What Economics Can and Cannot Do

AOKI Masahiko
Fellow, RIETI

INTERVIEWER: Looking at the debate on economic policy over the past decade reveals that it has revolved around the axis of reform versus economic stimulus. Most of the arguments advanced have been over which of these two tasks should take priority.

AOKI Masahiko: Unfortunately, this dichotomy doesn't really go to the heart of the problem. Those urging reform, for instance, have only addressed the appearance of things, clamoring for deregulation or the reorganization and privatization of special public corporations, such as those that build and manage the country's expressways and bridges. Members of the economic-stimulus camp, meanwhile-politicians in particular-continue to insist on outmoded public works projects to create jobs. Recently there has also been an increasingly audible chorus of people asserting that adopting an inflation target would alleviate the burden of clearing nonperforming debts and resolve deflation. I have yet to see a plausible concrete proposal for implementing this idea, however.

I am of the opinion that Japan is standing at a major turning point. The problem of deflation is not simply a byproduct of the business cycle; there are also much bigger, historical factors involved. For one thing, the rivalry between planned and market economies that defined much of the twentieth century has dissipated. The former Eastern bloc nations that had command economies have been integrated into the global market, and this has resulted in extensive changes in the structure of how goods are supplied. A second factor is the information revolution, as symbolized by the spread of the Internet. A telling development is the expansion of online trading. Until a few years ago, securities firms that did most of their trading over the Internet were a marginal presence; today, their transaction volume actually exceeds the total of Japan's Big Three brokerages-Nomura, Daiwa, and Nikko.

In the face of these realities, it's easy to see that deflation can't be eliminated simply by priming the pump with public works spending. What's being called into question is the very system that has supported Japan's growth since the end of World War II. The core components of this system are the large corporations, with their lifetime employment practices, and the close ties these and other companies enjoyed with the bureaucracy. An additional factor is the mediating role played by politicians to balance competing interests.

Social scientists must therefore seek answers to several big questions: What are the defining characteristics of the institutions and systems that have supported Japan's postwar economic growth? Can they be sustained? And what aspects need to be overhauled? Traditional theories of economics are unlikely to provide full answers to these queries. This is not a dodge; the problems confronting Japan today are simply beyond the scope of what can be remedied with traditional economic prescriptions.


INTERVIEWER: In what ways are the institutions that have sustained the postwar system changing?

AOKI: Let's start with a description of what an "institution" is. I would venture to say that there is broad agreement on the central role played by such corporate practices as lifetime employment and reliance on a single main bank during Japan's postwar development. There are no legal stipulations or contracts governing these practices, though. They may have prewar roots, but for the most part they sprung up rather spontaneously after the war and came to be widely accepted as givens. They were rules of the game, so to speak, in Japan's postwar economy.

These rules no longer seem to be taken for granted, however. Rather than enjoy the benefits of lifetime employment, young workers in their twenties and thirties-even those who have joined such "elite" organizations as the Bank of Japan or a central government ministry-are switching careers in increasing numbers.

Curtis Milhaupt, a professor at Columbia Law School, spent several months here at the Research Institute of Economy, Trade, and Industry as a visiting fellow and produced a very interesting report. He checked where the law department graduates of major national universities were employed over the past 15 years or so and discovered that the share of those who went on to become national civil servants has fallen dramatically. Conversely, the percentage of those choosing careers in law has risen. Many of those who leave the central bureaucracy in midcareer, moreover, start their own business, become consultants, or enter politics. This is an indication that young people are beginning to recognize the need to enhance their personal worth. It's a clear departure from the "safety in numbers" instinct that defined the postwar mentality and reflects a new perception of future trends.

New business models are being advanced by industry and academia as old rules break down, and new patterns of employment are emerging. These "grass-roots" experiments to devolve authority, though, are not enough. Creating an alternative set of rules requires strong leadership to lend directionality to the process.

Such directionality is called the "focal point" in game theory. Unless all the players in a game espouse more or less the same expectations, it is difficult to push a process in the desired direction. From this viewpoint as well, political leadership serves a crucial function.

