What is holding Japan back from fixing its bad loan problem and successfully restructuring its industries? The answer, according to Schaede, is an insufficient welfare system and a failure on the part of the government to carry out its share of the country's existing social contract in market-conforming ways. For a solution, Schaede argues one needs to focus on the troubles at the country's many small firms, an important part of the economy thus far neglected in foreign analysis of Japan's troubles.

Ulrike Schaede is Associate Professor of International and Pacific Affairs at the Graduate School of International Relations and Pacific Studies (IR/PS), the University of California, San Diego. Author of Cooperative Capitalism: Self-Regulation, Trade Associations, and the Antimonopoly Law in Japan (Oxford UP, 2000) and numerous other books and articles, Schaede.s research focuses on Japan.s government-business relationship, industrial policy, corporate strategy, and financial regulation. After earning her Ph.D. in Germany, she has spent a total of 6 years conducting research in Tokyo, including visiting appointments at Hitotsubashi University, the Ministry of Finance, and the Ministry of International Trade and Industry. Her current research focuses on small firm finance, both private and public, and recent shifts in Japan's small firm policies, including venture capital market initiatives.

Introduction

Japan has always looked like a country of contradictions, but the economic reforms of the late 20^th and early 21^st centuries are perhaps second to none. As Japan’s government is introducing new reform measures in rapid succession to clean up the bad loan problem and to restructure industry, it is also increasingly adopting market-intervening measures to protect the very subjects targeted by reform. For example, beginning in late 2002, the Bank of Japan (the central bank) began buying large firms’ shares from large banks, to infuse capital and keep both afloat. Earlier in the same year, Minister Takenaka, in charge of financial restructuring, requested that banks accelerate their clean-up, but the government also introduced loan guarantees for small firms and requested that large banks increase their lending to these small firms.[i]

As a result, with every step forward towards adopting more market-oriented measures – which is the explicit goal of Minister Takenaka – Japan seems to be taking at least a half step backwards. Mr. Takenaka’s plan is for Japan to reorganize and rejuvenate the banking system and the industrial structure, so as to allow young firms easier access to capital and help large, healthy firms to drive the country’s economic recovery. However, other parts of the government – namely, the various ministries in charge of certain industries such as retail, construction, or transportation – are structuring protective measures aimed to save firms from the discipline of the market. In addition, these protective measures are not simply welfare transfers, but they are implemented through increased government participation in the market, e.g., through subsidized loans offered by government banks to small firms. One might argue whether Japan is really best served by more market orientation; this, however, is not the point of this paper, since Minister Takenaka, with the backing of Prime Minister Koizumi, is already committed to this course of action. Rather, the issue here is why Japan is adopting these contradictory measures that have so far stalled most reform programs.

This paper argues that the main reasons for the government’s tendency to introduce protective measures to counterbalance the effects of market reforms are an insufficient welfare system and Japan’s existing social contract, which does not tolerate uncertainty and social suffering. For Japan to truly move towards more market orientation, some large and very many small firms would have to be weeded out, thus leading to higher structural, and therefore long-term, unemployment. While Japan’s unemployment insurance – which covers an unemployed individual for a maximum of 330 days – was recently restructured and seems to function, there is a huge welfare gap for the long-term unemployed. Thus, if somebody were to be laid off in his early 50s, he would have to rely on his savings until he qualifies for pension, however meager, at age 65. Women are mostly hired as so-called “part-timers” and as such cannot claim unemployment insurance or pension; only in March 2003 was a change made so that part-timers qualify for partial pension. Re-employment would be particularly difficult for previous owners of the very smallest firms in the service and manufacturing sectors, such as tatami (rice straw mat) makers, public bathhouse operators, or fourth-tier suppliers of automobile and electronics parts. In fact, these very small firms are a huge part of the problem. While dominant in number, these firms are not usually well off to begin with, and now find themselves without assets, competitive capabilities, or a safety net after years of recession.

Japanese small firms are central to the country’s society, and now also to its economic reforms, in ways different from most other nations. More than 99% of Japanese companies are small (defined as having fewer than 300 employees or capital of less than ¥300 million Yen), but more importantly, 75% of Japanese firms are “very small”, with fewer than 20 employees in manufacturing, or fewer than five employees in distribution and services (more details below). These very small firms employ more than 20% of the workforce, and almost half of the construction industry workforce (not counting “part-timers”, i.e., women, who account for a large portion of small firm employees).

