Japan’s Growth Model

Taking on a topic as big as Japan’s post-war economic miracle for my book project requires a good structure and solid preparation. I have used this blog before to digress on economic topics (e.g. here and here) but have so far shunned the main prize: how did Japan manage to pull off one of the most remarkable episodes of economic growth in human history?


Conveniently, as with everything else in the social sciences, there is no one definitive answer to that question.

One way of presenting the topic is to enumerate the main features of the East Asian growth model and comment briefly on each. Perhaps wrap it up in a chronology of notable events between 1953 and 1973, spice it up with a real-life “fact” here and there as well as feature the buildings and their stories at opportune moments. This could be already making for a good read and intro to some of the other chapters in the book.

A more elegant way perhaps would be to develop and use a framework within which the scale of Japan’s achievement becomes a little clearer. At the same time this would offer the reader some pointers for understanding contemporary Japan and its socio-economic problems. I’m just a little worried that of the frameworks that do exist, many would risk making the chapter too academic or too narrow in focus.

The “developmental state” by Chalmers Johnson proved pivotal in shaping (western) academia’s understanding of the East Asian economies through the study of the political economy. Johnson’s favourite topic, Japan’s MITI, is a case in point. But just as the real impact MITI had is contested (did Japan grow because or despite of it?), I feel that the developmental state leaves out some very important sociological and political explanations.

Just a few weeks ago, Michael Pettis posted a timely primer on development economics on his blog. Here, he discusses China’s growth model in historical perspective. What are the country’s prospects to one day become a fully developed nation (i.e. avoiding the middle income trap)? Pettis analyses the three main features of why the United States developed “successfully” and applies them to China. The features are:

  1. infant industry tariffs
  2. internal improvements, and
  3. a sound system of national finance

Given that China’s development model is widely held to be a more “muscular” version of the Japanese or East Asian model, perhaps this is a worthy framework for understanding Japan’s successful rise to the rich nations’ club. Especially so because it is comprehensive and takes the non-initiated reader along without being too simplistic or descriptive.

So in preparing my book chapter, I thought of working my way through Pettis’s article and look for ways of applying the main tenets to Japan. What follows is not necessarily a very enthralling piece but is intended to act as my mind map going forward. Fact checks for most data points have been made but need to be verified again before I put any of this to print. Comments, of course, are more than welcome!

* * *

Let’s start with infant industry protection: Japan was an early adopter of the so-called American System. Instead of relying mainly on exploiting its comparative advantage (e.g. tobacco production) upon its independence, the United States very quickly adopted an active industrial policy. Policymakers such as Hamilton were adamant that in order to achieve real independence, the United States needed the type of manufacturing prowess that could match colonial Britain.

The analogy used by my former professor Ha-Joon Chang is simple: just like you don’t send your little children to work but to school, you protect your industries during the early phases of their development and only expose them to foreign competition when they can compete in the marketplace on quality and price.

One of the main reasons Japan was to prefer the American System was the mere presence of American consultants who increasingly visited the country following the Meiji Restoration in 1868. Pettis refers to E. Pechine Smith of Columbia University being among the first of a stream of economists and lawyers.

By then, America had already gotten quite far by doing the “wrong” things, i.e. moving against the academic consensus of free trade prevalent at the time. The American and German success stories of industrial policy inspired generations of Japanese policymakers, well into the twentieth century.

It is somewhat ironic that the US had taken a very different position when they and Japan negotiated a trade agreement in 1955. C. Thayer White and his Japanese counterpart Kenichi Otabe had a very interesting exchange about car tariffs that shows just how opposite the positions had by now become.

The Americans wanted Japan to drop its tariffs and let American cars flood the market, allowing the Japanese to focus on areas of the economy where there was a comparative advantage (yes, tuna production, for example). The Japanese were instead advocating infant industry protection. Ian Fletcher quotes the exchange about mid-way through his Huffington Post article.

While the truth was a little more complex than that, one can say that the United States did not object mainly due to the realities of the ongoing Cold War. Japan had become the main US ally in the Pacific region and was not to be alienated or driven into the Communist camp that was making headway in Asia.

Perhaps emboldened by its strategic importance, Japan decided to protect its fledging car industry from the 1950s onwards, often through non-tariff barriers (e.g. through foreign exchange rationing). Japan only ever allowed foreign investment when this entailed a significant technology transfer to its own manufacturers, something that may seem familiar to us – albeit perhaps in a less aggressive form – from China today.

The following numbers underline how Japan pulled off the improbable: it acquired leading technology without ever having to rely on foreign direct investment for its economic growth. As a share of GDP, inward FDI flows were virtually zero for most of the high growth period. In post-Deng China, that figure oscillated between 2 and 6%, a significant contributor to economic growth and, importantly, foreign exchange earnings.

