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A volume in the series
CORNELL STUDIES IN POLITICAL ECONOMY
edited by Peter J. Katzenstein

A full list of titles in the series appears at the end of the book.
 Japan
Remodele
HOW GOVERNMENT AND

INDUSTRY ARE REFORRAING

JAPANESE CAPITALISM

STEVEN K. VOGEL

Cornell University Press 1THACA AND LONDON

Copyright © 2006 by Comell University

All rights reserved. Except for brief quotations in a review, this

book, or parts thereof, must not be reproduced in any form without
pennission in writing from the publisher. For information, address
Cornell University Press, Sage House, 512 East State Street, Ithaca,
New York‘14850.

First published 2006 by Cornell University Press

First printing, Comell paperbacks, 2007
Printed in the United States of America

Library of Congress Cataloging-in-Publication Data

Vogel, Steven Kent.
Japan remodeled : how government and industry are reforming OS
Japanese capitalism / Steven Vogel. Q a
p. cm.—(Comell studies in political economy) e
Includes bibliographical references and index. & 20
ISBN-13: 978-0-8014-4449-4 (cloth : alk. paper) j
ISBN-i0: 0-8014-4449-7 (cloth : alk. paper) Vv g 2k
ISBN-13: 978-0-8014-7371-5 (pbk. : alk. paper)
ISBN-Io: 0-8014-7371-3 (pbk.: alk. paper)
1. Japan—Economic policy—1989— 2, Capitalism Japan.
3. Industrial policy—Japan.
Japan. I. Title. II. Series.
HC462.95.V64 2006
338.952—dc22
2005032190

Cornell University Press strives to use environmentally responsible

suppliers and materials to the fullest extent possible in the
publishing of its books. Such materials include vegetable-based,
low-VOC inks and acid-free papers that are recycled, totally
chlorine-free, or partly composed of nonwood fibers. For further
information, visit our website at www.cornellpress.cornell.edu.

Cloth printing 109 8765432

Paperback printing 10987654321
To my mother
 CONTENTS

List of Tables and Figures ix

Acknowledgments xi

. The Japanese Model and Institutional Change 1

. The Crisis of Japanese Capitalism 22

. Policy Reform Japanese Style 51

. The Varieties of Reform 78

. Corporate Restructuring Japanese Style 115

. The Varieties of Restructuring 157

. Japan’s New Model 205

References 225

Index 239
 THE
JAPANESE
MODEL
AND
INSTITUTIONAL
CHANGE —_—

Once upon a time, would-be reformers from around the world

looked to Japan for lessons. Japan had somehow discovered how to balance
competition and coordination in a modern economy. It fostered cooperative
telations between government and industry, between financial institutions
and manufacturers, and between labor and management. The Japanese
model delivered tangible signs of success: rapid economic growth, a rising
standard of living, booming exports, technological leadership, and financial
power. Japan performed well across a broad range of social indicators, with
high educational achievement, excellent health standards, low crime rates,
and little income inequality. By the 1980s, even the modest Japanese had
developed a certain confidence and pride in their economic system.
Japan’s economic miracle did not fizzle out quietly but erupted in amoment
of market euphoria in the late 1980s—now referred to simply as “the Bubble”—
in which investors poured money into real estate and stock markets. When
the Bubble finally burst in 1991, Japan descended into a prolonged economic
slump. As the Nikkei stock index plunged, economic growth faltered, and
recovery failed to materialize, experts and amateurs alike rushed forward
with a daunting array of theories to explain Japan’s plight and to offer pre-
scriptions for revival (see Chapter 2).
Many government officials, business executives, and opinion leaders
simply concluded that the Japanese economic model had gone terribly wrong.
They questioned the very institutions that had been credited with Japan’s past
success: a powerful bureaucracy guiding the economy, close government-
industry ties, “lifetime” employment, the main bank system, and dense inter-
firm networks. Reform advocates declared that Japanese government and
industry would have to fundamentally alter their ways. The government
should liberate the economy, and companies should sever long-term ties with
workers, banks, suppliers, and other firms.
Despite popular perceptions to the contrary, Japanese government and
industry translated this collective reform frenzy into action. The government
lowered interest rates, increased and decreased public spending, lowered and
raised taxes, coddled and cracked down on ailing banks, liberalized financial
 2 JAPAN REMODELED

FIGURE I. GDP Growth in the United States and Japan, 1980-2004

-2

Source: International Monetary Fund, World Economic Outlook Database.

flows, eased labor standards, revised corporate law, lifted the ban on holding
companies, privatized special public corporations, and revised the pension
system. Just for good measure, the government also reorganized itself. Mean-
while, Japanese companies sold off subsidiaries, spun off divisions, switched
supply sources, moved production overseas, renegotiated loan repayment
schedules, introduced merit-based wage systems, reorganized their boards of
directors, and experimented with stock options and share buybacks.
As the United States and Japan traded places—with the Japanese economy
languishing and the U.S. economy resurging—U.S. government and business
leaders looked less to Japan as a model, and Japanese leaders looked more to
the United States as a model (Figures 1 and 2).’ Japanese government officials
grew more reticent about touting the merits of their economic model in bilat-
eral talks and multilateral forums, and their American counterparts grew
more confident in insisting on the superiority of the U.S. model.? Japanese
corporate executives became less assertive in transferring their practices to
their U.S. business partners, and U.S. executives became more aggressive in
imposing their standards on their Japanese business partners.* The Japanese

1. See Grimes 2002.

2. By the mid-1990s, for example, the Japanese government became less active in
promoting Japan’s own experience as a model for developing countries, and the U.S. gov-
ernment grew bolder in promoting liberalization on a global scale through multilateral
initiatives on telecommunications and financial reforms.
3. See Chapter 6 for detailed case studies of U.S. companies transferring practices to
their Japanese partners.
 THE JAPANESE MODEL AND INSTITUTIONAL CHANGE 3

FIGURE 2. Major Stock Indexes in the United States and Japan, 1980-2004
(1980 =100)

1,200
~
J; ’ ~. -
1,000 omen Japall 7 5 2
=== US. ’ Ne
800 +
‘
600 7 é
;
400 7 *
==!
one
200_—_—e—we _—* —