Knowing that small firm owners and employees on average can live on their savings for perhaps four years, and being aware that the current national welfare system is not equipped for this situation, Japan’s government is attempting to compensate for this deficiency by artificially keeping many companies in business through subsidy programs. Rather than designing an incomes policy that is market- and price-neutral (by collecting taxes and granting welfare checks), Japan’s government is participating in the market through subsidized loans and other projects that erode the effects of market-oriented reforms.

As long as this course of action prevails, Japan will be unable to reform. Foreign analysts, as well-meaning as their advice is intended to be (e.g., Krugman 2002, Posen, 1998), must not neglect the role of small firms in Japan’s economy and society, lest they fall into the trap of simply starting with their implicit assumptions about their own economy and generalize to solutions that a more sophisticated understanding would realize are inappropriate or incomplete. The root cause of Japan’s dilemma is that the government is unprepared to live up to its responsibilities within the country’s current social contract in market-neutral ways; or said differently, Japan’s government is unable to let go of its old ways of guiding the markets. The government will only be able to implement true market-oriented reforms if it is also willing to provide market-based welfare benefits to long-term, structurally unemployed. As long as the government balks on this responsibility, it will have to continue protecting inefficient and de facto bankrupt firms that have either many employers or many suppliers from its own reform measures.

Japan’s Social Contract

A social contract, at a very basic level, is a covenant, usually not codified, by which the society and state are constituted. While going back in its origins to the Greek sophists and later the great state philosophers of the 17^th and 18^th centuries (e.g., Locke 1690, Rousseau 1762), who were trying to come to grips with the relative roles of citizens and the state as well as the legitimacy of the state’s authority, in contemporary use the concept is often more narrowly applied to incomes policy. In particular, it addresses the question of how many services the government has to provide in return for its right to reduce citizen’s incomes, be that through high taxes, high prices, or other means. Reflecting significant differences in basic societal assumptions and preferences as well as political and economic struggles within and across nations, countries differ in how they have crafted this social contract over the course of their histories. In postwar West Germany, for example, the covenant reached between state, taxpayers, businesses and labor was that the state would be allowed to reduce household incomes and tax companies significantly, as a price for a reliable and comparatively generous social security system, free education, social stability, and general health care.

A social contract, grown over time and inclusive of a country’s leading interests as well as societal norms and values, is difficult to change, either incrementally or radically (e.g., Olson 1982). This is not only because the contract is not spelled out and signed; and neither is it just because of the economic logic that existing agreements on government transfers (such as subsidies, welfare payments etc.) have created vested interests that oppose change. Rather, a change in the covenant would require a change in fundamental values and implicit contracts in the society – something that was not at all observable in Japan in 2003. Instead, as the recession continued, Japanese citizens seemed to be ever more concerned with the existing values of security, stability and certainty.

Japan is not the only country, of course, where the existing social contract has created barriers to the change needed for a successful transition to a post-industrial society. For example, many in the U.S. are unhappy with a system where, in spite of significant country wealth, more than 40 million people are without health insurance. In Germany, a generous welfare system has created incentives against working, and it is beginning to bankrupt the country. Yet even in the face of such obvious problems, doing something about the social contract, the vested interests it has created over time, and the societal values it reflects, is an enormously difficult challenge. Such a change would require a transformation of the values and reciprocal deals that society would have to agree on, and politicians who are willing to look 50 years ahead (instead of up to the next election) to push it through. For these reasons it is rather inconceivable that Japan will change its social contract to fight the current recession.

