Japan's Reforms: No Turning Back

Koichi Kato
Secretary General, Liberal Democratic Party, Japan

Speech to the
Economic Strategy Institute
May 5, 1998

Vice President Gore, Ambassador Foley, ladies and gentlemen. I am honored to address this distinguished gathering. I particularly wish to thank Clyde Prestowitz of the Economic Strategy Institute for making this possible, and the emcee for his [her?] warm introduction.

This evening I would like to share with you my thoughts, as a private individual rather than a representative of the Japanese government, regarding Japan's present economic situationﾑwhich at one point was even being referred to as a crisisﾑand ways in which we are now trying to reform our country. I will also touch on the Asian economic crisis and offer some thoughts on the world economy in the twenty-first century. I hope not just to offer my own opinions but also to learn from yours.

As you all know, until the end of the 1980s the postwar Japanese economy expanded steadily, so much so that it was referred to as the ﾒJapanese miracle.ﾓ Of course Japan, like other countries, was buffeted by the 1973 oil crisis. But subsequently, with the help of the injection of massive government funds, Japan managed to achieve and maintain the highest growth rate among the developed countries.

Early in the 1990s, however, the economy took a sudden downturn. Share and land prices fell, and growth in personal consumption began to slow. Unemployment also started inching upward. The government did not stand idly by, of course. It tried desperately to stimulate the economy with tax cuts and public-works projects. In all, some 60 trillion yen was poured into the economy. But far from picking up, the economy slumped further

It now appears that the Japanese economy underwent a major structural change in the latter part of the 1980s and that as a result, we now find that our traditional methods of economic management no longer work.

One key issue in this connection relates to our loss of a national goal.

It was exactly 130 years ago, in 1868, that Japan experienced what we call the Meiji Restoration. This marked the end of the centuries of national seclusion and the start of Japan's reemergence as a member of the international community. In the decades that followed, through a process that involved repeated trial and error, our country pursued a single consistent national goal, namely, to catch us as quickly as possible with the West. In order to achieve this goal, power was concentrated in the hands of the national government, and the bureaucracy orchestrated the nation's efforts. The process lasted for more than a century, but at least in terms of the major economic indicators, Japan basically achieved this longstanding goal around 1985ﾐ86.

Having reached that goal, naturally our country needed to set a new goal for itself. But unfortunately we followed the common pattern of resting on our laurels. Both our leaders and the general public fooled themselves into thinking that Japan could continue to develop and prosper by continuing to follow an extension of its previous path. We failed to notice that the shortcomings of the Japanese development paradigm were gradually building up below the surface.

Business executives lost sight of the basic principle of pursuing greater efficiency in their core operations; instead they turned to simplistic investments and even to speculation, which appeared to offer easy gains. Bureaucrats, meanwhile, came up with simplistic plans for public works based on their existing track record of building up the infrastructure of public facilities; with all these outlays, the nation's finances deteriorated to a critical degree. Meanwhile, in recent years we have seen an appalling succession of scandals involving bureaucratic corruption. Here too, I believe the underlying cause is the loss of a national goal, which has led to a deterioration in ethical standards.

Another key issue relates to globalization.

The present World Trade Organization was not inaugurated until the 1990s, but at least as far as trade in goods is concerned, the Japanese market was opened up to a large degree during the 1980s. Our country now only produces 43 percent of its own food, importing the rest from overseas, and it also imports all sorts of other goods, with only a few exceptions; meanwhile, Japan's products are exported to overseas markets around the world. This heavily trade-dependent structure was basically completed by the end of the 1980s.

Japanese capital also headed overseas. During the first half of the 1980s the United States expanded investment in developing economies, especially in Asia. And in the latter half of the decade Japan increased its investment in Asia and also in the United States.

Needless to say, the Plaza accord of September 1985 was a watershed event. The yen rose from 240 to the dollar at the time of the accord to 150 about a year and a half thereafter. (Even with the recent weakening of the yen vis-�-vis the dollar, it is still about twice as strong as before the accord.)