0
° a + © ao 2 nN + = 2° N t
ie) oO «oO ow ow nn Dn an an na So So Oo
on
et
a
et
aad anm a
a
aal o&ea aa a
a
oH
we N
3 SN 3S
N

Sources: Nihon Keizat Shimbun; Dow Jones.

government embraced the U.S. government's rhetoric of privatization, dereg-

ulation, and globalization, and the private sector hailed American industry's
focus on flexibility, core competence, and shareholder value.
Yet a funny thing happened on Japan’s way to the U.S. model: it never got
there. As government officials and industry leaders scrutinized their options,
they selected reforms to modify or reinforce existing institutions rather than
to abandon ther.’ This in itself should come as no surprise. After all, Japan
preserved considerable institutional continuity through more dramatic
upheavals after the Meiji Restoration and World War II.° Japan could not
preserve its old system in the new environment, but it could not replicate the
American one either.
The tricky part is to specify how Japan is changing. This book seeks to do
so by carefully analyzing government and private-sector reforms. Political
scientists tend to focus on the “macro” level of politics and policy whereas
business experts address the “micro” level of corporations and strategy. Yet
we cannot understand government reforms without investigating how private-
sector institutions and corporate strategies drive support for and opposition
against reform proposals, and we cannot understand corporate restructuring

4. See Zeitlin and Herrigel 2000, especially 1-50, for a theoretical discussion of “Ameri-
canization” that stresses selective adaptation and creative modification rather than the
wholesale adoption of the U.S. model.
5. Westney 1987, Noguchi 1995.
 4 JAPAN REMODELED

without examining how policy reforms generate new options and foreclose
others. This book describes and explains patterns of institutional change in
Japan through the extended use of the comparative case method: systemati-
cally comparing across countries (Japan versus the United States and
Germany), across policy issues (abor market reform versus financial reform,
for example), across industrial sectors (automobiles versus retail), across com-
panies (Toyota versus Nissan), and across time (Seiyu before and after allying
with Wal-Mart).®

How the Japanese Model Shapes Its Own Transformation

To understand how the Japanese economic model is changing, we must
first recognize that the existing institutions of Japanese capitalism are shaping
their own transformation. Market systems are embedded in a complex web
of laws, practices, and norms. The process of liberalizing markets—just as
much as the process of constraining markets—involves the transformation of
these laws, practices, and norms. Liberal reformers sometimes contend that
if only the government would pull back, then markets would flourish. Yet
governments must create and foster the institutions that sustain market com-
petition. Some authors imply that the Japanese model is more embedded in
societal institutions than the U.S. model.’ Yet an American-style external
labor market is not less embedded than a Japanese-style internal labor market;
an American equity-based financial system is not less embedded than a Japa-
nese credit-based system; and an American antitrust regime is not less embed-
ded than a Japanese corporate network (keiretsu). Scholars have stressed that
the historical transition to market society in western Europe, the creation of
market institutions in developing countries, and the transition to a market
system in post-Communist countries all entail a complex process of building
market institutions.® Yet few have extended this logic to the more modest
transition from one type of market system to another. For Japan to shift
toward the U.S. model, it would not simply have to dismantle existing institu-
tions but also create new ones, and a full conversion would involve changes
at all levels of the system: laws, practices, and norms. So long as Japan does
not make a full conversion, therefore, the legacy of earlier institutions power-
fully influences the trajectory of change.

6. On the comparative case method, see Lijphart 1971 and 1975, George 1979.
7. Crouch and Streeck 1997. Hall and Soskice (2001, 64) also suggest that it should be
easier for coordinated market economies to become more like liberal market economies
than vice versa.
8. Polanyi 1944, North 1981, Chaudhry 1993, Cohen and Schwartz 1998, Fligstein 2001,
World Bank 2002.
 THE JAPANESE MODEL AND INSTITUTIONAL CHAMGE 5

To illustrate this point, let us engage in a brief thought experiment: What

would it take for Japan to shift to a U.S.-style liberal market system, with
active external labor markets, a market for corporate control, and the free
market entry and exit of firms? Table z presents selected examples of the types
of changes that would be required. In the employment system, for example,
Japan lacks an external labor market for “permanent” employees (shain) at
large corporations in the sense that companies do not buy arid sell these
employees’ labor on the free market. Employers do not ordinarily poach
workers from other firms, and employees do not move from one company to
a competitor. The government cannot simply legislate a change in these
practices. To cultivate such a market, the Japanese government would
‘have to reduce legal restrictions on dismissal, disseminate more information
to employers and workers, cultivate organizations to match employers
with workers, promote portable pension plans, and expand unemployment
insurance. It would have to revise financial regulations, accounting
standards, and corporate law to encourage firms to be more responsive to
shareholders and less beholden to their workers. Companies would have to
renegotiate their compacts with their workers and redesign their systems
of employee representation. Employers would have to become less loyal to
their workers, and workers would have to become less loyal to their
employers. And sufficient numbers of employers would need to be looking for
workers, and workers for new employers, to provide adequate liquidity in the
market. .
We can think of institutional change as occurring when an exogenous
shock pushes actors to reassess the balance between the costs and benefits of
the status quo. But institutional change is a function of the level of this shock
plus the incentives and constraints built in to the existing system. For our
purposes, the forces for change outlined below comprise the exogenous shock,
and the Japanese model itself constitutes the incentives and constraints that
shape the response to this shock. This means that even when the shock is big
enough to impose change, existing institutions still shape the substance of
change. In the Japanese case, these institutions leave an especially heavy
imprint owing to the stability of the actors. In politics, the same economic
ministries collaborate with the same ruling party to dominate the policy
process, so the primary arena of decision making is unlikely to shift, for
example, from the bureaucracy to the judiciary or from the national govern-
ment to local authorities. In business, few large firms exit the market and few
new firms rise to challenge them, so change comes via the incremental reform
of existing firms rather than their replacement by new firms with radically
different practices. Therefore, outside forces—such as foreign governments
demanding policy reforms or foreign companies bringing new business
 TABLE 1. What Would It Take to Turn Japan into a Liberal Market Economy?
Selected Examples
LABOR

GOVERNMENT POLICY CORPORATE BEHAVIOR

Laws Practices
¢ Labor market reform ¢ Lay off workers when necessary
¢ Changes in case law doctrine ¢ Do not favor new graduates over
* Corporate governance reform midcareer hires
¢ Pension reform * Shift from seniority to merit-based pay
© Lift holding company ban ¢ Introduce stock options

Norms Norms
* The government should not use * Companies should not preserve
regulation to preserve employment. employment at the expense of profits.

