Richard A. Werner, Princes of the Yen Peter Myers, June 12, 2005; update January 25, 2006. My comments are shown {thus}.

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Princes of the Yen is about the role of Japan's central bank in the "miracle" years and the recent "crisis" years.

It is also about banking, and central banking, in all countries. A primary source.

(1) Princes of the Yen (2) Reply to Princes of the Yen

Werner is Professor and Chair of International Banking at the University of Southampton. Previously he was Assistant Professor of Economics at Sophia University in Tokyo. He spent over a decade working in Asia, including at the Bank of Japan, the Japanese Ministry of Finance, Jardine Fleming Securities (Asia) Ltd, the Asian Development Bank and as asset allocator of a major pension fund.

Endnotes and charts are excluded here.

This book explains much of what was going on at a high political and economic level, but hidden, during the past 50 years, information that should be available to the citizenry to help their decision-making as is supposed to occur in a democracy.

Werner writes, 'Noguchi and Sakakibara were the first and only public figures to clearly identify and acknowledge the true nature of Japan's economic system. They called it the "wartime system for total economic mobilization."' (p. 80).

Only serious researchers will bother reading this material, and they will want the book - for the endnotes, the charts, the missing text, and something tangible to keep and show others.

Buy Princes of the Yen new at http://www3.addall.com;

order second-hand copies at http://dogbert.abebooks.com/abe/BookSearch?an=richard+werner&tn=princes+yen.

(1) Richard A. Werner, Princes of the Yen (M. E. Sharpe, Armonk, New York, 2003)

{p. ix} MoF, the Finance Ministry, is generally held responsible for the most flagrant economic mismanagement in modern peacetime Japanese history: the creation of the bubble of the 1980s and the long recession that followed in the 1990s.

{p. x} The recession had produced the general conviction that Japan's old economic system, headed by its leading bureaucracies, did not work anymore and thus had to be reformed drastically. Most commentators now claim that structural changes are "badly needed." Prime Minister Junichiro Koizumi's most repeated slogan is "No recovery without structural reform." Senior members of the Japanese central bank have been calling for far-reaching structural reform on an almost daily basis. These voices claim that liberalization, deregulation, and privatization, in other words, the introduction of U.S.-style capitalism, is necessary for Japan's economy to recover.

But is it really necessary to abandon Japanese-style capitalism? One would think so, when considering the dismal performance of the economy during the 1990s. But it is strange that Japan's economic system was far more closed, cartelized, and controlled in the 1980s, and yet nobody complained that its economy was growing too slowly then. The same applies to the 1950s or 1960s, when an almost completely cartelized economy delivered double-digit growth. Moreover, the U.S. economy itself still suffers from business cycles and downturns. It seems, then, that the same economic structure can deliver high or low growth, and growth performance depends on other factors as well. This book shows that the Japanese recession was indeed due to the main force driving the business cycle - money. It is not by coincidence that the main proponents of structural change are precisely those who are in control of Japan's money.

The Defiant Bank of Japan

The central bank has consistently defied calls by the government, finance minister, and prime minister to create more money to stimulate the economy and end the long recession. At crucial junctures, such as in 1992, 1993, early 1995, and much of 1999, the Bank of Japan (BoJ) even actively reduced the amount of money circulating in the economy. This shrank purchasing power, reduced domestic demand, rendered the government's currency intervention ineffective, and strengthened the yen, thus aborting emerging recoveries. Lacking sufficiently supportive monetary policies, the government had to rely on fiscal policies. Those were not effective, and instead produced the largest national debt mountain of any industrialized country.

The big puzzle of the 1990s is just why, despite record unemployment and deflation, the Bank of Japan failed to expand the amount of money further and thus create a recovery, reduce deflation, and stabilize employment. Sometimes fear of inflation is given as the answer. But Japan has witnessed sharp falls in inflation during the first half of the 1990s and outright deflation in the second. When prices rise and there is inflation, we know that monetary policy is too loose and too much money is being created. Then the central bank needs to tighten. When prices fall and there is deflation, the central bank has a duty to create more purchasing power. In general, it is the job of the central bank to create sufficient

{p. xi} amounts of money to keep the actual growth rate close to potential and hence avoid both inflation and deflation.

Given the obvious deflation problem, the Bank of Japan admitted a while ago that fear of inflation is not the reason for its cautious stance. To the contrary, for many years now the Bank of Japan has been saying that it is trying hard to stimulate the economy, noting that it has lowered interest rates to zero. But, it claims, the problem has been a lack of demand for money. Yet it is clear that the largest demand for money in the world is located precisely in Japan. First, the government sector demands record amounts of money to fund its fiscal spending. Second, the many small and medium-sized firms that are Japan's main employers would like to borrow money. But the banks, burdened with bad debts, have only been willing to lend to larger, lower-risk borrowers. That is why the central bank needs to step in and substitute for their lending.

Sometimes the Bank of Japan claims that it is already injecting plenty of money into the economy. But it has mostly poured its money into the very narrow money market to which only banks have access. At other times, worries about deflation are countered by its spokesmen with the assertion that deflation is due to desirable structural changes and hence good. But if those structural changes have indeed made Japan's economy more productive, this would raise Japan's potential growth rate, leaving an even larger gap with actual growth. In that case, the central bank would have to create even more money to reduce the deflationary gap.

The most recent argument by central bankers, apparently also backed by the prime minister and his minister of economic and fiscal policy, is that there is too much "excess capacity" in Japan. This is true, and another way of putting it would be to say that aggregate supply is larger than aggregate demand. But instead of drawing the logical conclusion that demand should be stimulated - which the central bank could easily do - the advice is given to restrict the supply by closing down firms. Reminiscent of the ill-fated policies of certain depression-era politicians in Japan, Germany and the United States, this "excess capacity" is said to result in "excess competition," which must be dealt with through bankruptcies. Ironically, this argument is proposed by the very same commentators who also argue that Japan needs more deregulation, because it suffers from a "lack of competition."

The pattern is clear: While the Bank of Japan's arguments vary - and are quickly changed, when countered - they always come to the same conclusion, namely that the central bank's monetary policy has been appropriate and that the blame lies with Japan's economic structure.

The Bank of Japan Could Have Helped, But It Didn't

Money is normally created by banks. It is precisely because banks did not lend that the central bank needed to inject more money directly into the economy. It would thus act as the banker to the nation - as other central banks have done before, and as, indeed, the Bank of Japan did after 1945, when banks' balance sheets

{p. xii} looked far worse than in the 1990s. This worked so well in the years after 1945 that credit growth quickly recovered and the economy boomed. But throughout much of the 1990s, the Bank of Japan failed to take these tested and tried policies and failed to create enough money for a sustained economic recovery. Moreover, it has refused to lend to those who needed money most, the government and the small firms. The Bank of Japan also has had it in its power to delete the entire mountain of bad debts in the banking system without any costs to itself, the tax payer, or society at large. Yet it chose not to act. Why?

It is natural to start with the incompetence hypothesis. Incompetence may indeed explain the actions of some of the actors in this drama. The Ministry of Finance, for instance, and the political leaders during the 1990s could have created a recovery simply by changing the way they funded their fiscal expenditure. Instead of borrowing from the public by issuing bonds - thus draining the money from the economy - they could have funded the public sector borrowing requirement by direct loan contracts from banks. When banks lend, they create money out of nothing, without withdrawing it from other parts of the economy. This way, fiscal policy would not have crowded out private-sector activity yen by yen, as actually happened. Had they fully understood this, I am sure they would have used this method to create a recovery. However, this mechanism is litle known among economists, whether in Japan, Europe, or the United States.1

{note 1 on p. 281 reads: 1. As we will see, it was used by Hjalmar Schcht in the 1930s and is used frequently by developing countries. I have recommended this to the Japanese government for years. See, for instance, Werner (1994b, 1998b, 2000a, 2002d, Appendix}

The more obvious and better-known mechanism is the one prescribed even by introductory economics textbooks: The central bank can inject money directly into the economy, even when banks are bankrupt, by increasing its purchases of assets, including government bonds.2 Yet the central bank has denied the truth of this fact for years - out of incompetence? The deeper I researched into the issues and their history, the clearer it became that the leaders at the Bank of Japan have personally been very familiar with Japan's predicament and how to end it. In several previous recessions that were due to a credit crunch (such as the 1960s slump), the central bank increased lending to the corporate sector and the government. Also today, the central bank has many options available to achieve this. To name a few, it could purchase debt paper issued by firms, lend to the government, buy more bonds, buy real estate and turn it into public parks, or just print money and hand some to each citizen. In all cases, purchasing power would increase and demand would be stimulated. Printing money might also weaken the yen, which would help exports.3 This would not produce inflation, since the very problem and cause of the recession is lack of money and hence deflation.

An economic recovery could have been engineered at any time during the 1990s by increased central bank credit creation. Japan could have had high growth throughout the 1990s if the Bank of Japan had wished it to happen.

All this is not rocket science. Moreover, today central bankers can look back on the rich history and experience of the Bank of Japan or other central banks that have dealt with the same issues, such as the German central bank or the U.S. Federal Reserve. So the puzzle remains: Why did the Bank of Japan not create more money?

{p. xiii} Concerning the motives of the players, there is little doubt that over the 1990s, the Ministry of Finance, just as the many governments that came and went, had every incentive to create an economic recovery. The ministry, in the firing line of fierce criticism, was painfully aware that a long recession endangered its legal predominance and that of the postwar economic structure. Upon closer examination, the motives of the central bank seem less clear.

By 1992, when I was a visiting researcher at the Bank of Japan, I had discovered the importance of credit creation and its allocation. I realized that Japan's recession was going to get worse and unemployment was going to soar if the central bank did not implement the right policies. Interest rate reductions and fiscal policy were not sufficient. What was needed was more central bank money creation. But at the time the central bank was doing the opposite, actively withdrawing money from the economy. I could not understand why and kept asking different members of the Bank of Japan to give me an answer. Finally, one particular central banker explained to me: "If we printed more money, we would get a recovery. But then nothing would change. Japan's structural problems would not be solved." At the time I could not believe his words. Would the Japanese central bank intentionally prolong the recession in order to change the economic structure? Would it be the job of the central bank to implement such economic and social change - especially change of such scale, at such economic and human cost, and in this opaque fashion? By 1998 suicides had reached a postwar high, many induced by the recession.4

The Bank of Japan's official statements about its policy have been highly contradictory. On one hand, the central bank has insisted that the recession was due not to its policies but to the economic structure. That's why structural changes, not monetary stimulation, were necessary - as its officers never tire of repeating. Yet its staff (including its governor) have also said that they did not want to stimulate the economy (thus admitting that they could), because this would put off "badly needed" structural changes.5 Central bank staff even argue that significant monetary easing "could cause harm" by inducing "a further delay in the progress of structural adjustment."6 Adam Posen, an economist at Washington's Institute for International Economics, has therefore concluded: "Between a process of elimination, and careful reading of the statements of BoJ policy board members, I am led to the conclusion that a desire to promote structural change in the Japanese economy is a primary motivation for the Bank's passive-aggressive acceptance of deflation."7 If the reader is as skeptical as I was in the early 1990s, then this is a conclusion that is hard to accept.

