Bill Emmott - International Author & Adviser


What Japan needs to do
Voice - 2009

The distinction between "manufacturing" and "services" does not really tell us much, about value, living standards and long-term prosperity. In America during the 1980s and early 1990s, "services" were often denigrated as being just the creation of jobs as "hamburger-flippers" in McDonalds restaurants. Now, thanks to the collapse of Wall Street, it is being denigrated as being just wasteful trading and speculation by risky investment banks. Yet neither slur is very informative. America really did enjoy rapid growth from 1993 until 2001, as its "new economy" generated an acceleration in productivity that was seen in both manufacturing and in services. The services that benefited included retailing, the law, advertising, accounting, logistics, design, education, health care and many others, including entertainment and the media. Information technology, which was the main source of that productivity revolution, can be applied to both, with benefits for productivity, costs and profit margins. It was not just a matter of booming banking or the flipping of hamburgers.

            This brings us to an even more basic question. What do we mean by "manufacturing"? What do we mean by "services"? It sounds simple: making cars or anything you can drop on your foot must be manufacturing, while lending money or running a restaurant or doing something else intangible must be a service. But in practice the two blend deeply into one another: design and most technological innovation are crucial for manufacturing, and yet both are services. Logistics, advertising, marketing, power distribution, telecommunications, legal advice: all these are services. But they are vital for manufacturers, just as the use of manufactured goods of many kinds (eg computers) is vital for service industries too. And these are sophisticated, high-technology, very knowledge-intensive activities which generate high wages and high profits.

            National statistics on manufacturing and services are quite dangerous to interpret. In countries where "outsourcing" has been a big trend, with manufacturers deciding to buy in from other companies many services such as design, market research, information technology, logistics or even cleaning and maintenance, the drop in the share of GDP officially accounted for by manufacturing has been more rapid than in countries where firms have continued to do these things in-house. But the difference is purely statistical: the activities are the same, even after the outsourcing has occurred.

            That is the real reason why it is a mistake to focus so much on manufacturing country. To focus on whether Japan makes goods or not is to focus on the wrong things. The right thing to focus on is value: whether the economic activities that are dominant in Japan are highly productive, of high value, generating high wages and high profits, which in turn will generate high tax revenues to finance government services. It does not matter whether those productive, high value activities are called "services" or "manufacturing". Many of them will be a blend of both. But in fact it doesn´t matter.

            The real, deep problem in the Japanese economy is that it is not doing enough productive, high value activities. This has been true ever since the 1980s. Overall, according to the OECD, labour productivity in Japan is 30% lower than in the United States. The result is that the potential growth rate of Japan—which is essentially the trend of the labour force multiplied by its productivity—has slumped to just 1.5% a year, on the OECD´s calculations. With the Japanese labour force now shrinking, slowly, as the population ages and declines, so that potential growth rate will depend even more on productivity.

            Broadly speaking, manufacturing in Japan achieves better rates of productivity growth than does services: according to the OECD, the growth rate of labour productivity in services in Japan was just 0.9% per year from 1999 to 2004, while manufacturing has consistently achieved 4% per year productivity growth for the past 30 years. From 2002-07, in fact, it achieved productivity increases of 7% a year while services achieved just 1.8% a year.

So, perhaps Japan should just expand its manufacturing rather than services? If only it could. The trouble is that it is not possible to change the contributions of these activities sufficiently to make the necessary difference: as was said earlier, manufacturing provides 20% of GDP while services provide about 70% of GDP. So even if manufacturing were to expand by half, to 30% of GDP, this would still not increase the overall rate of productivity growth for the whole economy very much. Competition from lower-cost producers in China, India, Korea and many other countries would anyway make it very hard to expand Japan´s manufacturing sector, especially as those lower-cost producers are emulating Japan by improving their technologies.

Instead, what Japan needs to do most urgently is to solve its productivity problem in services, while of course continuing to get more efficient and productive in its factories. If it could do that, then wages and profits in the service industries would rise, and this trend would in turn help manufacturers, as it would increase the domestic demand for their products.

The unproductive nation

All the other problems of Japan, the ones that Japanese and foreigners alike generally cite, flow from this basic productivity weakness. The high level of public debt, now approaching 200% of GDP in gross terms, exists because of weak economic growth and poor tax revenues, both of which arise from low productivity growth, which means that incomes and profits do not increase as much as they could, which limits the tax base. Demographics, namely the ageing and gradual shrinking of the labour force and of the population as a whole, would not be as big a burden on Japan if productivity growth would accelerate. Deflation, the enfeebling problem of falling prices and wages that has existed since the late 1990s and has now returned, following the shock of the global crisis, would be quickly dealt with if faster productivity growth permitted and encouraged the payment of higher wages.

