Financially and politically passive citizens. Obvious economic underperformance, fed by regulatory neglect and deflationary policies (not to mention overt corruption), would seem to be cause for public outcry. Yet Japanese democracy has not produced a demand for change. While prime ministers come and go, the Liberal Democratic Party retains leadership in the Diet, and neither its members nor the bureaucrats running economic policy are held accountable. The selection by party caucus, not by popular election, of Junichiro Koizumi as prime minister in April 2001 was thought by many to be a signal of potential reform, but nothing much has changed. In October 2002, Koizumi and his party simultaneously gutted the first true bank clean-up proposal since the bubble, and picked up five seats in by-elections nevertheless.

The Japanese population appears to fear high-level stagnation less than it does major changes in established relationships. Indeed, for all the talk of social solidarity, Japan is a society in which the relatively wealthy old exploit younger workers, politically over-represented rural residents exploit urban populations, and incumbent businesses and workers exploit their current relationships to exclude new entrants. These pernicious stabilities are enabled and reinforced by a process in which LDP politicians funnel public largesse and tax breaks to these older and rural voters in return for political (and personal) contributions and safe re-election. Bureaucrats, meanwhile, maintain their power by assuring that current businesses and regulatory structures reinforce each other.

Of course, all advanced societies have special interests, and farmers and pensioners often take advantage of the less-concentrated general public in government budgets. Only in Japan, however, have such narrowly-based interest groups so successfully snatched such a large share of national income, and managed to keep it coming in the face of obvious economic decline.

The same passivity pervades the Japanese financial system. Over 90 percent of Japanese household financial assets are kept in bank accounts, bank certificates of deposit, life insurance or cash. The result is that banks and life insurers in Japan have effectively captive deposits on which they can keep dropping the returns (now nearly zero on most accounts), while their management and shareholders keep their jobs and extract what dividends they can. No one pulls out their money in search of better investments, so there is no more accountability for the banks than for the politicians. This translates into no pressure to write off bad loans or lend to new businesses.

Lack of openness. As a result of all this, Japan's government and established interests have eluded most pressures for change. Passivity is reinforced by the closed nature of much of Japan's economy and society, as reflected by its discouragement of immigration and the virtual absence of regional security or trade integration--there is no East Asian equivalent of NATO, NAFTA or the EU.

Japan's lack of openness is particularly felt in the absence of economic competition for the bulk of its domestic businesses and of its savings to invest. I refer here not to the standard U.S. trade negotiator's demands for market access for American plate glass or apples. What is really at issue is the fact that 80-85 percent of the Japanese economy--particularly service sectors such as retail, transportation and construction--is horribly inefficient, with thousands of politically protected small companies squandering Japan's stock of economic assets. Even many larger manufacturing companies are insulated from competition by tight business-government connections, particularly of bureaucrats to middle management and corporate boards of insiders from companies with cross-shareholdings. These companies secretly allocate the losses from bad investments, delinquent loans and outright waste, and they transfer the cost of those losses to the Japanese consumer and to the 15 percent of Japanese business that is internationally competitive.

Naturally enough, these inefficient companies have a strong interest in not only the substance of protection, but in maintaining the ideological pretense that Japan should have an economic model distinct from that of "the West." In the end, of course, it turns out that the maintenance of their privileges, and that alone, is what constitutes that "distinct" model. This is hardly an environment conducive to the spread of new ideas; rather, it is one that encourages the scapegoating of foreign pressures as a source of difficulty, an indulgence with implications that go far beyond economics.

The German Way

These four determinants of an industrial democracy's proclivity toward the Japan syndrome are all measurable, and, thankfully, it appears that most OECD members have avoided them. The notable exception is Germany.

