RIETI Report April 2011

Post-Quake Restoration Policy for East Japan from the Viewpoint of Spatial Economics

In this month's RIETI Report, FUJITA Masahisa, President and Chief Research Officer of RIETI, Professor, Konan University, and Adjunct Professor, Institute of Economic Research, Kyoto University, looks into--from the viewpoint of spatial economics--what policies Japan should implement to restore economic vitality following the March 11 catastrophic earthquake.

In the report, Professor Fujita gives an overview of growth in the advanced manufacturing industries in the Tohoku and northern Kanto regions, especially since the mid-1990s, and how Japan's famous Kanban or just-in-time production system backfired and actually made businesses more vulnerable to such a disaster, in light of damaged supply chain systems. Professor Fujita offers his insight of what needs to be done to restore manufacturing activity in the affected areas, so that Japan's manufacturing industry as a whole does not lose its "lock-in effect," which was witnessed with the Port of Kobe following the Great Hanshin-Awaji Earthquake in 1995.
Gambare Nippon !

This month's featured article

Post-Quake Restoration Policy for East Japan from the Viewpoint of Spatial Economics

FUJITA MasahisaPresident, RIETI

Note: This article is based on the original Japanese article contributed to and published in the "Keizai kyoshitsu" column in the March 30, 2011 issue of the Nihon Keizai Shimbun but with some changes and significant additional information.

Introduction

We have yet to know the whole picture of damage caused by the Great East Japan Earthquake. It is expected, however, that the direct and indirect damage of the catastrophic earthquake on March 11, 2011 will be far greater than that of the Great Hanshin-Awaji Earthquake of 1995. Though devastating, the 1995 earthquake was an inland earthquake and its damage—mostly caused by the powerful jolt and ensuing fires—was geographically concentrated, specifically in an area encompassing 40 km east to west (including the western part of Osaka and city of Kobe). In contrast, what we see today is compounded damage brought on by the earthquake and tsunami of an unprecedented scale in Japan, as well as by the quake-triggered accident at the Fukushima No. 1 Nuclear Power Plant and resulting power shortage.

The vast area encompassing 600 km north to south from Aomori Prefecture to the northern part of the Kanto region, namely the Pacific Ocean side of East Japan, was directly affected by the damage. From the sheer spatial scale of the directly affected area, we can see that the situation we face today is completely different from what we experienced following the 1995 quake.

In this extensive stretch of affected area, transportation and logistics infrastructure was seriously damaged. As a result of this and an acute fuel shortage, logistics systems have broken down and many local governments are unable to perform administrative functions. Such functional impairment of logistic and administrative systems has been a major impediment to relief efforts including rescue operations and livelihood support for survivors, making the future task of reconstructing disaster-affected areas extremely difficult.

The Tohoku region, the area most severely damaged by the March 11 earthquake, is one of Japan's major manufacturing hubs. Thus, the impact of such indirect damage, combined with the impact of power shortages on production activities in the greater Tokyo metropolitan area, is now spreading across the country and even beyond the national boundaries. In the face of this daunting situation, Japan must make united efforts, mobilizing all available resources, taking in new and sometimes unconventional ideas, and working under bold and flexible government policies. Only then, would Japan be able to overcome what is the greatest crisis in its postwar history.

In this article, I would like to consider, from the viewpoint of spatial economics and with the spatial spread of the disaster-affected area, what policies should be implemented to restore economic activity, particularly in the affected area. Spatial economics is a new filed of economics that analyzes dynamic changes in inter-city, inter-regional, and international spatial economic systems by focusing on agglomeration forces (improvement in productivity and creativity) arising from the proximity of diverse human activities and through complementary relationships among them. This field of economics was developed in the early 1990s through the vigorous efforts of a group of economists, led by Princeton University Professor Paul Krugman, who was awarded the 2008 Nobel Prize in Economics.

Heart of Japan's manufacturing industry with an agglomeration of critical parts and material manufacturing industries

The delivery of relief and livelihood support to those people in the affected area and responses to the critical situation at the Fukushima nuclear power plant are the top priorities. At the same time, however, we must not forget that without restoration of business activity in the affected area, there will be no recovery of employment or income.