It took a while before Japan became a major exporter itself. Yet slowly and steadily, the Japanese were creating niches for themselves, often with “borrowed” technology but increasingly also with advanced domestic R&D. In 1960, French president de Gaulle famously referred to Japanese prime minister Hayato Ikeda as “that transistor radio salesman”.


NHK Broadcasting Museum

By the late 1960s, Japan was already running trade surpluses with most major economies. Infant industry protection had thus “worked” – Japan was increasingly producing and exporting things the world wanted: machinery, motor vehicles and consumer goods.

However, the contribution to GDP growth from exports was never as high as it was in post-Deng China. Infant industry protection was thus not about export promotion, but first about fostering a more productive domestic economy.

Only in the 1980s did the resistance against Japanese protectionism grow, mainly as a result of growing trade deficits the US was running with the East Asian powerhouse. In a discussion akin to today’s trade spats with China, the US requested ever more adamantly the opening of the Japanese market.

In 1985, the Plaza Accord was signed, leading to a sharp Yen appreciation that was to eliminate the effect of some of the tariffs against foreign goods. It also paved the way for a massively accommodative monetary policy (i.e. low interest rates) that was to set in motion the real estate boom and eventually led to the market crash of 1990.

One of the main areas in which Japan remains fiercely protectionist to this day is the agricultural sector, often said to represent the desire to remain a self-sufficient country. However, this protectionism appears more akin to France’s lobbying for its own agricultural sector and is often downright political: Due to peculiarities in Japanese voting laws, the rural support is extremely important for the governing party LDP.

The current debate between agricultural lobby and industrial sector about opening up to more free trade agreements as well as joining the pacific free trade bloc (TPP) is a case in point.

* * *

The second point Pettis raises in his three-point framework are the inevitably vague “internal improvements”. While the American System in its pure form (and hence Pettis in his article) focuses mainly on physical infrastructure, it should include much more than just that, especially with regards to institutions.

But first, let’s talk about physical infrastructure. In 1945, the new Japan “inherited” a railroad grid that had been among the world’s most advanced before the war. Although US carpet bombing destroyed large swaths of (mainly urban) Japan, only 10% of the railway grid got destroyed. The Allies were also not as strict in claiming capital stock as reparation as they had been in Germany. Hence, rail services quickly resumed running on pre-war stock.

But although the first years after the war saw some reorganisation of the railways, no major investment push took place as of yet. The first concerted effort to further develop railroads came with the first five-year plan – as late as 1957. In 1960, the decision to build the Shinkansen line between Tokyo and Osaka was reached using, among others, World Bank funds.

The road grid dating back to the Shogunate had in Meiji Japan always played second fiddle to developing the railroad system. When US forces landed in Japan in 1945 they were surprised about how bad the roads were. The World Bank funded studies of German engineer Franz Xaver Dorsch revealed that by the late 1950s, Japan still had a shockingly inadequate road network.

From the late 1950s onwards, but especially in the 1960s, infrastructure development gained pace. The first time that it attained quasi-religious status in the bureaucracy was in then prime minister Hayato Ikeda’s “income doubling plan”. Specific goals for various sectors were set. It was now widely recognised that infrastructure was a key ingredient of economic growth.

What is striking in Japan’s case, however, is how at least in the beginning so little was spent on railway, roads and other infrastructure without compromising economic growth rates in excess of at least 5% p.a. Gross capital formation of government as a percentage of GDP (which is a good proxy of government infrastructure spending) stood at a mere 3.9% of GDP in 1960. It subsequently grew to 6.0% by 1980, well short of the 10% of GDP China spends on infrastructure today.

Part of this can be explained by spatial economics as well as institutional factors: Japan was a comparatively developed country before the war with urbanisation rates of about 40% as well as a population largely concentrated along the Pacific Coast (Taiheiyo Belt). Moreover, the Economic Planning Agency ensured coordination and prioritisation of the investments.

Today, and somewhat anachronistically, Japan spends more on infrastructure than most of its developed country peers. When the government stepped in to offset sluggish private sector demand after the market crash of 1990, the instinct of the bureaucracy often was to dole out money on infrastructure projects simply because it had worked so well in the past.

A big construction lobby with good political connections formed as a result. Infrastructure spending often turned wasteful and no longer productivity enhancing. Moreover, it contributed to ever growing indebtedness of the national government.

Pettis says that, beyond physical infrastructure, “other things matter too” when we speak about internal improvements. In Japan’s case, these “other things” were arguably at the very heart of the miraculous growth spurt. The interpretation of these factors from institutional economics to sociology has also been subject to some serious, often ideological, disagreement among scholars.

Japan employed an industrial policy, i.e. the government intervened directly in the development of strategic industries. This interventionist approach was in line with Japan’s trade policy of the time, i.e. that of infant industry protection through high tariffs on foreign goods as described above. One of the main agents of this industrial policy was the Ministry of International Trade and Industry, or short “MITI”.