The strong yen was highly advantageous to Japanese investors in developing countries, given those countries' strong faith in the dollar. Not only financial institutions but also electronics manufacturers, construction firms, and even small businesses began moving into other Asian countries. All this investment has made these countries much more to Japan than simply import and export markets.

Like investors everywhere, Japanese investors in Asian countries thought first and foremost of the potential of those countries' domestic markets. Another motive, of course, was to take advantage of cheap labor. By outsourcing production to Asian countries, these investors sought to position themselves strategically vis-�-vis the Japanese, U.S., and European markets. In this sense, their motivation was probably the same as that of the American firms that had set up manufacturing operations overseas. Most Japanese-brand television sets sold domestically today are actually made in East Asia.

In any case, without a clear vision of how to deal with the structural changes that had occurred, the Japan of the late 1980s ended up devoting its economic energies to the formation of huge speculative bubbles.

During this period a cycle formed whereby share prices and land prices rose, the increased value was used as collateral for bank loans, and the money borrowed was used to purchase more shares and land, driving their prices up further. But once share and land prices peaked and began to fall, the cycle became unsustainable. And Japanese financial institutions are still struggling to deal with the bad loans left over from these bubble years. The weakness of the economy has led to reduction of the official discount rate, and this in turn has caused interest rates on deposits to fall.

Under these conditions, the economic stimulus produced by tax cuts is limited. Over the years the Japanese have saved virtually all their extra money. And by comparison with people in other countries, they have put a very large share of their funds into bank deposits. And they have counted on the interest income from their savings to supplement their pensions as a source of old-age financial security. But interest rates in Japan are at record low levels. The official discount rate is 0.5 percent, and interest even on long-term deposits is less than 1 percent. In other words, interest income doesn't offer much of a prospect for financial security. And when they're worried about the future, the Japanese try to save all the more, even if lower taxes give them more leeway to spend. Consumption has also been dampened by concern over the aging of the population, along with the feeling that the economy has lost its vitality and will not develop any further.

One of the main reasons the government has sharply increased its appropriations for science and technology, and especially for basic research, in recent years, is that it wants to restore national self-confidence and an optimistic vision of the future. Even if these efforts don't produce any immediate fruits, we should see the benefits ten or twenty years from now. If at that point Japanese people are able to share their dreams with people elsewhere in Asia and around the world in areas like energy and environment, our country should be able to recover its self-confidence and vitality.

In order to truly reenergize our economy, we also must tackle the task of drastically reforming our society. In order to address this challenge we are now working on a program of major reforms in six areas: public administration, public finance, economic structure, the financial sector, social welfare, and education. The top batter in this sweeping program is the reform of the financial sector, the Japanese ﾒBig Bang.ﾓ

On April 1 this year Japan implemented full liberalization of financial transactions. As a result, it has become possible to use dollars for payments even within Japan. Foreign financial institutions are also free to raise funds in Japan and transfer them overseas. In the past the so-called convoy system, whereby the Ministry of Finance exercised strong control to ensure that financial institutions moved in the same direction and at more or less the same speed, protected Japanese financial institutions from direct competition with foreign institutions at home as well as abroad. Things have changed, though. Last autumn Hokkaido Takushoku Bank and Yamaichi Securities failed. This was the first case of a ship falling out of formation because it couldn't keep up with the rest of the fleet.

In the future, as liberalization spreads and the fleet splits up, there will probably be more dropouts. But the end of the convoy system means that the decision on its survival will be in the hands of the market from now on. This is a change from which there is no turning back.

Japan's financial institutions are now doing their utmost to strengthen their balance sheets and operations so as to meet the challenge of competition from non-Japanese institutions within the domestic market. In specific terms, they are rushing to deal with their piles of bad debts and working desperately to find new investment targets.

