation. Likewise, the downturn of the U.S. economy was also signaled by the sharp reduction in Federal Reserve credit injections in early 2000.
The BoJ Reflated in 1998

The Japanese economy recovered temporarily in 1999, because the Bank of Japan suddenly—and, as it turned out, temporarily—switched on the printing presses on 31 March 1998, creating money at the fastest rate in a quarter century. One day later, the new Bank of Japan Law became effective and the Bank of Japan had achieved legal independence. Perhaps it was celebrating its victory?
The money newly created by the central bank was injected into the economy via purchases of government bonds and commercial paper. This was not immediately visible from the standard money supply indicators that the BoJ publishes. Central banks have no great incentive to publicize the details of their actions. While they publish a large number of financial data series, they greatly downplay data on their total credit creation. As a result, many investors and analysts focus on the short-term money market operations because these can be closely followed on a daily basis. However, they constitute only a part of the central bank’s actions.
As we saw, the Bank of Japan’s credit creation can be measured by adding up all the transactions of the central bank, including lending to the banking system, money market operations, long bond operations, foreign exchange intervention, sterilization operations, and so on. This is shown with my Leading Liquidity Index. As we saw in Figure 10.1, the Bank of Japan pursued a highly stimulatory monetary policy in 1998. With a time lag of approximately one year, the economy staged a surprise recovery in 1999. Meanwhile, the exchange rate reacted immediately—the BoJ’s dramatic liquidity injections were the cause of the sudden drop of the yen, which fell to ¥147/$ in mid-1998.
At that stage, many currency models were predicting further substantial yen weakness. However, it was not meant to happen: The Bank of Japan reduced its credit creation sharply in 1999, actively withdrawing credit from the economy for most of the year. The yen moved back close to ¥100/$, and a year later the recovery of 1999 stalled. Economic growth started to decelerate in 2000. The stock market therefore also hit a high in the first quarter of 2000, and then more than halved, falling from ¥20,800 in March 2000 to ¥8,300 in November 2002.
Koizumi: A Man to the Princes’ Liking

Why the Bank of Japan tightened again in 1999 is not immediately clear. What is clear is that thanks to the dramatic economic slump of 2000 and 2001 the structural reform agenda was further accelerated. As the recession got worse again, the administrative reform of January 2001 was pushed through on schedule, and Ōkurashō was scrapped in the process. Then in early 2001 the slump swept a new type of politician to power, and Junichiro Koizumi became prime minister. He arrived with surprising popular appeal. In terms of his popularity and his policies, he is often compared to Margaret Thatcher or Ronald Reagan. His message was simple: “No recovery without structural reform.”
Reformer Koizumi is a man to the BoJ’s liking, since he firmly believes in the need for structural change. Should such a prime minister not be supported? The Bank of Japan’s princes may have sabotaged all previous governments through their tight credit policies. But they have less of an incentive to undermine the first prime minister who appears to fully share their structural reform agenda.3
That is why the princes switched on the printing presses again. In May 2001, purchases of commercial paper rose by over 500 percent YoY. Bond purchases increased rapidly. Our Liquidity Index was also propelled close to the high levels of March 1998 again. For the first time, Bank of Japan staff also hinted to the government that they might be willing to inject money into a public institution that would buy the banks’ bad debts (as long as certain conditions were met, namely foreclosures that would create distressed asset sales and thus allow foreign “vulture” funds to expand in Japan).4
Bond Boom Bails Out Bust Banks

