Twenty years ago, when Ezra Vogel published Japan as Number One: Lessons for Americans, the lessons seemed all too clear. Today, as Japan falls into a severe recession, it's a different story. The Japanese economy hasn't just stopped growing; it's hurting the very workers it claimed to protect. Wages are falling, pensions are being chiseled away, two million manufacturing jobs have already been lost, and the unemployment rate -- already at a postwar record -- continues to rise. Ironically, despite Japan's export-driven economic formula, it is the only major industrial nation that trades no more today relative to gross domestic product (GDP) than it did four decades ago.
While Japan's current problems have been worsened by East Asia's general economic crisis, their roots lie in the country's long-standing policy of protecting its domestic markets. Exactly why protectionism should have had these delayed effects is not widely understood. The lessons of Japan's current predicament, moreover, are not only for protectionists. Japan also demonstrates how the political pressure for protection can become irresistible when the social safety net lacks strength and resiliency.
A DEFORMED DUAL ECONOMY
Japan is a textbook case of an economy that once thrived through the selective use of protectionism but soured because it failed to evolve. The Japanese economic model -- industrial policy, import protection, corporate collusion, and bank-centered finance -- once served as a marvelous transition belt, helping a poor agricultural country catch up to the world's industrial leaders in record time. But after reaching economic maturity in the 1970s, the country failed to move on. As a result, Japan now has a deformed "dual economy" of super-strong exporters and extraordinarily inefficient domestic sectors.
Most of the star industries from Japan's export sector owe their initial takeoff to the promotional policies of the 1950s and 1960s. These include autos, consumer electronics, semiconductors, and machinery. Back then, these really were infant industries, lacking the economies of scale and learning-curve efficiencies to compete globally. A temporary period of import restrictions and subsidies gave them an indispensable jump start. In the early 1950s, for example, the Japanese auto industry was rescued from oblivion by a solid wall of barriers against cheap European imports.
But in the 1970s, Japan also extended protection to a host of industries that had either ceased to be competitive (like basic steel) or never had been (like cement, glass, and petroleum refining). In so doing Japan made a critical shift from promoting winners to protecting losers. Like a permanent crutch that atrophies the muscles, protection left whole industries ossified. In food processing, for instance, Japanese productivity is an abysmal one-third of United States performance. Yet, it employs almost two million people -- more than auto and steel combined. Low imports didn't directly create these inefficiencies; domestic cartels, price fixing, and other anti-competitive practices are to blame. But these slipshod practices never could have been sustained if imports had been free to come in and seize markets.
The deep industrial slump that followed the 1973 oil shock was the initial impetus for Japan's renewed protectionism. Such industries as aluminum, petrochemicals, shipbuilding, textiles, and basic steel -- accounting for half of Japan's manufacturing output and a third of its factory workers -- were permanently priced out of the market. Companies and workers unwilling or unable to endure the pain of downsizing cried out for relief. Tokyo's decision to provide it was driven in part by an instinctive protectionism and a desire to bolster companies that had invested billions in now-useless plants and equipment. But an electoral calculus deeply rooted in Japanese politics was also at work. By the 1970s, the traditional bases of the ruling Liberal-Democratic Party (LDP) -- farmers and "mom and pop" retailers -- were shrinking as a share of the electorate. Meanwhile, blue-collar workers, who traditionally supported the Communists and Socialists, were increasing. In the face of predictions of an imminent defeat, the LDP supplied massive "save the jobs" protectionism to win over the labor vote.
Politically, the bargain worked. The LDP's share of the labor vote rose from 27 percent in 1965 to 40 percent by 1980, and, with one brief interruption, the LDP has stayed in power ever since. But the economic cost was severe.
Explicit protectionism was also accompanied by other government policies that had the effect of shielding Japanese industry from the consequences of slack productivity. Throughout the 1970s and 1980s, Japan's government officially authorized "recession cartels" in industry after industry. These cartels allowed industries to fix monopolistic prices and to allocate production cuts and investment quotas to their members. Efficient companies that could have undercut the cartel price were sometimes coerced into joining under pressure of government fines.
While there were no formal restraints on imports in the cartelized sectors, imports were nonetheless negligible. And in fact, import impediments acted as indispensable supports for the domestic cartels. How could Japanese producers have charged domestic customers 60 percent more than world prices for steel, 70 percent more for cement, and 64 percent more for petrochemicals if imports had been allowed to come in freely? They couldn't have. Not surprisingly, in each of these industries imports as of 1992 remained negligible, comprising only 1.2 percent of cement, 7 percent of steel, and 8 percent of petrochemicals.
Under pressure from the United States, Japan abandoned formal cartels in 1987, yet the same collusive practices have continued to this day. In the cement industry, where five companies control about 60 percent of sales, members of the construction association promise not to buy from any cement firm that sells below the cartel's price. Cement firms vow to cut off supplies to any construction firm that tries to undercut its competitors by buying cement from a "cheater" or a low-cost import. In one famous case in which a construction firm did order Korean cement, the cement cartel successfully pressured Japanese longshoring companies not to handle it. These practices violate Japanese law, but they continue unabated because the government turns a blind eye.
