Arthritic Japan: The Slow Pace of Economic Reform

Arthritic Japan: The Slow Pace of Economic Reform

by Edward J. Lincoln

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In the late 1980s, Japan's strong economic performance put it on a the verge of becoming a major player in regional and global affairs. But nearly a decade of economic stagnation, a mounting of bad debts, and a continuing stream of scandals have tarnished the country's distinctive economic model. At the turn of the millennium, the Japanese economy remained mired


In the late 1980s, Japan's strong economic performance put it on a the verge of becoming a major player in regional and global affairs. But nearly a decade of economic stagnation, a mounting of bad debts, and a continuing stream of scandals have tarnished the country's distinctive economic model. At the turn of the millennium, the Japanese economy remained mired in a pattern of stagnation. As this disappointing condition dragged on, the government pursued policies to restore economic health. Yet Japan has been slow to embrace the systemic reform on which a robust economic recovery depends. In Arthritic Japan, Edward J. Lincoln examines the causes and implications of this weak response. Concluding that Japan is unlikely to pursue the vigorous reform necessary for economic growth, Lincoln warns of serious consequences: a stumbling economy bedeviled by recession and financial crisis, eroding leadership in economic and security issues, a continued defensive trade posture, and a disgruntled population that could turn a more nationalistic stance in foreign policy.

Editorial Reviews

From the Publisher

"Edward Lincoln, a long-time Japan watcher, provides the most convincing explanation for [Japan's economic troubles] in 'Arthritic Japan'." —Brad Glosserman, Pacific Forum CSIS, The Japan Times, 4/21/2002

"A cogently argued, highly persuasive study of the structural factors that caused the Japanese economy to chart a course that led inexorably to the current doldrums." —Mark Austin, The Daily Yomiuri (Tokyo), 3/3/2002

"[The] book offers very clear and convincing explanations for the slow pace of Japanese economic reform, explanations that in turn yield sound predictions." —Hodaka Morita, University of New South Wales, Journal of the Asia Pacific Economy 7(3) 2002

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Arthritic Japan
The Slow Pace of Economic Reform

By Edward J. Lincoln

Brookings Institution Press

Copyright © 2001 Brookings Institution Press.
All rights reserved.
ISBN: 0815700741

Chapter One


At the turn of the millennium, the Japanese economy remained mired in a pattern of stagnation that had continued since the early 1990s. As this disappointing condition dragged on, some in Japan called for systemic reform as a central part of policies to restore economic health. Beginning in 1994, the government formally pursued an agenda of broad economic deregulation, a specific package of deregulation measures for financial markets, and administrative reform. The private sector, prompted by substantial excess capacity in some industries, has also carried out some restructuring. The casual outside observer might easily infer that substantial—and beneficial—systemic change was well under way by 2001. Having recognized their problems, the Japanese appeared on the surface to be charging forward to embrace practical market-oriented solutions.

    That appearance is deceiving. The central conclusion of this study is that fundamental aspects of the economic system are not changing very much. Like a person with arthritis, the existing Japanese economic system has lost much of its nimbleness; its joints have become creaky and painful. Japan has been taking aspirin for its arthritis—partially alleviating the pain temporarily. Something more radical—like hip replacement—would restore some mobility on a long-term basis, but so far this is not happening. As is the case with arthritis, surgery and more powerful medicine will not return Japan to its youth; Japan is a mature industrial economy with a diminishing population of working age, so even reform will not restore the high growth pattern of the past. Nevertheless, more radical treatment would produce better economic performance than in the past decade.

    To be sure, the formal policy of deregulation has been proceeding since 1994 and has increased competition in some markets. However, the nature of corporate governance, corporate finance, labor markets, and the role of government in the economy continue without much alteration. This conclusion will elicit some protest among readers. As reform was getting under way in 1997, Wall Street Journal editor Paul Gigot opined that the Japanese economic system had failed, proving that the American style of capitalism is superior and that Japan would now reform to be more like the United States. Then-prime minister Keizo Obuchi published an op-ed in the New York Times in 1999 stating that his nation recognized the need for extensive reform and was pushing boldly ahead. Even some outside observers believe that radical changes are under way that will propel the economy back on to a stronger growth path. Careful analysis, however, leads to the conclusion that such views are incorrect and provide misleading expectations for American businesses and policy makers.

    This conclusion has important implications. The economic stagnation of the 1990s was largely macroeconomic in origin, stemming from the rise and collapse of real estate and stock prices. Such asset bubbles can occur—and have—in any economy. However, the macroeconomic origin of the problems obscures the fact that structural flaws in the existing system contributed to the creation of the asset bubble. Furthermore, the failure to reform through most of the 1990s complicated and delayed the recovery of the economy. Therefore, robust economic recovery depends on further systemic reform and not just macroeconomic fixes. Cyclical macroeconomic developments and simple downsizing in the corporate sector should produce an upturn in growth over the next few years. However, Japan's moving to a sustained higher growth path and avoiding renewed recession or financial crisis over the next decade requires more substantial reform. Given the nation's grim demographics—decreasing population and a rapid increase of retirees relative to workers—acceleration of economic and productivity growth is crucial. Without reform, the economy will not achieve this acceleration.