The Rise and Rise of the Bank of Japan

If a recovery would prevent structural changes, then this means that structural changes are not necessary for a recovery. So why are structural changes needed? While the Japanese system has had many problems and there is room for improve-

{p. xiv} ment - especially when it comes to increasing the quality of life, the size of houses, leisure time available, the number of parks, and so on - it is not clear that a U.S.style economic system will significantly improve living standards. A U.S.-style economic system also has disadvantages. The Japanese economic system had many positive aspects that could have been preserved if a public debate had occurred about the structural change agenda.

The fact is that the recession of the 1990s has indeed triggered a structural transformation that many experts refer to as "remarkable."8 The structural and administrative reforms of the 1990s did not just create losers. While former Okurasho {MoF} bureaucrats may have been close to tears on New Year's Eve 2000, the champagne corks were perhaps popping elsewhere. When the Okurasho {MoF} was scrapped, its tasks had already been either abolished or reassined to other agencies. In 1998 monetary policy was put into the hands of the newly independent Bank of Japan and regulation of the financial sector was put into the hands of the independent Financial Services Agency (FSA). Since many of the influential FSA staff hailed from the central bank, a clear winner had emerged from the administrative reshuffling.9 That was none other than the Bank of Japan, MoF's long-standing rival. It had finally triumphed and was now more powerful than ever before.

Despite the ministry's dominant legal status, the central bank had the better cards: It was in charge of a little-known and extralegal credit control mechanism. Hiding behind the smoke screen of traditional interest rate policies, its decision makers remained entirely unaccountable. All this was possible because of a lack of transparency and a lack of meaningful accountability by the central bank for its monetary policy.

Central Bank Independence

The new Bank of Japan Law was proposed in 1997 as part of Prime Minister Hashimoto's administrative reform program. At the time, the financial press argued that the new law merely meant a "slight increase in autonomy" for the Bank of Japan. 10 The deputy governor of the Bank of Japan at the time, Toshihiko Fukui, lobbied press and politicians and argued that the new Bank of Japan Law "would allow the bank to make monetary decisions faster and more flexibly, and help it gain more credibility from the financial markets."11

This is not what happened - just as I had feared in 1997, when the new law was being debated. By that time I had done enough research to become convinced that the new BoJ Law was against the interests of the Japanese people, and by example also a threat to democracies in other countries. So I did my best to stop its passage. I faxed a letter to as many parliamentarians as I could. I also tried to arrange meetings with the members of the relevant parliamentary committees. Many ignored my faxes and phone calls. But a substantial number did take the time to see me and hear what I had to tell them. But it was an uphill

{p. xv} battle. Just as I had thought myself before my years of research on the Bank of Japan, most experts also felt that central bank independence was a good thing. We will see later in this book that the arguments in favor of central bank independence, whether in Europe or Asia, have serious flaws. This includes the argument that the German Bundesbank's great success was based on its independence. The truth, as we shall see, was quite the opposite.

The new Bank of Japan Law was passed. And that is why today the government has no more control over monetary policy. After the stock market falls of 2001 and 2002, many politicians called for the resignation of the BoJ governor. Mr. Hayami responded to such criticism by demanding that Japanese people give up lifetime employment and face less job security. His own job security was assured. There was nothing the government could do to sack him. Under the new Bank of Japan Law he was not doing anything wrong, because it does not clearly state that it is the job of the central bank to achieve healthy economic growth.

There is no mechanism for politicians to exert their will, except changing the central bank law again. It is not the government but the BoJ that decides whether we will have a boom or a recession.

Just Who Are the Central Bankers?

While the central bankers are good at keeping a low profile, their career paths tend to be more predictable than those of ordinary citizens or politicians. Few people would venture to guess who the next finance minister is going to be or how long the current prime minister will last. During the postwar era there has been no such uncertainty about the top job at the Bank of Japan.

Japan has had twenty-six prime ministers in the fifty-eight years since the war. However, a much smaller number of people have been in control of Japan's money and hence the heart of its economy. Known as "princes" by their colleagues, they were the men behind the Bank of Japan. Like the puppeteers of Japanese bunraku. dressed in black and moving in the background, these little-known central bankers shaped key events in Japan's postwar history. Politicians, governments, and bureaucrats - even the mighty Ministry of Finance - became unwitting puppets in their money game. Yet until now very little has been known about them and their policy tools. I hope this book will shed some light on their activities and make the reader more aware of the power wielded by unelected central bankers.

Even today, a large number of journalists and commentators seem quite sure about who is going to be the next Bank of Japan governor. In May 2001, in the same week this book was published in Japanese, Toshihiko Fukui, head of the Fujitsu Research Institute, staged an attempt to take over from Governor Hayami as the new governor. The media had been touting Fukui as an "impressive" candidate, the leading contender "in the running for the BoJ governorship," and "in line for the top job.''l' The Nikkei, Japan's leading financial newspaper, prematurely introduced him on its cover page, with a photo, as the new governor. In

{p. xvi} the event, Governor Hayami refused to resign. However, his five-year term ends in March 2003. Until December last year, despite other plausible candidates, the media agreed on the likeliest successor: Toshihiko Fukui, called the "compromise candidate at the top of the list" by the Financial Times. Why? He is an "effective leader, capable of steering the BoJ through the murky waters that lie ahead."13

In actual fact, in postwar history there has been little compromise in the selection of the true heads of the Bank of Japan. The same unanimous case was made by the media and well-informed observers before Yasushi Mieno became governor in 1989, and ten years before that, when Haruo Maekawa became governor. Again, ten years earlier, the insiders knew that Tadashi Sasaki would become governor. We find in this book that Fukui, Mieno, Maekawa, and Sasaki have many things in common. The least of those is that they were at the helm of the central bank for ten years each, and they all played a leading role in the Japan Association of Corporate Executives (Keizai Doyukai), which has argued since the 1970s that Japan should radically change its economic structure. More ominously, all of them had been known as "princes" since their youthful early years at the central bank - the anointed future heads of the Bank of Japan. It was an epithet that was not awarded lightly: only one central banker per decade could become a prince.

In its earlier Japanese version this book contributed to an increasing awareness by the Japanese public about these princes, their goals and their way of implementing their policies - including Fukui's pivotal role in the events that led to the creation of the financial bubble of the 1980s and the decade-long period of underperformance in the 1990s. Moreover, more politicians appear to understand that the Bank of Japan has been the main culprit behind the Japanese malaise and that a more supportive policy by the central bank is a necessary condition for an economic recovery. Perhaps as a result, Prime Minister Koizumi stated in late December 2002 that he would appoint as governor of the Bank of Japan only someone who is "aggressive in fighting deflation."14 This should effectively have ruled out "prince" Fukui as contender: not only his past actions but also his recent statements seemed to indicate that he is unwilling to fight deflation.15 To the contrary, he demanded that more companies should be bankrupted and that Japan's unemployment rate should rise further to at least 8 percent.16 But what is said is not always what is done.

If an outsider had been appointed as new Bank of Japan governor, in place of Fukui, the old guard at the Bank of Japan would likely have resorted to a welltried method of staying in charge in such cases: we will see in this book that whenever a former Finance Ministry official or an outsider from the private sector became Bank of Japan governor, he would be kept in the dark about the - allegedly "technical" - details of the actual monetary policy implementation, namely the quantity of the central bank's credit creation. These were decided by the deputy governor, one of the princes, who would after five years become official governor.

During the first five years, the official governor would have control over the

{p. xvii} minor policy tools of interest rates and banks' reserves with the central bank, while the old guard would remain in charge through their control over the quantity of credit.

In the event, Toshihiko Fukui once again made the race, just as had been planned thirty-five years ago. Back in 2000, when I was finishing the Japanese version of this book, I predicted that he woud become the next governor of the Bank of Japan. The fact that he was duly appointed, despite contrary statements by the prime minister and by an administration famous for surprise appointments, merely serves to demonstrate the extent of the power wielded by the princes.

Public Debate Is Needed

Nobody knows better than prince Fukui that the introduction of an inflation target, now thought to be favored by the prime minister, is also not itself a solution. He knows that what is needed are policies to expand credit creation. Instead, just like the Reichsbank during the Weimar Republic, the Bank of Japan has been implementing inappropriate credit policies that go significantly beyond the call of duty without the necessary accountability. There is a danger that the European Central Bank and the U.S. Federal Reserve are following in the footsteps of these central banks.

Even central bankers are human. As such, they are as prone to errors and acts of selfishness as anyone else. What they need is the right incentive structure to limit these tendencies, namely, democratic checks and balances. Implementing such checks does not mean that money should be debauched and inflation allowed. To the contrary, history teaches that the only guarantor of stable money is accountability of a centrJ bank that has been given the right policy goals.

A broader debate about the correct role of central banks in democracies is necessary. Any such debate must be based on knowledge of the facts and the history of central banking. This includes the realization that central banks often may use interest rates as a smoke screen to distract others from their true policies, which usually can be judged better when measuring the quantity of credit.

I am happy to report that my book has made a modest contribution to this effort. The Japanese version was published with a print run of 150,000 copies, becoming a number one best-seller. Many members of parliament read it. Several LDP members took it to heart and established the LDP Central Bank Reform Research Group. I hope the English edition will contribute to the stimulation of such debate also in other countries.

Tokyo, 28 February 2003

Richard A. Werner

{p. xviii} Acknowledgments

During the past decade of research I was blessed to receive the support, encour-

agement, guidance, and advice of many people, without whom this book would not have been completed. ... Kenneth Courtis, ... Eammon Fingleton, ... Chalmers Johnson, ... Karel van Wolferen, ... the friendly staff of the former Japan Development Bank, the helpful staff I met at the Nomura Research Institute, the many honest staff of the Bank of Japan (and who had best remain unnamed), the members of the Ministry of Finance's research institute; ...

{p. xx} Note on the Representation of Personal Names: The ordering of first names and surnames follows the conventions of the English language.

{p. 1} Japanese Lesson

New Era Dawning in Japan

Fundamental changes in Japan's economic, social, and political system have happened only twice in modern Japanese history: during the Meiji period, in the late nineteenth century, and during war and defeat sixty years ago. In both cases, crises triggered the change. The threat of colonization by foreign countries propelled the Meiji reforms. The Great Depression, the Pacific War, and consequent defeat were the triggers for the second major mutation.