Net Result: An Active External Labor Market

FINANCE
GOVERNMENT POLICY CORPORATE BEHAVIOR

Laws Practices
* Financial reform * Sell off cross-held shares
* Banking crisis resolution ¢ Banks make lending decisions and price
* Corporate governance reform loans on the basis of risk
¢ Pension reform * Corporations choose banks on the basis
* Lift holding company ban of price
¢ Banks stop lending to insolvent firms

Norms Norms
¢ The government should not protect §*° Companies should maximize
banks or manipulate financial markets. shareholder value.

Net Result: A Market for Corporate Control

COMPETITION

GOVERNMENT POLICY CORPORATE BEHAVIOR

Laws Practices
¢ Strengthen antitrust policy © Choose business partners on the basis of
* Regulatory reform price and not relationships
¢ Bankruptcy law reform * Do not cooperate or collude with competitors
¢ Strengthen social safety net ¢ Banks refuse to bail out failing firms

Norms Norms
* The government should not try to © Companies should not favor long-term
protect companies from failure. business partners.

Net Result: Free Market Entry and Exit

 THE JAPAMESE MODEL AND INSTITUTIOMAL CHANGE 7

practices—play an especially important role in institutional change. Having

lost confidence in their own institutions since the 1990s, Japanese govern-
ment and business leaders are especially susceptible to this outside
influence.
In addition, the complementarity (interaction) among the different com-
ponents of the economic system conditions the trajectory of institutional
change.’ Masahiko Aoki stresses that national systems of economic gover-
nance incorporate complementary labor, financial, and political systems. The
Japanese financial system, with patient capital channeled to firms by banks,
for example, complements the Japanese labor system, with long-term employ-
ment stability and strong labor-management collaboration at the firm level.
Japanese firms can uphold their employment guarantee to workers in a down-
turn because they are not subject to shareholder pressures for short-term
returns. This means that the evolution of the Japanese labor relations system
is shaped not only by the existing institutions of the labor market but by the
distinctive institutions of the financial market as well. Moreover, actors are
likely to be cautious in tampering with one element of the system for fear that
it will negatively affect other parts. For example, firms might be reluctant to
embrace new financial strategies—such as courting international investors or
listing on a foreign stock exchange—that could undermine their labor rela-
tions systems.
The existing institutions of Japanese capitalism do not simply act as fric-
tion, impeding fuller liberalization or convergence on the U.S. model. These
institutions shape the trajectory of change in a much more active way: they
enable other types of institutional innovation. The Japanese government and
industry can build on their existing ties, for example, to forge new public-
private partnerships to facilitate adjustment to changing market conditions
(Chapter 4), Or company managers and labor union leaders can use existing
channels of communication to design new pacts to preserve employment and
enhance productivity (Chapter 6). One could view Japan as doubly con-
strained: it cannot maintain its existing economic system owing to the forces
for change, and it cannot converge on the liberal market model owing to the
logic of its existing institutions. Yet these dual constraints are themselves
major drivers of institutional innovation.

g. Paul Pierson (2000) describes this dynamic in terms of increasing returns: the prob-
ability of further steps along a given path increases with each move down the path because
the relative benefits of these steps over other options increase over time. So once a critical
institution, such as a collective bargaining system or a main bank system, takes hold, it is
reinforced over time by complementary laws, regulations, norms, and procedures, as well
as by the entrenchment of supporting political interests.
to. Aoki 1988.
 8 JAPAN REMODELID

The Japanese Model

Before shifting to the model of institutional change, let us briefly review
the core features of the postwar economic system before 1990 and outline the
forces driving change. For present purposes, we can define the Japanese
model as a constellation of institutions (including political institutions, inter-
mediate associations, financial systems, labor relations systems, and interfirm
networks) linked together into a distinct national system of economic gover-
nance. Japan was similar to other coordinated market economies (CMEs)
such as Germany and different from liberal market economies (LMEs) such
as the United States in that it fostered long-term cooperative relationships
between firms and labor, between firms and banks, and between different
firms.” These relationships combined to produce relatively stable networks
of business relationships (keiretsu), including horizontal industrial groups
and supply and distribution networks,” The bureaucracy played a critical role
in protecting industry from international competition, promoting industry
through an active industrial policy, managing competition in sectoral markets,
and establishing and maintaining the framework for private-sector coordina-
tion. Industry associations served as important intermediaries between the
government and industry, especially in industrial sectors with a large number
of firms.!? Here we focus particularly on the core “micro” institutions of the
Japanese model: the “lifetime” employment system, the main bank system,
the corporate governance system, and supplier networks.
The labor relations system combined a grand bargain of wage moderation
and few strikes in exchange for employment security with firm-level pacts
that promoted labor-management cooperation. Labor unions were organized
primarily at the enterprise level, rather than at the sectoral level, facilitating
cooperative agreements between management and labor. Large Japanese
firms developed channels to incorporate labor into the management process
and to enhance communication between managers and workers. They culti-
vated the loyalty of their core workers by offering long-term employment, by
tying wage increases primarily to seniority, and by offering firm-specific
benefit programs such as nonportable pension plans. They fostered internal
labor markets by encouraging personnel transfers within the firm or the
corporate group while impeding external labor markets by restricting most
hiring to recent graduates. With lower turnover, Japanese firms had a greater

ur. Hall and Soskice 2001.