INTERVIEWER: When did the institutional changes begin? And how long will they continue?

AOKI: I would identify 1993 as a major threshold. This was when the nearly forty years of single-party rule by the Liberal Democratic Party came to an end.

Under the lifetime employment system, companies essentially provided their employees a steady income for the duration of their working life, so the continued survival of the company was of utmost importance. Companies formed industrial associations and developed close ties with the relevant ministries and agencies to ensure their survival and to protect the interests of their respective industries. The interests of these bodies sometimes conflicted; in such cases, mediating roles were usually played by the Budget Bureau of the Ministry of Finance and politicians. As long as there was a unified process of distributing benefits and arbitrating between competing claims, losses from this process could be held down. There were merits, therefore, to the LDP's virtually uninterrupted grip on political power. The Japan Socialist Party [predecessor of the current Social Democratic Party], which was the LDP's perennial top rival, played a complementary role in this setup.

Changes in government became a distinct possibility after 1993, however, when the LDP was briefly driven out of power, and this has had a significant impact on the behavior of politicians. A book on the political economy of the financial Big Bang authored by Toya Tetsuro-a friend of mine who died all too young-was recently published by Toyo Keizai. Toya was a Finance Ministry official who earned a doctorate at Stanford University, and the book is essentially based on his doctoral thesis.

Toya makes an excellent analysis of why the Finance Ministry in the mid-1990s abandoned its "convoy" approach to regulating financial institutions and embraced the Big Bang program of liberalization. Banks and the Finance Ministry at the time were under heavy criticism over a series of scandals. Public outrage was such that the politicians in power had to undertake major surgery on the ministry to save their own necks. They knew that their constituents were angry and aware that they could very well be voted out of power. The Big Bang, Toya concluded, was thus engendered by the incorporation of bureaucrats and politicians into a democratic framework in which the distinct possibility of a change of government was present.

This was a very astute observation. One reason that Koizumi Jun'ichiro, who is without a strong base of support within his own LDP, continues to serve as prime minister is because of this very threat that without Koizumi the party might well be thrown out of power again.

Also by around 1993 the fact that Japan's bubble economy had burst became common knowledge. This was when rules that had been thought of as givens began to crumble, such as main banks coming to the rescue of their troubled borrowers and banks themselves being immune to insolvency. This is another factor that makes 1993 a critical watershed.

As I mentioned earlier, many people in their twenties and thirties are changing jobs to pursue new career options. But inasmuch as lifetime employment was a core component of Japan's postwar system, I think it will take at least a generation for it to undergo a complete change. In other words, the process of building a replacement system could take another twenty or thirty years.

We are now in the middle of a process that began in 1993. When people look back over this period about fifteen years from now, they will no doubt recognize it as a time of stupendous changes.


INTERVIEWER: Will the changes result in a US-style capitalist system or something quite different?

AOKI: Japan's leading companies don't necessarily operate on the American model. From my personal experience, when I returned to Japan after living in Silicon Valley for ten years, the industries that I felt represented new, competitive business models were convenience-store chains and parcel delivery services. They developed new ways of reaching out to consumers and linked information technology and human needs with a uniquely Japanese touch. While precedents existed in the United States, the Japanese businesses weren't mere carbon copies. Such examples suggest that there is plenty of potential for Japanese-style evolution.

I don't think there are any absolutes when it comes to the superiority of one system or arrangement over another. The capitalist economies of countries around the world are products of their respective histories, and they display what in economics is called "path dependency." Corporate governance in the United States, for instance, has been defined by a system based on market appraisal, particularly that of the stock market. The system in Japan, on the other hand, has been focused on distributing profits internally, especially to employees. As long as companies were operating profitably, shareholders and banks refrained from making demands on management.

The nature of corporate scandals has also tended to be shaped by the characteristics peculiar to each economic system. Because market perceptions play a key role in the United States, scandals there have involved attempts to dress up accounts to improve market assessments. In Japan, where the chief consideration is preventing outside interference, an effort has been made to stop any bad news from leaking, as exemplified by the falsification of nuclear plant inspection reports by Tokyo Electric Power and of the outbreak of food poisoning by Snow Brand Milk Products. This is not a question of which capitalist system is better. Each system has evolved along its own path and has its peculiar set of problems that it must address.