    Failure to change will result in a stumbling economy bedeviled by recession and financial crisis, a scenario that would be worrisome for Japanese society, the rest of the region, and the United States. Should the economy sink into recession and crisis—a distinct possibility—Japanese households will obviously suffer. In a larger perspective, Japan will not contribute much to global growth by sucking in more imports and investment. Furthermore, the politics of a disgruntled population could easily lead toward a more nationalistic stance in foreign policy.

    None of this need happen. More extensive reforms that enhance reliance on freely operating and transparent markets for goods, services, and finance, with a concomitant decline in interference by the government, would underwrite a brighter future. Economic growth under the best of circumstances will not be high, given the decline in the working age population and the financial burden of handling the exploding share of retirees. A more vibrant economy is crucial to surviving these problems without incurring a decline in standards of living. With reform Japan might manage a growth rate of two to two-and-a-half percent annually in the next decade; without reform annual growth of one percent or less will be Japan's fate.

    The record of the past 130 years in Japan since modernization began is one of a pragmatic people who dramatically and successfully transformed their nation into one of the leading industrial nations of the world. That record does not guarantee success this time. The obstacles to reform have been formidable, and success itself may have made society less flexible.


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

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

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

    Arguably, any market economy could encounter the problems Japan experienced in the 1990s. Speculative bubbles, driven by excessively positive expectations about the future, can occur anywhere. Collapse of asset prices of the magnitude experienced in Japan would have a negative macroeconomic effect in any economy and would produce massive amounts of bad debt in the banking sector. The record of policy on the nonperforming loans of the savings and loan industry in the United States during the 1980s amply demonstrates that poor policymaking is certainly not unique to Japan.

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

    Poor economic performance in the 1990s, therefore, sparked a vigorous domestic debate over the need for government administrative reform, economic deregulation, new accounting rules, and other changes to spur more efficient corporate behavior. Beginning in 1993, all of these topics gained serious attention in government and the private sector. Over the course of the rest of the decade, government moved forward with a plan for general economic deregulation, a "big bang" deregulation of the financial sector, and government administrative reform. Corporations also began to cope with their own problems—bad debts, excess labor, and excess facilities—by late in the decade. By 2001, talk of change was very much in the air.

    Is Japan really forging ahead with major economic restructuring, institutional reform, and deregulation? This study argues that the surface image of change is misleading. That "something" is changing cannot be denied, and the pace of change has clearly increased from the stasis of the preceding two decades. Nevertheless, a number of important and interrelated factors impede the reform process, and the result will be an economy that continues to differ in organization and behavior from that of the United States and most other industrial nations. The government will remain more intrusive in the economy than is the case in the United States or some other nations that have been deregulating. Mistrust of markets will continue, leading to constraints on the scope of their function. Corporate governance will not change to put shareholders in the driver's seat, and corporations will temper their drive for efficiency by other social considerations. Corporations might succeed in raising their return on investment relative to the dismal performance of the 1990s, but remain less profitable than their western counterparts.

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

    What other kinds of changes have occurred? In just the past decade the number of franchise outlets (an American corporate organizational innovation of the 1950s) has increased four-fold, with convenience stores and fast food outlets popping up everywhere. Franchised convenience stores have morphed into a distinctly Japanese format, providing a set of goods and services quite different from their American counterparts. Cellular telephones have come into widespread use since substantial deregulation occurred in 1994; the number of cellular telephone subscribers rose explosively from 2.1 million to 60 million in the seven years from 1993 to 2000.

    These rather dramatic changes in the context of a largely stagnant economy certainly suggest that economic vitality was not entirely lost. However, such examples do not offset the harsh reality of a stagnant economy and the need for broader reform. The fact is, Japan does not have enough examples of such successes to drive the economy back to health and needs further systemic change to provide a more receptive environment for them.

    The Japanese are well aware of the trends in the rest of the world. They have been deeply interested in deregulation in the United States and in changes in other countries that have reduced the role of government in the economy. Much of the call for change at home has been driven by knowledge of these trends abroad. The continuing revolution in information technology and its explosive deployment in the United States have attracted particular attention. In many aspects of information technology the Japanese economy lags behind that of the United States, but it is moving forward quite rapidly (and leads in some areas, such as wireless communication). Japanese society is rich in technical expertise and generally has a pragmatic approach to new industries and technologies that will enable the economy to adjust reasonably quickly to the information revolution. Concern over lagging behind the Americans provides a powerful incentive to both corporations and government to push development of this sector of the economy.