Japan’s Social Contract in the Period of Postwar Growth

The story of Japan’s postwar economic growth and success has been well told (e.g., Nakamura 1981, Johnson 1982). Based on strict financial regulation, the government assumed a huge role in guiding the economy towards growth. It channeled funds with preferential conditions to “strategic industries” that were politically and pragmatically determined as export firms. In the 1950s and 1960s, these were steel, energy, and heavy machinery, petrochemicals, chemicals, and shipbuilding. Within a short time, their fast growth transformed Japan’s economy from an exporter of toys and textiles into a heavily polluting economic juggernaut. The 1973 oil crisis then triggered a feat of industrial restructuring: after one decade of recession and suffering, Japan emerged as a leading world power in precision machinery, electronics, cars, banking and insurance. Underlying these stunning performances were, most importantly, a producer-oriented policy of keeping costs of borrowing low; a particular form of flexible, informal regulation based on close ties between businessmen and bureaucrats; a stable political system; a high savings rate; hard-working, well-educated people and advanced corporate skill formation techniques; a supportive world economy; a lot of managerial ingenuity; and maybe a little bit of luck.

Based on the dominant interests at the time – large businesses, bureaucrats with war-economy experience, and politicians -- in the immediate postwar years, a social contract emerged that centered on producer-oriented policies and large firms. The notion was that if large firms could grow fast, they could provide employment and carry the rest of the economy with them; even if large firms accounted for only a third of total employment, over time the small firms would benefit from their spearheading the development. This fast growth of large firms was supported by a series of policies including low interest rates (to keep the cost of borrowing low), and by allowing large firms to charge high prices (by way of limited antitrust enforcement and proactive government guidance on uniform price-setting; Schaede 2000). In return, large firms offered “lifetime employment”, not as a contract or legal obligation, but rather a social norm, a part of an understood bargain as the price to pay for their privileges in the system. At the time of early retirement in the mid-50s, “lifetime” employees received a lump-sum “pension payment” of, on average, two-to-three annual salaries, and then were helped to find continuing employment in smaller firms that were usually affiliated with the original employer. This continued employment, and the repeated lump-sum pension payouts, increased the employees’ lifetime incomes.

This system, combined with fast economic growth, made a national, fully-fledged pension and welfare system less essential – even for small firm employees, as we will see shortly. Pension payments remained comparatively low, and were thought to supplement after-retirement income of an employee, either through working in a small firm or using up his lifetime savings, rather than be the sole source of income. The system of lifetime employment also greatly reduced the need for a comprehensive unemployment insurance system. Only in 1973 did the government begin to tackle the dicey issue of building a social security system, though initial efforts were soon thwarted by the 1973 oil shock. Pension payouts and the general welfare system in Japan remain comparatively limited to this date.

For households, the social contract tradeoff was social stability at the price of low real incomes (low returns on savings, low wages, and high prices). Stable employment for a growing portion of the workforce led to increasing income certainty and good education, and with continuous high growth rates life was getting better as households benefited indirectly through a slowly improving infrastructure. Households largely agreed to producer-oriented policies and cartels because they highly valued the resulting stable, predictable employment and social development. The Liberal Democratic Party held power without interruption between 1955 and 1993.

The social norms and values underlying this covenant were risk aversion, societal stability, perceived income equality (expressed in repeated public questionnaires, yoron chōsa, in the 1970s and 1980s, when 90% of households regularly considered themselves “middle class”), education, and safety. In this system, no huge bankruptcies would occur, and no social unrest would be fueled. Everybody proclaimed to be working as hard as possible, all under the heading of a common effort for the common good.

This interpretation of Japan’s social contract is based on a synthesis of numerous writings by Japanese authors on the country’s postwar success, and is also often reflected in political speeches and corporate public statements. As is true for social contracts everywhere, there were dissidents. What is more, some parts of society were overlooked in this arrangement. In particular, there was little if any room in this covenant for one group that is both large and arguably most crucial for economic reform in the 21^st century: the small and very small firms. As long as macroeconomic conditions remained strong, small firms benefited indirectly, but since the 1990s it has become clear that they are outsiders in this system.

