A major historical era is ending in Japan. Institutions that created the country's economic miracle a generation ago have now brought Japan to the verge of an economic debacle. And the changes needed to resolve that crisis will broadly affect the nation's economy, finances, politics, foreign policy, and family life.

The roots of the current malaise extend back to the years between 1937 and 1945, when most of the economic structures that still dominate Japan today were created. This "1940 system" was developed as a rational way to put Japan's economy on a wartime footing, and it served that purpose well. It also proved useful after the war; the 1940 system functioned brilliantly for many years after Japan's surrender, helping the country rebuild and leading to years of spectacular growth.

The same features that once did so much good for Japan, however, have now brought the nation to the brink of collapse. Thus the question today is no longer whether the country will reform its economy and finally abandon its wartime footing; Tokyo no longer has any choice. The question, rather, is how Japan will manage such a radical change, for the 1940 system has grown deeply entrenched in all aspects of Japanese society.


Wartime mobilization created many of the practices now regarded as distinctively Japanese and wove them into the 1940 system. As one authoritative study of the country describes,

Before the war it was common for employees to move from one enterprise to another, most industrial funding was secured through issues of stocks and bonds, and shareholders were granted high status in corporate governance. Frequent bankruptcies brought down businesses of all types, including banks, and the government introduced no economic planning or detailed regulations.

Such a chaotic system was, unsurprisingly, ill suited to the extreme demands of war. The solution was the creation of a new, highly centralized economy partly modeled on aspects of Hitler's Germany and Stalin's Soviet Union. Among the changes introduced by the Japanese government were lifetime employment, seniority pay, company unions, firms that gave priority to employees over shareholders, government policies that put banks before capital markets, and the institutionalization of policy coordination between government and corporations.

All of these changes made sense as Japan ramped up for war. The new system squeezed individual consumption to a minimum, channeled savings into the government and thence into favored industries, allowed banks to focus their lending on affiliated companies, coordinated business and government planning, and gave bureaucrats vast financial and economic power with limited political accountability. It also reduced shareholders' rights in favor of the interests of banks and employees, made it harder for workers to leave big companies, and encouraged domestic cartels and international protectionism to safeguard Japan's most important industries.

The general principles behind these arrangements, in fact, were not very different from the ideas behind the centralization of the U.S. economy during the war. The difference is that the Japanese measures went much further and lasted a lot longer -- until today, in fact. Soon after the fighting stopped, Washington dismantled much of its wartime economic system. But Tokyo instead strengthened its version. General Douglas MacArthur, Japan's postwar governor, did initially try to eliminate certain aspects of the 1940 system. He especially wanted to weaken the zaibatsu, Japan's family-controlled conglomerates. But the Japanese government complained that the country's weak economy demonstrated the need for "controlled, organized capitalism," and MacArthur subsequently concurred.

In 1949, the American banker and government adviser Joseph Dodge suggested new policies to stabilize Japan's economy. These further entrenched the 1940 system by creating the powerful Ministry of International Trade and Industry, strengthening the Ministry of Finance, permitting the emergence of interlocking corporate directorates, and giving Tokyo strong controls over trade, investment, capital flows, and currency. Electoral victories by Japan's conservatives from 1948 onward soon returned the creators of the 1940 system to power. Red purges, the revision of labor laws, and physical pummeling by new, employer-sponsored alternative unions made Japan's unions even more compliant. And when the Korean War broke out several years later, the increased American need for Japanese goods strengthened the 1940 system even more by disproportionately benefiting those industries and companies the system favored. Postoccupation legislation encouraged the cartelization of the economy.

Of course, the 1940 system has undergone important changes in the 61 years since its creation. For example, the old, family-led zaibatsu, which were dominated by manufacturing companies, have been replaced by bank-dominated groups known as keiretsu. Management and labor unions have reached a compact: workers, in return for limited profit-sharing, have agreed not to disrupt production. Japan's economy has gradually become more market-oriented. But the core of the 1940 system has endured.