The postwar miracle of high growth was, despite all its achievements, largely a quantitative change, one that took place within the unchanged economic and political institutions that had earlier been put into place. Today, Japan is once again at a crossroads. The crisis of the 1990s has spelled the end of the "Japanese-style" economic system as we know it. Japan is now in the process of switching to a fundamentally different form of economic organization, namely, a U.S.-style free market economy.

Back to the Future - Forward to the Past

The irony is that this system is not new for Japan. Few people are aware of the fact that free markets were almost the norm in Japan before the war. In the 1920s, the famous postwar Japanese system did not exist. Then, Japan's economy in many ways looked like a carbon copy of today's U.S. economy - with fierce competition, aggressive hiring and firing, takeover battles between large companies, few bureaucratic controls, strong shareholders that demanded high dividends, and corporate funding from the markets, not banks. Yet throughout the postwar era, Japan's economy has been the opposite: highly regulated, with cartels limiting competition, bank financing and cross shareholdings reducing shareholder power, no takeovers, and a frozen labor market with lifetime employment and seniority pay.

The peculiar nature of this postwar economic system has puzzled observers for decades. Leading economic theories indicate that only free markets can lead to success. But Japan rose within decades from developed-country status to become the second largest economy in the world without relying only on the "invisible hand" of free markets. Many theories have been advanced to explain this enigma.

{p. 2} War Economy

What changed Japan was an event that is often neglected in research on Japan, one that took place between the prewar era and the postwar era: the war itself. The Japanese economic system was created largely during World War II. Its true nature is that of an output-maximizing mobilized war economy.

Japanese corporations have been on a war footing since the early 1940s. In the early postwar era, the United States was keen to demonstrate to the world that post-occupation Japan had been reshaped in its image. In reality, with the beginning of the Cold War, the United States decided to maintain Japan's war footing and keep its wartime bureaucratic elite in power.

While Germany's minister of the war economy, Albert Speer, remained in Spandau Prison as a war criminal, his Japanese wartime colleague became prime minister and, together with his brother, governed Japan for twelve crucial years. During this period, from the late fifties to the early seventies, the wartime bureaucratic elite, still at the control levers, managed to complete the system of the "total economy" that had delivered rapid resource mobilization during the war years. Capable of servicing a far larger market than the restricted domestic economy, it had to expand overseas. The United States, interested in strengthening Japan, allowed this to happen. It was the system of a mobilized war economy that spearheaded Japan's postwar conquest of world markets.

The main reason why the extraordinary nature of Japan's system has remained unknown for so long is the ahistoric and usually counterfactual approach of many current economic theories. History provides the data set for the scientific economist to study. Ignoring history means neglecting the facts.

Big business and politicians also had a role to play in Japan's miracle model, but in the end the economy was controlled not by the triangle of business, politicians, and bureaucrats but by the much narrower triangle of the Ministry of Finance (MoF), the Ministry of International Trade and Industry (MITI), and the Bank of Japan (BoJ). Among these three institutions, the Bank of Japan has had the lowest profile. There was a reason why it was so self-effacing. Although its technical knowledge of the most powerful control tool ensured that in practice the central bank ruled Japan, it was legally subordmate to MoF. Therefore it has always pretended to have very little power. This book tells the story of the true extent of the use and misuse of its power.

Government Intervention Can Create Fast Growth

Economic success and free market economics are virtually synonymous in the eyes of many opinion makers today. This is why developing countries are persuaded to adopt the mantra of the World Bank and the IMF - liberalization, privatization, and deregulation - to achieve economic development. When the Iron Curtain fell and many communist countries adopted market-oriented economic systems, some ob-

{p. 3} servers even argued that the "end of history" had arrived: The struggle between rival economic systems was over, and the free market system had won.

However, Japan did not use free markets to become the second largest economy in the world. This means that there is a rival capitalist economic system, based on the very visible hand of planners, that has outperformed other systems in terms of economic growth rates over a sustained period of time.

The Japanese experience also teaches that government intervention has been misunderstood so far, for it did not take the form of meddling micromanagement, as in a planned economy. Instead, Japan's wartime government officials primarily intervened visibly by conscious institutional design that was aimed at creating the right incentive structures for fast growth. Successful government intervention is about organizational design, not picking winners.

Institutional Design

Influenced by German thinkers, the war economy leaders encouraged the creation of large-scale firms. They realized that among the three stakeholders involved in large companies - management, shareholders, and employees - shareholders' aims were least in line with the planners' overall goal of fast growth. So shareholders were eliminated, managers elevated, and employees motivated through company unions and job security.

Management, freed by cross shareholdings from dividend-oriented shareholders, did not pay out profits but reinvested them. This allowed them to grow their companies and expand market share. It biased Japan's economy toward high growth.

At home, the ensuing cutthroat competition for market share had to be contained by the formation of cartels. This did not mean that competition ended; companies continued to compete to keep up their rankings within the cartel. Most importantly, there were no cartels restricting competition abroad. The world's open doors and free markets meant that Japan's growth machines wreaked havoc. In the 1960s and 1970s, one leading U.S. industry after another was eliminated. Europeans, less dogmatic about free trade, simply restricted Japanese entry. The Japanese complied - managed trade was what they were used to and trade friction never became a major issue with Europe.

The High Price of Success

The war economy system was highly successful in achieving its goal of rapid economic growth. But there was a price to pay. Worker benefits were usurped by the small minority employed by the large firms. About two-thirds of all employees still work for small firms, where they never enjoyed the lifetime employment, housing and welfare support, and big expense accounts that large firms offered. A number of mechanisms forced the majority of the workforce to underconsume and save much of their hard-earned income. These included tax incentives, high costs

{p. 4} for necessities such as food and education, high and rising land prices, and a patchy pension system.

In the race for a higher ranking in the world, goals such as quality of life and the environment, as well as individual freedom and choice, were judged lower priorities. Living conditions in Japan are still relatively poor or at least not commensurate with the country's status as the world's number two economic power. Houses are small, commuting in crowded trains often takes two hours or more, and leisure time is limited. Concentration in a few urban areas and conformity even of leisure patterns limit the quality of holidays.

At the same time, the Japanese system delivered great income and wealth equality and hence social cohesion, stability, and peace. Japan's low crime rate is still the envy of the world. Many developing countries would accept such a price for success. The implication for them, as well as for economies changing from a noncapitalist system to a capitalist one, is that they can potentially do much better by adopting the Japanese mobilized economy model than by simply introducing free markets and waiting for the invisible hand to deliver growth. Which economic and social system is preferable - free markets or the mobilized economy - is a political decision. It should be treated as such.

The implication for Japan is that its system is not immutable. It does not go back over two thousand years. The postwar system of the war economy was introduced barely sixty years ago. This proves that Japan is capable of dramatic change. All we need is a crisis - a shock that is large enough to trigger the change.

Hitler's Control Tool

While most of the intervention in Japan's economy took an indirect, market-oriented form, there was a control tool that was used for powerful direct intervention. However, it works in such a subtle way that today many economists would still dispute its presence. The tool is money. The wartime bureaucrats understood what money is, where it comes from, and how it could be used to control every aspect of the economy.

In Europe, the evolution of monetary economics was hampered by the backwardness of its economic system. While the Chinese emperors had already invented paper money and used it to totally control their empire in the tenth century A.D., European rulers still believed that only precious metals could be money. As a result, they were not in charge of the money supply, and hence also not in control of their countries. Gold proved cumbersome to deal with, so it was deposited with goldsmiths, who became the first bankers. A mistaken understanding of their activity led generations of politicians and economists astray as they ignored the farreaching implications of the fact that banks create money and decide who gets it. This also explains why the levers that have been manipulating the Japanese economy remain largely unknown. The war bureaucrats, on the other hand, understood the role of banks and recognized that money is the lifeblood of an economy.

{p. 5} Influenced by the methods of Hitler's central banker, Hjalmar Schacht, the leaders of the Japanese war economy turned credit creation into their most powerful mechanism for total control. They used the banking system purposely and skillfully to allocate resources to targeted industries.

Window Guidance

The credit controls used by the war bureaucrats survived virtually unchanged into the postwar era. They took the form of the extralegal and secretive "window guidance" operated by the Bank of Japan. This "guidance" consisted of direct credit allocation quotas strictly enforced by the central bank. It was at the core of Japan's postwar economic success. It also explains the success of Korea and Taiwan, where the Japanese installed the same during the war, and where the postwar leaders continued to use it.

In the 1950s and 1960s, window guidance controls became instrumental in the emerging struggle for supremacy between the powerful Ministry of Finance and the legally subordinated Bank of Japan. While the ministry won the first political battle and avoided a change in the Bank of Japan Law (which had been introduced in 1942, largely as a translation of Hitler's Reichsbank Law of 1939), the Bank of Japan remained solely in charge of window guidance. It lulled the ministry into a false sense of security by allowing it control over interest rates and downplaying the importance of quantitative credit policies. A string of Bank of Japan studies, supported by conventional neoclassical economics (which at best sees no role for credit policy and at worst simply assumes money does not exist), "proved" that credit controls were ineffective. Thus the Bank of Japan announced that they were abolished. Memories of the powerful nature of the controls faded over the years. By the 1970s, few observers were aware of the fact that while the Finance Ministry might reign, it was the Bank of Japan that ruled.

Test Run: The First Bubble

In the 1970s, the Bank of Japan flexed its credit control muscles to test the limits of its autonomy over running the economy. Using window guidance, it ordered the banks to expand credit to speculative real estate borrowers. As a result, land prices soared and Japan found itself in the midst of the first postwar bubble economy. The recession that inevitably followed shook the established elite, foremost the Ministry of Finance. The role of window guidance credit controls remained little known, so virtually no blame fell on the Bank of Japan.

This experience laid the groundwork for the events of the 1980s and 1990s. It emboldened the central bank to develop its own plans for a new economic, social, and political system for Japan to replace the war economy. The new system was modeled on U.S.-style free markets. The Bank of Japan preferred to move "back to the future" of Japan's free market past, where shareholders were in charge, not

{p. 6} other stakeholders, such as employees. Equally importantly, a free market system often leaves the central bank as the uncontested authority over the economy. Of course, to introduce such deep structural changes, the entire war economy system had to be dismantled. That amounted to a revolution. And revolutions happen only in times of crisis.

Buying up the World

From around 1986 until 1990, Japanese money flooded the world. From real estate in New York, Hawaii, and Australia to corporate takeovers in the United States, Europe, and Asia, Japanese money seemed to buy up the planet. The scale of overseas investments was unprecedented and its sheer size left the experts without explanations. Japan was not just using up the dollars it had earned through its sizable exports and trade surpluses; in 1987, Japanese net long-term foreign investment was almost twice as large as the record-high current account surplus. Foreign investment of that scale defied traditional economic models. Japanese money flows remained a mystery. The plot thickened in 1991, when Japan suddenly turned from being the biggest net capital exporter ever to a net importer of capital. What was the cause of these events?