In all cases, however, it's crucial to achieve greater transparency. Progress toward this end has been made in Japan with the recent amendments to the Commercial Code, and the number of outside directors is expected to grow. Management will no doubt go smoothly if monitoring by outside directors promotes stricter internal discipline. Companies that are reluctant to introduce external auditors will lack the ability to purge themselves when problems do occur and will gradually be weeded out. Adherence to stringent corporate governance standards will pay off in the long run, as this represents the best hedge against being driven out of business.


INTERVIEWER: Will this provide a sufficient driving force to achieve needed reforms?

AOKI: As I mentioned, a major systemic change requires more than just experiments with new business models by the private sector. Reforms must be spearheaded by strong leadership in the sphere of economic policy. And fiscal reform is of decisive importance in this process.

Long-term debts of the national and local governments combined now run to approximately 700 trillion yen. This will impact on future generations in the form of higher taxes and a decline in public services. We cannot continue down this path indefinitely, but how can we change course for the better? Makeshift measures like setting ceilings on the issuance of deficit-covering bonds or turning government-owned corporations into independent organizations aren't enough. A more fundamental solution is in order.

I believe there are three key requisites to fiscal reform. First is the revamping of the structure of public spending. At present, each ministry submits its appropriation request to the Finance Ministry's Budget Bureau, which carefully assesses the requests in drafting each fiscal year's budget, and the ministries then use up the amounts allotted to them. In an increasingly complex society, though, it's impossible for the Budget Bureau to conduct detailed assessments from scratch, no matter how motivated and capable its staff. So in practice the previous year's appropriations serve as the starting point for the entire process, and much of the Budget Bureau's work involves negotiations with the individual ministries over incremental changes in funding for specific items, with the result that the level of allocations has become more or less fixed.

Securing additional funding for the same budgetary items has thus emerged as the primary goal of the officials in each ministry charged with negotiating budgetary requests, since this is the chief measure of success. One might say that a mechanism for ever-expanding expenditures was built into the system. And the more assessment functions were concentrated in the Budget Bureau, the more pressure from politicians was also focused there. So it has become common practice for politicians to intervene during the final adjustment phase of budget formulation.

This must be stopped. The government should set its basic fiscal policy for the year at the cabinet level based on deliberations by organs like the prime minister's Council on Economic and Fiscal Policy, with each ministry and agency being allotted lump sums. The ministries and agencies should bear the basic responsibility for how these appropriations are disbursed. The Public Finance Law should be amended so as to give each ministry greater leeway in how its budget is used. If funds are left over thanks to economizing efforts, ministries should be allowed to carry them over into the new fiscal year. To balance out the increased flexibility, though, specialists should conduct follow-up evaluations of each spending item's economic and social benefits, to be fed back to the budget drafters the following year.

Frequently, the officials who make the budgetary requests have already moved to new posts by the stage of execution. This means that they're not held responsible even for those spending items that turn out to be highly inefficient.

Conducting assessments after appropriation, rather than before, will clarify the responsibility of the government and the advisory functions of the Council on Economic and Fiscal Policy. Politicians will be compelled to debate which areas require budgetary priority. Instead of mediating between competing interests, the Budget Bureau will focus on planning and on follow-up evaluations. This will greatly simplify the budget formulation process.

The second key component of fiscal reform is an overhaul of the tax system. Because expenditures are largely in the hands of each ministry and agency, there are no caps on total spending. The tax system is about the only tool that can be used to restrain this spending in some way. At present, control over tax policy is closely guarded by the LDP's Research Commission on the Tax System, without whose approval no revisions can be made. Taxes are highly complex, so only veteran politicians with firsthand knowledge of the system's historical evolution are deemed to have the knowledge necessary to make changes. This is why fiscal measures to stimulate economic activity always focus on expanding public works spending; the tax system is too rigid to be used as a countercyclical tool.