            This poor record on productivity has many causes. The bursting of the bubble in the early 1990s left Japan with excess production capacity even in manufacturing, which discouraged productivity-enhancing capital investment. The growing competition from China and other emerging economies has forced down prices for many manufactured goods and hurt profit margins: this could, in theory, have encouraged productivity-enhancing investment as a response, and the achievement of 7% annual growth in labour productivity in 2002-07 suggests that it did. But that impact was softened by the reforms to labour laws. As was explained earlier, these did reduce companies´ production costs for a few years and thus protected profit margins. But they did so at the price of falling household incomes, declining consumer spending and so weak domestic demand.

            The 34% of the labour force now working part-time and on temporary contracts are employed both in service industries and in manufacturing. Cutting labour costs in this way helped keep Japanese export industries competitive against Chinese and Korean rivals. The result is a strange one. For Japan´s economy is extraordinarily lopsided.

            As has been noted, Japan´s growth, during the recovery that began in 2002 under the Koizumi administration and continued until the global economic crisis intervened, was heavily dependent on expansion in exports. Yet exports are not, in fact, a large contributor to Japan´s overall GDP. Exports of goods and services are equivalent to only 17.6% of GDP in total. The figure for Germany is 47%. So Japan´s export-dependent growth in the past half decade actually implies a dependence on industries producing less than one-fifth of economic output. The other four-fifths did not produce much growth. Crucially, most of those four-fifths consisted of services.

            Cheap labour, provided by the new labour laws, helped slow down productivity growth in services too. So, however, did a basic lack of competition. Manufacturing industry, especially the part of manufacturing that produces for export, faces huge amounts of competition from countries all over the world, competition that has become steadily more intense. That is not true of service sectors in Japan. They are not exposed to international competition, which ought to arise either from imported services or from foreign direct investment by service firms, neither of which have been prevalent.

             Nor is competition intense between domestic firms. Think of advertising, television, the law or wholesale distribution and logistics: is there a lot of competition in those sectors in Japan? No: either they are protected by government regulation against new competitors, or cartels and oligopolies restrict competition. The cost of electricity, one of the most basic services that exists, for both companies and for households, is higher than in other OECD countries, according to the OECD´s economists. The same is true for telecommunications costs.  The pressure to innovate and to raise productivity is weak in many service sectors. Hence the bad outcome in recent years, despite the great opportunities offered by information technology and the internet. Hence, therefore, the bad performance of wages, consumer spending and the Japanese economy as a whole.

What Japan should be: "the intelligent nation"

The economic answer for Japan is not that it should focus on its traditional strength, of manufacturing. Nor is it the opposite, that it should ditch manufacturing and focus on some service industries. It has to be both. Only by improving productivity growth in both services and in manufacturing, by increasing efficiency and improving technology, will Japan maintain and even raise the living standards of its people in the future. What this means, overall, is that Japan and Japanese policymakers need to remind themselves of one of the key insights of Peter Drucker, the great Austrian-American management guru who died in 2005 just before his 96th birthday. This was his observation, first made as long ago as 1959, that we now live in a knowledge economy.

            Knowledge is what makes the difference between success and failure, progress and regress, profitability or loss-making, in all aspects of economic life. This means that a primary goal of public policy should be to increase the knowledge-content—in other words, the intelligence, efficiency, innovativeness and productivity—of every section of the economy, both public sector and private, and whether in manufacturing, services or agriculture.

            The poor record in productivity growth in the services sector, 70% of the economy, shows that this insight of Peter Drucker´s has been ignored or misunderstood in Japan. Indeed, in most respects Japan has been becoming a less intelligent, less knowledge-oriented economy during the past 10-15 years. The fact that Japanese universities have generally slipped down the rankings of the world´s top research and teaching institutions confirms that point. If Japan had been following Drucker´s analysis, the opposite would have happened: as it got wealthier, it would have invested more in its universities and turned them into world leaders.

            Further and even more damaging confirmation comes from the spread during the past 15 years of part-time and irregular contract working, now extending to 30% of the workforce. Such workers receive little training from their companies and so accumulate little human capital. They are not being treated as the "knowledge workers" that Peter Drucker recommended they should be: they are being treated as cheap, untrained, unskilled labour. There are now fewer "knowledge workers" in Japan than there were two decades ago.