12. Gerlach 1992, Lincoln and Gerlach 2004. The Japanese originally differentiated the
horizontal industrial groups (referring to them as kigyd shiidan) from other corporate net-
works, but they now employ the term keiretsu for the horizontal groups as well,
1g. Representative works on government-industry relations include Johnson 1982,
Samuels 1987, Okimoto 1989, Hiwatari 1991, and Schaede 2000.
 THE FAPANESE RFAODE? AND INSTITUTIOHAL CHANGE 9

incentive to invest in training their workers. At the same time, they retained
considerable flexibility with a starkly tiered system of permanent emplayees,
who enjoyed job security and full benefits, and nonregular workers, who
might work full time but did not enjoy the same level of wages, benefits, or
security."*
The financial system centered on bank lending rather than capital market
finance. The government actively directed the allocation of credit through
public financial institutions and private banks. The government insulated the
market from international capital flows, segmented financial institutions
into distinct niches (securities houses, insurance firms, and various types of
banks), and heavily regulated the financial sector to prevent both market
entry and exit. Meanwhile, firms maintained long-term relationships with
their “main” banks. The main banks would provide their clients with a stable
line of credit at favorable rates, monitor the clients’ performance, and aid the
clients in the’case of.financial distress. The firms, in turn, would conduct a
large and consistent share of their borrowing and transaction business with
the main bank.’ Firms and their main banks often shared ties to a common
industrial group—also known as a horizontal keiretsu—such as the Mitsubi-
shi, Mitsui, Sumitomo, Daiichi Kangyo, Sanwa, and Fuyo groups. Companies
within these groups tended to engage in preferential business relationships
and to cross-hold each other’s shares. In this way, they kept a large proportion
of their shares in stable hands, insulating them from outside shareholders and
all but eliminating the risk of hostile takeover. Japanese managers practiced
“stakeholder” governance in the sense that they viewed workers, banks, sup-
pliers, and distributors as members of a corporate community, and they
considered the interests of this broader community in making management
decisions. Corporate boards were typically composed of a large number of
career executives, with little or no input from outsiders.’
Japanese manufacturers cultivated extensive supply networks, also known
as vertical keiretsu. Assemblers remained loyal to their suppliers in exchange
for supplier efforts to control costs, maintain quality, develop products to
specification, deliver supplies in a timely fashion, and provide superior after-
delivery service. Assemblers collaborated closely with their core suppliers on
research and design, and they often cemented these relationships with cross-
shareholdings. Toyota incorporated this approach to supply-chain manage-
ment into its “just-in-time” lean production system, which emerged as the

14. Koike 1988, Aoki 1988, Ariga et al. 2000.

15. Aoki 1988, Aoki and Patrick 1994, Aoki and Dore 1994.
16. Teramoto 1997, 32-36; Itami 2000; Inagami 2000; Dore 2000, 23-48; Itd 2002;
Jackson 2003, 263-67.
 10 JAPAN REMODELED

dominant production paradigm in the world in the auto sector.” Japanese

firms in other manufacturing sectors, such as electronics, adopted similar
practices. These supply networks offered firms an attractive alternative to a
stark buy-or-make decision. They could hold down labor costs and shift some
of the burden of adjustment onto suppliers by outsourcing yet also leverage
long-term relationships to collaborate on reducing costs, raising quality, and
fostering innovation,”

The Forces for Change

More than any other factor, the prolonged economic slump that began in
1991 has driven institutional change in Japan. We review the economic crisis
in more detail in the following chapter, but for present purposes we can
simply note that it generated enormous economic and political pressures for
change. It strained core institutions of the Japanese model such as the lifetime
employment system, the main bank system, and supplier networks by forcing
firms to cut costs. It forced the ruling Liberal Democratic Party (LDP) and
the opposition parties to propose major reform programs. And it undermined
the legitimacy of the postwar model, leading opinion leaders to question the
merits of their own economic system and to view the U.S. model more
favorably.!® -
Japan also confronted the accumulated legacy of its own postwar success.”
As the economy matured, the natural growth rate slowed, exacerbating dis-
tributional conflicts. The government had to adjust industrial policies as
Japan moved from catch-up to technological leadership, to redesign fiscal
and social policies as population growth slowed, and to reorient programs as
public priorities shifted from recovery and growth to quality of life. Mean-
while, corporations moved from competing for scarce capital to leveraging
the benefits of abundant capital, and from capitalizing on low-cost labor to
investing in high-skill labor.
Furthermore, Japan faced the challenge of integration into the global
economy. The growing mobility of capital and corporate activity broke down
the relative insulation of the Japanese market: it not only undermined the
government’s ability to control corporate behavior but also encouraged the
government to reform policies to prevent capital or corporate flight. Firms had
a greater ability to move production abroad, to switch to foreign suppliers, or

17. Womack et al. 1990.

18. Aoki 1988, 208-23; Gerlach 1992; Lincoln and Gerlach 2004.
1g. The economic crisis is not a purely exogenous shock, for the institutions of Japanese
capitalism have played a role in the crisis. We survey this debate in detail in the next
chapter.
20. Lincoln 1988.
 THE JAPANESE MODEL AND INSTITUTIONAL CHANGE II

to shift from domestic borrowing to global capital market financing. Japanese

companies were exposed to new patterns of behavior as they moved abroad,
and domestic markets were increasingly infiltrated by foreign companies that
did not behave according to local norms. Japan also experienced a sharp
appreciation of the yen in the late 1980s and early 1990s, which increased
pressure on corporations to cut costs to compete in international markets.
Meanwhile, scholars, journalists, financial analysts, and other opinion
leaders argued that Japan should conform to “global standards,” which they
equated with U.S. standards. The U.S. government, other national govern-
ments, and international organizations such as the World Trade Organization
(WTO) pressed Japan to lower trade restrictions, to promote competition in
domestic markets, and to adopt international regulatory standards. In the
chapters that follow we examine how the distinct mechanisms of globaliza-
tion—including market pressures, the diffusion of norms, and direct political
pressures—shape reform outcomes across issue areas and across companies
within Japan. Specifically, we assess whether the government enacts more
substantial policy reforms in issue areas subject to strong foreign pressure and
whether corporations with greater exposure to foreign influence—such as
firms with high levels of foreign ownership, exports, or investments abroad—
restructure more aggressively.