For many years, this extension of the 1940 system into peacetime proved beneficial. Industries such as steel production were already efficiently organized and had the technologies they needed; what they lacked during the reconstruction era was capital, and this the government funneled to them in vast amounts. This capital supply led to a huge and rapid industrial buildup that enabled Japan to flood the world with exports; no one could compete with firms that had access to such cheap capital and that enjoyed lifetime control over a disciplined and highly trained work force. During these years Japan enjoyed the highest economic growth rates ever recorded in a diversified, advanced economy. The entire population seemed to join together in a successful common cause and was rewarded with the economic benefits of the resulting boom.


Beginning in 1975, however, Japan's efficiency and growth rates started to decline. Nonetheless, the mystique of Japan's "miracle economy" endured until 1990, as over-investment and a financial bubble masked the decline of efficiency. Those few Japanese industries that had opened up to international investment -- most notably automobile and consumer electronics manufacturing -- became exceptionally efficient and expanded market share throughout the world. Japanese banks, mustering the country's huge captive savings at very low interest rates, were able to undercut virtually any competitor in virtually any market. Their capital and assets dwarfed all competitors.

Trouble was brewing, however. The government continued channeling funds into favored industries, which created vast waste, overcapacity, and overpricing. The cartels and protectionism created inefficiency and raised costs, producing what the Japanese call "the high-cost economy," and the more efficient firms began to move overseas to escape these skyrocketing costs.

These problems blended into the great asset bubble of the 1980s. Access to easy money and fear of the rising yen led to a great investment and productivity boom. The stock market took off, reaching a value of 49 percent of all the world's stock markets combined. This explosion in the market allowed companies to raise money at near-zero interest rates by granting stock options, so companies stopped borrowing from the banks. The banks, desperate for business, poured money into mortgages, creating the greatest real estate bubble in history. The land under the emperor's Tokyo palace came to be valued at the same price as of all of California. Japan seemed to be king of the world. But when the bubble burst in the 1990s, it revealed potentially fatal problems caused by the catastrophic waste of capital.

The 1940 system had filled Japan's big banks and corporations with more money than they could use efficiently. As a result, these firms started spending the cash on risky loans and investments at home and abroad. The system encouraged banks to support favored companies without carefully researching their creditworthiness, and to stick with these companies when they became insolvent. The easy credit afforded to such favored companies led them in turn to invest in more than they could use and to purchase prestigious but overpriced trophies such as Rockefeller Center or world-famous golf courses.

An economy that squeezed its consumers and channeled so much surplus money to corporations did not provide sufficient domestic demand to fuel growth. Capital restrictions inhibited the excess money from being invested efficiently overseas. The economy could keep growing, therefore, only if Japan kept increasing its current-account surpluses -- or if the government kept spending vast amounts on fiscal stimuli. Tokyo did both. By the turn of the century, however, both sources of growth had reached natural limits: foreign countries refused to let Japanese trade surpluses get any bigger, and the government's many liabilities were becoming unsustainable.

Once crisis struck in the early 1990s, had Tokyo rapidly cleaned out the banks, forcing them to close down the inefficient firms they supported, the situation would have worsened slightly but conditions would have remained tolerable. The basic 1940 economic system might have been kept in place for decades longer, as the Japanese economy continued gradually to slow down. But Japanese politicians found it impossible to force the banks to take the necessary tough measures, and so the problems only grew worse. As a result, one of the world's strongest economies became one of its most precarious in the span of a single decade.

Now the 1940 system's days are numbered. Propping the system up yet again would require more government stimulus to offset weak individual consumption, subsidies for the banks that refuse to push their loan recipients into bankruptcy, and the rescue of banks and corporations that have become insolvent themselves. Economic efficiency would grow still worse as labor and capital continued to be misallocated and the few remaining efficient firms fled the country.