The toolkit of MITI and other government agencies in promoting these strategic industries (e.g. car manufacturing, consumer electronics, etc.) was similar to that of other countries. The Japanese authorities “just” implemented them more stringently and successfully: preferential taxes, direct subsidies, low-interest policy loans, assistance in research and development, entry restriction to avoid harmful over-competition, coordination of output, building infrastructure were some of the measures employed.

The inner workings of MITI have been clouded in mystery. In short, though, the bureaucrats did not employ sophisticated mathematic models of predicting future demand and expected productivity gains. Yet they kept their eyes and ears open to the private sector while not falling hostage to the demands of special interest groups. Despite its apparent simplicity, this component of Japan’s miracle is probably the hardest one to copy for other aspiring countries. Concepts such as “embedded autonomy” are helpful in understanding the initial success of Japan’s bureaucracy.

* * *

Pettis’s third point is the “sound system of national finance”. In the American System, however, this did not mean a prudent and stable system. Frequent bankruptcies and bad loans were part and parcel of America’s 19th century development, e.g. during the great rush towards the West. One of the key strengths of the American way of finance, however, was to quickly recognise losses, liquidate and re-price distressed assets.

In Japan the financial system is and was somewhat more opaque but explains why the miracle could take place in its form during the high-growth years. It can also explain at what cost some of the development was to be achieved: Japan continues to suffer deeply from some of the excesses in corporate finance during the 1980s.

A major feature of post-war Japan was the large-scale mobilisation of private savings for the reconstruction effort. A great account of Japan’s savings culture as well as the government’s strategy of fostering it is available for reading online here.

In 1951, MITI created the Development Bank of Japan which could spend these resources largely off-budget through the FILP – the Fiscal Investment and Loan Plan. While other countries had a similar way of putting their citizens’ savings to work, hardly any other achieved the scale with which this was done in Japan, mainly thanks to high household savings rates. Among other uses, FILP funds allowed for the increasingly rapid infrastructure spending under Ikeda.

The other main feature of the financial system is rooted in Japan’s corporate governance, often dubbed “Japan Inc.”. While the Allied Forces dismantled the largely family-owned zaibatsu conglomerates that dominated the Japanese economy before the war, many of their features survived in the keiretsu that emerged after 1945.

At the heart of a keiretsu was a house bank which lent to conglomerate members and coordinated investments across the group. In turn, these private banks borrowed funds from public banks such as the Bank of Japan. To a large extent, this channelled private savings back into the private sector, albeit under tight supervision of the authorities, chiefly MITI.

An intricate link of cross-holdings between the keiretsu conglomerate members ensured horizontal as well vertical integration where possible. These mutual links also prevented hostile takeovers and ensured stability while the members forayed into new and initially unprofitable business lines.

The horizontal keiretsu (e.g. Sumitomo, Mitsubishi) were involved in almost all large-scale industrial activity from shipbuilding to steel. Toyota developed into the largest vertical keiretsu primarily involved in car manufacturing but controlling the entire value chain.

Japan’s economic miracle unfolded most dramatically in the keiretsu. The role of the bureaucracy is also most visible here. MITI controlled the allocation of capital, foreign exchange and permits to “pick winners” and avoid “detrimental competition” between the conglomerates.

This worked extremely well in an age of industrial mass production, where scale is important and start-up losses are significant: Japan’s steel and automobile industries, for example, were world class by the late 1960s. Technical ingenuity also made Japan world market leader in the up and coming electronics sector.

But just as Japan Inc. had been identified as the reason for Japan’s rise to the top, it was also drawn to explain what went wrong following the bursting of the bubble in the late 1980s and early 1990s. Holding banks were awash with cash and began speculating. Stock market valuations were sky-high (the Nikkei almost breached 40,000 points in the late 1980s), reinforcing the exuberance and leading to more bad lending.

Meanwhile, manufacturing margins began to compress amid growing competition from other Asian nations. Japan did not manage to stay on top of technological innovation as it used to during the boom years. This has become even more apparent in the last couple of years with Japanese electronics giants Sony, Panasonic and Sharp loosing out to their competition. [One notable exception is automobiles, in which Japanese companies continue to excel.]

The above is a far cry from a complete list of factors explaining the Japanese miracle between 1950 and 1973. Other important Japan specific factors were the boost to Japanese GDP derived from the Korean War and Japan’s “pacifist” constitution, which drastically limited defence expenditure.

Over the next weeks, I will read more widely to give the above more meat and detail where necessary. I also want to collect “episodes” that will help to bring the miracle back to life (such as the initial Toyopet export debacle) and that could together with the more serious facts above make the chapter worthwhile. Much work left to be done!

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