Why Did Japan, Inc. Fail?

In 1991 Japan could look back on three decades of growth at an average rate of 6.5 percent. In the 1980's Japan dominated consumer electronics, semiconductors, automobiles and Japanese companies were buying up American properties at an alarming rate. But the past five years have been ones of economic gloom and the solution is elusive. Nissan's auto sales have fallen 22 percent and it has closed factories. Property values have fallen 50 percent and resulted in bad loan losses for Japanese banks of as much as $1 trillion. Homebuyers on around 1990 are burdened with properties that are worth half of what they paid for them.

Japanese companies are suffering and not investing, at least not in Japan. The new factories are going to Malaysia and Thailand. This is called kudoka, the hollowing out of the Japanese economy.

-"The Failed Miracle" by Edward W. Desmond Time April 22, 1996, pp. 60-64.

I. Introduction

In the 1970s and 1980s, Japan appeared to be destined for greatness.  The focused industrial policy of MITI combined with the long-term thinking of the keiretsu, employing the latest quality control and supply chain management techniques, seemed to be an unstoppable force.  Even the Plaza Accords didn't derail Japan's rise.  Yet, after the real estate bubble collapsed in the early 1990s, corporate Japan's momentum appeared to be mortally wounded, never to recover.  To be sure, some internationally-focused firms like Toyota continue to prosper even today, but the electronics giants–Toshiba, Sony, Panasonic, Hitachi, et cetera–entered a long period of decline, and have struggled to restructure and regain competitiveness ever since.  What happened?

II.  Perception and Reality

While much has been written about the drivers of Japan's economic miracle, the following table summarizes the point nicely:


U.S. 1900-1986 2.1% 0.25% 1.85%
JAPAN 1970-1989 0.3% 2.9% 1.5%

Source: Shigeto Tsuru, Japan's Capitalism: Creative Defeat and Beyond (via Thayer Watkins)

Capital investments drove most of Japan's growth, while technological change accounted for a large portion of the remainder.  This accords well with the general perception of Japan's economy, as based on advanced manufacturing and R&D to support Japan's competitive advantage in that regard.  It's important to note that the time periods of comparison between the US and Japan are not aligned, so this shouldn't be used to draw conclusions about what the US should have done (e.g. its capital stock was not destroyed in WWII, unlike Japan, so a project of capital deepening similar in scale to Japan's would not have been appropriate).

But was Japanese industry, even at its peak, really so efficient?  It turns out that Japan had an internationally-facing, super-efficient manfaucturing segment that accounted for about one third of manufacturing employment, and the rest was a coddled, domestic-facing and inefficient manufacturing industry.  Per Thayer Watkins:


Richard Katz in Japan, the System That Soured: The Rise and Fall of the Japanese Economic Miracle makes the case that Japan has a dual economy, one part which is efficient, even super efficient, and another that is notable inefficient compared to the U.S. He substantiates this point by displaying the data on the relative output per hour in the U.S., Japan and for comparison Germany.

Indices of Output per Hour in Various Industries, 1990
Industry United States Japan Germany
Machinery and Equipment 100 114 88
Basic and Fabricated
Metal Products
100 96 99
Chemicals and Allied Products 100 84 77
Other Manufacturing 100 55 80
Textiles, Apparel
and Leather
100 48 88
Food, Beverages
and Tobacco
100 37 76
Total Manufacturing 100 78 86

While Japan has some industries that have higher labor productivity than the U.S. overall in 1990 Japanese manufacturing was 22 percent less productive than American manufacturing. Overall German manufacturing industry, while less productive than the U.S., was more productive than Japan. 

Indices of
Real Value-Added 
per Hour, 1993
Country Index
United States 100.0
France 87.8
Germany 82.5
Japan 76.2
United Kingdom 69.8

The conclusion is that Japan industry is a mixture of efficient and inefficient sectors and the overall mix is such that Japan's manufacturing has a lower labor productivity than the U.S. and other industrialized countries such as Germany and France.

In essence, a small segment of Japan, Inc. was disproportionately driving Japan's growth, and once that sector fell into stagnation, Japan didn't have alternative growth engines to fall back on to spur economic activity.  Despite the common perception at the time, Japan was not, on the whole, the fearsome economic machine whose economic philosophy was unilaterally superior to that of America's.

III. The Digital Economy and Modularization

We've seen some of the numbers behind Japan's inefficiency, but what happened to Japan's "super-efficient" manufacturing sector?  What was the cause for the decline of Japan's electronic titans? According to Reiji Yoshida at the Japan Times, it was modularization:

Experts say a common enemy of the Japanese manufacturing titans was modularization, an approach that changed the landscape of the global home electronics industry.