Japan is approaching its financial limits. Government debt already exceeds 130 percent of GDP. Add in other liabilities such as unfunded pensions, other public-sector debts, and contingent liabilities such as government guarantees for troubled medium-sized companies, and the number grows to well above 300 percent of GDP; one estimate, by Goldman Sachs' vice chairman for Asia, puts it above 400 percent. Such debt is bearable now only because of Japan's interest rates, which hover near zero. But by mid-decade, if Tokyo's current policies are continued, interest rates will begin to rise as they incorporate substantial risk premiums. At that point, Japan's economy will simply collapse, possibly taking much of the Asian and world economies with it.

Even before that happens, Japan will face another potential banking crisis. By some reports, the country's banking system has as much as $2 trillion in nonperforming loans, and its top 15 banks are thought to be losing more than $30 billion per year.

Numerous Western economists have proposed standard Keynesian and monetarist solutions to Japan's problems. Reasoning by analogy from the Great Depression, they argue that more cheap money and more fiscal spending will resolve the crisis. But in the Japanese context, these solutions have only exacerbated the underlying problems. Zero-cost capital has encouraged banks and corporations to keep carrying and even increase their bad assets. Fiscal stimulation has subsidized the growing inefficiency of Japan's protected economic sectors; Japan's construction industry, for example, already absorbed 10 percent of the country's work force in 1990 (when the number should have been more like 5 percent), and the country has even more construction companies today. If fiscal stimulus is attempted by cutting taxes in the hope that this will trigger a supply-side response, it will work only if there is an easy flow of labor and capital into new areas -- something the 1940 system prevents. Although stimulus remains necessary, it will work only if married to structural reform.

Japan's prime minister, Junichiro Koizumi, has proposed his own measures to address the crisis. Koizumi favors forcing banks to get rid of their many nonperforming loans -- even if this leads to bankruptcies, substantial unemployment, and a prolonged recession. The prime minister has also promised to limit the fiscal deficit to 30 trillion Yen ($240 billion). Better yet, he has proposed to start chopping off some of the roots of the 1940 system. One of those roots is the Postal Savings Bank, the assets of which currently exceed those of the entire U.S. banking system. The Postal Savings Bank gathers funds from individuals at low interest rates and then grants credit in ways approved by the government. Koizumi has suggested privatizing the Postal Bank and the mortgage business and reducing payouts to the pampered construction sector (traditionally the beneficiary of many of Tokyo's pump-priming projects). Although such proposals are a step in the right direction, however, they are inadequate to resolve the crisis.

More reforms are therefore needed, and fast; the 1940 system is about to run out of money. The largess the system provided can simply no longer be afforded, and the graying of Japan's population will only make matters worse. The unsustainability of the 1940 system has ceased to be a question of politics; it has become a matter of simple arithmetic. Actually changing the system, however, will have profound ramifications for Japan's political system, its foreign policy, and even its traditional social arrangements.


Although Koizumi has finally begun to change some aspects of the 1940 system, remarkably few reforms have been enacted before now. Japan has already stagnated for a decade, while other Asian countries with similar structural problems -- most notably South Korea and China -- have responded much more effectively. China, for example, saw the problems coming by 1994 and began addressing them decisively before the debt problem became severe. South Korea was forced to face its similar dilemmas at the end of 1997, and it has totally transformed its banking system in the years since -- closing large numbers of banks, laying off 38 percent of all bank employees, and shutting down 14 of its top 30 chaebol (conglomerates). Both countries have abandoned lifetime employment and related practices. Yet although its economic problems have been evident for three times longer than South Korea's, Japan has done relatively little.

One reason for this inaction is that Japan's financial liabilities are denominated in local currency. Consequently, the country has avoided a foreign-exchange crisis and, unlike South Korea, has not been forced to answer to the International Monetary Fund.

Another explanation has to do with the fact that Japan remains relatively wealthy and comfortable. The country's citizens are still rich enough that the rapid growth of government debt has not greatly affected their lives. The average Japanese person has seemed unaware of the growing problems and apathetic toward them. Such indifference, however, is not genuine -- as the sharp decline in consumer confidence shows. Japanese citizens may still have money, but they are no longer spending it the way they once did. Even elderly pensioners, who have no reason to fear unemployment, have cut their spending. This trend stands in sharp contrast with China, where consumer confidence and retail sales have kept climbing, despite 47 million layoffs since January 1997. Chinese consumers see Beijing addressing serious problems with painful but credible policies, and they have been reassured. Japanese consumers, however, see Tokyo hiding the country's problems, and they have been terrified. Each quarter, the difference between the countries increases: the wealthy Japanese consumer spends a little less, and the impoverished Chinese consumer a little more; Japan contracts and China grows.