With a significant agglomeration of factories and plants producing critical parts and materials for assembling manufacturers such as automobile and electric appliance makers, the Tohoku and northern Kanto regions together constitute a major supporting hub for Japanese and global advanced manufacturing industries. At present, operations at a number of parts factories and materials plants remain suspended since the March 11 quake and, for many of them, the restoration of operations is nowhere in sight.

The disaster-affected area has been serving as a major source of supply chain flows of goods (from the procurement of parts to the delivery of finished products) that support Japan's manufacturing industry. The suspension in the supply of parts and materials from this area has forced many manufacturers—ranging from assembling manufacturers such as automobile and electric appliance makers to other parts and materials makers—across the country to suspend their operations as well. The Japanese manufacturing sector is facing a grave crisis rarely seen before, if ever, and the impact has begun to spread to other economies in East Asia and across the world. Restoring operations as soon as possible at parts factories and materials plants in the Tohoku and northern Kanto regions is vital to the future of the Japanese manufacturing sector.

The world's manufacturing industries, as they stand today, are supported by closely-knit supply chain networks connecting an enormous number of companies. Figure 1 shows a conceptual diagram illustrating the overall production activity in the assembly-type manufacturing industry.

Take automobile production as an example. An automobile is made of 20,000 to 30,000 parts produced by processing various materials (see (i) in Figure 1). These parts are shipped to mass production plants equipped with manufacturing machines ((ii) in Figure 1) and assembled into automobiles ((iii) in Figure 1) for sale to consumers in Japan and abroad. Such auto parts are produced by a vast number of affiliated or otherwise associated companies located across Japan (and some in overseas locations), each engaging in either of the primary, secondary, and tertiary stages of production.

The Japanese automotive industry as a whole constitutes a closely-knit supply chain network across the country and beyond national boundaries, which is in turn supported by transport and logistics ((iv) in Figure 1). Out of those few dozens of parts, just one missing part is enough to stop automobile production. The same holds true for the electric appliance and many other manufacturing industries.

Figure 1: Triangle of Production Activity
Figure 1: Triangle of Production Activity

Japan has been able to maintain its place as one of the world's largest hubs for advanced manufacturing industries because of an overwhelmingly large agglomeration of critical parts and materials suppliers as well as of production machinery manufacturers ((i), (ii) in Figure 1) that serve as a source of such supply chain flows.

Meanwhile, Figure 2 illustrates the snowball mechanism of agglomeration observed in Japanese manufacturing industries (particularly advanced technology-oriented ones). When suppliers of diverse intermediate and capital goods are present in Japan ((i) in Figure 2), mass production manufacturers can achieve high productivity by locating their plants in Japan and taking advantage of easy access to those suppliers ((ii) in Figure 2).

When this mechanism is at work, more mass production manufacturers would locate their bases in Japan with the growth of the Japanese and world economy (forward linkage effect). This, in turn, would create great demand for diverse intermediate and capital goods, prompting more intermediate and capital goods manufacturers to locate in Japan because of easy access to their market ((iv) in Figure 2). This would result in the production of even more diverse intermediate and capital goods in Japan (backward linkage effect), hence the proceeding of agglomeration with a snowball effect.

Widespread technology-based mass production activities can be easily relocated to overseas locations in pursuit of easier market access and cheap labor. However, advanced technology-based mass production manufacturers would find it difficult to leave Japan, because having good access to critical parts and materials as well as to production machinery manufacturers is of crucial importance for them.

In other words, the existing agglomeration of critical parts and materials manufacturers and production machinery manufacturers is serving as the source of agglomeration forces to lock in Japan's entire advanced manufacturing industries in the country. It is because of this lock-in effect that the Japanese manufacturing sector has been able to keep its place in the world. Conversely, the loss of the accumulation of critical parts and materials manufacturers or production machinery manufacturers would significantly undermine the source of competitive advantage of Japan's advanced manufacturing industries, marking a severe blow to a country which has already lost its competitive advantage in widespread technology-based mass production.