What about the banks? The latest initiative of a public entity that purchases bad debts from the banks will complete the bailout of banks. Even before that, the situation of most of the large banks improved dramatically in 1997 and 1998. This went almost unnoticed by the public. Abrief look at what happened in the United States from 1991 to 1994 will help to illustrate.
In the 1980s, U.S. banks lent too much to real estate speculators. We know that credit creation used for nonproductive purposes must eventually turn into bad debts. When that happened in America in 1991, U.S. banks were hurt and credit growth turned negative. As a consequence, GDP shrank in 1991. The U.S. newspapers frequently reported about a credit crunch.5 As late as July 1993, Alan Greenspan warned that the “credit crunch phenomenon … is not over” and that the economy faced “stiff headwinds” due to “weakening asset values” and “excessive debt burdens.”6 However, all negative forecasts turned out to be wrong. When it suddenly became clear that the U.S. economy was really recovering, the bond market crashed in February 1994 and stocks started to rise.
What had happened? When the Fed was faced with a credit crunch in 1991, it could only kick-start the economy by, first, printing money itself and, second, making sure that bank credit creation would recover quickly. But even the top money center banks were on the verge of technical insolvency. The Fed was unwilling to let them default (of course, it did not hurt that many of the large money center banks are shareholders of the Fed). To solve the credit crunch problem, banks needed to write off their bad debts and restore their balance sheets. The big banks needed money, but it was politically out of the question to use tax money to bail out the likes of Citicorp or Chase Manhattan.
Profits for the Banks

As the Fed printed dollars and bought bonds, the banks also stepped up bond purchases. As both the central bank and the banking system were buying bonds, the bond market had only one way to go—up. Declining yields were a reflection of the fact that the central bank was reflating and banks were earning money through income gains as well as capital gains. All this meant, of course, that the economy had to recover, which in turn implied that the bond market was doomed to crash. It did. That caused huge losses for bond investors. Indeed, a few hedge funds went bankrupt. But how did the biggest holders of bonds fare—the banks? By the end of 1993, almost a quarter of their assets were government bonds.7 Instead of being badly hit by the bond crash, many recorded large profits and could write off virtually all of their bad debts. That is not surprising if one assumes that the bond bubble had been engineered by the central bank to bail out the banks. Then it would not surprise anyone to find that the banks had sold their bonds at the peak of the market. Technically speaking, the banks still owned the bonds, since they were still on their books. Indeed, as the main owners of bonds, banks could not possibly have sold them in the cash market. So they built up short positions. In late 1993, many analysts became worried about the rapid expansion in U.S. banks’ derivative positions. Off-balance-sheet derivatives were a multiple of total assets for some banks. Analysts were not quite sure what to make of these statistics and put them down to increasing sophistication of bank products and financial engineering. Instead, banks had mainly used derivatives to short the bond market. When the bond market crashed, they made appreciable profits.
Loan Statistics Distorted

Thanks to the profits made in the bond market, the banks could write off a large part of their bad debts. However, there is another irony: As the banks did just that in 1992 and 1993, most observers became even more pessimistic, as they noticed that bank loan growth by many money center banks had turned negative again. That is why worries about a credit crunch were virtually ubiquitous in 1992 and 1993. The reason for the misunderstanding is the impact write-offs of bad debt have on banks’ loan books: They suddenly shrink and, compared to the previous period, show a negative growth rate. However, that does not mean that credit creation is slowing.
Write-offs are purely an accounting exercise that has no bearing on economic activity. If, for instance, banks extend U.S. $50 billion worth of net new loans (loans minus repayments) but write off old nonperforming loans worth U.S. $60 billion, then their loan books will shrink and observers may believe that there is a credit crunch, when actually credit creation is rising. Only the post-write-off situation is made public and visible to investors. Thus, in time periods where ailing banking systems are bailed out, loan growth data have to be regarded with suspicion. This is also the experience in Sweden, where a sizable credit boom was followed by a credit bust.8
When most observers were writing off Sweden as a hopeless case with a bust banking system and a massive credit crunch problem, Sweden had gone through the worst; in 1994 it recorded growth of around 4 percent. Similarly, when most economists were expecting weak economic growth in the early 1990s, the U.S. economy surprised by continued and lasting high growth.
Large Banks Benefit from Bonds