            This is very strange. As the bubble economy reached its peak in the late 1980s, so Japan´s GDP per head started to overtake America´s. At that time, Japan looked like the ultimate modern knowledge economy, using high technology, well trained and educated workers, and excellent social organization to produce competitive products. A country where living standards were so high, relative to other countries, looked likely to be a country that would invest more than others in knowledge, and would therefore increase its wealth in the future. In one sense, Japan did just that, and still does: Japan´s spending on research and development, at 3.5% of GDP, is one of the highest among the rich OECD member countries. But a knowledge economy is not driven by R&D alone. It is driven by productivity and the application of new technologies to lower costs and create new goods and services. It is driven by the spread of intelligence and of intelligent ways of working, throughout the country, not just in manufacturers´ R&D laboratories. That is what Japan has failed to do. It has failed to become an intelligent nation.

Will the Hatoyama government make things better, or worse?

We are, however, at the beginning of a great change: the change to a system of politics in which parties alternate in power; a change to a system in which politicians have a greater influence over policy than do bureaucrats, which ought also to make policy more open and accountable to the public; and, most immediately, we are at the beginning of a period in government of the DPJ-led coalition. The question is, whether the policies proposed by this new government will rise to the task of making Japan a more intelligent, more productive and so wealthier nation.

            Many economists are skeptical. Their skepticism begins with Mr Hatoyama´s attack on "market fundamentalism". If what is needed to boost service-sector productivity is more competition and deregulation, then his position during the campaign does not bode well. Nor do his appointment of Kamei Shizuka as the minister in charge of Japan Post, and Mr Kamei´s immediate move to reverse the Koizumi policy of privatization. Economists become even more skeptical when they examine the DPJ´s proposals for reforming the labour market: they intend to reduce the use of part-time and irregular workers, which may be good, but they have produced no plan to reform the labour market as a whole. What is needed is a single, more flexible set of labour laws that apply to all workers, whether full or part time, whether regular or irregular.

            However, as Richard Jerram, chief economist at Macquarie Research in Tokyo and a long-time expert on Japan, has written in an excellent report in September 2009, "Four Challenges for the DPJ", it may well be a mistake to be too impatient as well as to take the DPJ´s election manifesto too literally. Political reform, in order to take full control of the organs of government away from the bureaucracy, may well be necessary before economic reform can truly be attempted. And dealing with the immediate weakness of the economy, by maintaining the fiscal stimulus while re-allocating some of the spending towards the poorest in society, could well be extremely sensible.

            It is certainly necessary for the DPJ to show that it can maintain economic growth and progress during the next few months, in order to have a chance of winning a majority in the Upper House of the Diet in the July 2010 elections. If the DPJ were to introduce any shocking or dramatic economic reforms during the pre-election period it would risk scaring away voters. The long-term prospects for reform are more important than the immediate prospects.

            Here, there is at least a chance that the DPJ could follow the right path. In my opinion, the right combination of policies would be to make a major effort to rebuild Japan´s welfare system, allocating more money to the poorest and to parents and reducing the extreme inequality that now characterizes Japanese society, while beginning a programme of deregulation and structural reform in the service industries. This would, in other words, be a mixture of fairly socialist measures in public spending and very pro-market, or economically liberal, measures in terms of deregulation.

            When I met Mr Hatoyama last November, I asked him what his domestic-policy priorities would be, in his first year in office. Certainly, he made it clear that he is serious about wanting to re-allocate public spending away from wasteful projects and in order to re-build the welfare system of pensions and health care. He also wants to reform the labour market as soon as possible. But also, he acknowledged the possible need for more deregulation in the service industries in order to re-invigorate Japan. This is encouraging.

            Such a mixture  of welfare spending, labour reform and service-sector deregulation could have the immediate benefit of boosting consumption. People earning the lowest incomes tend to spend anything they earn or borrow: they cannot afford to save. So if their incomes rise a little, whether because of higher social benefits or a higher statutory minimum wage, they are likely to spend the extra income rather than saving it. As a way to boost consumption, giving money to the poor is much better than cutting taxes or increasing subsidies for richer people and companies.

            In the longer term, it would also meet a real need, as Japan´s society changes. In the past, state welfare support could be small, by comparison with European countries, because so much of it was provided by companies and by families. But that is no longer strong enough to be relied upon. Families are smaller, thanks to the declining birth rate, and fewer young people are getting married. The spread of part-time and irregular working has greatly weakened the influence of companies on the welfare of their employees. Many employees—certainly the 34% in the part-time and irregular categories—can no longer rely upon an employer to look after them.