At first glance, Japanese citizens seem resigned to their fate. Voter turnout, for example, has been low. This phenomenon reflects structural flaws in Japan's political system, however, and not cultural apathy. In the late 1950s and 1960s, Japanese politics were highly dramatic: campaigns sometimes involved large demonstrations and often real suspense over whether socialists or communists would gain influence. As choices have diminished, however, so has the excitement. In the past two decades, opposition parties have failed to present a coherent alternative to the colorless candidates of the ruling Liberal Democratic Party (LDP), and actual power has become concentrated in the hands of LDP elders who hold no elected office. These factional leaders, and not the public, choose the prime minister, and it is these shoguns who wield the real power.

The stifling LDP political system is the analogue of the 1940 economic structure. Even the use of the word "party" to denote the LDP is misleading; Japan's ruling party is more like a wide-ranging regime. In the United States, the Democratic and Republican parties remain quite distinct from the interest groups they serve and the bureaucracies they oversee. The LDP, by contrast, is much more tightly bound to the interest groups that support it, and this effectively gives it an equity stake in associated companies and industries. Interest groups supply party leaders with vast funds, the use of which is weakly regulated. This system, which the Japanese call "structural corruption," enables the LDP to financially dominate Japanese politics.

The LDP's integration with Japan's bureaucracy is also far tighter than in the West. Bureaucrats control about half of the government's revenues off-budget, free of normal parliamentary accountability. They can therefore funnel trillions of yen into wasteful institutions and projects that provide LDP patronage. Meanwhile, faceless civil servants become prime minister without having direct public support. Ministries force the companies they regulate to provide lucrative jobs to retiring public regulators and impose many other decisions that serve political rather than shareholder interests. Judges, whose careers depend on LDP support, tend to be compliant, and the news media remain relatively tame.

By contrast, in South Korea and China political leaders have, over the past decade, differentiated themselves from interest groups and bureaucracies enough to be able to reform them decisively. Ruling parties are no longer so beholden to chaebol, state enterprises, and entrenched bureaucrats that rapid reform is impossible. Japan has not yet taken this step in its political development, however; the rigidly integrated LDP regime still precludes dramatic reform. Only a nasty shock to the system will make change possible.

Although the LDP system has enjoyed remarkable longevity, it is finally beginning to crumble. As Japan's financial crisis worsens, the government can no longer afford the special deals, payoffs, and protections it has proffered to farmers, construction firms, property companies, banks, retailers, and other sectors of the economy to buy their support.

Moreover, after decades of apparent apathy, Japan's voters are finally becoming restive. The popularity of cabinets rises and falls wildly, with the caretaker prime minister Yoshiro Mori scoring a puny 9 percent approval rating in February 2001 and his successor, Koizumi, garnering an 86 percent rating just four months later. Nine prime ministers have held office since 1990. Around half of all voters now call themselves independents. And the results of the July 2001 election for the upper house of Japan's parliament were ambiguous; Koizumi managed to carry the election for the LDP with his reform promises, but a large number of LDP conservatives won as well. Another sure sign of dissatisfaction is the April 1999 election of Shintaro Ishihara as mayor of Tokyo. Ishihara is an impressive reformer, but a potentially dangerous xenophobe.

How Koizumi will perform in this restless political environment remains uncertain, despite his initial popularity. If he reforms the economy, as he must, he risks destroying the LDP's political support structure or facing a revolt from within the party. If he bends to conservatives in his party and does nothing, however, the public will repudiate him and the LDP. Either way, the LDP regime seems as doomed as the 1940 system. Koizumi seems unafraid to destroy either of them.