    However, this technical strength and the ability to respond to foreign trends should be kept in perspective. The Japanese economy has coped quite successfully in the past century with a constantly changing economic structure. Industries have emerged, grown, and died. A massive movement of people out of agriculture into modern industry occurred in the past century, and it was accompanied by a wholesale relocation of population from rural to urban areas. The textile industry, once a dominant exporter, has shrunk to insignificance. Much of the current news in Japan relates to restructuring—bloated corporations shedding capital and workers, banks recouping from disastrous amounts of nonperforming loans, and new industries taking off. Structural change is quite different from systemic change, however, and the big question is not restructuring, but systemic change. Are the basic rules and practices that constitute the architecture for economic behavior in Japan undergoing major reform? No. Is the economy moving toward greater reliance on freely operating markets for goods, services, labor, and corporate control? Not much. Will the Japanese economic system continue to appear distinctive when compared with that of the United States or other advanced industrial economies? Yes.

    A decade from now the Japanese economic model or system will not have converged on the practices of the United States or other industrial nations. Why Japan will not adopt radical reforms and embrace a more market-oriented economic architecture is the central topic of this study. Japan's economic system will be somewhat different a decade from now, but it will remain distinctive. Government will remain intrusive in a number of areas of the economy, driven by a continuing belief that its guidance remains necessary for prosperity and to ensure the competitiveness of Japanese firms vis-à-vis their American and European competitors. Financial markets, labor markets, and corporate governance will experience some reform, without converging on American practices. Deregulation will unleash new competition in some markets, to the benefit of consumers, but the tendency even in those markets to temper competition with informal cartel arrangements will remain strong.

    The terms American model and American standards have become quite faddish and are thrown around loosely in Japan. One could argue that Japan is not so different from European countries, but when people discuss reform that would move the Japanese economy to greater reliance on markets, it is the contemporary American system that they usually have in mind as a model. This study does not attempt to define an American economic model; it is, therefore, occasionally guilty of using the term rather loosely as shorthand for a system that relies heavily on markets for goods, services, and corporate control. Keep in mind that American institutions and behavior have also changed considerably in the past several decades, and they continue to change. Economic regulation in the United States has lessened or been eliminated in some industries, including transportation and telecommunica-tions, but the economy is hardly a completely unregulated laissez-faire model today. American venture capital, and equity markets in general, play a larger role today than they did three or four decades ago. Shareholders—especially mutual funds and pension funds—exercise strong roles in corporate governance, representing another change from the past. Government plays less of a role than in the past in overt economic regulation, but retains a critical function in establishing ground rules for markets and monitoring them to combat fraudulent or other undesirable behavior. In summary, though, the contemporary American economic model relies more on mar-kets with relatively freely determined interaction of demand and supply for exchanging goods, services, labor, corporate finance, and corporate control than is the case in Japan or even in most other advanced industrial nations.

    The Japanese economy will not come to resemble the more market-dominated American model over the next decade. The comforting notion that it might, as expressed by Paul Gigot or Prime Minister Obuchi, is a misinterpretation of what is occurring in Japan. Despite the evident need for systemic reform, a set of powerful interconnected factors implies that change will not produce a clone of the American economy. The five main inhibiting factors emphasized in this study are:

    —belief in the value of the existing system, which has been shaken but hardly destroyed by the events of the 1990s;

    —the interconnected nature of the distinctive features of the existing system, implying that tampering with a few pieces of the system is not sufficient to change the whole;

    —strong vested interests in the current system that may include a majority of the population;

    —conformity of the system to broader social norms and expectations, representing values that society is loath to lose; and

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

    These five factors are mutually reinforcing, and together they will shape the nature of change. A decade from now, the organization and behavior of the Japanese economy will certainly be different from that of today; as formidable as they may appear, these factors will not totally block systemic change. The resulting economic framework will still look quite distinctive from an American viewpoint, however.

    The nature of change matters, for both Japan and the United States. For Japan, if the restraining factors identified here are too powerful, then very little systemic change will occur, and the economy will perform poorly for many more years. Renewed recession, dangerously rising levels of government debt, and generalized failure to meet the financial needs of a burgeoning retired population are clear possibilities. The Japanese public will be less well off than they could be.

    This outcome matters to the United States and the rest of the world. With the Japanese economy just muddling through, it will not contribute much to regional or global growth, and U.S. officials will have to cope with the international consequences of recurring financial problems in Japan. Meanwhile, Japan is unlikely to adopt a more liberal stance on bilateral or multilateral trade negotiations because weakness at home will result in a continued defensive trade posture. Even security policy could be affected, including both the specifics of the bilateral alliance and Japan's broader participation in regional or global security issues. Self-absorption with domestic economic problems will leave Japan in a marginal role in security discussions among the major powers. In general, Japan's failure to produce more vigorous economic reform creates a series of challenges and problems for American policy.


Excerpted from Arthritic Japan by Edward J. Lincoln. Copyright © 2001 by Brookings Institution Press. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.

Meet the Author

Edward J. Lincoln is a senior fellow in Asia and Economic Studies at the Council on Foreign Relations. His previous Brookings books include Arthritic Japan (2001), Troubled Times: U.S.-Japan Trade Relations in the 1990s (1999), Japan's New Global Role (1995), and Japan's Unequal Trade (1990). In the mid-1990s, Lincoln served as special economic advisor to Walter Mondale, former U.S. ambassador to Japan.

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