A Model of Institutional Change

Here I build on insights from the New Institutional Economics, the Variet-
ies of Capitalism school, and economic sociology to outline a simple model of
institutional change and apply it to Japan today.” The New Institutional
Economics suggests that actors create and reform institutions in order to
reduce “transaction costs,” such as the cost of obtaining information about a
firm or a product (information costs) and the cost of monitoring and enforcing
contracts (enforcement costs). Sometimes these elements simply make the
transaction more costly, as the term implies, but often they are sufficiently
high to prevent the transaction from taking place at all. Institutions such as
labor relations systems, financial systems, and interfirm networks can reduce
transaction costs. Ronald Coase, in his seminal article, argues that businesses
create firms (corporate organizations) to reduce transaction costs.” Oliver
Williamson refines this approach to explore how firms choose among differ-
ent institutional arrangements. He uses it to explain, for example, how firms
choose when to incorporate parts production within the hierarchy of the firm,

21. Coase 1952, Williamson 1985, Aoki 1988, North 1990, Hall and Soskice 2001, Fligstein
2001.
22, Coase 1952.
 I2 JAPARM REMODELED

when to negotiate long-term contracts with suppliers, and when to procure

parts on the open market.”*
Douglass North applies the transaction costs approach explicitly to the
question of institutional change, arguing that actors reform institutions when
exogenous shocks alter relative prices. He takes a more functionalist line in
his earlier work, implying that economic actors respond to altered incentives
by developing better institutional solutions over time.” In later work, however,
he depicts institutional change as a more open-ended process in which
politics and ideology weigh heavily and changes may or may not constitute
improvements.” Masahiko Aoki applies institutional economics to Japan,
demonstrating how actors use institutions such as lifetime employment, the
main bank system, and supplier networks to reduce transaction costs.”° He
depicts institutional change as an evolving equilibrium. Building on a game-
theoretic model, he suggests that actors revise institutions in response to
exogenous shocks but do so within the context of an existing matrix of
institutions. So they are more likely to adopt revisions that are compatible
with existing institutions than to opt for ones that undermine the prevailing
equilibrium.”
The Varieties of Capitalism literature adopts the basic logic of institutional
economics but embraces a wider range of political and sociological factors.
Although it builds on earlier traditions in comparative political economy, it
gives greater attention to the “micro” level of the firm. Peter Hall and David
Soskice focus especially on the dichotomy between liberal market economies
and coordinated market economies, arguing that these constitute alternative
models with distinctive logics. Like Aoki, they emphasize the interconnec-
tions between the components of national models and suggest that partial
deviations from these equilibria are likely to be less stable and less successful
than more internally consistent versions of the models. They contend that
governments and firms are likely to adjust to changing circumstances by
trying to preserve their comparative institutional advantages and that
this process is more likely to reinforce national differences than to erode
them.”*
Hall and Soskice emphasize how these national models have comparative
advantages in some sectors and not others but do not explore the sectoral
variations within the national models themselves. German and Japanese

23. Williamson 1985.

24. North r98z.
25. North 1990.
26. Aoki 1988.
27. Aoki 2001.
28. Hall and Soskice 2001, especially 62-66.
 THE JAPANESE MODEL AND INSTITUTIONAL CHANGE 13

firms have an advantage in sectors that rely on incremental innovation, such

as machine tools and factory equipment, consumer durables, engines, and
specialized transport equipment. U.S. firms have the edge in sectors that
require radical innovation, such as biotechnology, semiconductors, and soft-
ware development.” Hall and Soskice generalize from core sectors, such as
machine tools for Germany and automobiles for Japan, producing character-
izations of national models that are more valid for these sectors than for
others, such as finance or retail. The Varieties of Capitalism framework does
not preclude a more fine-grained analysis of sectoral variations, however. In
fact, the logic of the argument should lead us to expect substantial variation
across sectors within a given country precisely because the foundation of
comparative institutional advantage varies across sectors. The value of a
long-term employment system, for example, depends on the level of training
required and the nature of the work, and that in turn varies considerably by
industrial sector. So we should expect countries not to develop one-size-fits-
all employment systems but rather to create differentiated variations on the
national model that reflect the different requirements of these sectors. Hence
in this study I propose to examine the sectoral varieties of capitalism as well
as national varieties. In later chapters I explore the broader variation between
manufacturing and services as well as the more subtle variation between
manufacturing sectors characterized by more integrated production systems,
such-as autos, and those geared toward more modular production, such as
electronics.
Sociological institutionalists generally depart from the rationalism of insti-
tutional economics and stress a logic of appropriateness over a logic of calcu-
lation. Mark Granovetter accepts the assumption of rationality but argues that
it should be broadened to focus more on social structure.*° Walter Powell and
Paul Dimaggio reject the rationality assumption outright, emphasizing that
actors are more likely to satisfice than to maximize, to search for meaning
than to pursue utility, and to conform to norms than to calculate interests.”!
Neil Fligstein combines a sociological perspective with a more political one,
showing, for example, how dominant firms exert control over sectoral
markets.*? Sociologists tend to view institutional change asa diffusion process:
the diffusion of new norms or beliefs across countries, firms, or arenas of
social interaction.
I begin with a simple model based on a New Institutional Economics/
Varieties of Capitalism logic and then explore ways to expand it to incorporate

29. Hall and Soskice 2001, 39.

30. Granovetter 1985, 505-6.
31. Powell and Dimaggio 1991.
32. Fligstein 2001.
 14 JAPAN REMODELED

a broader range of political and social factors. Let us first view Japanese capi-
talism as a system of incentives and constraints. That is, actors within the
system (firms, banks, unions) use institutions such as lifetime employment,
main bank relations, and interfirm networks to reduce transaction costs. They
then incorporate these institutions into their cost-benefit calculus as they
adapt to new circumstances. Corporations will abandon their stable part-
ners—such as labor unions, banks, and other corporations—only when the
efficiency gains from doing so outweigh the cost of forgoing future benefits
from cooperation with these partners. And in most cases, the marginal
increase in efficiency does not justify the large fixed cost of undermining
these relationships. This perspective helps to explain not only why the Japa-
nese model has been slow to change but also how it has been changing. Cor-
porations will adjust in ways that preserve the benefits of these long-term
relationships, or even build on these benefits if possible.
In many cases, we can account for the resilience of these relationships
equally well in economic terms, with reference to rationality and interests, or
in sociological terms, with reference to legitimacy and norms. If a Japanese
firm is reluctant to lay off workers, for example, it may be calculating the cost
savings against the potential damage to its cooperative relationship with
remaining workers, or it may be simply adhering to prevailing norms of
acceptable firm behavior. The concept of reciprocity offers some clues as to
how a rational calculus and an adherence to norms might blend in practice,
for relationships of reciprocity have both a rational and a normative element.
Japanese managers feel that they benefit from long-term relationships of
reciprocity with workers, banks, and other firms, but they also have norma-
tive commitments to these relationships.
We can attempt to incorporate norms and social ties into a cost-benefit
framework by thinking in terms of broadening circles of rationality. In the
first circle, for example, a manager would simply calculate the estimated costs
of financing with the firm’s main bank versus the costs with a U.S. investment
bank. If the competitor were less costly, he would abandon the main bank. In
the second circle, however, he would consider the implications for the firm’s
comparative institutional advantage: he would weigh the cost savings against
the potential damage to the long-term cooperative relationship with the main
bank. And in the third circle, he would broaden the calculus further to include
possible costs beyond the main bank relationship, such as damage to the firm's
reputation or strains in relationships with workers, other business partners,
intermediary associations, or the government. The first circle represents a
simple economic calculus, the second adds institutional factors along the lines
of the Varieties of Capitalism approach, and the third incorporates broader
social factors.
 THE PAPANESE MODEL AMD INSTITUTIONAL CHANGE I5