Small Firms in Japan

Until 1999, “small firms” in Japan were defined as manufacturing firms with capital of less than ¥100 million and/or less than 300 employees; for the wholesale, retail and services industries, the limits were significantly lower. Given economic growth and industrial change, these limits were raised through a 1999 reform of the “Small- and Medium Enterprise Basic Law”, so that manufacturing firms now are “small” if they have capital of less than ¥300 million and/or fewer than 300 employees.ii There is no legal definition for very small firms. In the leading statistics, e.g., those produced by METI’s Small- and Medium-Sized Enterprise Agency, these are considered to have fewer than 20 employees in manufacturing, and fewer than 5 employees in wholesale, retail, food and services.[iii]

Figures 1 and 2 shed some light on the current situation of small versus large firms in Japan. Figure 1 highlights the situation often referred to as Japan’s “dual structure”: large firms, while accounting for less than 1% of all firms, employ about 20% of the workforce. It is this 20% of the workforce (plus those in the government and public firms, which are not included in the data), plus the employees of the primary suppliers to these large firms, that have gotten used to the expectation of “lifetime employment” in the postwar period. Looking at the data by industry, we see in Figure 2 that the very small firms are most important in the construction industry, where they account for 95% of the firms and employ 45% of all workers. Other industries where very small firms stand out are, not surprisingly, restaurants and food services.

Separate data also show that in 1997, small firms accounted for 55.7% of value added, and 50.8% of shipments in manufacturing, 64.2% of shipments in wholesale, and 75.7% of shipments in retail.[iv] Overall, the two figures underscore that Japan’s industry is indeed dominated by small firms.

Interestingly, international comparisons are complicated and easily cause misinterpretation. For one, the definition of a “small” firm differs across countries, and in the U.S. also greatly across industries and policy issues. Roughly speaking, in the U.S., manufacturing small firms are considered as those with fewer than 500 employees (1000 in automobiles, and 1500 in aircraft). In construction, “small firms” are those with 700-1,700 employees – this is more than five times the limit used in Japan. In general, U.S. limits for what is “small” are much higher than in Japan.[v]

In Europe, Germany has traditionally been somewhat closer to Japan in its definition of “medium firms” (defined as those with fewer than 500 employees or annual sales of less than DM 100 million), and “small firms” (fewer than 9 employees or sales of less than DM 1 million). In 1996, the EU developed its own definition of a “small firm” as one with fewer than 250 employees or annual sales of less than 10 million Euro.[vi]

In addition to these definitional differences, there are also great discrepancies in the societal and economic standing of “very small firms”. Official data indicate that in the U.S., as of 1995, 98% of firms were “small”, employing 53% of the workforce and contributing roughly 47% of GDP. While this seems to be similar to Japan, note that in addition to the larger size limits on “small”, the U.S. tax system sets incentives for individual professionals to become “proprietorships”. Of the total of 22.6 million U.S. firms in 1995, only 6.4 million firms had any employees at all.[vii]

Using the EU definition of less than 250 employees, in 1996 in Germany, 99.6% of firms were “small”, employing 57% of the workforce. Germany, therefore, is in a similar situation as Japan, with the important difference that Germany’s social contract is clearly geared towards small firms.

In Japan, the “very small firms” are not usually highly skilled consultants, lawyers or other professionals, but rather establishments with two or three employees. These could be startup firms and successful small businesses, but importantly this group also includes numerous traditional, small-scale industries such as tatami (rice straw mat) weaving, tōfu or small plastic (lacquer-) ware production. Such firms also include the small stationery and grocery stores, public bath houses and what might be referred to as “mom-and-pop drygoods stores” that sell mostly cigarettes and instant noodle soups. There are many social, political and economic reasons why these small stores continue to exist in Japan, one of which will be discussed next.[viii]

Small Firms and the Social Contract in Japan

Unlike elsewhere, the division into “large” and “small” also divides Japan’s society. On the “large” side are the “sarari-man”, the suited white-collar workers who commute to a downtown office building, and about whom so much research has been conducted. Their children attend the country’s best universities, in order to enjoy a similarly stable employment, and they receive help in finding a series of jobs after retirement, in affiliated smaller companies.

On the “small” side, workers are usually not white collar; rather, they may be engineers who do office work, but even then they usually wear the plant uniform. They may have attended a regional university, and they do not expect lifetime employment. In fact, on average they are laid off more than once (Aoyama 2001). Because they usually have some transferable general knowledge – be that in engineering, chemistry, or another science – they are often hired by another small firm. Japan’s current unemployment insurance system is geared towards these workers: after being laid off, Japanese workers receive a fairly generous 80% of the last salary, but only for six to twelve months, depending on age. During the postwar period of rapid growth, many employees of small and medium-sized firms could find another job within half a year.