Germany appears especially susceptible to the Japanese syndrome on account of the structural similarities of the German and Japanese economies. Both were beneficiaries of U.S. reconstruction and open markets after World War II. Both are one-time exemplar economies whose growth rates slowed in the 1980s and fell on increasingly hard times in the 1990s. Both are self-described "consensus" or "stakeholder" societies that organize much of their economic decision-making around tight business-bank ties and collaborative corporate governance. Both de-emphasize stock markets. Both are aging societies with high domestic rates of savings, high labor productivity and low return on capital. And both have been and remain critically dependent on exports for growth.

Of course, these similarities can be misleading, for they do not foreordain similar behavior. Until the late 1990s, there were significant differences in the functioning of the two economies. Postwar West Germany was always more market-friendly than Japan, even after the liberal architect of the Sozialmarktwirtschaft, Ludwig Erhard, left office in 1966. While certainly more regulated than the United States, in contrast to Japan individual German business decisions were not directly influenced by government intervention. German civil servants also tended to stay in government rather than join companies--so that direct business-government ties were limited. Germany also allowed more competition, both domestic and foreign: on the trade side, the value of Germany's imports and exports composes nearly twice the share of its economy as Japan's, and foreign direct investment in Germany is nine times that of Japan. Banks did play the dominant role in German corporate finance and as the place for savings, but German banks were allowed occasionally to fail or be taken over. German bank supervisors were strict.

The electorate held German politicians accountable for economic performance, as well. The decentralized federal political system, installed by the occupying Allied powers, allotted a strong role in determining policy to the opposition in the Bundesrat and in the Länder (state) governments. This gave German citizens a sense of political responsiveness that never developed in one-party, bureaucrat-dominated postwar Japan. The generous distribution of government spoils to average workers and consumers, too, usually through universal welfare programs, reflected the fact that political power in Germany lay with the majority and not, as in Japan, with business management and select interest groups.

Most important, Germany was always more engaged internationally than Japan. This was in large part due to political geography, with West Germany in NATO and on the Cold War's front line. A partial welcome to resident foreigners, from Turkish Gästarbeitern to U.S. troops, added to the sense of openness. (Japan has also hosted resident U.S. troops, of course, but they have been allowed much less social influence in Japan than in Germany.) This was also a matter of enlightened leadership by a succession of German chancellors, strongly backed by a majority of Germans, who simultaneously pursued European integration and the maintenance of transatlantic ties. Membership in the EU, in turn, was then a force for economic liberalization, at least within the single market.

Nevertheless, as with Japan in 1990-92, Germany's main concern now is how to respond to a bubble and its recessionary aftermath. Germany has experienced a real stock market crash--at bottom on October 9, 2002, the DAX index was 68 percent off of its March 2000 peak (compared with a 49 percent drop in the analogous S&P 500 index over the same peak-to-trough period), and the Neuer Markt, Germany's version of NASDAQ, is to be completely shut down by year-end 2003 due to the collapse of the vast majority of its listed companies. Germany also confronts a severe slowdown; since the post-reunification boom of 1990-92, Germany has beaten out Italy for the distinction of being the slowest growing economy in the EU, at an average rate of 1.3 percent a year. In 2002, the German economy grew a mere 0.2 percent, and the government's own revised forecast for real growth in 2003 is only 1.0 percent, which is insufficient to keep public deficits and unemployment from rising further. This is the objective situation. How are German economic decision-makers likely to handle it?

On the first criterion of the Japanese model, incomplete financial liberalization, there is real cause to worry about Germany. In theory, because Germany always had universal banks, there was little to deregulate in terms of bank activities, and banks were already well diversified and so better able to handle shocks. Banks' hidden reserves, comprised of unrealized capital gains on shareholdings of non-financial companies and retained dividends, were supposed to provide cushions to capital adequacy. In practice, however, German financial markets have been in a state of transition in recent years akin to that which preceded the U.S. S&L crisis in the 1980s and Japan's banking problems of the 1990s. And similar to the discoveries made of late by U.S. bank-holding companies, diverse lines of business have proven no defense against cyclical losses.

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