The first Japanese bond bubble began in early 1995, when benchmark bond yields stood at 4.7 percent, and lasted until September 1998, when bond yields had fallen by four hundred basis points to an extraordinary 0.7 percent.9 Large banks that were aware of the situation made significant capital gains, some beginning to rival the capital gains of the equity bubble of the late 1980s in Japan.
As in the United States, Japanese banks had been shorting the bond market, using derivatives.10 The simplest way is to buy put options or sell call options and earn the premium. When the gains were brought onto the banks’ balance sheets, they had to appear as some form of increase in their assets. In fact, the “other asset” item on the aggregated all-bank balance sheet was used to book derivative transactions. Figure 16.1 shows an account on the aggregate bank balance sheet that is classified only as “other assets.” This account is normally not of much interest. However, it started to balloon in mid-1997. Whatever the banks did, it helped them expand this account by 125 percent YoY at the peak. While all other bank assets were shrinking or at a standstill, the expansion of this account single-handedly boosted aggregate bank assets by around 5 percent YoY—hardly an indication of a credit crunch. Between November 1996 and November 1998, somehow the banks had ¥33 trillion yen more in their pockets. This game was replayed in 2000 and 2001, on a somewhat smaller scale. As a result, several of the large banks had accumulated enough money to address the bad debts from the bubble era.
The Primary Bad Debts have been Written Off

Many observers worry, however, that the bad debt problem may be even larger than expected. To the contrary, I would argue that the bad debts that were due to the bubble—that is, the “true” bad debts due to unproductive lending of the 1980s— have already been written off.
The problem with estimating bad debts is that their size depends on the state of the economy. And that depends on the state of the banks. This means that in boom times bank balance sheets look very strong and are improving further, while in bad times they look weak and seem to deteriorate. It is therefore necessary to distinguish between merely cyclical or secondary bad debts (i.e., those that would not have come about if the economy had not turned down, and a large part of which will be recoverable when it does turn up) and primary bad debts. The latter result from credit creation used for speculative and nonproductive investment. The bulk of these primary bad debts derive from the bank loans to real estate, construction, and nonbank financial institutions between the end of 1985 and the end of 1993, extended under instructions by the Bank of Japan. Adding up the loans to these three “bubble sectors,” we obtain a bubble sector loan total of ¥58.4 trillion in 1986. By 1993, this had risen to ¥131.9 trillion.

Figure 16.1  Japanese Banks’ “Other Assets”

Source: Bank of Japan
Subtracting the banks’ bubble loan books in 1985 from those in 1993, we obtain a top-down estimate of nonproductive credit creation, amounting to approximately ¥74 trillion. Of course, some loans extended to other sectors of the economy were also used for speculative purposes. But equally, not all of the loans extended to the three bubble sectors were nonproductive; some included funding for viable projects as well. To be on the safe side, we add another 15 percent and thus obtain an estimate of total primary bad debts of Y85 trillion.11
Banks brought at least ¥33 trillion through derivatives and other methods onto their balance sheets, and they received around ¥10 trillion in public and third-party money in February 1999. In addition, banks had already undertaken a cumulative total of around ¥22 trillion in declared write-offs in the period from 1993 to September 1996.12 This means that around ¥65 trillion of the bad debt total of ¥85 trillion was already accounted for by mid-1999. By 2002, this figure had risen to ¥80 trillion.13 Thus, we must conclude that the bubble-era primary bad debts had been virtually completely written off by late 2002.
Yet, investors and commentators continued to be worried about far larger estimates of bad debts in the banking system. All remaining bad debts are secondary bad debts that resulted from the deflationary and contractionary policies pursued by the Bank of Japan during the 1990s. Their size is therefore open-ended: if those policies were to continue, the banks could not write off bad debts as fast as they are newly created due to the shrinking economy. The very activity of foreclosing and writing off bad debts indeed reduces demand and thus creates new bad debts.
The Bank of Japan Plan to Increase Bankruptcies