Modularization refers to the packaging of multiple digital functions into a single electronic component equipped with standardized interfaces. Using standardized modules makes it easy to assemble them into products with little adjustment or customization. Products built this way now include TVs, computers, DVD players and low-end digital cameras.

“I don’t think Japanese companies can win when it comes to assembling module components,” said Yukihiko Nakata, a former top Sharp engineer who is now a professor at Ritsumeikan Asia Pacific University in Beppu, Oita Prefecture.

Unfortunately for Japan Inc., the modularization revolution, made possible by the 1990s digitization boom, has drastically lowered the cost of making home electronics, which means companies that can mass-produce parts using cheap labor anywhere in the world have a distinct advantage.

Notorious for its slow decision-making, Japan Inc. lost much of its hard-earned competitiveness by sticking to its traditional approach of integrating customized technologies from different fields — an approach that usually involved both analog and digital technologies.

In other words, the curse of conglomeratization finally caught up with Japan.  As global trade was quickly followed by the globalization of supply chains, manufacturers could being to select components a-la-carte from the most competitive sources, instead of being locked in to the entire portoflio of components, and their integration into a coherent product, of a single Japanese conglomerate.  Yoshida provides a good example:

Another was its failure to adapt to the sudden modularization of cellphone architecture in 2007, Nakata said.

In that year, numerous Chinese firms began assembling cellphones based on an open architecture design released by MediaTek, a Taiwanese semiconductor company, Nakata said.

MediaTek publicized its “reference designs,” or cellphone blueprints, because it wanted to sell more semiconductor products.

“Such a move was unthinkable at the time because design was usually the top secret of secrets,” Nakata said.

By making use of open designs, a key semiconductor chip and free software from MediaTek, many companies became capable of making cell phones on the cheap.

This sparked competition among hundreds of new cell phone makers, Nakata said.

But it also destroyed Sharp’s business model, which was based on profiting from long-term relationships with a handful of cellphone makers who were dependent on customized designs and components, Nakata said.

An article from the BBC attemps to explain this phenomenon through the prism of software:

Digital challenge

According to Tokyo-based economist Gerhard Fasol, the Japanese giants were overtaken by the digital revolution.

The Japanese giants, he says, actually built their empires on making complex electrical machines – colour televisions, radios, cassette players, refrigerators, washing machines.

Yes, they contained electronic components, but they were basically mechanical devices.

But then came the digital revolution, and the world changed.

"The Sony Walkman is a classic example," Gerhard Fasol says. "It has no software in it. It is purely mechanical. Today you need to have software business models that are completely different."

The digital revolution not only changed the way electronic devices work, they changed the way they are made.

The whole manufacturing model shifted as companies moved production to low-cost countries. That has put huge downward pressure on profit margins for Japanese manufacturers.

"Look at Apple," Mr Fasol says. "They make iPods and iPhones."

"Apple makes at least 50% profit margins on those. People say iPhones are made in China, but maybe only 3% of the value of an iPhone stays in China."

"So it's hard to become rich today on the scale of a Panasonic just by manufacturing – you have to do a lot more."

IV.  The Global Supply Chain

Capitalism's comparative advantage explains why corporate America abandoned the conglomeration model decades before Japan, and therefore why corporate America had the flexibility to restructure and regain momentum while Japan did not.  Per Wikipedia:

The theory of comparative advantage is an economic theory about the work gains from trade for individuals, firms, or nations that arise from differences in their factor endowments or technological progress.[1] In an economic model, an agent has a comparative advantage over another in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.[2] One does not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries.[3] The closely related law or principle of comparative advantage holds that under free trade, an agent will produce more of and consume less of a good for which they have a comparative advantage.[4]

David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country's workers are more efficient at producing every single good than workers in other countries. He demonstrated that if two countries capable of producing two commodities engage in the free market, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labor productivity between both countries.[5][6] Widely regarded as one of the most powerful[7] yet counter-intuitive[8] insights in economics, Ricardo's theory implies that comparative advantage rather than absolute advantage is responsible for much of international trade.