Three Circles of Rationality

i. Simple cost-benefit analysis (market calculus)
2. Add institutional costs and benefits (Varieties of Capitalism
perspective)
3. Add social/reputational costs and benefits (broader sociological
perspective)

In practice, of course, the three circles of rationality overlap to a consider-

able degree. The case studies and other evidence presented in Chapters 3-6
cannot prove that one logic of rationality trumps another, but they can help
us to specify how these different logics combine to shape outcomes.
The task of analyzing institutional change is made all the more difficult
because it operates simultaneously at many different levels of the political-
economic system. Japanese firms are renegotiating agreements with their
workers, banks, and business partners; industry associations and union fed-
erations are reorganizing and redefining their missions; and the government
is revising regulatory procedures and passing reform legislation—all at the
same time. To make the situation even more complex, adjustments at one level
have ramifications for adjustments at other levels. In order to make sense of
this analytically, I simplify the picture and focus on adjustments at two levels,
those of the firm (micro level) and the government (macro level).
1. The Micro Level. At the firm level, the forces for change outlined above
translate most tangibly into increased pressure to cut costs. As Japanese firms
strive to cut costs, however, they are constrained from laying off workers,
abandoning their main banks, and cutting off stable suppliers by the logic of
the Japanese model itself. Their options for adjustment are limited by legal
and regulatory constraints, such as laws governing the dismissal of workers,
and their preferred strategies for adjustment within these legal constraints
are shaped by their existing relations with workers, banks, and other firms
(Figure 3).
We can view a company’s options in terms of Albert Hirschman’s categories
of “exit” and “voice.”*® The Japanese system differs from the liberal market
model in that it imposes greater constraints on exit (withdrawal) from busi-
ness relationships but has more fully developed channels for voice (negotia-
tion) within these relationships. This is no accident, of course, because actors
who are constrained from exit have a greater incentive to cultivate mecha-
nisms for voice. So when Japanese firms confront tougher competition or a
weaker economy, they are more likely to exercise voice than exit.
This simple model already provides us with substantial hints about the
substance of corporate adjustment. As much as possible, Japanese companies
33. Hirschman 1970.
 16 JAPAN REMODELED

FIGURE 3. Micro Level: Factors Shaping Patterns of Corporate Adjustment

MACRO MICRO MICRO

CONSTRAINTS CONSTRAINTS CHANGE

laws and long-term relations patterns of

Tegulations c> with banks, unions, c> corporate
limit firms’ and other adjustment
possible companies shape
adjustment firms’ preferred
strategies adjustment
strategies

will not abandon their workers, their banks, and their suppliers, but they will
renegotiate the terms of their relationships with these partners. They will not
lay off workers but will demand wage restraint or greater flexibility in deploy-
ing workers. They will not abandon their-main banks but will press the banks
to hold down lending rates or to offer more sophisticated financial instru-
ments. And they will not cut off their loyal suppliers but will ask the suppliers
to cut prices or to improve delivery and after-sales service. In short, as we
shall see in detail in Chapters 5 and 6, companies will strive to adjust without
undermining these relationships, and they will leverage the benefits of these
relationships to ride out their problems.
We can fill out this pattern further by building on more specific knowledge
of the Japanese model. For example, the proposition that Japanese firms will
leverage the benefits of long-term relationships does not mean much until we
specify what these benefits are. In labor relations, we know that large Japa-
nese companies offer employment security to their permanent employees in
exchange for wage moderation and cooperation in raising productivity. So in
an economic downturn, we would expect them to press for further wage
restraint or to redouble efforts at labor-management coordination. Likewise,
in bank relations, we know that companies remain loyal to their main banks
in exchange for an enhanced level of service plus insurance that the bank will
extend credit or otherwise bail out the company if necessary. In hard times,
then, we would expect stronger companies to demand enhanced services and
weaker companies to cash in on this insurance. And in supplier relations, we
know that companies remain loyal to suppliers in exchange for flexibility
on price and service, investment in research and development, and co-
development of higher-quality or lower-cost products. So in a recession, we
would expect them to reinforce their collaboration with their most
 THE JAPANESE MODEL AND INSTITUTIOMAL CHANGE 17

FIGURE 4. Macro Level: Factors Shaping Patterns of Policy Reform

MICRO MACRO MACRO

CONSTRAINTS CONSTRAINTS CHANGE

long-term relations societal policy patterns of

with banks, unions, c> preferences c> policy
and other mediated through reform
companies shape political institutions,
firms’ policy such as industry
preferences associations and
political parties

important suppliers to cut production costs. “We do not ask our suppliers to
cut prices,” explains one Toyota executive, “but we work with them to reduce
real costs. In this way, we both benefit.”**
2. The Macro Level. Just as firms’ preferred business strategies reflect the
incentives and constraints of the Japanese model, so do their positions on
policy reform. There is a micro logic to macro preferences: industry policy
positions reflect the institutions of Japanese capitalism, such as labor rela-
tions, financial systems, and corporate networks. Firms derive comparative
advantage from these institutions, so they have to weigh the expected effi-
ciency gains from policy reforms against the possible costs of undermining
these institutions (Figure 4).
Political economy models typically deduce industry policy preferences
from their (macro) position within the economy.** That is, they deduce these
preferences from economic models of how various policies affect different
economic groups, such as employers versus workers, or producers versus con-
sumers, or firms in competitive sectors versus firms in protected sectors.
Employer interests, for example, are expected to differ from worker interests
in fairly predictable ways across different national contexts: employers will
want policies that lower wages and benefits, and workers will want policies
that raise them. In contrast, the Varieties of Capitalism approach pushes us
to look at the microlevel determinants of policy preferences. In this view,
employer interests reflect the specific market institutions of a given country.
Employers in liberal market economies will support labor deregulation
because they rely on competitive labor markets to minimize production costs