The very small firms with less than five employees are different again; in many cases, employees are family members. When a very small firm faces hard times, the family has to rely on their savings, relatives, or the local community for support. The savings rate in Japan continues to be high, even among the poorer part of the population, for exactly this reason.

Japan’s government policies are concerned with small firms to some degree. To compensate for the disadvantages in terms of export promotion policies and lack of lifetime employment, government and business over time established two mechanisms that were meant to tie at least the medium-sized firms into the logic of the covenant. The first was a series of laws that protected small firms from exploitation by large firms and allowed cooperation through cooperatives. The first such law was the “Small- and Medium-Sized Enterprise Law” of 1957; a series of other laws that followed in the 1960s. These offered preferential financing, subsidies and other support mechanisms for small firms. A new series of small firm support laws passed in the late 1990s and early 2000s indicates that this policy continues.

A second stabilizing mechanism for small firms developed through the so-called subcontractor (shitauke) system. Several authors have explained the economics of this particular system, especially for the automobile industry (e.g., Smitka 1991, McMillan 1990). The social relevance of the subcontractor network was that it provided stability and certainty through exclusivity for the small suppliers. By having an exclusive tie-up with one automobile maker, the medium- or small-sized supplier small firm benefited by receiving management support and technological upgrades from the buyer, and being supported (though often squeezed to minuscule margins) in times of recession. The main benefit for the small firm was a predictable, stable series of incoming orders that provided safety and survival through business cycles. This stability allowed the firm’s employees to expect quasi-lifetime employment.

While the automobile industry was special in the degree to which subcontractors had exclusive relationships with large firms, the social logic held even for small firms that were non-exclusive suppliers. As long as they had a repeated relationship with a larger firm, the small firms could consider themselves fairly safe. This explains why, in spite of numerous accounts of large firms inappropriately squeezing profits of suppliers and not paying bills when due, even as of 1998, 47.9% of the small manufacturing firms (and as high as 76.4% of those in the textile industry) opted to be in a subcontractor relationship (Yabushita/Bushimata 2002).

For the very small firms, no such logic exists. Very small manufacturing firms were often “4^th tier” suppliers to small firms, who in turn supplied to firms who supplied to the large firm. The very small firms were usually easily replaceable, and therefore not assured of any help in times of trouble.

It is the substantial number of small and very small firms that are now in trouble. Of a postwar record-high 19,164 bankruptcies in 2002, 18,889 were of small- and medium-sized firms (METI SMEA 2002b). If economic reform were truly pushed towards market orientation, as Minister Takenaka has suggested, then even more firms should be allowed to fail, and the number of bankruptcies as well as unemployment would skyrocket. In a way, unemployment may be the tell-tale indicator of Japan’s reform progress: as long as it remains at 5%, one must suspect that artificial job maintenance is continuing, and that the market is not allowed to work on the allocation of resources. The main reason why the government is continuing this intervention in the job market through saving large, de facto bankrupt firms is that the country’s welfare system is ill-equipped to handle a large number of permanently unemployed Japanese.

Moreover, the way in which Japan’s government has chosen to provide direct support to small firms further undermines ongoing reforms. Observable in industry after industry, perhaps this is most visible in banking. Through three government banks for small firm finance, the government is offering special loan program to small firms at subsidized rates, which private banks claim distort market rates.[ix] Small firms are also eligible for public loan guarantees that allow them to borrow from private banks. These government loans and loan guarantees have been greatly increased since the late 1990s, and then again in October 2002 with the aggressive move toward banking reform. For very small firms, these loans and guarantees are as easy to get as welfare, but they save the borrower’s face.