A friend of mine who is the president of a Japanese company listed on the Tokyo Stock Exchange recently was shocked when the bank that his company has been dealing with for many years suddenly told him that they wanted to cancel their lending relationship. As they explained it, his company was in good shape, so it should raise money directly from investors on the stock market. Until now blue-chip companies like his haven't had to worry about borrowing from banks. As long as they were able to provide collateral, bank loans were basically there for the asking, and the interest rate was low. The ties with the bank were cemented on the individual level with golf and entertainment. But Japanese banks find that they can no longer keep up this sort of lending based on special relationships. In order to compete successfully, they have to look for forms of investment that offer higher yields than their traditional loans to domestic corporations, even if it means accepting greater risks. Since late last year, we've been witnessing a widespread phenomenon called kashishiburi in Japanese. Literally it means ﾒreluctance to lendﾓ; in practical terms it means a credit crunch. Like my friend's company, many Japanese corporations, large and small alike, find that the banks with which they have longstanding relationships no longer want to lend them money. This may be taken as evidence that Japanese financial institutions are now actually weaning themselves of their past habits.

The sweeping set of financial-sector reforms now underway has been dubbed the Japanese ﾒBig Bang,ﾓ after the deregulation of the securities industry carried out in Britain under Margaret Thatcher. It will have a drastic impact on Japanese society as a whole. Both banks and business corporations will find that they can no longer survive in a competitive environment by continuing to conduct transactions favoring members of their keiretsu, or corporate groups, regardless of price or quality. And products that have to pass through a long and complex distribution network will no longer be able to compete at the retail level. Winning the competitive race will require superior human resources. There's already an intense headhunting drive underway among financial institutions in Japan, and eventually this can be expected to spread to the nonfinancial sector as well. This is going to mean a major change in the traditional practice of lifetime employment, which has kept the labor market rigid and acted as hurdle to new entrants.

Starting last spring, the government has announced the outline of its reform program successively in the six areas that have been targeted. But immediately after the plans were announced, we encountered a barrage of media criticism. According to the pundits, our program was too slow and not ambitious enough. Then last fall there was a chorus of calls for us to postpone the deficit-cutting and financial-liberalization drives and concentrate on reviving the economy. But the government is continuing with the reforms. The cries of pain that can now be heard are an inevitable result of the effort to change our country. The very fact that they are so loud and widespread should be seen as a sign that Japan is actually changing.

The Big Bang and other forms of deregulation will turn Japan into a place where the cold logic of the marketplace takes precedence over the ties of sentiment and tradition.

One additional point that I'd like to emphasize here is that the bureaucracy took virtually no initiative in developing the current set of reforms. The bureaucrats were consistently incapable of finding an approach other than the linear extension of existing policy vectors. I know that the conventional wisdom among foreign observers is that policy in Japan is made by the bureaucrats, and that politicians just follow along. And I don't deny that this tendency did exist. But the current reform initiatives came from Prime Minister Hashimoto and other politicians. This too is a sign of change in our country.

It's true, of course, that an economy is a living thing, and we mustn't let reform kill it. The 16-trillion-yen economic stimulus package that the government recently decided on is like a shot in the arm in the middle of an operation. I won't go into the details of this package now, because Chairman Alan Greenspan of your Federal Reserve Board has reacted favorably to it.

Naturally we were not just thinking of domestic considerations in designing this stimulus. Providing support to deal with the Asian economic crisis was also a major element. It has been calculated that this crisis has caused the loss of 95 billion dollars in economic output last year and this year. Since last year Japan has provided 42 billion dollars in funding to help the countries affected by the crisis. The scale of the Japanese contribution can be seen by comparing it with the 11 billion dollars provided by the United States and the 1.2 billion dollars provided by China.