Figure 2: Agglomeration of Businesses through a Snowball Mechanism
Figure 2: Agglomeration of Businesses through a Snowball Mechanism

Japan's manufacturing activity used to be located primarily in the area from southern Kanto to the west. However, since the mid-1990s, the presence of advanced manufacturing industries in the Tohoku and northern Kanto regions has steadily increased as they have come to see greater advantage in locating their operations in the regions for a set of reasons, which include: relatively cheap labor and land available in abundance in the regions; improved accessibility to the Tokyo metropolitan area thanks to transportation infrastructure developments over the years; enhanced academic and research infrastructure led by Tohoku University, and the enthusiasm of local communities in supporting their areas. This has been further fueled by the occurrence of devastating earthquakes—such as the Hanshin-Awaji Great Earthquake in 1995 and the Niigata ken Chuetsu-oki Earthquake in 2007—which, together and the need to prepare for the anticipated Tokai Earthquake, prompted many Japanese companies to look for new locations for their operations as a way to diversify risk.

Today, the Tohoku and northern Kanto regions together account for about 20% of Japan's semiconductor production in shipment value, and their combined share is about 13% for electronic parts and 15% for information and telecommunication equipment. Japanese automobile manufacturers and their supporting industries, led by the Toyota Motor group, have built up their production capacities in the Tohoku region, defining it as their third production base in Japan following those in the Chubu and Kyushu regions.

Delay in production recovery spells the loss of competitive advantage: Safeguard the forces of industrial agglomeration

However, following the catastrophic earthquake in March, many plants located in the Tohoku and northern Kanto regions—including those producing critical parts and materials—suspended operations. Among them are plants operated by companies with significant world market shares, such as: the Moka Plant (Tochigi Prefecture) of Kobe Steel, Ltd. and the Nikko Works (Tochigi Prefecture) of Furukawa Electric Co., Ltd., which respectively hold 60% and 40% shares of the world market for aluminum substrates for hard disk drives typically used in personal computers; the Shirakawa Plant (Fukushima Prefecture) of Shin-Etsu Handotai (SHE), an affiliate of Shin-Etsu Chemical Co., Ltd., the world's top maker of silicon wafers; the Isohara Works (Ibaraki Prefecture) of JX Nippon Mining & Metals Corp., which holds a 45% share in the world's thin film materials for liquid crystal display (LCD) panels; six plants in Ibaraki and Yamagata Prefectures of Renesas Electronics Corp., which has a 30% share for microcontrollers used in automobiles and a 60% share for large-scale integrated (LSI) circuit systems used in automotive navigation systems.

Due to the suspension of operations at many plants and factories and disrupted transportation and logistics operations in the disaster-affected area, many Japanese manufacturers—including most automobile manufacturers such as Toyota Motor Corp., Honda Motor Co., Ltd., and Nissan Motor Co., Ltd., as well as a number of major electrical and electronic manufacturers such as Hitachi, Ltd., Sony Corp., Panasonic Corp., Toshiba Corp., Canon Inc., and Murata Manufacturing Co., Ltd.—have suspended manufacturing operations entirely or significantly cut operating rates at their manufacturing plants across Japan. Under lean supply chain management based on the kanban or just-in-time system of production control, Japanese manufacturers have long strived to minimize in-process inventories of parts and materials at every stage of production. This production management scheme, designed to achieve higher efficiency, backfired in the wake of the devastating earthquake.

After a lag time, the impact of a sudden halt in the supply of parts and materials from Japan, including those directly from the affected area, has reached other countries and now the ripples are being felt in various parts of the world. Production activity in East Asia, a region touted as the world's factory, is supported by closely-knit networks of production networks involving the physical transaction of various intermediate goods such as materials, parts, half-finished products, and manufacturing equipment. While being the primary supply center for a number of advanced parts and materials within those production networks in East Asia, Japan is also a major supplier of such parts and materials to the rest of the world.

As a general tendency, inventories are maintained in a relatively large volume in an international supply chain as compared to inventory levels typically observed in a domestic supply chain. Yet, if a shortage in the supply of parts and materials from Japan continues for a prolonged period of time, it would have a significant impact on production activity not only in South Korea, Taiwan, China, and member countries of the Association of Southeast Asian Nations (ASEAN), but also in the United States and Europe. Indeed, the impact has already been felt in some parts. General Motors Corp. (GM) suspended operations at its Louisiana plant on March 21due to a delay in the supply of parts from Japan, while 59 workers have been laid off at the company's engine plant in the State of New York.