The desired direction of tax reform is toward greater transparency. The Special Tax Measures Law and other provisions that give preferential treatment to certain groups should be eliminated to the fullest possible degree, and the pool of people subject to income tax should be expanded. There may also be a need to introduce a new form of corporate taxation based on something other than net income (profits). Even companies that are operating in the red benefit from a broad range of public services, such as guarantees that contracts are duly executed and the use of roads and other public goods. It's not fair that some companies pay no taxes.

The third component is decentralization. How new roads and other infrastructure can be built during these times of straitened fiscal resources has become a difficult issue. If local governments can count on the central government to finance public works projects as long as they put up 30 or 50 percent of total costs, they may be motivated to persist with even wasteful projects. It's better for both the responsibility and financial burden to be borne locally. Local leaders will have to convince area residents and other beneficiaries of the merits of any new project and ask them to accept the cost. In this way, it will be clear who is to blame for projects that fail to meet expectations.

These three components must be part of the fiscal reform agenda. Unless sweeping changes are made in the very structure of government, a return to robust economic growth will remain elusive.


INTERVIEWER: Debates over economic policy seem to have been reduced to petty arguments over methodology in the absence of a grand design.

AOKI: We have to discuss issues that go to the heart of how Japan is organized. All the opposition parties are doing today is taking issue with the minute particulars of antirecessionary measures. It isn't clear how their criticisms differ from those being made by the so-called resistance forces within the LDP. There's a growing sense of frustration as the electorate shows its readiness to exercise the option of voting in a new government, while the politicians dawdle over an appropriate response.

In matters of public policy, the only way to arrive at an optimum solution is through trial and error. This process ideally involves a showdown over policy during an election and the execution of the policies of the winning camp. If they turn out to be ineffective, they should be corrected at the next election. This is the essence of a process of trial and error in public policy, but unfortunately, this is not functioning properly today. No assessments are made of earlier budgetary decisions, and the blame for inappropriate measures is not clearly assigned. This is one major factor behind the dullness of the debate on public policy.

We at the Research Institute of Economy, Trade, and Industry are now attempting to develop our own econometric model to project the impact of policy decisions. The model that has been used by the Cabinet Office is on a very large scale, and about the only ones who can identify which of the many variables are mutually dependent are those who actually created the model. And some of the hypotheses used in the model are highly idiosyncratic. We perceived a need for a model that's not on such a grand scale and yet whose structure is very clear-cut. Where possible, we wish to isolate such sectors as public entities, energy, the environment, and private businesses into modules, which can be combined to make an intuitive estimate of how, say, a fiscal policy decision will affect the environment.

INTERVIEWER: In a sense, this may be a very difficult time to be an economist.

AOKI: I believe that expecting economists to provide a definitive prescription for modern society's ailments is asking for too much. The information revolution has created a realm called cyberspace through which people can now communicate on a global basis. Internet technology, in one sense, has come to set a standard of governance. Unlawful transactions, for example, have hitherto been checked by the threat of legal penalties if companies violate market rules. But now, when one downloads software from the Internet, technology has been developed that will disenable that software unless payment for it is made by a certain date.

Digital technology, in other words, is beginning to serve a supplementary role in the protection of private property rights and the fulfillment of contracts, alongside the forces of law and of social castigation. No one can say yet how legal and technological mechanisms to induce normative behavior can best be combined, but it's clear that this is not a task to be addressed by economists alone. They must work together with engineers, legal experts, sociologists, and also psychologists. This endeavor to deepen dialogue among such disparate fields as sociology, psychology, political science, and law should not merely be an attempt at interdisciplinary research but a process by which the social sciences are integrated, with the walls separating the various disciplines being swept away. Ideas borrowed from game theory, I believe, would be of great help in creating a framework for such an integrated, transdisciplinary approach.

* The article was reprinted from Japan Echo June edition. The original article appeared in the Ronza, April 2003. (Translation by Japan Echo) No reproduction or republication without written permission of the author, The Asahi Shimbun, and Japan Echo.

June 2003 Japan Echo

June 11, 2003

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