            At the same time, the health system, which is much admired all around the world for its efficiency, equity and success in terms of life expectancy, is under severe financial strain. The ageing of the population inevitably means that medical costs are rising, and demand for hospital treatment are rising too. This has to be financed out of higher taxation.

            So the traditional situation, in which Japan´s taxation has been at American-style levels of about 35% of GDP, even as its social stability, sense of welfare support and quality of health care have been more comparable with those of Western Europe, is no longer sustainable. Japanese public spending has already risen to nearly 45% of GDP: the gap between that number and the tax revenues represents the budget deficit. Western European countries typically raise taxes and spend public money at levels of 45-55% of GDP, with smaller budget deficits (except in Britain, where the deficit is now emulating Japan). Japan is going to have to move in that direction, raising its public spending still further, to closer to the levels typical in Europe. The DPJ´s election manifesto offers a clear acknowledgement of that need. Japan needs to become more European in the way in which its state functions and finances itself.

            In that case, however, Japan will have to become more European on the tax side of the public ledger, as well as on spending. In other words, it needs to generate the tax revenues to finance this extra public spending. It cannot carry on financing public spending essentially through borrowing the accumulated savings of the Japanese people, as has been the strategy since 1990. That is what is meant by Japan having net public debts equal to 100% of GDP: once you exclude money owed by one government agency to another (which is what is included in figures for "gross public debts", amounting to 200% of GDP), what you are left with is the government´s borrowing of the Japanese people´s savings.

            Those savings are declining year by year, as the population ages and as incomes have been falling. The cost of borrowing all that money has been low, chiefly thanks to deflation which has kept interest rates very low. But that cannot be guaranteed to last. The high level of public debt leaves Japan´s government vulnerable to any sudden rise in borrowing costs. And, in any case, the logic of the DPJ´s programme is that public spending is destined to rise, over the longer term. So a way must be found to generate sufficient tax revenues to finance that programme, as well as to reduce the public debt.

            That way can only be faster growth in Japan´s service industries. As I have already shown, manufacturing industries are simply too small to support the whole economy, and the prospects for their export growth in a rebalancing world economy is anyway not very good. The only way to achieve faster service-industry growth is deregulation and tougher enforcement of competition laws.

            So "market fundamentalism", if that is what Mr Hatoyama means by deregulation, is the only possible solution to Japan´s basic problem: slow growth, because of slow productivity growth in the service industries that make up 70% of the economy. Most likely, what he was really trying to attack was free-wheeling finance of the sort practiced by Wall Street during this decade: rampant speculation and trading in credit derivatives. I do not disagree with him: the principal underlying causes of the financial crisis of 2007-09 was the combination of the very expansionary monetary policy favoured by Alan Greenspan when he was chairman of the Federal Reserve Board until 2006 with non-existent regulation of financial institutions´ trading in derivatives. As I argued in earlier articles in this series, there is an urgent need to raise capital requirements for banks and to bring derivatives into the transparent and strict regulatory system co-ordinated globally by the Bank for International Settlements in Basel, Switzerland.

            By contrast, while more regulation is needed for financial institutions, Japan´s main service industries—retailing, wholesaling, telecommunications, transportation, the law, media, entertainment, advertising, electricity distribution, seaports, airports, and many others—need more competition, more innovation, and faster productivity growth, all of which can come only from deregulation. Such deregulation can, as in Britain, be combined with the setting up or strengthening of government agencies to police competition and to ensure prices are kept low in utility sectors such as electricity or telecoms.

            If the DPJ were to adopt this strategy, it would be able to claim a complete contrast between its approach and that of the LDP. Governments led by the LDP and by the traditional bureaucracy have favoured the manufacturing sector, where many of Japan´s biggest companies can be found. By doing so, they were focusing just on 20% of GDP. By emphasizing deregulation and growth for service industries, alongside manufacturing, the DPJ could claim to be genuinely supporting prosperity in the whole nation, not just one-fifth of it.

            A stronger welfare state combined with service-sector deregulation: that is the path towards a truly intelligent nation. It would stand a good chance of fulfilling Peter Drucker´s vision of the modern knowledge economy. It would stand a good chance of generating the tax revenues to finance itself, and the rising wages necessary for higher living standards. It is the only combination, the only path, that is capable of dealing with the burden of an ageing population. In fact, it is the only viable path for Japan.


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