The United States became the world's most powerful country after World War I and is still the leader of the international economy. I imagine that American economic policies are based on consideration of their international as well as domestic impact. In Japan as well, the need to formulate economic policies that take account of the world as a whole is now widely recognized. The United States is indispensable to Japan as a security partner, but Japan's basic stance is that it must also share responsibility with America in supporting the world economy.

The contribution that Japan has been making as a locomotive for the world economy, regardless of the cost to itself, should be clear from the growth of our national debt. Back in 1975, in the wake of the first oil crisis, Japan's government debt was only 12 percent of gross domestic product. At the time, the figures for other major countries were 26 percent for the United States, 40 percent for Britain, 9 percent for Germany, and under 4 percent for France. But looking at the most recent available figures, we find that Japan's debt has grown to 75 percent of its GDP, while America's is 59 percent, Britain's 49 percent, Germany's 23 percent, and France's 27 percent. Furthermore, this is only the national debt; it doesn't include local government indebtedness, which has also swollen under direction from Tokyo. If we factor that in, the total comes to 101 percent of GDP.

EU countries that want to participate in European monetary union are required to keep their budget deficits under 3 percent of GDP. But in Japan's initial budget for fiscal 1998 the figure exceeds 5 percent. And with the April 26 stimulus package the government will be borrowing an additional 12 trillion yen.

Japan is now struggling desperately to reform itself so as to become a market that's open to the world. But this is not a perfect solution. Capitalism is now presenting us with a new challenge. I believe meeting that challenge, along with the United States, will be one of Japan's major tasks in the twenty-first century.

I still remember vividly how I was struck by trenchant criticism of the fundamental flaws of capitalism that was published in the New York Times in 1989. The author stressed that capitalism, being based on the principle of competition, doesn't encourage cooperation among people, and observed that because it pursues profits and efficiency, by nature it isn't conducive to preservation of the environment, human rights, and the historical heritage. Nevertheless, with all its faults capitalism is clearly better than other economic systems.

Fortunately, the principles of democracy can compensate for the flaws of capitalism. Under democracy we have been able to point out to each other specific faults to which capitalism can lead and deliberate and decide on steps to correct or prevent them. It is thanks to the presence of democracy alongside of market principles that advanced capitalist countries today enjoy effective protection of social welfare, the environment, human rights, and the historical heritage.

History also teaches us that democracy functions well only in affluent societies. In short, democracy and capitalism are complementary, and each is indispensable to the other. The United States and Japan, which are resolved to take responsibility for the world economy based on market principles, must also act as defenders of democracy.

It is a fact, however, that economic globalization is generating new problems. The most serious ones are those having to do with the movements of international capital, especially speculative capital. As a result of the Asian crisis, almost 100 billion dollars of wealth was removed from Asian countries over an extremely short period of time. We cannot simply ignore developments like this as the inevitable result of capitalism, but must share in the responsibility for dealing with them.

We must do our utmost to avoid a situation where people who yesterday were earning an honest living and could have dreams for the future find themselves without a job today and have no idea how to make ends meet tomorrow. George Soros wrote in the Atlantic Monthly in February 1997: ﾒI now fear that the untrammeled intensification of laissez-faire capitalism and the spread of market values into all areas of life is endangering our open and democratic society.ﾓ That this alarm was sounded by an international investor of his caliber impressed upon me the flexibility and good will to be found in the United States. The other countries responsible for the world economy cannot shrug off this warning.

International financial capital is now threatening to get the bit between its teeth and run away with us. We haven's yet figured out how to bring this unruly mount under control. I don't have a concrete solution to propose. But I fear that if economic storms like the hurricane that struck Asia last year keep recurring, we will see a backlash in the developing world against moves toward free trade and open economic systems. So if we hope to create a truly open world market, we must confront this matter head on.

Solving this problem together with the United States, the home of bronco-busting rodeos, will be an extremely exciting task for Japan. I look forward to joining all of you in meeting the heady new challenges posed by the capitalist system we cherish.

Thank you.