Japan is Cursed by Gresham's Law: Let Darwin's Law Rule

C. H. Kwan
Senior Fellow, RIETI

The Collapse of the Myth of Innate Goodness of Human Nature

The 20th century was an era of confrontation between capitalism, which assumes the innate evilness of human nature, and socialism, which assumes innate goodness. The era ended with the total defeat of socialism, as symbolized by the collapse of the Soviet Union. In Japan, which has been dubbed the "only successful socialist state," the long-held myth about the innate goodness of human nature has collapsed as the country went through the lost decade of the 1990s.

Socialism assumes that men are good by nature; they hope for the happiness not only of themselves but also of others. Accordingly, there would be no need for the government to enforce laws and contracts through the police, courts, and prisons. When these circumstances are satisfied, socialism is a wonderful system; both efficiency and equality can be achieved because people trust each other, cooperate to achieve a goal, and put harmony before competition.

Japan in the postwar high-growth period was close to that ideal. Communities played a significant role in enabling the goodness belief to come, or appear to come, into effect. Companies and industry organizations, along with close cooperation among politicians, businesses and bureaucrats served as "soft" institutions - in place of laws and other "hard" institutions - to supervise people's behavior and help prevent antisocial acts. This moral force, however, has ceased to function now that communities and mutual trust are falling apart as nuclear families spread and people's lifestyle diversifies as a result of economic development. Despite the collapse of the very foundation that supported the goodness belief, however, Japan has been trying to maintain the lost paradise of socialism. This results in the distortions that are now plaguing Japan in the form of "institutional fatigue."

Japan's personnel system based on lifetime employment and seniority rule is one example. Under this system, a man, once employed by a company, continues to work there till retirement. He can expect steady salary increases and promotion in accordance with the length of service, regardless of performance, and there is not the remotest possibility of getting fired unless he makes a hideous mistake. The system served well in an era when people buckled together to work for the company they belong to. The prevailing sentiment among today's company employees, however, is not "what they can do for the company" but "what the company can do for them." This idea, consistent with the evilness of human nature, has now become mainstream. As a result, Japan's traditional personnel system, which bears close resemblance to that of a state enterprise in a socialist state, no longer works.

In the financial sector where the "Big Bang" reform is proceeding, Japanese banks and other financial institutions are suffering from the hollowing out of human resources, losing highly motivated and capable employees to their foreign rivals whose personnel system is strictly based on merit principles. Japanese companies are serving as a training center, turning new recruits into skilled workers and then sending them out, in many cases, to foreign companies. Meanwhile, those who are neither eager nor talented find it more advantageous to stay on with a Japanese company and have a free ride. Surrounded by an increasing number of free riders, even highly motivated employees may lose their zeal for work and conceal their talent (chart). The drain of human resources is just one example where "bad money drives out good money," as stipulated by Gresham's Law. Similar phenomena - hollowing out of industry and scandals involving politicians and corporate managers, to name a few - can be observed in diverse areas. As a result, the Japanese economy has lost its vigor and begun to decline.

Complementarity between Gresham's Law and Darwin's Law

Gresham's Law: "Bad money drives out good money"
Under bimetallism in which two metals - gold and silver - are used for coinage, depreciated or debased money (bad money) drives out the other money of high value (good money) from circulation when their legal rates deviate from market values.

Darwin's Law: "Survival of the fittest"
There is a natural selection of which species will evolve and which will cease to exist, so that only the fittest species will survive and continue to descent.

The two laws are seemingly unrelated to each other; the first one explains economic phenomena and the second one is biological. Nevertheless, if we restate Gresham's Law as the "survival of the unfit," and Darwin's Law as "good money drives out bad money," we can see that the two have much in common. By clarifying premises upon which the two laws stand, we can see that they do not contradict but complement each other. In a world where Gresham's Law applies, the exceptional cannot make full use of his capabilities since he is given the same rewards as the mediocre. If gold's exchange rate against silver in the market is higher than the legal rate, people begin to hoard gold (good money), leaving only silver (bad money) circulating in the market. In a world where Darwin's law governs, however, rewards are in line with ability and competition drives progress.

In an environment dominated by the Gresham's Law, value that expresses the degree of fitness diverges from price. Even under bimetallism, both gold and silver circulate concurrently if the legal exchange rate fluctuates in line with their supply-demand conditions in the market. In this case, Gresham's Law does not work. When market mechanism is in full play, prices of goods and services are supposed to be determined in line with values that reflect the scarcity of resources (supply-side factor) and the consumer's choice (demand-side factor), thereby, achieving the optimal distribution of resources. Still, we know that prices often deviate from values. "Market failures" and "government failures" are the reasons behind this.

Government intervention is necessary to correct market failures but excessive intervention would distort resource allocation. Typical examples of such government failures include over-regulation and tax preference or subsidies for specific industries. These measures generate vested interests that, once formed, are very difficult to abolish. Also, social security measures, implemented by a government to achieve greater equality in income distribution, often lead to moral hazard problems.

History tells us that a state flourishes when it has institutions and an environment that allow Darwin's Law to rule but it declines when Gresham's Law prevails. The Cold War ended with the defeat of socialism, as symbolized by the collapse of the Soviet Union, and the victory of capitalism. In socialist states led by the Soviet Union, priority was given to the equality of results. Because workers were given the same rewards regardless of their performance, they had no motivation to work hard, leading to economic stagnation. The socialist states turned into a paradise for the untalented, but it was a hell for the talented. In Western countries, by contrast, the equality of opportunities is respected, and through competition, industry and technology have developed and the standards of living have improved.

Japan Must Adopt Darwin's Law to Revive Economy

Amid the prolonged economic stagnation, Japan has begun to stress the importance of competition in general principle. When it comes to the particulars, however, the socialist ideal still prevails. Japan's income distribution is far more equitable than any other countries in the world. Allowing income gaps to widen to a certain extent helps enhance motivation for work, and this will bring benefits and no harm to Japan.

To revive its economy, Japan should move away from the current environment where Gresham's Law works, and quickly adopt an environment ruled by Darwin's Law. Gresham's Law comes in play when price deviates from value. To prevent this, political and business leaders (and those who select them) must be able to judge value. If second-generation politicians and corporate managers promoted from within fail to demonstrate this ability, the system must be reformed to select leaders based on the principle of competition. Economic agents must also determine prices of human and other resources at levels that match their values. Through these measures, the conventional institutional system that promotes false egalitarianism can be corrected and replaced by one that purveys dreams to those making effort.

July 9, 2002

July 9, 2002