To give just one hypothetical example, a 51-year-old tatami weaver who is unable to sell rice straw mats due to the continuing recession, can opt to close down his store, receive unemployment for one year, and live off his lifetime savings for perhaps four years. At age 56, he can either apply for welfare and move in with his children (since welfare will be insufficient), sell his house and become homeless, or commit suicide (with the added “advantage” that his wife and children may receive a more generous single-mother welfare program). Alternatively, if this person were to keep his store open, he could receive a series of government-sponsored loans that would be largely equivalent in function and even volume to welfare.[x]

Thus, given the way in which the government is offering support, a bankrupt small firm faces incentives to stay in business rather than closing down. While in terms of welfare provision, offering subsidized loans to very small firms may be equivalent or better (in terms of personal self-esteem, etc.) than a monthly welfare check, for the Japanese economy as a whole this direct government participation in the market is distorting. As it occurs in banking, it undermines reform efforts to clean up the banks’ balance sheets by suppressing market interest rates and thus bank profits; as it occurs in construction, it creates artificial demand at below-cost prices. For one industry after another, we find that the very way in which Japan’s government is supporting very small firms by offering “make work” schemes is undermining true reform.

The Social Contract after the Bubble

The social contract was not on people’s minds during the “bubble economy” of 1987-1991, when an easy monetary policy, a land price boom, and a stock market frenzy coincided to trigger speculative investments by almost all parts of society. Even when clear signs of a “bubble” economy became visible, hubris led politicians, bureaucrats, firms and households to believe that their system had made them a world leader, and therefore Japan’s land prices would never collapse. Rules on pension fund investment were deregulated, and public welfare corporations joined in the investment frenzy, as did the postal bank’s life and pension insurance systems.

When the bubble burst, banks and large companies faced huge amounts of bad loans. Private life insurance companies came under great strain when losing fortunes in the crashing stock market (and in the deflation of the late 1990s, when for several years interest rates were much lower than the insurance payout premiums). Some life insurance companies were closed down in the mid-1990s, spelling a social disaster: not only was there limited funding for social security to begin with, but with the stock market returning to 1985 levels, Japan lost tremendous amounts of private and public social security buildup.

Given these “bubble” losses, and the ongoing transition to a post-industrialized and rapidly aging society, Japan’s social security system came under increasing pressure. First, as large firms caught up with Western technology and then began to mature, they faced growth limits, making them unable to hire more “lifetime employees”. Because lifetime employment used to be coupled with seniority wages (i.e. increase in wages depending on tenure with the company), this system was predicated on continuing growth. To lower their costs, many large firms moved production abroad, thus reducing their domestic workforce and putting pressure on their suppliers. Second, with financial globalization and deregulation, the financial system had been opened up. This meant that Japanese firms faced increased costs of borrowing, and Japanese banks lost their previous profit cushion (guaranteed through the spread between loan and deposit rates under interest regulation). Third, with trade liberalization based on legal reforms in the 1980s and 1990s, many industries faced more import competition; while some industries were successful in keeping their markets closed, others opened.[xi] Furthermore, over many years of high economic growth, lifetime employment had become almost institutionalized through a series of court decisions that made it increasingly difficult for firms to lay off workers. While there were ways around the rules, during the recession of the 1990s large firms could not easily restructure. One large firm after another found itself in trouble, unable to launch a managerial turnaround given institutional constraints. With an increasing number of large firms facing bankruptcy, large banks – fighting a bad loan problem – were less and less able to bail out their clients.

A 2001 change by the Ministry of Labor on employment rules made large-scale lay-offs of certain non-performing employees a possibility (previously, a demonstrated incapability to perform a certain job was insufficient reason to dismiss a worker; the employer was obligated to find the person a different position within the company). However, after the 2001 change in rules, the politicians became even more active in intervening in corporate failures: nearly every time a large firm faced bankruptcy, the government apparently felt that it was its responsibility to protect employment. Thus, for example, while pushing large banks to clean up their bad loans in 2002, the government requested these same banks bail out failing firms that happen to be large employers and large buyers from small firms, such as the Daiei discount chain or Sogo Department Store. Later in the same year, the authorities agreed to purchase shares from banks to raise the banks’ equity ratios. Again, a reform measure – the clean-up of banks -- was accompanied by a status quo preserving countermeasure.

Thus, good reforms were undermined because the government had neglected to construct a meaningful public safety net for employees. The concerns were gravest for the smallest firms that had the fewest resources to lean on, and thus were hit the hardest. A conspicuous increase in poverty and homelessness in the early 2000s made it increasingly apparent that Japan’s government had defaulted on its responsibilities within the social contract. Most politicians, therefore, were keenly interested in maintaining official unemployment data at the 5% level, lest they be voted out of office or stir social unrest in the country.