34. Interview with Hidehiko Tajima, General Manager, Global Purchasing Division,
Global Purchasing Center, Toyota Motor Corporation, Toyota City, January 18, 2002.
35. Frieden and Rogowski 1996, Frieden 1999.
 18 JAPAN REMODELED

FIGURE 5. Micro-Macro Interaction

POLICY
REFORM

CORPORATE CORPORATE
ADJUSTMENT ADJUSTMENT

whereas employers in coordinated market economies may oppose it because

they rely on close labor-management collaboration to maximize product
quality.** In Japan, market institutions tend to modify industry preferences
for liberal market reforms: fewer firms advocate these reforms than one
would otherwise expect, and those firms that do so are more ambivalent than
one would otherwise expect.*’ As a result, Japanese government leaders move
cautiously on reforms, package delicate compromises, and design reform to
preserve the core institutions of the Japanese model and to leverage the
strengths of the model as much as possible (Chapters 3 and 4).
3. Micro-Macro Interaction. Thus the Japanese model generates relatively
predictable patterns of corporate adjustment and policy reform. But the actual
trajectory of change over the longer term is complicated by the fact that the
two levels interact. As the government enacts policy reforms, these reforms
create new opportunities and constraints for further corporate adjustment;
and as firms adjust to new challenges, these adjustments modify firms’ policy
preferences and thereby affect future policy reforms (Figure 5).
We can see the interaction between these two levels of adjustment in
examples from postwar Japanese history. When the Japanese government
relaxed capital controls in the 1960s, it prompted Japanese firms to increase
their cross-holding of shares, producing what came to be considered a primary
feature of the Japanese model. In doing so, the firms helped to preserve fea-

36. Thelen 1999, Hall and Soskice 2001 (especially chapters by Soskice, and King and
Wood).
37. Moreover, these preferences are aggregated in the political arena in a manner that
further moderates demands for liberal reform (Chapter 3).
 THE JAPANESE MODEL AND INSTITUTIONAL CHANGE I9

tures of the Japanese system—such as industrial policy, administrative guid-

ance, and interfirm collaboration—that function best in a market protected
from foreign capital. And they were able to accomplish this only in the context
of close government-industry collaboration, relatively weak antitrust regula-
tion, and well-organized interfirm networks. In the 1970s, when the Japanese
government moved forward with trade liberalization, some industries
replaced tariffs and quotas with private-sector substitutes, including prefer-
ential procurement practices, exclusive dealerships, and cartels. Kodak
argued this point in its WTO case against Fuji Film, contending that the Min-
istry of International Trade and Industry (MITI) worked with Fuji to establish
exclusive dealer networks that effectively shut out foreign suppliers.** Then,
in 1985, the G-5 governments launched a substantial appreciation of the yen
with the Plaza Accord. Many Japanese firms responded by shifting manufac-
turing activity to Southeast Asia to reduce production costs. But rather than
abandon their favored suppliers, large manufacturers moved abroad in
tandem with their suppliers, extending national supply networks into the
Asian region.*? In each of these cases, the Japanese model transformed yet
did not converge on the liberal market model. In fact, government and indus-
try interacted to produce a transformation of the model conditioned by the
incentives and constraints of the model itself. I contend that this is precisely
what has been happening since the 19gos. We shall review more recent exam-
ples in the case study chapters and speculate about possibilities for the future
in the conclusion.

Refining the Model /

This simple model allows us to describe and explain Japan’s distinctive
trajectory of institutional change, yet it excludes some important factors.
Here I present two ways to flesh out the model, albeit at the expense of parsi-
mony. The case study chapters do just that: they build on the simple model
but incorporate a broad range of social and political factors to portray Japan’s
ongoing transformation in its full complexity.

A MORE SOCIOLOGICAL PERSPECTIVE

One could argue that the simple model is still too rationalistic. It incorpo-
rates social factors via the third circle of rationality, but it cannot fully resolve
the tension between the logics of the three circles. Efficiency concerns and
normative commitments can complement each other, but they may also con-
flict. For example, firm managers sometimes have to make a stark choice

38. Johnson 1982, Dewey Ballantine 1995, Tilton 1996.

39. Hatch and Yamamura 1996.
 20 IAPAM REMODELED

among maximizing profits (first circle), enhancing their comparative institu-

tional advantage (second circle), and honoring social obligations (third circle).
Furthermore, there are limits to how effectively one can incorporate norma-
tive commitments, social networks, or cognitive maps into a cost-benefit
framework. Sociological perspectives suggest that actors facing new circum-
stances do not rationally calculate costs and benefits so much as fall back on
existing norms, beliefs, and routines.*°
Focusing on beliefs and identity would turn our attention more to decision
makers’ own qualities. This poses a challenge for a model that centers on the
profitability, comparative advantage, or reputation of the firm rather than the
beliefs or social ties of the individual decision makers. To illustrate this point,
let us look at two examples of how the simple model might not capture the
decision process. First, the model implies that firm managers might be reluc-
tant to damage a long-term cooperative relationship by cutting off a stable
supplier but that they would act once they determined that the efficiency
benefits outweighed the long-term costs. In reality, however, managers may
not adhere to their own cost-benefit analysis. One Japanese manager recalls
precisely such a debate in which board members agreed that they would save
money without compromising quality by switching from a stable domestic
supplier to a foreign rival. The board member with the closest personal rela-
tionship to the domestic supplier’s managers nonetheless successfully fought
off the proposal because he personally felt that he could not betray these
partners.”’ Second, we find in the case studies that foreign managers some-
times shift a Japanese company in a dramatically new direction. A cost-benefit
model cannot account for such a shift because the company’s objective cir-
cumstances have not changed. The new manager has greater freedom because
he is less encumbered by the values and/or social ties of his Japanese prede-
cessors. For precisely this reason, we go beyond the simple model in the
case study chapters (especially Chapter 6) to examine how the identity of
the managers influences a company’s behavior. At the same time, however,
our third circle of rationality may help us to understand how foreign
opinion leaders or foreign firms might accelerate institutional change by
disseminating new ideas or practices widely enough to alter the prevailing
discourse about policy reform or corporate adjustment, thereby shifting
actors’ judgments about what constitutes an appropriate response. We shall
explore this international diffusion of policies and practices throughout the
book.