Japan ignored David Ricardo's theory at its own peril, and for too long retained production in-house of those components that it would have been better off outsourcing to more competitive suppliers.  Even as Japan moved production offshore in the 1990s, it was its own production, simply in a different geographic location, rather than outsourcing the production to a subcontractor abroad.  Despite the hue and cry of the American worker over lost jobs, this is a lesson that corporate America learned early, and exploited by offshoring to China.  The alternative was not necessarily jobs at home in America, but rather zombie companies supported by ailing banks, and a long period of national stagnation–that is, America's non-offshoring future would have been Japan, not the America of today.

Japan, Inc.'s failure to recognize the reality of its diminished competitiveness led to Japanese manufacturers hesitating to rationalize production in the hope that an economic rebound would increase utilization rates and restore profitability; banks continued to finance these zombie companies in the hope that they would someday rebound, be able to repay their loans, and allow banks to avoid writing off non-performing loans and thus imparing their own balance sheets; and the central government continued to pour massive amounts of taxpayer funds into wasteful public works projects and corporate bailouts, further driving Japan into unimaginable levels of debt:

Date Amount
Aug 92 98.2 Public works, housing loans
Apr 93 121.1 Public housing and infrastructure
Sept 93 56.9 Deregulation of the
corporate bond market
Feb 94 140.4 Direct spending (64%)
tax cuts (36%)
Apr 95 44.1 Issuance of general revenue bonds
Sept 95 130.3 Public works (Kobe earthquake
reconstruction) (90%)
Deregulation (10%)

Fortune, August 19, 1996, "Japan's Endless Rescue Package" (via Thayer Watkins)

Japan has come to embrace the same offshoring and outsourcing strategy, sending much of its lower value-added production to China and Southeast Asia, but it has lost precious time:

Japan Corporate Investment 3

(Source: IMF)

In addition, Japan hasn't kept up its investments in plant and equipment, which impedes its ability to use the latest techniques and technology.  The level of absolute investment has fallen to levels last seen in the 1980s:

Japan Corporate Investment 2

(Source: IMF)

China has begun to move up the value chain, investing massive resources in R&D, and may soon challenge Japan in the high value-added segment, while Japan's relatively poor demographic outlook and high labor and ancillary manufacturing costs (e.g. electricity) mean that even the increasing use of robotic assembly may not be enough to preserve Japan's place in the top tier of advanced manufacturing.

V.  Galapagos Syndrome

Another reason for Japan, Inc.'s failure to adjust and succeed globally is what the Japanese like to call "Galapagos Syndrome."  Per the New York Times:

“Japan is years ahead in any innovation. But it hasn’t been able to get business out of it,” said Gerhard Fasol, president of the Tokyo-based IT consulting firm, Eurotechnology Japan.

The Japanese have a name for their problem: Galápagos syndrome.

Japan’s cellphones are like the endemic species that Darwin encountered on the Galápagos Islands — fantastically evolved and divergent from their mainland cousins — explains Takeshi Natsuno, who teaches at Tokyo’s Keio University.

Yet Japan’s lack of global clout is all the more surprising because its cellphones set the pace in almost every industry innovation: e-mail capabilities in 1999, camera phones in 2000, third-generation networks in 2001, full music downloads in 2002, electronic payments in 2004 and digital TV in 2005.

Japan has 100 million users of advanced third-generation smartphones, twice the number used in the United States, a much larger market. Many Japanese rely on their phones, not a PC, for Internet access.

Indeed, Japanese makers thought they had positioned themselves to dominate the age of digital data. But Japanese cellphone makers were a little too clever. The industry turned increasingly inward. In the 1990s, they set a standard for the second-generation network that was rejected everywhere else. Carriers created fenced-in Web services, like i-Mode. Those mobile Web universes fostered huge e-commerce and content markets within Japan, but they have also increased the country’s isolation from the global market.

Then Japan quickly adopted a third-generation standard in 2001. The rest of the world dallied, essentially making Japanese phones too advanced for most markets.

At the same time, the rapid growth of Japan’s cellphone market in the late 1990s and early 2000s gave Japanese companies little incentive to market overseas. But now the market is shrinking significantly, hit by a recession and a graying economy; makers shipped 19 percent fewer handsets in 2008 and expect to ship even fewer in 2009. The industry remains fragmented, with eight cellphone makers vying for part of a market that will be less than 30 million units this year.

Several Japanese companies are now considering a push into overseas markets, including NEC, which pulled the plug on its money-losing international cellphone efforts in 2006. Panasonic, Sharp, Toshiba and Fujitsu are said to be planning similar moves.

The discussion then turned to the cellphones themselves. Despite their advanced hardware, handsets here often have primitive, clunky interfaces, some participants said. Most handsets have no way to easily synchronize data with PCs as the iPhone and other smartphones do.