The underlying motivation for this behavior is that Japan’s social contract — with the implicit political obligations and bureaucratic rigidities — is based on the pillars of stability, certainty, and security, and therefore does not allow a sharp increase in homelessness and other social suffering that would be the necessary result of truly market-oriented corporate restructuring. In a way, Japanese leaders may not sufficiently believe in the market to promote true market-oriented reform. Thus, when Minister Takenaka began to promote his reform program, many of the older members of the Liberal Democratic Party pushed for more compensating countermeasures that offered small firms some measure of protection from the harsh effects of these market-oriented reforms. Every protective moves created new problems to solve, such as the loan guarantees that made it more difficult to close down small credit cooperatives that were effectively moribund. As a result, reforms had limited effects, and required more “reforms” to deal with the newly created issues. As a result, “reforms” in the 1990s and early 2000s took the painful, winding path they did.

Conclusion: The First Step

Many observers agree that Japan needs to fundamentally change its industrial structure – not unlike it did after the “oil shock” in the 1970s – if the economy is to adjust to Japan’s new status as a post-industrial society with an emphasis on the service industries. Even those who argue that some of Japan’s features may be preferable to those of more market-oriented economies will have to agree that a weeding out of the old dinosaurs – large and small – can only be beneficial. Accordingly, Japan’s prime minister has appointed a team that is diligently working on the reform of banks, companies, and rules. Yet the overall economy has been resistant to change, because with every reform measure comes a counterbalancing quasi-welfare measure that impedes true reform.

There are several political and societal reasons for this resistance to change, but the biggest systemic reason, this paper has argued, is the lack of welfare system sufficiently funded to absorb a high rate of structural (i.e., long-term) unemployment that corporate and industrial structure reform will necessarily bring about. If Japan were to tackle the issue of economic structure reform at full force, unemployment could easily double. Already, at an official level of 5%, Japan’s incidence of poverty, homelessness, and suicides has skyrocketed.[xii] Many politicians therefore push hard to protect small firms as well as some large firms that have either many employees or many small-firm suppliers.

The lack of a full-fledged welfare system also depresses consumption. As of 2002, the average household had savings of an estimated 500 million Yen, which is estimated as lasting for about four years for an extremely frugal family of three.[xiii] Wives are worried that their husbands may suddenly be laid off, and therefore suppress consumption to save for this eventuality. A reliable and adequate welfare system would alleviate many of these fears. The critical role of social security and Japan’s social contract is overlooked by many in the U.S. who have pushed for macroeconomic policies that pull Japan out of the liquidity trap (Krugman 2002), or inflation targeting to fight deflation (e.g. Posen 1998). These proposals may be based on a misreading of what the market reforms have actually accomplished in Japan.

A first basic step towards reform in Japan is to introduce a social security system capable of cushioning the negative social effects of reform. How exactly this system should be financed is a subject that warrants a separate paper. Note, however, that what is necessary at this point is the government’s promise and commitment to provide welfare support – which could be funded through future revenues. In fact, this commitment already exists, as is evident in the government’s generously subsidized loan programs for very small firms, the government’s participation in small firm finance through public banks, and the support offered to banks that are willing to bail out de facto bankrupt firms.

However, one has to take issue with this “big government in the market ” approach: welfare payments, as laid out in the social contract, are best arranged through a transfer of wealth from the rich to the needy, e.g. through progressive taxes. The Japanese government, instead, is participating in the market through low rate loan programs, loan guarantees and other such means. The upside of this approach is that the recipient does not have to visit the welfare office, but can go to a bank and continue to run his business, however inefficiently. He thus saves face, something that continues to be very important in Japanese society. The downside of this approach is price distortion in the market. If Japan really wants to move to more market-oriented measures, the government has to consider a more direct and transparent incomes policy.

References

Endnotes

*I am very grateful to Charles O’Reilly III., Patricia Hagan-Kuwayama, Hiroshi Fujiki, Peter Gourevitch, Takeo Hoshi, Hugh Patrick, and two anonymous reviewers for extensive and extremely insightful comments on earlier drafts.