In the past generation, Japan, despite the strict constraints on its military imposed by its postwar constitution, managed to transform itself into a major power. The key to this change was Tokyo's economic diplomacy, the foreign policy counterpart of the postwar 1940 system. Although the military ban imposed on Japan by Article 9 of its U.S.-sponsored constitution may once have been a symbol of the country's ignominious defeat, it subsequently became the respected signature of Japan's unique role in global politics.

Economic diplomacy originated as a way to make virtue of necessity: Japan would take care of itself and resolve foreign problems without recourse to a large or assertive military, becoming something like an Asian Switzerland. In the 1980s, however, Japan managed to leverage its economic might, becoming a world power and preeminent in Asia. As the country's economic power increased, Japanese thinkers began to openly boast that the twenty-first century would be the Asian century, with Japan at the helm; that the yen would become Asia's currency; and that Japanese companies would manage the economies of the region. By the late 1980s, Japan had almost entirely dropped its humble postwar posture for an increasingly overbearing attitude toward the world.

Japan's preeminence in Asia rested on several pillars. First was the country's prestige. Japan grew faster in the postwar years than any other modern economy. People everywhere, especially in Asia, studied Japanese management techniques, admired its stable labor-management relations, tried to copy its banking and industrial policies, were awed by the overwhelming assets of its banks and big companies, and envied the mutual support within its giant conglomerates.

Japan also came to exert more direct financial power over its neighbors. Its banks managed the finances of much of Asia, thanks to the vast capital and easy access to cheap cash that allowed them to overwhelm their American and European counterparts. Japan's stock market was the world's biggest and best performing. The yen seemed a safe currency in which to invest.

Asia increasingly became Japan's industrial back yard. South Korean factories assembled Japanese vcrs or used Japanese-licensed parts. Thai auto-parts factories sent most of their products to Japanese manufacturers. Japan became so dominant in certain sectors, in fact, that it began to dictate some of the domestic policies of its neighbors. Once, when the Thai government tendered bids for a new steel mill, an Australian firm presented the lowest offer. Most of the potential customers for the mill were joint ventures with Japanese partners, however, and these firms simply informed the Thai government that they would buy steel only from a mill run by a Japanese firm. The Australians, needless to say, did not get the contract.

Japanese companies in Southeast Asian countries also increased Japanese influence by creating loosely integrated networks, sometimes called "villages," that allowed them to communicate and cooperate closely with Tokyo. Japanese aid programs contributed to these networks, closely tying Tokyo's foreign policy to the interests of Japanese corporations.

As the 1940 system has crumbled in recent years, however, Japan's international prestige and influence have dropped with it. Today the world admires American, not Japanese, management strategy. In Asia, China is now known as the country that faces its problems and resolves them, and this reputation has seriously undermined Japan's aspirations to lead the region. Japanese banks have had to reduce even their good loans to other Asian countries in order to cover their bad loans at home. In 1997-98, Japanese banks withdrew hundreds of billions of dollars from Hong Kong and Singapore, Asia's great financial centers, inflicting severe damage throughout the region.

Japan's industrial presence in Asia has remained pervasive; indeed, it continues to expand. But Japan's foreign investments no longer bring with them the industrial dominance or political clout they once did. For one thing, there is now more competition: American and European firms have increased their presence in Asia, and Hong Kong and Taiwan have become major regional investors. Moreover, much of Japan's investment now goes to China, which is so big that it can absorb immense amounts of foreign money without ceding political or industrial control. The interconnectedness of Japanese corporations, once an asset, has become a liability. For example, Uniqlo -- a Japanese retailer that has taken Japanese markets by storm thanks to its high-quality imports from China -- cannot compete outside Japan because it insists on using Japanese suppliers, which are often relatively expensive. More cosmopolitan firms, meanwhile, such as Hong Kong-based Li & Fung, rely on suppliers from several dozen countries and, by ignoring nationality, incur lower costs than their Japanese competitors.