Credit Bubble and Bust

During much of the late 1980s, Japan created too much money, and some of it spilled over abroad. Bank credit creation expanded at a rate of about 15 percent, while national income grew by only about 6 percent. The newly created money was not used productively. It went into speculative purchases of land and stocks. Enormous amounts of new purchasing power pushed asset prices to dizzying heights. In 1989, the little plot of land surrounding the Imperial Palace in Tokyo had the same market value as the entire state of California. It was a bubble.

In the long run, credit creation that is not used productively cannot be paid back. The excess credit creation beyond the needs of the economy had to turn into bad debts. This is what happened from 1990 onward. Bank loan growth slowed. As asset prices fell, speculators were bankrupted and banks were left holding the bag. About 100 trillion worth of loans, a fifth of Japan's GDP, turned into bad debts in the 1990s. Banks were paralyzed and stopped lending. The credit crunch boosted unemployment. The economy moved into the worst recession since the Great Depression.

Who was to blame? Most observers believed the Ministry of Finance was in charge. The ministry also thought so. But all its attempts to create a recovery were to no avail. Despite record low interest rates and unprecedented spending packages, the economy failed to recover. Most observers concluded that the system did not seem to work anymore. The long recession of the 1990s took the shine away from Japan's postwar miracle and destroyed the consensus that had maintained the war economy.

{p. 7} But the system was not the reason why the economy went trom boom to bust. Nor could lowering interest rates or fiscal policy help. There was a simple policy that could easily have created a recovery as early as 1993 or 1994. Since banks were not creating enough money, prices were falling, demand shrinking, unemployment rising. The economy simply needed more money. Nothing could have been easier than that - the Bank of Japan could just have switched on the printing presses.

The Battle of the Yen

So just how much money did the Bank of Japan print in the 1990s? Very little. While the Ministry of Finance desperately tried to create a recovery, the Bank of Japan didn't seem in a hurry. Although it lowered interest rates, as ordered by the ministry, it simultaneously reduced the amount of money in circulation. Zero interest rates don't help if the majority of firms (small firms) can't borrow money at any rate. When the ministry increased fiscal spending, the central bank failed to fund it with new money creation. So it was funded by bond issuance to private investors, which merely crowded out private demand. In early 1995, when in desperation the ministry tried to boost exports through a weaker yen and thus ordered record amounts of foreign exchange intervention, the central bank quietly sterilized all intervention. The yen remained strong. In March 1995, the central bank oversterilized and so sent the yen to its postwar high of 79.75. This delivered another severe blow to the economy and the ministry.

No doubt, the recession of the 1990s was the result of the central bank's policies. It could fine-tune it through the quantity of credit. An analysis of its actions indicates that it chose to prolong it.

Meanwhile, the central bank launched a frontal assault on the power base of the ministry. For the first time since the 1960s, it reignited a public debate about the Bank of Japan Law and lobbied politicians for its cause. Its goal was to become legally independent. Since the ministry was blamed for the recession, the central bank won the battle. The ministry was defeated and stripped of all key power levers. The central bank is now independent and unaccountable. In Asia, defeated enemies often are at least allowed to save face. No such mercy for the ministry: To add insult to injury, it was stripped of its grand old name. In January 2001 the Okurasho ceased to exist.

The Strange Policies of the Central Bankers

Why did the Bank of Japan prolong the recession of the 1990s? A conclusive answer can be found only when another puzzle is solved. The events of the 1 990s are rooted in the bubble of the 1980s. How did the bubble, the greatest resource misallocation in peacetime history, come about in the first place'? We know that it was due to excessive credit creation by banks. But why did the banks lend so much'?

We know that from about 1940 until the end of the 1970s, bank lending was

{p. 8} determined by Bank of Japan window guidance. However, according to official statements by the Bank of Japan, these credit controls had been abolished and were not in use during the crucial 1980s. This is the accepted view to date. Is it true? The evidence is that window guidance continued. It is the smoking gun. Who pulled the trigger'? What were the motivations of the decision makers? The answer will provide clues to why the Bank of Japan prolonged the recession of the 1990s.

Japan's remarkable story is not without parallel. In the early 1990s, the central banks of Korea, Thailand, and Indonesia embarked on the same policies as the Bank of Japan in the 1980s. Using the extralegal "guidance" of bank lending pioneered by the Reichsbank in Germany, they forced their banks to lend excessively to real estate speculators. The bubble was further inflated by central bank policies to maintain an overvalued fixed exchange rate and higher domestic than foreign interest rates. Speculators were given every incentive to borrow from abroad. Record amounts of U.S. dollars flooded the Asian region, further fuelling the asset bubble and rendering the situation more precarious. In 1997, investors pulled out. Simultaneously, the central banks forced the commercial banks to restrict credit creation. The bubbles burst.

Instead of quickly floating their currencies, the central banks ensured that their substantial foreign exchange reserves were wasted in a futile attempt to defend the overvalued exchange rates. By late 1997, all three countries were insolvent. As central banks reduced credit creation further, the crisis turned into recession. Why did they all take these same, disastrous policies?

The Second Economic Miracle Ahead

By the 1970s, more voices argued that Japan's wartime system would not deliver high growth anymore. The old system had maximized output by increasing inputs, such as land, labor, capital, and technology. But by the 1970s, Japan was running out of inputs, and hence the potential growth rate was declining. A similar story was told about other Asian countries in the 1990s. One proposed solution was to boost productivity by introducing U.S.-style capitalism.

Almost sixty years after its introduction and extremely successful performance, the Japanese war economy structure was scrapped. The historic deregulation, legal changes, and market-oriented reforms of the 1990s eroded its foundations. Market forces are now pushing ever faster toward the goal of U.S.-style markets. New industries were born of deregulation.

The domestic economy has become more productive and is now able to deliver up to 4 percent noninflationary growth. For an advanced economy such as Japan's, this is nothing short of a second economic miracle. So is all fine and well with Japan and its Asian neighbors? We will know only once we have answered all the puzzling questions.

{p. 9} 2 The Total War Economy

The Future Is in the Past

The defeat of 1945 is often regarded as a watershed that heralded the beginning of a new Japan. The dark past was left behind and a fresh start was made with new institutions and economic structures, set up from scratch under the guiding hand of the U.S. occupation. The pictures of burned-down cities, destroyed factories, and ruined bridges sometimes give the impression that a new era started in the ashes of August 1945 . The U.S. occupation, of ficially in charge until 1952 - longer than in Germany - implemented the U.S. program of reeducation and democratization of the Japanese people. It provided Japan with a new constitution, political parties, free elections also for women, and a market-oriented capitalist economic system. MacArthur's reforms allowed labor unions, broke up the aibatsu, and introduced sweeping land reforms.

Many books and especially popular accounts of Japan therefore start their analysis in 1945, and Japanese history is usually divided into the neat segments of postwar and prewar. Not all scholars look at it this way, as the division into postwar and prewar periods leaves out the most important period in Japanese history this century - wartime.1 For it is during the war that virtually all of the characteristics of the Japanese social, economic, and even political system of the postwar era, all that we call "typically Japanese," were formed.

Postwar sales drives and inroads into world markets by Japanese companies have often been likened to military campaigns. The employees of Japanese companies call themselves senshi (soldiers), and their well-known lifestyle is comparable to that of troops in an army. However, the characterization of Japan's postwar economic system as a war economy is not meant metaphorically; it is literally true. Japan's postwar economy is a fully mobilized war economy, with production shifted from weapons to consumer products.

Guess the Free Market Economy

The reader is asked to guess which country is described by the following facts. It is a country characterized by virtually unmitigated capitalism. The stock market is the main source of external funding tor companies in this country. Shareholders

{p. 3} are all-powerful and demand high dividends. This forces management to be oriented toward short-term profits. Most managers are appointed from the outside, not from the ranks of the company. Fierce takeover battles and corporate buyouts keep management on their toes. If they don't perform, they could be out of a job in no hme.

The labor market in this country is characterized by hiring and firing and a high rate of job switching by employees. Income and wealth differentials are large. A whole class of rich capitalist families lives off their dividend income. The overall savings rate is low and consumption constitutes the biggest part of GDP - about 80 percent. There are few government regulations, and government officials exert little direct influence over the economy. Indeed, bureaucrats have to do as politicians tell them. There are fierce disputes over policy issues and public interest in politics is high, at times even passionate.

It would be natural to identify the country in question as the present-day United States; the description fits that country fairly well. However, the country referred to is Japan - the Japan of the early 1920s. Many observers believe that the typical, "Japanese-style" economic system has been around since before this century and has its roots in age-old Japanese culture. But scholars have by now established as fact that, to the contrary, the Japanese-style economic system that we know hardly existed in the 1920s.

Japan in the 1920s: Hotbed of Free Market Capitalism

In the 1920s, in many ways Japan was a different country from the one we have known since the postwar era. Its economic system was not pure free market capitalism, but it was much closer to this ideal than it has been ever since.2 Neither lifetime employment, a seniority-based wage and bonus system, nor company unions were widespread. Firms had few scruples about rapid hiring and firing. Neither did employees have any qualms about quitting to seek greener pastures: Japanese employees changed jobs as much as U.S. employees do now (a figure three times as high as in the Japan of the 1980s). Unions were organized by trade, not by company, thus providing employees with a better voice to call for pay raises - something that became effectively impossible with the company union system of the postwar era. Influential labor unions organized many seriously disruptive strikes in the 1920s, something unheard of in postwar Japan. The unemployment rate was not 2 percent, as during much of the postwar era, but in the double digits.

Firms were not majority-owned by other companies, as in the postwar system of cross shareholding. In the 1920s, there were real capitalists, individuals and families, holding substantial portions of stock. Individual share ownership accounted for the large majority of all shareholdings, while by the early 1990s it had fallen to less than 15 percent. It was natural that the shareholders would be directly represented on the company board and have their voices heard in the determination of company policy. Before the war, the majority of directors on the boards of large

{p. 11} companies were outside appointees, put in place by the shareholders. By contrast, in 1990, over 90 percent of directors on the boards of large firms were internal appointees, raised from the management of the firm.