THE POLITICS OF PROTECTIONISM
It would be easy to dismiss Tokyo's new round of protectionism in the 1970s as crass electioneering, but that would miss a broader political dynamic that should be particularly instructive for American policymakers. No modern democratic state can actually practice "Let 'em Drown" free trade for any length of time; a voter reaction will inevitably set in. Hence, all modern states have to provide some sort of social safety net -- in North America and Europe, via the welfare state; in Japan, via the welfare society.
Japan does have such government programs as unemployment compensation and deposit insurance, but their funding is woefully insufficient. Instead, Japan relies on a "convoy system," where the strong and efficient buoy the weak and inefficient. The predominant responsibility rests on individual companies and families. Big companies provide "lifetime employment" to about a third of the workforce and find work for small suppliers during slumps -- at reduced prices. Wages are cut, but people are not thrown onto the streets. Banks on the brink of failure are simply taken over by bigger banks.
The catch is that sustaining this "share the pain" philosophy leads almost inevitably to systemic inefficiencies and bloat. If banks can't be allowed to fail, neither can many of their borrowers. And if secure employment depends on keeping people on the payroll -- rather than transitioning them to new jobs elsewhere -- companies can't be allowed to go under either. Even Japan's notorious high prices are really a form of disguised unemployment as well as a mechanism of income redistribution from the efficient to the inefficient. For example, consumers pay high prices to Toyota, which in turn pays high prices for glass, rubber, steel, electricity, and even wages since food prices are so high.
COMES THE SQUEEZE
In the long run, this sort of disguised safety net was sustainable only as long as the superefficient export sector could continue subsidizing the inefficient domestic sectors. But by the late 1980s, the exporters could no longer afford the burden. They were caught in a squeeze between high costs at home and a rising yen, which made it difficult to pass along those high costs in exports. But what made this such a bind was that the high value of the yen was itself rooted in the need to rein in Japan's growing trade surpluses.
As exports continued to rise without proportionate increases in imports, Japan's trade surplus swelled. In our political climate where we so often fret about the consequences of trade deficits, it may be hard to imagine that trade surpluses could be a cause for concern. But, for economic reasons, the rest of the world is unable to absorb a Japanese trade surplus any larger than 2 to 3 percent of Japanese gross domestic product. Hence, if Japan refuses to import more than 10 percent of GDP, then it cannot export more than 12 to 13 percent of GDP no matter how competitive its industries are. If Japan were willing to import 20 percent of GDP -- as it should if it acted like other countries -- then it could export 22 to 23 percent of GDP.
Whenever growth in Japan's exports starts to produce a trade surplus straining that 2 to 3 percent limit, then the yen has to rise to restrain those exports. In fact, for 25 years Japan has been on a roller coaster cycle: a rising trade surplus causes the yen to rise, which slows exports and brings the surplus back down; then the yen drops again, which causes the surplus to rebound (today we are in a low yen/rising surplus phase). With each passing cycle, the peak yen rate is higher than in the cycle before. The great irony is that, despite Japan's attempt to promote export-led growth, its own protectionism has made it the one major country that actually exports no more relative to GDP today than it did a few decades back.
Japan's protectionism not only raises costs for consumers at home but also limits the country's ability to export cars, VCRs, and computer chips. Today, when Japanese firms want to produce goods for export, they increasingly have to leave Japan to do it, building plants overseas from Kuala Lumpur to Kentucky. More Japanese consumer electronics are made outside of Japan than at home. And soon the same will be true of other big-ticket items, from cars to refrigerators.
The protectionism that was supposed to protect jobs ended up exporting some of the country's highest-paying, most productive jobs. After the loss of two million manufacturing jobs in the last six years, Tokyo says another 1.3 million will be lost in the next five. The losses may eventually be greater in percentage terms than what America's Rust Belt suffered in the 1979-1983 recession. And the biggest losses have come in the export-oriented high-productivity sectors of manufacturing. This "hollowing out" of the export sector has left the economy increasingly dominated by its low-productivity sectors, which has in turn steadily reduced the country's growth potential. Today, even at full capacity, the fastest Japan could grow is 2 percent -- half the rate of 1975 to 1990.
Yet, today Japan cannot even reach that meager 2 percent rate of growth. One of the biggest reasons is that cartelization of the country's economy -- so essential to the Japanese economic model -- also gives workers too small a slice of the economic pie. As each moribund sector passed along high prices to the next, Japan developed a pattern of high prices and high profits. The labor share of national income is far too low and the capital share far too high.
This lopsided income distribution creates "economic anorexia" -- that is, a chronic shortfall of private domestic demand. Corporations still rake in cash and pile up business savings at the same rates they did in the high-growth era. But with slower growth, the country's investment needs have diminished. As a result, companies have far fewer outlets for profitable investments within Japan. Every year an excess cash flow to the tune of 3 to 4 percent of GDP piles up in corporate treasuries and bank vaults, from which it is desperately thrown into property ventures from Tokyo to Thailand.