40. Powell and Dimaggio 1991, Herrigel 1996.

41. Interview, February 1997.
 THE JAPANESE MODEL AHD INSTITUTIONAL CHANGE 21

A MORE POLITICAL PERSPECTIVE

The model is inherently political because it suggests that corporate adjust-
ments are subject to legal and regulatory constraints and that changes in
these constraints must survive the political process. It emphasizes how insti-
tutions shape societal preferences about policy reforms and how these prefer-
ences in turn affect the substance of reforms. Nonetheless, this leaves open
the question of how these preferences are aggregated in the political arena.
We shall fill out the politics of reform by addressing how the overall structure
of the political system facilitates or impedes reform (Chapter 2), how bureau-
cratic ideology constrains policy outcomes (Chapter 2), and how political
parties, government ministries, and industry associations mediate prefer-
ences in ways that tend to produce incremental reforms with substantial
compensation for the potential losers from reform (Chapter 3). Nonetheless,
I would argue that the micro institutions that shape industry preferences are
even more critical in shaping the substance of reform than the macro institu-
tions that mediate these preferences. Political institutions may determine
how the government weighs the demands of business versus labor, for
example, but market institutions shape the specific content of the demands
that business makes.
 THE
CRISIS
OF
JAPANESE
CAPITALISM

Japan astounded the world with its economic performance not

once, but twice. Japan performed its economic “miracle” from the 1950s
through the 1980s, and then it produced an equally stunning descent into
crisis in the 1990s. In the former period Japan had the strongest economic
performance in the industrialized world; in the latter it had the worst.’ Japan’s
transition from hyper-success to hyper-failure presents a compelling puzzle
for analysts: What went wrong? This book’s primary purpose is not to unravel
this puzzle but to assess what new Japanese economic system is emerging.
Nevertheless, we must grasp the nature of Japan’s economic problems in order
to analyze the reforms the government and corporations designed to address
these problems.

The Policy Failures

Economists have engaged in an extraordinary debate about the causes of
and cures for Japan’s prolonged economic stagnation. Many Western com-
mentators have implied that the solutions were all too obvious, and only poli-
tics stood in the way. In reality, however, the experts themselves disagreed
about how the government should respond to the crisis, and the lack of con-
sensus on remedies constituted a major impediment to decisive action. Mean-
while, popular commentators spun out an even wider array of theories about
how to reform Japan, from the psychological to the geo-strategic, and their
views have shaped the public debate as well.? We begin by making a crude
distinction between the “policy failure” and the “structural crisis” schools of
thought and then review the considerable variations within each category. As
we shall see, most serious analysts acknowledge that Japan has suffered from
both macroeconomic policy failures and structural inefficiencies, but they

1. The Institute for the German Economy calculates that Japan led the field of twenty
industrialized countries by a substantial margin in economic performance over the course
of the twentieth century with 1,660 percent growth (Asahi Shimbun, November 26, 1999,
12), But Japan came in dead last among OECD countries in the 1990s (Katz 2003, 25-26).
2. Uchihashi 1995, Kikkawa 1998, Sakakibara 2002. See Gao 2000 on competing views
within Japan.
 THE CRISIS OF JAPANEGE CAPITALISMA 23

differ in the relative weight they ascribe to the two and in the prescriptions
they propose.”
Those in the policy failure school emphasize that the Japanese government
made policy errors that are crucial to understanding Japan’s dismal economic
performance after 1990. The government fueled the bubble economy of the
late 1980s, responded inappropriately to the downturn in the early 1990s,
addressed the banking crisis slowly and ineffectively, and made mistakes in
macroeconomic management in the late 1990s. Those within this broad camp
vary substantially, for example, in how they judge the relative importance of
fiscal policy, monetary policy, and banking regulation. They generally differ
from those in the structural crisis school, however, in that they interpret
Japan’s dilemma primarily as one of insufficient demand rather than excess
supply, and they view the bubble economy as a major cause of the prolonged
stagnation rather than simply as a symptom of underlying structural
problems.

THE BUBBLE ECONOMY ;

On May 31, 1989, the Bank of Japan (BOJ) raised the official discount rate
from 2.5 to 3.25 percent, setting in motion a process that eventually led to
a drastic plunge in stock and real estate values, a full-fledged crisis of the
financial system, and more than a decade of near-zero economic growth. The
Bank’s primary error was not in bursting the asset bubble, however, but in
allowing it to inflate so much in the first place by waiting too long to raise
interest rates. The bank then overshot in response by hiking rates too
much.
From mid-1985 to mid-1989, the total valuation of stocks on the first tier of
the Tokyo Stock Exchange soared'from ¥169 trillion to ¥527 trillion.* By 1987,
Bank of Japan officials realized that the economy was overheating, and
Deputy Governor Yasushi Mieno ‘and others recommended raising interest
rates. Although consumer prices were stable, asset prices were booming and
the money supply was expanding. So why didn’t the Bank act? Some bank
officials suggest that financial liberalization had increased the volatility of
monetary indicators by the 1980s, making it more difficult to control the
money supply. Therefore, they were justified in ignoring signs of asset

3. Posen 1998, Krugman 1999, Svensson 1999, and Harada 1999 stress policy failures,
for example, whereas Nakatani 1996, Yoshitomi 1998, Katz (1998 and 2003), Kobayashi
2000, Porter et al. 2000, McKinsey Global Institute 2000, and Madsen 2004 emphasize
structural factors. Muramatsu and Okuno 2002 and Ito and Patrick 2005 provide useful
overviews of the debate.
4. Grimes 2001, 138.
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