Back in the 1920s or 1930s, shareholders were powerful because companies obtained between 30 and 50 percent of their external funding from the stock market. In the postwar era, such as the 1960s and 1970s, fund-raising from the stock market accounted for merely 5 to 10 percent of total external fund-raising.5 The shareholders in the 1920s used their influence to demand high dividends. This required the tirms to pay out as much of the profits as possible.6

Going for Profits, Not Market Share

In the 1920s and early 1930s, more than two-thirds of profits among leading Japanese companies were paid out as dividends, a sizable 6 percent were paid out as directors' bonuses, and only 25 percent were kept as reserves.7 By contrast, in the period from 1966 to 1970, 43 percent of profits were paid out as dividends, only 2 percent as directors' bonuses, and a massive 55 percent was reinvested.8 In other words, before the war the distribution of profits was heavily skewed in favor of the capitalist owners. Dividends reflected the fortune of the firm and thus fluctuated with it (unlike the low, virtually fixed dividends of the postwar era).

If management did not implement the owners' orders, they would quickly be sacked and replaced by a new team. This was quite in contrast to postwar Japan, where annual general meetings were rubber-stamp affairs that approved management in a matter of minutes, without discussions or questions being raised (a reason why the sokaiya racketeers could make a living simply by threatening to ask questions at shareholders' meetings).9 Today's salarimen consider the firm "their own," not the property of shareholders, and feel justified to run it as they see fit, without explanations to shareholders.

While in postwar Japan income and wealth were highly equalized, in the 1920s there were significant disparities, with many affluent owners of real estate and stocks who lived off dividends and rents. An important part of this capitalist class were the families that owned the main zaibatsu through their control of the holding companies that concentrated shares. But there were others. Only ten of the sixty largest mining and manufacturing firms were related to the zaibatsu.10 The majority of firms were non-zaibatsu, and they had diffused share ownership.

The zaibatsu firms were keen to expand their influence, however. They aggressively bought up other firms in stock acquisitions and takeovers - a practice unheard of in most of the postwar era. Often rival zaibatsu would engage each other in hostile takeover battles. In the 1930s, the Mitsui group bought Meiji Sugar from the Mitsubishi group and two Toyo Sugar factories from the Suzuki group. Oji Paper took over management of Fuji Paper, although it was part of the competing Mitsui zaibatsu.

The contrast between prewar and postwar Japan is also reflected in savings

{p. 12} rates and the consumption share of GDP. While consumption today makes up less than 60 percent of GDP, in the 1920s it accounted for about 80 percent - as much as in the United States today. Likewise, the percentage of income that is saved, currently running at about 20 percent, was only about 5 percent before the war. Strong consumption sucked in many imports of final consumption goods, which was not the case in the postwar decades.

The reform bureaucrats of the 1930s criticized Japan for looking just like "the stereotyped view of American firms in the present time." 11 Had U.S. trade negotiators been transported from the 1980s to the 1920s, they would not have demanded that Japan change to become more like the United States, for it resembled modern-day U.S.-style capitalism.

The Crisis That Changed Japan

Japanese-style capitalism does not go back to Japan's mystical past and peculiar Asian values. Compared to the well-known postwar version, it barely existed in embryonic form in the prewar era. But when and how was Japan so fundamentally transformed from a fairly free market economy to the highly regulated postwar system? The answer must be found in the event that happened between the prewar and postwar eras: the war itself.

History teaches that no country changes fundamentally without a crisis. The 1930s and early 1940s were such a period. Until the early 1930s the paradigm that had prevailed outside communist countries was that of liberal free market capitalism without much government interference. In Japan there had been a strong tradition of government intervention, but by the early 1920s the arguments of free market capitalism had become influential. There was also considerable external pressure from the United States for Japan to liberalize.12 However, in the 1930s, the intellectual tide in Japan was changing back to the idea of government intervention, because the free market system did not seem to deliver: The fallout from the New York stock market crash of 1929 was borderless. Worldwide, distressed banks withdrew their loans, bankrupting large proportions of the corporate sector and choking off demand, which led to deflation and large-scale unemployment.13 This cast doubt on the capitalist paradigm. Quite apparently, free markets, left to their own devices, could also produce major economic disasters.

As economies shrank (13 percent in the United States, 23 percent in the United Kingdom,14 12 percent in Germany, and 9.6 percent in Japan),15 poverty became widespread. 16 The scale of deprivation is hard to imagine today. Starvation and selling of children into prostitution occurred in the United States, Germany, and Japan. A countrywide survey conducted by the military in Japan in the early 1930s found that a high percentage of young men were physically unfit for military service due to malnutrition, disease, and job-induced disabilities. Meanwhile, the capitalist "fat cats" continued to live in style. The Japanese elite saw that both military capability and the workforce would be severely affected if nothing was done.

{p. 13} Not fully comprehending the causes of the Great Depression, more and more thinkers and policymakers concluded that the capitalist system itself was at fault. Sitting idly on one's hands, as free market orthodoxy prescribed, was getting increasingly risky. It was the stuff revolutions were made of. The Bolshevik takeover of 1917, facilitated by dire economic straits and public discontent, was still fresh in everybody's memory.

Internal and External Threats

In Japan, the ruling elite and the bureaucracy became more worried about the possibility of a communist revolution. At the same time, a crisis loomed outside Japan's borders: As the Great Depression spread, countries engaged in competitive devaluation and trade wars to increase demand and income at home. As a result, prices were driven down further, heightening deflation. So more and more countries began to close themselves off from free trade, introducing quotas and tariffs. This was potentially disastrous, for, as a country with hardly any raw material resources, Japan had trade as its lifeblood. If it was not self-sufficient in food, it could survive only if it imported raw materials, processed them, and sold the value-added products abroad.

Japan's economy was crucially dependent on energy imports, mainly of coal and oil. These came largely across the Pacific from the United States. However, the United States had begun to turn protectionist and was fending off Japanese exports. It also increasingly disapproved of Japan's colonial ambitions in Asia.

The Quest for Autarky

Japan ignored U.S. critique. After all, the United Kingdom and the United States had so far been the colonial aggressors in Asia (together with France and Holland). Japan's leaders, especially in the army, had examined closely how Germany was starved of raw material and food imports during the trade blockade of World War I. They concluded that as long as Japan was dependent on imports from the white man, it was not free. With the internal threats of recession, unemployment, and communist takeover and the external threat of being cut off from world trade, the military concluded that Japan could survive in such a hostile world only if it was strong and free from blackmail. That meant a strong and autarkic economy.17

Externally, the military began to implement the dream of "Asia for the Asians." When they advanced beyond Manchuria into China in their quest for autarky, indications that the United States might play the trade boycott card merely confirmed their suspicions, and they accelerated the implementation of their plans.

Internally, they worked on dismantling the system of classical laissez-faire economics, which Japan had tried but found wanting. It was time to try something else. Military thinkers and reform-minded bureaucrats in Japan noticed that economists in Germany were offering a different prescription. Under the Nazi adminis-

{p. 14} tration their counsel bore fruit. Indeed, to quote British economist Joan Robinson. "Hitler had already found how to cure unemployment before Keynes had finished explaining why it occurred."18 Moreover, Japanese bureaucrats noticed that one major country had escaped the Great Depression altogether: the Soviet Union. In the 1930s, it embarked on a frantic government-led industrialization drive that was admired in many capitalist countries.

Reform Bureaucrats Pushed for a New System

In Japan, the move away from the free market economy was spearheaded by the military and the "reform bureaucrats" who had entered the ministries during times of high unemployment and had often witnessed starvation in the countryside. They were sympathetic to the critique by Japanese thinkers, such as Kamekichi Takahashi, and German economists, who censured the free market system for allowing rich shareholders to pursue profits while unemployment was endemic.19 The capitalist shareholders often squeezed firms just to raise their dividends. As funds were drained, firms had little to reinvest. Managers were thus often unable to act in the interest of longer-term profitability and survival. Meanwhile, large-scale stockowners often engaged in speculation, driving up share prices and then dumping the stocks for the capital gain, rendering the stock market little more than a rigged casino.

To the military, the equation was simple: To be strong, Japan's economy needed to grow fast. To increase growth, all resources had to be mobilized, ending the waste of unemployment. The reform bureaucrats also did not want to wait for Adam Smith's "invisible hand." They felt it had to be their quite visible hands that would strengthen Japan's economy. They urged government controls - thus they were often also called "control bureaucrats."

Their desire for controls did not imply micromanagement as in a Soviet-style planned economy. Their ideas were strongly influenced by anticapitalist and especially national socialist thought from Germany, which placed emphasis on government intervention in the form of redesigning the incentive structures.20 Thus it happened that by the early 1930s Japan had already started to embark on a mobilized war economy. The reformers met resistance on the way, so what we describe as the mobilized war economy was completed only toward the end of the war or even, in many ways, during the early postwar period.21

When hostilities with China turned into full-scale war in 1937, the military pushed through major changes under the cover of emergency war legislation, which gave the reform bureaucrats the mandate to establish a mobilized economy with strong government intervention. A new economic, industrial, social, and political structure began to emerge. When the hostilities turned into world war, even stronger legislation was used to completely reshape the Japanese economic, social, and political system. The redesigned institutional setup was to ensure that managers and employees would work toward greater output, not for the sake of short-term profits. It was a transformation that created the postwar Japanese miracle economy.

{p. 15} The Militarization of Japan

In 1936, the Hirota cabinet agreed to put the economy on a quasi-war footing. The first step was to boost the budget for military expenditure. As companies in the munitions sector watched the formation of the 1937 budget, they realized that substantial amounts of raw material imports were required to increase military production. A speculative import boom of raw materials ensued, throwing the balance of payments into sizable deficit. The 1932 foreign exchange control laws were used to restrict imports. They had represented the first set of reforms that would eventually create a controlled war economy.22

The 1937 promilitary cabinet of Konoe (the grandfather of 1993 prime minister Hosokawa) promulgated three wartime control laws. The Export-Import Commodities Emergency Measures Law ordered priority allocation of critical materials to the munitions industry. The Emergency Capital Allocation Law controlled the establishment of companies, capital increases, dividend payments, bond flotations, and borrowing of funds. It was used to channel money to the munitions industry according to priority. The Munitions Industrial Mobilization Law furnished bureaucrats with further powers of control.

In April 1938, the sweeping National General Mobilization Law was put to the Diet. It allowed the mobilization of all physical things in the country, and it stated that "the Government may in time of war (including incidents that are to be treated as war) draft Imperial subjects and employ them in mobilization work as stipulated by Imperial Decree whenever necessary." It was pushed through by Konoe against vigorous resistance from politicians and business leaders, who realized it was a carte blanche - it did not specify the particulars of controls.23 The principle of a general law that leaves the details to be filled in later by ministerial ordinances gave all authority to the government bureaucracy that could freely wield it as it saw fit. The law gave the government the power to determine prices, establish controls over production, distribution, consumption, movement of goods, and foreign trade and to set up control agencies to implement the decrees.24

System for Maximum Production

With such legal powers in their hands and with the approach of Japan's entry into World War II, the Konoe cabinet in 1940 proclaimed the New Economic Order, composed of a New Financial System, a New Fiscal Policy, and a New Labor System. Overall coordination lay in the hands of the Cabinet Planning Board, set up in October 1937. It was designed as the economic general staff of the militarized economy. Its job was to set up a new economic system that would deliver maximum economic growth and to direct resources toward the priority industries.