In response to disruptions in parts and materials supplies from the disaster-affected area, many Japanese companies are seeking to shift to suppliers, or increase production, in the area from the Chubu region to the west. Furthermore, some Japanese manufacturers are considering backup or full-fledged production of those parts at overseas plants. Meanwhile, many overseas manufacturers have begun to look for alternative suppliers, not limited to Japanese suppliers and/or their affiliates, but including those from around the world.

The Great Hanshin-Awaji Earthquake of 1995 caused disastrous damage to the Port of Kobe and it took two years to restore the port facilities. In the meantime, Busan, Shanghai, and Kaohsiung emerged as international hub ports in Asia, taking over the role that used to be played and has since not been regained by Kobe. That is, the Port of Kobe had been able to maintain its status as an international hub port because of the lock-in effect of its being a hub of the international marine transport network; but it turned out to be impossible to recapture this effect once lost.

In order to prevent Japan's advanced manufacturing industries from falling into the same fate as the Port of Kobe, it is imperative to act fast to restore manufacturing activity in the directly affected area as well as in the Kanto region in general where the limited power supply resulting from the disaster-triggered collapse of a nuclear power plant in Fukushima Prefecture is starting have a serious impact. Delay in restoring manufacturing industries in the affected area could spell an ominous future for Japan. Once Japanese manufacturers' backup or substitute production in overseas locations gets into full motion and their overseas counterparts secure substitute suppliers, parts and materials suppliers in the Tohoku and northern Kanto regions will never be able to restore demand for their products to the pre-disaster level even if their plants and factories are rebuilt and restored to operation. The result would be the disappearance of jobs not only in the Tohoku and northern Kanto regions but all across Japan and a significant loss of agglomeration forces within the Japanese manufacturing sector as a whole.

For the time being, the best possible strategy is to have manufacturing bases in non-affected areas—i.e., the Chubu region to the west—take over, as much as possible, the manufacturing task that has been undertaken by plants and factories in the affected area. However, even in this case, it would be important to return to the pre-disaster state as quickly as possible once plants and factories in the affected area are able to restore operations. One reason for this is that the risk of a major quake is extremely high for the area from the Chubu region to the west.

According to estimate by the Headquarters for Earthquake Research Promotion (HERP), a government organ within the Ministry of Education, Culture, Sports, and Science and Technology, three periodic great earthquakes—the Tokai earthquake (with a magnitude of around 8.0), Tonankai earthquake (8.1), and Nankai earthquake (8.4)—will occur within 30 years with the probabilities of 87%, 70%, and 60%, respectively. Kyoto University Professor Manabu Hashimoto warns that the simultaneous occurrence of those three anticipated earthquakes could constitute an enormous, magnitude 9.0 earthquake similar to the one that hit the Tohoku and northern Kanto regions on March 11. Should this happen, the coastal areas along the Pacific Ocean from the Kanto region to the west as well as those along the Seto Inland Sea would be hit by giant tsunami, according to a 2003 report compiled by the Cabinet Office's Central Disaster Management Council. It is highly likely that the resulting damage would be as catastrophic as what we see today. In contrast, with the occurrence of the March 11 earthquake, the probability of another giant earthquake in the Tohoku region in the next half century has been significantly reduced. In terms of national risk management, we must avoid the folly of allowing the nation's manufacturing industries, including those relocated to the west in a rush, get washed away in an instant.

The public and private sectors of Japan must join forces and act quickly to facilitate and support the restoration of business activity in the affected area. Major Japanese companies are already making frantic efforts to help their suppliers—plants, factories, and local companies—to restore operations. However, there is a limit to what can be accomplished through such self-help efforts of individual business groups. The affected area is home to a large number of companies that are not directly linked to any of the supply chains of major manufacturers. Only through the combined support of the public and private sectors and nonprofit organizations (NPOs), would it be possible for those numerous companies to restore operations. It is imperative to provide financial support in the forms of emergency loans from public financial institutions and private-sector banks, debt guarantee, various tax breaks and financial assistance. Support must be provided to small and medium-sized local financial institutions in the affected area. Also, along with the restoration of transportation and logistics systems, livelihood support for all people in the affected area must be given utmost priority and undertaken under the close cooperation of the central and local governments and nonprofit organizations.