Because each handset model is designed with a customized user interface, development is time-consuming and expensive, said Tetsuzo Matsumoto, senior executive vice president at Softbank Mobile, a leading carrier. “Japan’s phones are all ‘handmade’ from scratch,” he said. “That’s reaching the limit.”

Then there are the peculiarities of the Japanese market, like the almost universal clamshell design, which is not as popular overseas. Recent hardware innovations, like solar-powered batteries or waterproofing, have been incremental rather than groundbreaking.

The emphasis on hardware makes even the newest phones here surprisingly bulky. Some analysts say cellphone carriers stifle innovation by demanding so many peripheral hardware functions for phones.

The conflict between Japan’s advanced hardware and its primitive software has contributed to some confusion over whether the Japanese find the iPhone cutting edge or boring. One analyst said they just aren’t used to handsets that connect to a computer.

The forum Mr. Natsuno convened to address Galápagos syndrome has come up with a series of recommendations: Japan’s handset makers must focus more on software and must be more aggressive in hiring foreign talent, and the country’s cellphone carriers must also set their sights overseas.

“It’s not too late for Japan’s cellphone industry to look overseas,” said Tetsuro Tsusaka, a telecom analyst at Barclays Capital Japan. “Besides, most phones outside the Galápagos are just so basic.”

The article was written in 2009, and in 2016, we can see that the various companies mentioned have failed in their attempt to gain market share overseas.  It's become clear that Japan has reached the logical end of its manufacturing prowess, and without a successful transition to more holistic thinking (e.g. how the phone fits in the overall technological ecosystem) and a focus on software, Japan, Inc. will be at a disadvantage to more nimble and innovative firms abroad.

VI.  The Way Forward

As mentioned in the previous section, Japan can attempt to imitate America's strengths, and try to compete through better software design and innovation (although in Japan's case, it is more likely to be innovation driven by large corporations rather than start-ups).  Alternatively, Japan can focus on its core competencies and re-embrace the advantages that made Japan, Inc. strong to begin with.  Returning to the BBC article:

Hiroaki Nakanishi is the 66-year-old English-speaking president of Hitachi Corporation.

When he took over the reins at the 100-year-old engineering giant in 2010 it too was bleeding red ink. Mr Nakanishi immediately decided to do something very un-Japanese. He closed or sold loss-making divisions, most of them in consumer electronics.

"Digital technology changed everything," he says.

"In the television industry it means that just one chip is now needed to produce a large and high quality TV picture. So now everybody can do it."

"That means the new players from Korea and China, they now have the advantage."

Hitachi had built its reputation on having the best technology. But now competition has switched to who has the best sales and marketing strategy, and the biggest advertising budgets. Mr Nakanishi says the Japanese companies just couldn't keep up.

"The structure of the industry had completely changed," he says. "We could not adjust to such an environment. So that is why I gave up those segments."

'Brain country'

Mr Nakanishi decided to return Hitachi to its core business: heavy engineering. Gas turbines, steam turbines, nuclear power plants, high-speed trains, these are the areas he believes Hitachi can still be a world beater, especially in the developing world.

"In developing countries they don't have specific planning and construction know-how [for big infrastructure projects], but we have," he says.

"It is not simply a case of selling machinery, but also the engineering, planning, even sometimes the financing of a project. That total process, that is our most important advantage."

Mr Nakanishi's strategy is working. Hitachi is back in profit. Hitachi trains are the front-runner in the competition to replace all of the UK's fleet of inter-city high-speed trains.

But it will not be as easy for the others.

Sony is the strongest of the three. But even Sony makes far more money today out of selling life insurance than it does out of making electronics. Panasonic and Sharp have less to fall back on.

Gerhard Fasol says that once again, just as they did back in the 1950s and 60s, the Japanese companies need to learn from America.

"It's no coincidence that many of the most successful companies today are in Silicon Valley," Mr Fasol says.

"Companies like Cisco or Oracle are not affected by the Korean competition. Japan has to become a brain country. It's a country like Switzerland or England."

"You have very high education and very clever people so you have to use that. Sometimes that value can be captured through manufacturing, but in other cases through software. And software has been neglected in Japan."

Manufacturing for those who can be competitive, software for everyone else.  But can Japan be competitive in software?  That remains to be seen.

VII.  Conclusion

The economic fallout in Japan led policymakers to draw conclusions that would help some of the Asian Tigers recover quickly after the Asian Financial Crisis in 1997.