The aim of the structural transformation was to develop an institutional framework that changed incentives such that everybody would be striving toward the goal of maximum output growth. Economic growth is achieved when some re-

{p. 16} sources are saved and invested. The more is invested, the faster the economy will grow and the greater national income will become. A farmer starting out with nothing but a bag of rice seeds faces the choice between saving and consuming. If he maximizes current consumption, he can have a feast this year, but will starve the next. The more he saves and replants (invests), the greater the crop in the future, as each plant delivers more than one hundred grains of rice. The more he consumes, the less is left for replanting.

Firms are the farmers of the economy. They face the decision whether to save and reinvest their profits or to pay them out to the shareholders as dividends. The smaller the dividends and the more money reinvested, the faster the company will grow. To create an economy that grows rapidly, the institutions of the economy must be shaped such that individuals will save and firms will retain earnings and reinvest.

Separation of Ownership from Control

There are three parties involved in the organization of firms: the owners, the managers, and the employees. In small, family-owned firms, all three roles may be played by the same person. This is what classical and neoclassical economics assumes, for its models consist of many small firms, run and owned by one individual. However, the rise of the large-scale corporation has driven a wedge between the three functions. Usually, large firms cannot be funded, hence owned, by one individual; they cannot be managed by one individual, and they employ a large number of workers.

So the rise of the large corporation produced a separation of ownership from control and the detachment of employees from the goals of the firms. Each group has different aims and incentives. In a one-man firm, all the incentives of the three different functions coincide and the firm is pulling in the same direction. However, in large firms, as the three groups become separate units, each is striving for what is best from their viewpoint and the firm begins to pull in different directions. The final outcome may not be what produces fastest economic growth. It may also not be what is best for society and the country.

Shareholders Versus Growth

The goal of the shareholders is profit maximization. If they are mainly interested in high dividend payments, companies may be starved of funds to reinvest and hence may grow more slowly. This tends to create surplus funds that a small class of rich owners spend on more trivial pursuits than productive investment. Income inequality rises, speculation and production of wasteful goods increases. Economic growth slows. For the super-rich, consumption is a small percentage of their total income and wealth.25 With high income and wealth inequality, consumption will be weaker than in an economy with an egalitarian distribution.

If employees are not motivated to work hard, and if they squeeze higher wages

{p. 17} and shorter working hours out of firms, it will also dampen profits and - if an economy-wide phenomenon - lower overall economic growth. So the reform bureaucrats concluded that giving too much power to either shareholders or employees was bad for growth.

They found the story different for managers. Managers receive not only higher pay but also greater prestige and power over corporate resources (including expense budgets) if they move up the hierarchy. Since the hierarchy is pyramidshaped, with fewer people at the top, more at the bottom, more managers will be able to rise up the ranks if the firm grows. So the pursuit of their own goals leads managers to strive for faster growth of the firm. While the aims of shareholders and workers are not directly in line with fast overall economic growth, the goals of the managers are.26

Capitalism Without Capitalists

The New Economic System aimed at setting the firm "free from control of stockholders pursuing profit making."27 Disempowering shareholders and workers while empowering managers would boost growth, the war planners concluded in the 1930s. The managers of large-scale firms were their allies, shareholders and unruly unionized workers their enemy.28 Workers, though, could be won over if treated the right way. To curb worker discontent and communist agitators, employees had to identify closely with the firm - for instance, by having a greater say in company matters and through indoctrination with an ideology of the "firm as family."

However, shareholders would be difficult to reconcile with the overall goal of fast growth. Among the three interest groups, they were least crucial for growth. The reformers concluded that in a modern economy dominated by large-scale corporations, capitalism would work better without capitalists, and instead with powerful managers.

{See James Burnham, The Managerial Revolution: burnham.html}

Managerial Capitalism and the Firm as Family

Given such analysis, the reformers had their work cut out for them. Managers were elevated. This came naturally, since in large-scale organizations they are essentially private-sector bureaucrats. Modern bureaucracy is modeled on the Prussian bureaucracy, which in turn was designed on the basis of the Prussian army. Naturally, the military looked at managers as private-sector soldiers, and as controls strengthened, they were fully integrated into the military chain of command. In the end it extended down to the worker, who was a corporate soldier.

The doctrine of the firm as an "organic organization" binding employers and employees together and serving for the public benefit was officially implemented in 1938, with the establishment of Industrial Patriotic Societies in all companies. Joint meetings with management and employees were organized where workers could raise their concerns and participate in management decisions. At the same

{p. 18} time, trade unions were abolished and all union activity channeled to the company level. This ensured that concessions to workers would not become too large to endanger fast growth of the firm.

Meanwhile, the role of stockholders was cut down to size. The New Labor System proclaimed in 1940 that the firm was not the property of the shareholders, but a communal organization composed of those who worked there. Army Ministry bureaucrats argued, "It is necessary to transform stocks to interest-bearing securities, and the character of stockholders to recipients of such interest. ... In management it is essential to consider first and foremost the people who work for the firm. In one way or another, management, technology and labor all depend on the overall manipulation of people. This aspect of management is invariably more important than capital itself."9 New laws set limits on dividend growth. Beginning in April 1939, firms with dividend rates of 10 percent or more - about two-thirds of large firms at the time - required a permit from the Ministry of Finance to increase their dividend rate. This made stock investments less attractive. Moreover, since the assassination of Mitsui chief Dan Takuma, the zalbatsu families had increasingly been selling their shares to the public. This was not only in response to pressure from the military and bureaucrats, but also to mitigate the anti-zaibatsu feelings among the public.

It was soon found that if firms within a group issued shares and simply swapped them among each other, the influence of outside stockholders could be reduced without diluting group ties. Thus cross shareholdings rose in the 1930s, among the zaibatsu firms reaching as high as 40 percent of all outstanding stock during wartime.30 This increased the independence of managers, as the new shareholders were other managers with the same growth orientation.

The New Labor System: Creation of Japan as We Know It

Yet by 1943, the control bureaucrats and military felt that profit orientation of firms was still dominant and growth orientation insufficient. They found that managers were still afraid of shareholders. Although dividends had been reduced, shareholders could still threaten managers during general meetings. Thus as part of the 1943 Measures to Strengthen the Domestic System, the corporate law was changed and a new Munitions Corporation Law was promulgated in October of that year. It eliminated shareholders' influence on firm management. Instead, the authorities designated one manager as the responsible person for production in every firm. He was given the power to run the firm as he saw fit to achieve the twin goals of quantity and quality. He could not be sacked by stockholders and was dispensed from the necessity to obtain stockholder permission for his actions.3l He was only to be held accountable by the planning bureaucrats for the fulfillment of quantitative production objectives. The planners' powers were also strengthened, when in November 1943 the Cabinet Planning Board was united

{p. 19} with the Ministry of Commerce and Industry to form the powerful Munitions Ministry.32

In March 1944, the annual share dividend was decreased to 5 percent. Any residual influence by shareholders over profit allocation, fund-raising matters, and the appointment of managers was eliminated. They had been reduced to fixed-income investors without a vote. The bulk of profits were divided among reinvestment, salaries for managers and employees, and special bonuses for workers to reward specific productivity improvements.33

Since managers had been given great powers, they had to be prevented from boosting their own bonuses too much. So managers and employees received salaries according to the number of years they had served in the firm - seniority pay. Promotion was to be decided on relative merit. If a firm grew fast, the less able manager could be promoted also. In return, employees and managers had to vow loyalty to the firm. They were effectively prevented from quitting, because other firms, organized on the same principles of seniority and lifetime employment, would not hire them.

Welfare schemes for managers and employees were introduced that were the most advanced in Asia. The National Health Insurance Law of 1938 and the Personnel Health Insurance Law of 1939 provided virtually complete health coverage to employees. The 1942 Workmen's Annuity and Insurance Law for the first time required the payment of annuities in case of old age, disability, or death. In 1944 it was broadened to include other personnel and women.34

Creation of the Main Bank System

Large-scale firms vere the bureaucrats' friends. So several "national policy firms" were set up, which evolved into giant conglomerates. Most of them were stock companies, but the majority of the stocks were held by the government and shareholder influence was limited. The government chose the top managers, and bureaucrats oversaw company policy. The number of these firms jumped from 27 in 1937 to 154 in June 1941.35 In 1944, key producers of military supplies were designated as "munitions companies." In 1945, over six hundred firms received necessary funds to fulfill their production quota via one or two banks that had been allocated to them by the Ministry of Finance.36 This main bank was the designated "Financial Institution Authorized to Finance Munitions Companies," ordered to ensure a steady flow of bank loans to the firm as it required - a compulsory lending system. The "main bank" relationships lasted until today.

Banks were compensated against losses for risky lending, either through the government loan guarantee program or by being bailed out by the government if they got into trouble. In March 1945, the system was further expanded. Soon more than two thousand firms, including many companies not involved with munitions, had each been assigned a bank charged with tending to their financing needs. The allocation of bank credit thus shifted drastically from other sectors to priority manu-

{p. 20} facturing.37 And bank credit accounted for almost 100 percent of corporate fundraising by the end of the war. Funding through the stock market had ceased.

The Origin of Japan's High Savings Rate

As more and more purchasing power was given to the military producers who then made claims on the limited resources, fewer goods and services were available for private consumption. If consumers were to spend as much as they had in the 1920s, they would compete with the military and bid up prices. Inflation would be the result, and that would threaten labor disputes and worker unrest, as it did in 1937 and earlier. The solution was to get the population to withhold their purchasing power by saving. This would prevent inflation.

The first step was to encourage voluntary savings. In April 1938, a National Savings Promotion Campaign was launched that aimed at boosting the savings rate to 30 percent of GNP. Savings Promotion Committees and cooperatives mushroomed throughout government offices and private firms and among ordinary workers and neighborhoods throughout the country. An agency for the promotion of savings was established at the Bank of Japan (where it is still in operation today). Most of the savings took the form of deposits with the postal savings system or with banks. The result was underconsumption and a transfer of purchasing power from the household sector to the corporate sector.

Creation of the Trade and Business Associations

In the New Economic Order the visible hands of the mobilization planners directed resources from the top down by formulating quantitative output targets, which were then divided into the various industries and passed on to the control organizations that had been created in each industry. They exist until this day as the ubiquitous industry or trade associations. Thanks to the associations, the bureaucrats could deleg3.te the task of implementation and monitoring of theilordel s to the private sector. It was the control associations, not bureaucrats, that divided overall quotas into orders for individual firms and ensured compliance. Human resources were allocated similarly, achieving a historic transfer of labor from agriculture and nonpriority firms to munitions companies.