While America suffers from too low a savings rate, Japan suffers from just the opposite problem. Excess business savings means that purchasing power is drained from the economy but not poured back in. In 1986, the famous Maekawa Commission report suggested that Japan solve this problem by moving to a consumption-led economy. But that would have required the politically difficult task of dismantling the cartels. Instead, Japan's leaders injected the economy with monetary steroids, setting off the late-1980s "bubble" and the resulting mountain of bad debts. Japan's current financial mess is a symptom, not the cause, of its problems.
The only way Japan has been able to make up for the shortfall in demand is by either exporting excess production through piling up big trade surpluses or having the government sop the shortfall up in big budget deficits -- or both. During most of the 1973-1985 era, nearly half of all GDP growth came from a growing trade surplus. Today, Japan's budget deficit and trade surplus are growing, but not enough to overcome an even worse case of anorexia. Since 1992, Japan's growth has averaged only 1 percent and industrial production is below the peak hit eight years ago. Officially measured unemployment is already above 4 percent, and economists say it is heading toward 6 percent. (If U.S. definitions and methods were used, some economists say the measured rate would be at least 2 to 3 percent higher.) Meanwhile, compensation for the entire labor force has fallen 2 percent over the past year. Almost all the jobs created since 1994 have been temporary or part-time jobs without bonuses -- which in Japan ordinarily provide up to one-third of annual income. Cuts in pensions are especially painful since interest rates on savings have been cut to only 0.25 percent to keep the banks afloat.
THE MIDDLE GROUND
Protectionism may appear to provide a solution for worker insecurity and the declining numbers of jobs in high-paying manufacturing industries, but the long-term consequences are severe and debilitating. Those who would sacrifice efficiency for job security will eventually end up with neither. But the political dynamics underlying Japan's experiment with protectionism are also instructive. Without a robust safety net capable of cushioning the effects of economic dynamism and spreading the benefits of trade, the pressure for protectionism can become irresistible.
Fortunately, there is a middle ground -- and it's one that the American people have already demonstrated a willingness to vote for. Bill Clinton's platform in 1992, after all, included not just open markets at home and a drive for market access abroad, but also a raft of safety net provisions, such as an increased earned income tax credit, mandated investments in worker retraining, and lifelong training initiatives.
This was the program proposed by Robert Reich in his 1990 book The Work of Nations, and it is a formula that was developed more than 150 years ago by John Stuart Mill. The logic of this approach -- known as "free trade plus compensation," or better, "free trade and a fair shake" -- is straightforward. Trade with either developing countries or advanced countries raises economic growth for all the countries involved. (Most United States trade is with industrialized countries where average hourly wages are actually higher than ours.) But not everyone benefits equally. Trade accelerates America's shift to its own special niches in capital-intensive and skill-intensive products, raising demand for capital and well-educated labor and reducing demand for unskilled and blue-collar labor. While educated employees and owners of capital both gain, many blue-collar workers -- even those in industries not directly competing with imports -- have to accept somewhat lower real wages to stay employed. And it takes quite a while for the economy's overall growth to overcome these losses.
But it should be possible to even out these disparities, because the benefits to the winners far outweigh the harm to the losers. Suppose the winners gain $2,000 for each $1,000 lost by the losers; tax and budget measures can be used to transfer $1,500 from the former to the latter. Unlike protectionist policies or Japanese-style cartels, such transfers create no broader economic inefficiencies. In this hypothetical case, everyone would be $500 better off with free trade.
The policy agenda to accomplish these ends would include improving the Trade Adjustment Assistance program, particularly the training portion; providing lifelong training vouchers, "portable pensions," and "portable health insurance" to assist workers through repeated shifts from job to job; incrementally increasing the minimum wage; enhancing the earned income tax credit for low-wage workers; restoring progressivity to the income tax; improving aid to education, including adult education; and gearing monetary policy toward full employment.
But if "free trade and a fair shake" is such a win-win solution, why has it been so difficult to implement since 1993? The Clinton administration came into office promising a form of this program but opinions on trade policy have become increasingly polarized during the 1990s -- especially among Democrats. Here again the Japanese example is instructive. For reasons of political economy, if nothing else, the benefits of trade cannot be realized without a safety net that can make its rigors and dynamism socially tolerable. As recent reverses on fast track trading authority have demonstrated, the politics of expanding trade become unworkable unless trade expansion moves forward in tandem with robust safety net provisions. And thus the lessons of Japan are no less for the proponents of trade than they are for the champions of protectionism. "Free trade plus a fair shake" is the way to reconcile legitimate interests in both economic efficiency and worker security. It is a winning program that can end the unnecessary fratricide between pro-labor liberals and pro-free trade liberals. The counterexample of Japan should point the way.