  • Don't underestimate required speed and scope for the needed reforms
  • Act fast to clean up financial systems hobbled by bad debt
  • Promote transparency
  • Accept short-term pain, such as lay-offs, for long-term economic gain
  • Use capital efficiently

(Source: "This Will Hurt," Far Eastern Economic Review, Dec. 4, 1997, pp. 74-78, via Thayer Watkins)

Ironically, China appears to be a poor student in this regard, in that it has strongly embraced a mercantilist strategy of maximizing domestic economic activity at the cost of maximizing economic value.  While China did a remarkable job cleaning up its own banking crisis in the 1990s, its current leadership appears to be working counter to the above lessons by slow-walking reform, reversing transparency and increasing opacity, showing unwillingness to accept short-term pain, and using capital in increasingly wasteful endeavors.

China's zero-sum game of building national wealth while simultaneously hollowing out the economies of its trading partners is, by definition, unsustainable, and we have already seen global trade beginning to contract in response.  Will China, Inc. someday suffer the same fate as Japan, Inc., or will it embrace the lessons (and benefits) of globalization before it's too late?  

This excerpt from an IMF working paper attempting to explain why global trade growth is slowing (and recently, even contracting) is in accord with my speculation above.  Among other factors:

In this respect, China and the United States are paradigmatic of two different situations. Because of data limitations, we can only present some circumstantial evidence. Note that the manufacturing supply chain between China and the United States, took to a large extent the form of parts and components being imported by the former and then being assembled into final goods which were exporter to the latter. The diminishing importance of such trade is reflected in the falling share of imports of parts and components in China’s merchandise exports, from the peak in the mid-1990s of 60 percent to the current share of approximately 35 percent (Figure 8).16 This decline is even more pronounced as a share of manufacturing exports, which is not surprising given the growing importance of Chinese manufacturing exports in total merchandise exports over the period. The falling share of imports of parts and components reflects the substitution of domestic inputs for foreign inputs by Chinese firms, a finding that is corroborated by evidence of increasing domestic value added in Chinese firms (Kee and Tang, 2014).17

The reduced responsiveness of manufacturing trade with respect to income for the United States mirrors in some ways developments in China. In the 1990s, as US firms increasingly relocated production stages outside national borders, trade tended to respond more to changes in income as variations in domestic demand were increasingly met by imports. In recent years, the international fragmentation process seems to have leveled off. Figure 9 provides preliminary evidence. While merchandise imports grew consistently in the United States since the 1980s, the share of manufacturing imports in merchandise imports (and in national GDP) declined since the early 2000s. In fact, US manufacturing imports as a share of GDP have been stable at around 8 percent since the turn of the century, after nearly doubling in the preceding decade-and-a-half. Interestingly, Chinese manufacturing imports as a share of GDP rose from 10 percent at the beginning of the long 1990s to almost 30 percent in the early 2000s and have sharply declined since then.

And here is footnote 17, relating to the sentence I set in bold above:

These changes do not mean that China is turning its back on globalization. As discussed in Kee and Tang (2014), the enhanced availability of inputs domestically is in part linked to growing foreign direct investment in these industries. Moreover, there may be a geographical dimension to these changes, with China’s coastal regions beginning to source relatively more from the Chinese interior, because transport and communication costs have declined more sharply with the interior than with the rest of the world. Trade integration may now be taking the form of greater internal trade than international trade, which is captured by official statistics.

China is a large economy with a massive population, so there is nothing sinister in this development.  That said, until and unless China does for the rest of the world what the United States did for China (i.e. investing and offshoring production, then providing a vast market for Chinese manufacturers to export into), it's likely that global trade will enter a secular decline.  Given China's primacy in global trade flows, one wonders whether China will bear a disproportionate consequence for this development, or if it will sufficiently reform and rebalance its investment-led economy to a consumption-led economy in time to avoid a negative result.  One can hope that China, perhaps under more visionary leadership, may learn the lessons of Japan and the United States and achieve a better outcome.

Ultimately, however, this article is about Japan.  Will Japan be able to turn around its stagnant economy, and once again become a dynamic, innovative, and efficient engine of the world economy?  Prime Minister Shinzo Abe's inability to push through his "third arrow" of reform, the structural component, bodes ill for Japan.  While joining the TPP should open up the Japanese economy to more competition, and thus drive efficiency gains, it's unclear what will spark the change in Japan that will lead it to embrace a more risk-taking, innovative culture.  Only time will tell–but in many ways, time is running out for Japan.