To organize industry more efficiently, firms and factories were amalgamated into fewer, larger units that could enjoy economies of scale. The economic structure became highly concentrated. At the same time, the large firms found it efficient to subcontract production of certain components to smaller firms, who were dependent on them - virtual external subsidiaries.

The New Japan

The changes implemented between 1937 and 1945 reshaped the function of the firm. Under the slogan "Public interest above individual interest," the New Economic Order successfully transformed firms from private profit-seeking undertakings to quasi-public ones focusing on growth, not profits. The market mechanism of the prewar period was substituted by a system of planning and government guidance that used private property and rank competition as an incentive device. Import penetration was successfully reduced.38 Resources had been shifted from nonessential industries to the heavy machinery and manufacturing industries crucial for munitions. Textiles halved from 29.3 percent of total production in 1937 to 14.7 percent in 1941, while the machinery production share more than doubled trom 14.4 percent to 30.2 percent.39 Private-sector savings rose from only 9.1 percent in the 1920s to 54.8 percent of GNP from 1941 to 1944.4° Real GDP grew by 25 percent during the war years (from 1940 to 1944).4l Munitions production grew 197 percent between 1941 and 1944.42 Labor was fully mobilized and shifted from agriculture to industry in a transformation that irreversibly rendered Japan an industrialized nation.43 Unemployment had been eliminated. The planners of the war economy achieved the goal of maximizing output from the available resources.

Introduction of One-Party Rule

On the political front, the military and reform bureaucrats felt that a system had to be created that would keep meddling politicians at bay. For this purpose, political parties were simply abolished and all politicians united in a one-party system, as pioneered by the Soviet Union. The single party was called the Imperial Rule Assistance Association. The police force was reorganized in an attempt to increase surveillance of individuals. A system of neighborhood police checkpoints was developed, which put up police microstations in virtually every corner of the country and enlisted senior citizens in each neighborhood as police informers (the system is intact today). Japan also became the most advanced social welfare state in Asia. Schooling was transformed, agriculture revamped. The changes were long lasting.44

Japan's System: An Economy at War

By the time Japan surrendered in 1945, most key features of the postwar economic structure had been established and Japan had been transformed from the free market capitalism of the 1920s to the controlled, "Japanese-style" capitalism of the postwar era. The labor structure among large firms changed to low job mobility and high loyalty to the firm, lifetime employment, seniority system, company unions, and bonus pay. The corporate organization clearly separated ownership from control, allowed few outside board directors, left shareholders weak, and thus made low dividends and a growth orientation possible. A "dual" structure was created, characterized by a few large firms with many small subcontractors linked in business groups. Funding shifted to borrowing from banks. The role of the bureaucracy became more interventionist and "administrative guidance" was cru-

{p. 22} cia1. Politicians did not make policies, and their influence was kept in check by the one-party system. The war mobilization changed what previously was a largely agrarian society into an industrial workforce trained to serve according to military work schedules.

The sudden emergence of the war economy system in the short time from 1937 to 1945 should surprise economists and historians. First, the system itself is surprisingly consistent, logically coherent, and highly efficient. Taking one individual component alone, it would not work. Implemented in its entirety, as happened in the postwar era, it beat the free market system of other countries hands down and created the postwar Japanese "economic miracle."

How could the wartime planners so quickly design such a consistent and efficient system? They had gained invaluable experience in implementing and running this system when they were experimenting with its prototype in Manchuria, which had been under direct army rule since 1931. The same bureaucrats then moved back to Japan to implement it there. The Manchurian planners did not have to invent it from scratch, either; they took most of their ideas from European thinkers and economists, with the biggest input coming from Germany.45

{p. 23} 3 Winning the Peace

An Economy at War

The Cold War Propaganda Myth of the Postwar Reforms

If Japan's postwar economic, social, and even political system was created during the war, then what were the U.S. occupation and the postwar reforms all about? General MacArthur's Occupation Administration was given orders to democratize, deconcentrate, demilitarize, and liberalize Japan. To implement this goal, first the wartime laws and ordinances, such as the National General Mobilization Law, were abolished and the control associations and other wartime organizations dissolved. The military and their bureaucracies were disbanded. The Munitions Ministry, at the heart of the war economy, was broken up in December 1945. So was the powerful Home Ministry, with its police apparatus, including the dreaded Thought Police. War criminals were brought to trial.

Second, the political system was reshaped. Japan was given a new constitution, which established democratic principles and the freedom of speech and religion. Female suffrage and free elections were introduced. Third, MacArthur's GHQ implemented three major reforms designed to dismantle the war economy system: the breakup of the zaibatsu, land retorm, and labor democratization.

Thanks to these high-profile reforms, it seemed that Japan made a break with the past and was about to become a free, democratic, and liberal capitalist country, partner of the United States, the leader of the "free world." This, at least, is how Cold War propaganda on both sides of the Pacific presented it.

At first glance it looks as if the U.S. occupation fulllled its official goal. But when the occupation ended in April 1952, its fruits were quite different from those it had promised. Instead of dismantling the war economy system and deregulating and liberalizing the economy, the opposite had happened. The U.S. occupation succeeded in strengthening and further entrenching the fully mobilized war economy system.

With the advent of the Cold War, some lobbyists in the United States were more interested in establishing Japan as a "bulwark against Communism" and hence urged that Japan's economy be strengthened as quickly as possible.1 "Japan hands"

{p. 24} in the State Department, such as prewar ambassador Joseph Grew, succeeded in pushing for far milder occupation policies than were implemented in Germany. Ultimately, interests in New York and Washington came to the same conclusion as the wartime economic planners did in the 1930s: that the visible hand of the government should be used to accelerate growth.3 Already by 1947, General MacArthur's democratization policies had been seriously undermined. Although there was no official announcement, a major U-turn of the U.S. stance vis-a-vis Japan had taken place. The GHQ now actively advanced the continuation and strengthening of the successful war system of total resource mobilization.

Reform by Relabeling

As a result, for all intents and purposes Japan's wartime economic controls remained unchanged even after the end of World War II. The Munitions Ministry merely split into the Ministry of International Trade and Industry (MITI) and the Economic Planning Agency (noticeably less menacing labels).4 The wartime control associations soon resurfaced as private-sector business associations of the various trades and industrial sectors. The postwar carmakers' lobby, the Japan Automobiles Manufacturers Association, for instance, was the automobile control association during the war. The keidanren, the powerful umbrella organization of all sectoral associations, is the successor to the wartime center of economic control associations. A random check into the history of many postwar companies and associations, not to mention laws, rules and customs, inevitably unearths wartime roots - whether it is the Tokyo Eidan Subway Corporation, the Japan Productivity Center, the Bankers' Association, the Association for the Promotion of Savings, or the neighborhood police reporting system.5

Certain wartime legislation was officially reintroduced soon after the war, especially by MITI and MoF: the Order No. 3 of the occupation forces of September 1945 declared the continuation of economic controls. Foreign currency rationing was reintroduced immediately. A materials supply and demand plan was drawn up in place of the materials mobilization-plan.6

The continuation of the war system was most blatant when it came to the monetary system and financial controls: the wartime Temporary Funds Adjustment Law of 1937 and the Ordinance on Funds Operation of Banks of 1940 remained effective. So did the Bank of Japan Law of 1942 (it was changed fundamentally only in April 1998). The Foreign Exchange and Foreign Trade Control Law, promulgated in 1949, was merely a continuation of the laws that started with the Capital Flight Prevention Law of 1932, the first series of laws that established the controlled war economy. It lasted until April 1998.

The close relationships between companies and banks that were set up during the war also reestablished themselves when the U.S. occupation ended, in the form of the powerful keiretsu and the main bank system. Even key parts of the postwar tax system can be traced to the war economy. The Enterprise Rational-

{p. 25} ization Promotion Law of 1952 established a depreciation system for important machinery with very high rates of depreciation and hence large tax incentives to accelerate capital investment. This furthered the corporate bias of overinvestment and underconsumption. Its origin is to be found in the Price Compensation System of 1943.

Supreme Rule of the War Economy Bureaucrats

It was not only the institutions of the wartime system that survived intact with only minor name changes. More importantly, there was virtually complete continuity of wartime bureaucrats and managers. While the troops were disbanded, the leaders and war planners who had run the war economy remained in their positions.7

General MacArthur had decided to implement systematically the principle of indirect rule through the Japanese bureaucracy, unlike the more direct rule established by the occupation forces in Germany. This left the bureaucracy practically completely in place. If anything, the power of the economic bureaucracy that had pushed for the war economy system increased after the war. Thanks to the U.S. occupation, their principal rivals for power, the military and the Home Ministry, had been disbanded. Another, somewhat lesser rival, the once proud Foreign Ministry, had also greatly diminished, as Japan's foreign policy was mostly made in Washington, not Tokyo. As long as they could agree with the goals of MacArthur, the economic bureaucrats at MoF, MITI, the predecessor of the Economic Planning Agency, and the Bank of Japan had become the rulers of Japan.

Even though with the abolition of the National General Mobilization Law their powers were now "informal," this did not diminish them in practice. The principal source of bureaucratic power, the licensing system, was still in place and terminology merely changed from "control," "planning," and "allocation" to "guidance" and "moral suasion." Since their private-sector counterparts were also largely the same people they had been working with during the war, strict obedience was assured. "Japan was placed under an American system of rule, but the ideological pattern remained exactly as hitherto."8

The Return of the Manchurians

The very bureaucrats and managers who had demonstrated excellence in running the fully mobilized war economy, whether in Manchuria or back home, received rapid promotions to even more elevated positions in the postwar system. This is not surprising, since of the economic war planners, hardly any were purged by the United States - forty-two Ministry of Munitions, nine MoF bureaucrats and basically no Bank of Japan officials.9 And as soon as the U.S. occupation left, practically all the nonmilitary men who had been purged were rehabilitated in order to fill the ranks that their seniority deserved. This includes wartime politicians and most Home Ministry bureaucrats who had been in charge

{p. 26} of the Thought Police. A number moved into the Education Ministry to take care of postwar education policy in Japan.10

The wartime planners did not just move back to modest positions in the public arena. The suspected Class A war criminals took center stage in the 1960s and early 1970s in positions as high as Japan's prime ministership.11 The most important postwar economic and political leaders came from the elite group of wartime bureaucrats, the "Manchurians."