Needless to say, we cannot forbid companies from raising substitute production in overseas facilities to a significant level or relocating production to overseas locations. However, the source of competitive advantage of Japan's cutting-edge manufacturers is in agglomeration forces (improvement in productivity and creativity) arising from close interactions and collaborations between major cutting-edge manufacturers and their supporting industries, namely, suppliers of critical parts and materials, and manufacturers of production machinery. In other words, the competitive advantage of Japanese advanced manufacturers hinges on the broadly defined external economy that is outside the capacity of individual companies. Therefore, it is economically justifiable for the government to provide public support to facilitate the quick rehabilitation of disaster-affected companies so as to prevent further industrial hollowing-out.

Rebuilding Japan's economic and social system into one with greater resilience

While working toward the quick rehabilitation of the affected area, Japan must make united efforts—i.e., political leaders must act in the spirit of non-partisanship and the public and privates sectors must join forces—to quickly draw up and implement bold and flexible policies based on new and unconventional ideas. The supplementary budget formed for reconstruction after the Great Hanshin-Awaji Earthquake amounted to more than 3 trillion yen. This time, it is widely estimated that total expenditures for post-quake reconstruction could exceed 10 trillion yen, apart from expenditures related to the Fukushima nuclear power plant accident. In order to secure funds for reconstruction, the government must drastically revise the budget for the new fiscal year, issue construction and/or post-quake reconstruction bonds, and introduce a new, post-quake reconstruction tax. At the same time, the government must set out a credible path toward restoring its fiscal health to underpin Japanese and foreign investors' confidence and avoid a fiscal collapse.

In order to secure such massive funds by whatever means possible, it is indispensable for the government to secure nationwide support for its cause. To achieve this end, it is necessary to involve all members of Japanese society to draw up and share visions for true "restoration," which is to create a new, better Japan by overcoming this tragic event, rather than "rehabilitation" to the original state. We would like to strongly call for rebuilding Japan's entire economic and social system into one that is more resilient to external shocks. In doing so, it is particularly important to draw on lessons learnt through this painful experience.

First, the disaster revealed the fragility of the Japanese production system characterized by an extreme emphasis on efficiency. Under a typical Japanese production system, each and every one of numerous parts and materials—those required to create a single finished product—would be mass-produced in very few locations within Japan so as to take maximum advantage of economies of scale. Such parts and materials would then be delivered, through a just-in-time supply chain, to a mass-assembly plant to produce the finished product. Underneath the sea off the coast of Japan is the junction of four of the earth's tectonic plates, which means that the occurrence of a major earthquake every 30 years somewhere in Japan is a near certainty. In due consideration of this scientific prediction, Japanese companies should rebuild their supply chain system into more resilient one by spatially dispersing risk.

The disaster also revealed the limitations of Japan's highly centralized control structure in dealing with risk. It is predicted that a major inland earthquake will hit the Tokyo metropolitan area within 30 years with the probability of 70%. The Great East Japan Earthquake has awakened us to the certainty that metropolitan functions would be instantly paralyzed in the event of such a major quake. It has been long argued that Japan should promote decentralization by transferring authority to local governments. By vigorously pushing forward such decentralization initiatives, we must redesign the structure of our nation, shifting from the current highly centralized structure to a more resilient, multi-polar structure supported by a variety of more autonomous and independent "regions," which altogether cover 60% to 70% of the national land.

The Tohoku region, which was most severely hit by the disaster, should be made a role model by building it back into a better, more autonomous and independent region. Presenting such a vision with viable plans would be the way to ensure nationwide support for massive reconstruction efforts. We must make nationwide efforts to face and overcome the greatest crisis in Japan's postwar history so as to create a new, better, and more resilient Japan. This would be the best we can do to comfort the souls of those who lost their lives in the Great East Japan Earthquake.

>> The original column was published in Japanese on April 1, 2011.

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