The three pillars of Japan's economic dominance, then, have all fallen, and Japan's economic diplomacy has failed -- because, ironically, it was built on an economic strategy designed for war. Japan's economy remains bigger than the rest of Northeast and Southeast Asia combined, even when China is included. Japan remains an industrial presence and the region's biggest aid provider. Moreover, Japan's ability to project military power still dwarfs China's. But its edge is slipping; with so many problems at its core, Japan can no longer dominate as it once did. Galling though this may be to Japan's leaders, China is becoming ever more powerful in the region, not due to its military clout (since China has little) but thanks to its superior economic management.

None of these changes has diminished the ambition of many Japanese scholars and politicians, however, who still yearn for a geopolitical role for their country proportionate to its stature as the globe's second-largest economy. Such yearning is being expressed in a number of ways. Many serious economic reformers, for example, now advocate a more nationalistic foreign policy. Even moderate reformers such as Koizumi advocate a more assertive international posture, pushing for the revision of Article 9, a modestly more active military role, moderately increased autonomy from the United States, and regular visits to the Yasukuni Shrine, where many of Japan's war dead (including some war criminals) are buried. Some stronger reformers question the presence of U.S. bases on Okinawa, decry Tokyo's foreign-policy subordination to Washington, express strong antagonism toward China and South Korea, and, in order to weaken regional competitors, are determined to preserve Korea's division and promote Taiwan's independence.


Postwar Japan was built on a series of institutions that functioned well for both war-fighting and postwar reconstruction, but its economic and political structures have proven too rigid for success in a fast-paced, postindustrial, and global age. Even Japanese society was reshaped to reflect the demands of the 1940 system, with its emphasis on loyalty to one's employer above one's family. But this too must now change. Some foreigners and Japanese conservatives like to view Japan's World War II-era institutions as characteristic of Japanese culture. Although some of these institutions have important historical antecedents, however, the 1940 system is essentially a recent innovation. And it is one that no longer works.

Fortunately, the changes have already begun -- although there is no guarantee that the moderate reforms undertaken by Koizumi will succeed. Moreover, even in the economic sphere, Koizumi's proposals have been too modest. For example, he has demanded that Japan's banks deal with 11.7 trillion Yen ($97.5 billion) of the bad loans on their books -- but most analysts think that the real figure is much higher, between 150 trillion Yen ($1.25 trillion) and 240 trillion Yen ($2 trillion). And even Koizumi's modest proposals have been resisted by the prime minister's LDP colleagues.

Nevertheless, as politically dangerous as it may be for Koizumi to push for more change, to delay would be even worse. If Tokyo procrastinates for several more years, it could well find itself in a crisis similar to that which engulfed Weimar Germany. And if Japan's economy collapses under the weight of its debt, neighboring countries and even major American and European firms may be swept up in the ensuing storm of defaults, inflation, and currency collapse. Given that so many Japanese assets are now located in the United States, the impact there could be particularly severe. And within Japan, such a crisis might bring to power repressive demagogues such as the xenophobic Ishihara, which could lead to nasty conflicts with the two Koreas, the United States, or China. The whole world, then, has a stake in Japan's economic health and therefore in its reform.

Fortunately, although Koizumi's measures have so far been inadequate to avert a crisis, Japan still has major advantages. It is an extremely well-educated society and enough of a democracy that the restive public may yet manage to pressure the government into undertaking serious reform. If it does, Japan's prospects could once again brighten; the country has everything necessary to trounce its competitors except for the sense of urgency that has allowed South Korea and China to threaten its dominance in recent years.

Indeed, if the millions of Japanese now trapped in unproductive jobs are given better opportunities, Japan could enjoy the kind of renaissance now occurring in China and South Korea. If the role of women changes as fast in Japan as it has in China and South Korea, then the flood of highly educated women into productive jobs could further augment this boom. Japan's problems are intrinsically smaller than China's or South Korea's. The real challenge is forcing Japan's politicians to address them seriously.

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  • William H. Overholt is a Fellow at Harvard University's Asia Center. He has served as Chief Economist and Asia Strategist for three major investment banks based in Hong Kong and Singapore and is the author of The Rise of China.
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