Instead of switching its policies to demand stimulation, in September 2002 the Bank of Japan strengthened its efforts to worsen bank balance sheets and force banks to foreclose on their borrowers. Until then, Hakuo Yanagisawa, Minister for Financial Services, had resisted the Bank of Japan-inspired proposal to inject tax money into banks, effectively nationalizing them, taking over their management and using this power to pull loans from companies, thus triggering many bankruptcies of large firms. Mr. Yanagisawa argued that this plan did not make sense, because the remaining bad debts did not derive from the bubble of the 1980s, but the recession of the 1990s. That recession was due to the Bank of Japan’s policies, he argued, and hence antideflation and demand-stimulation policies were called for, not further bankruptcies and more deflation. So Mr. Yanagisawa resisted the Bank of Japan’s plans.
He paid for it with his job: in September 2002, the central bank surprised the world with its announcement that it would be prepared to purchase stocks from banks—ostensibly in order to help them. However, as became quickly clear, this announcement was aimed at embarrassing Mr. Yanagisawa, by giving the impression that the bad debt problem in the banking system had reached dramatic proportions and he was obstructing the necessary policies. Mr. Yanagisawa was duely sacked by the prime minister and replaced with Heizo Takenaka, already minister for economic and fiscal policy. Takenaka is a supporter of the Bank of Japan’s plan to increase foreclosures of borrowers and immediately appointed a task force to oversee the banking policies, which included two former Bank of Japan staff. One of them, Takeshi Kimura, immediately demanded that accounting changes be implemented which would worsen bank balance sheets and render nationalization unavoidable.14
That the Takenaka plan is strongly supported by the Bank of Japan elite was made explicit by the chairman of the Fujitsu Research Institute and former deputy governor of the Bank of Japan, Toshihiko Fukui. He argued in the Japanese media that the government should inject taxpayers’ money into banks and force “bank management to take responsibility for their institutions’ financial mess.”15 We notice that this proposal creates moral hazard (taxpayers did not create the problem), is economically inefficient (there is a zero-cost way of addressing it), and exacerbates the root problem by reducing demand. Takuro Morinaga, a well-known economist in Tokyo, argued forcefully that the Bank of Japan-inspired proposal by Takenaka would not have many indigenous beneficiaries, but instead would mainly benefit U.S. “vulture” funds specializing in purchasing distressed assets just before central banks switch their policies toward reflation.16 These vulture funds had faced the difficulty that despite almost 200,000 bankruptcies during the 1990s, few firms sufficiently large for the “vulture” funds to be interested were bankrupted. In this context it may be of interest that when Fukui’s and Kimura’s support for the bankruptcy plan was voiced, the former was adviser of the Wall Street investment firm Goldman Sachs (operator of “vulture” funds) and the latter operated a private company that advises on securitization (also of distressed assets). Economist Morinaga thus suggested that as soon as sufficient transfers of distressed assets have taken place, an inflation target will be proclaimed and a recovery may be engineered.17 This seems like an exaggeration—certainly if one is not familiar with events in Asia, which we will consider in the following chapter.
Recovery: Another Miracle in the Making

We saw that in May 2001, later than its March 2001 official announcement of “quantitative easing,” the Bank of Japan once again boosted its credit creation significantly. In a policy rivaling its record reflation of 1998, the Bank of Japan had once again decided to stimulate the economy. Given the normal time lag, this meant that by late 2002, industrial production, as well as domestic consumption, and hence real GDP, staged a recovery that surprised most observers.
Whether this recovery will remain temporary is solely in the hands of those who decide about credit creation. It is important to realize that Japan’s economy has been held back for a decade by a lack of money circulating in the economy, not complex structural problems. Thus, when the princes decide to give the go-ahead and increase credit creation, Japan’s economy will be able to enjoy a rapid recovery, similar to the ones seen in 1999 and 1996. Thanks to the output gap, about 4 percent noninflationary growth is now possible for several years. For an advanced industrialized country, this borders on a second “economic miracle.” Whether such high potential growth will be realized, however, depends on the whims of the princes at the Bank of Japan.