While Albert Speer, the German wartime economy minister, was incarcerated in Berlin's Spandau Prison, his Japanese wartime colleague, Nobosuke Kishi, became prime minister. Kishi had been the leading Manchurian control bureaucrat, and during the war he became the minister for munitions, heading the war economy. As such, he had been a key designer of the wartime economic system.12 He was also the nephew of Yosuke Matsuoka, a general director of the South Manchurian Railway Company - the core of the Manchurian mobilized war economy and one of the largest companies in the world at the time. Matsuoka was a staunch backer of the army and the Manchurian experiment, and later rose to become pro-German foreign minister of the second Konoe Cabinet (from July 1940 to July 1941).

Kishi and his brother, Eisako Sato (a former railway bureaucrat), were prime ministers for altogether ten years, between 1957 until 1972.13 Other prime ministers with experience of the wartime system include Yasuhiro Nakasone, a former Home Ministry official. A key figure later in this book, the governor of the Bank of Japan in the 1990s, Yasushi Mieno, was born in Manchuria, since his father was a top control bureaucrat in the Manchurian Railway, the cadre school of the wartime economy. Finally, one should not forget the emperor himself, who was also an active leader during the war and a willing collaborator afterward.14

Among the eleven major automobile manufacturers of postwar Japan, only Honda is a true postwar creation. Toyota, Nissan, and Isuzu were key producers of trucks for the military. The seven other carmakers switched to car production from aircraft, tank, and warship manufacturing. Nissan and Hitachi were the core of the conglomerate operaled by Yoshisuke Ayukawa, a supporter of the Manchurian experiment of the controlled economy. He moved the headquarters of his conglomerate, including Nissan, to Manchuria, where he named it the Mangyo (Manchurian Industries) concern. Ayukawa became a member of parliament after the war.

Even the postwar media scene is the result of wartime concentration legacy: The Nikkei and the Sankei Shinbun are basically the result of wartime mergers, as are many other firms. Dentsu, Japan's top advertising company, is the product of the wartime concentration of the advertising industry, which reduced the number of firms from almost two hundred to only twelve. "It recruited so many former military and Manchukuo bureaucrats that in the early postwar era it was often called the 'Second Manchurian Railway Building."15 Manchurian origins can also be found with many large publishing companies. The list of successful or important postwar companies, institutions, and individuals with Manchurian or war economy backgrounds is a long one.16

{p. 27} LDP - "Bureaucratic Rule Assistance Association"

The minor role of political parties in forming serious economic policies in postwar Japan is well known. It remains to say that the unification of several parties to create the so-called Liberal Democratic Party in 1955 established the one-party reign (if not rule) that provided the democratic fig leaf for the control bureaucrats who were actually running the country. The so-called 1955 system closely resembled the one-party Imperial Rule Assistance Association system of the war era.17 The minor, and clever, improvement was that an opposition was allowed to provide an outlet for dissenters and to show the world that Japan was, really, a democracy.18 For forty years, until 1993, all governments were constituted solely by the LDP

With a Little Help from My U.S. Friends

Michio Morishima, a seasoned expert on Japan's economy, concluded: "As a result of this shift [in U.S. policy], Japanese capitalism re-emerged like a phoenix in a form almost identical to that of the prewar period."19 More than that: The irony is that only during the postwar era did the reform bureaucrats succeed in implementing their boldest reforms. During the war, they had failed to implement their ideas in two important areas. One was the complete elimination of the capitalist class from public and business life - the purge of the powerful zaibatsu families. The control bureaucrats considered this necessary to ensure continued growth orientation and the permanent neglect of profit maximization.20 The other was full-scale land reform that would expropriate large-scale landowners and redistribute land to boost wealth equality. This was expected to raise productivity and living standards in the agricultural sector. Despite their far-reaching powers, the reformers had faced stiff resistance during the war, as both policies smacked of communism. It was therefore anathema to the more capitalistically inclined leaders of the wartime period. Although the economic planners had to shelve these radical ideas, they remained convinced that they were necessary to enhance Japan's growth potential.

They did not have to wait very long. General MacArthur volunteered to implement these socialist policies, employing all the force of an occupation power. He purged the capitalist class, the zaibatsu families (the official reason was that they had allegedly been instrumental in setting up the militarist regime). They had mainly controlled their zaibatsu firms through holding companies, which owned the majority of zaibatsll firm stock. In 1946, holding companies held 167 million shares of stock. Since the total number of shares in all companies in the country was 443 million, they owned almost 40 percent of the total.21 The zaibatsu owners were forced to sell their stocks to the public, and the holding companies were forbidden entirely (until 1998). Zaibasu leaders, including illustrious members of the founding families - the core of the capitalist elite in Japan - were purged as war criminals or supporters of a criminal war and prohibited from further business activity. An

{p. 28} Anti-Monopoly Law and a Law for the Elimination of Excessive Concentration of Economic Power were enacted in 1947.

While the capitalist families disappeared from the economic landscape, their large conglomerates remained. Of the 325 firms scheduled for dismantling in 1948, only 18 were actually split up. By 1953, just a year after the departure of the U.S. occupation, the Anti-Monopoly Law had already been drastically watered down. Restrictions on stock retention, interlocking directorships, and mergers were relaxed, depression and rationalization cartels allowed. In the 1950s and 1960s about 30 laws were passed that provided exemptions to many industries from the Anti-Monopoly Law as well as the Export-Import Law. These included the Insurance Industry Law, the Aviation Industry Law, the Securities Investment Trust Law, the Fruit Industry Promotion Special Mearures Law, and so forth. Thanks to such vigorous intervention, the number of official cartels swelled from 162 in 1955 to 1,079 in 1966 - as we shall see, an important part of the war economy system.22 Most of all, the originally planned breakup of the five largest banks was abandoned, leaving the financial system entirely unchanged from its wartime setup.

Meanwhile, the companies regrouped as keiretsu business groups. While they were not held together by centralized holding companies, the companies simply tied themselves together by issuing more shares and swapping them, that is, by rapidly expanding the cross shareholdings. The war bureaucrats preferred this to holding companies, because the latter could be influenced by shareholders, but diffuse cross shareholdings established their system of capitalism without capitalists. Thanks to MacArthur's anti-zaibatsu reform, Japan's corporate giants had been rendered even more independent from shareholder influence and unaccountable to outsiders. Although banks could only hold up to 5 percent of stock of any industrial corporation, and since 1953 up to 10 percent, by arranging the purchase of stock by related keiretsu firms - each buying a small percentage of stock from each other's firm - they could cumulatively control over two-thirds of all shares. The resulting bank-centered business groups were identical to the prewar conglomerates, only they were now controlled by managers, not the capitalist shareholders. And in this managerial capitalism it was only the banks and ultimately the bureaucrats who had the say and could allocate resources as they saw fit.

Expropriation of Capitalists

The U.S. occupation also helped the wartime bureaucrats in implementing another one of their key goals. During the war, they had made attempts at sweeping land reforms. Politically unable to expropriate the large-scale owners during the war, the bureaucrats had instead opted for rendering them de facto irrelevant, just like the shareholders. By having a government agency buy rice at a high price directly from the farmer while paying landowners low rents for their land, they had severed the tie between tenant and owner and, crucially, between owner and land. Like shareholders, landowners had become receivers of a fixed income without

{p. 29} actual say over their property. However, a full-blown reallocation of landownership had remained impossible during the war. The U.S. occupation did the job for them by reallocating landownership to the tenant farmers. The postwar land reform almost completely wiped out the pre-1945 landlord class. This reallocation of land property went so smoothly only because the preparation had already taken place during the war. As a result, a major step toward social equality was achieved.

The U.S. occupation initially pushed for the democratization of the labor market, introducing new labor legislation and a nationwide labor union movement. Accordingly, the share of unionized labor rose from zero in 1945 to almost 60 percent in 1949. The increasingly powerful communist influence over this movement, with the background of the Cold War, convinced the U.S. occupation to change course. In July 1948 it restricted the right to form trade-based unions and abolished the right of civil servants to engage in strikes. From then on, the wartime company labor unions, the Industrial Patriotic Associations, were revived and mushroomed all over the country. After this, all the other wartime labor practices, from lifetime employment to bonus payments, were reinforced. This ensured that real strikes declined sharply, because workers would only hurt their firm, and hence themselves. The health insurance system introduced during the war essentially laid the foundation for the postwar Japanese social security system.

Kamikaze Capitalism: The Fight for Market Share

Thanks to the efforts of the U.S. occupation, the system of a fully mobilized war economy was led to completion in the postwar years - almost. Only in one aspect was the wartime economic model not yet complete, despite the tacit support from the United States. Indeed, there is a snag in the model that became visible during peacetime. Since the structure of the firm is designed such that the goal is growth, not profits, managers will compete for market share. Although concentration was greatly increased in every industry in order to rationalize production and take advantage of economies of scale, the planners always made sure that enough firms would remain to compete against each other to prevent managers from resting on their laurels. Since there are no trade unions any more, the company tie is more important than the fate shared with fellow employees in other firms. Steelworkers thus compete with each other instead of uniting. The management of one firm battles the management of another. Being in a firm with higher rank brought more prestige and had material benefits of higher incomes, pension plans, and more company facilities for housing, health care, and recreation.

In wartime, there was no problem with this, because firms focused on the production of their allocated quota with the simultaneous goal of highest quality. But in peacetime, bureaucrats soon found that their structure was getting too successful: When these market-share-oriented firms were let loose against each other without production quotas, fierce competition for market share would ensue. Like competition for ranking among managers in the hierarchy, the result of the war

{p. 30} system was that entire firms would compete not for profits but for ranking - the corporate pecking order decided by market share.

Since market share was the goal, firms would competitively lower prices; cutthroat competition and a dumping war would ensue until no firm was making any profits. In U.S.-style capitalism, the profit motive is the goal. Market shares are only a means to the ultimate end of higher profits. When competing against another firm, the profit motive would limit competition. As margins of both competitors approach zero, firms would stop lowering prices. They would be satisfied with profits and would be happy to coexist with each other. Not Japan's corporate warriors. Since the whole corporate structure was not aimed at profit maximization, low profitability, even losses, failed to stop the combatants from continuing their ruthless battle.

War Model Too Successful for Its Own Good

This was the inevitable result of an institutional setup where competition takes place between parallel groups of the same kind, as the "enemy" is so similar.23 It is also a major strength of the collectivist ranking competition on which the war economy is based: Society is divided into homogeneous groups, all ranked, and competition exists between those in the same category for ranking.24 "The pursuit of maximum growth has serious industrial and macroeconomic consequences," notes an observer of the phenomenon.25 The war-mobilized model was so successful in inducing growth and market-share expansion that firms would not stop. This phenomenon was soon recognized by the bureaucracy and called "excess competition" (kato kyo-so) - competition beyond what is necessary and good for the firms. Firms would go deeply into the red and even borrow to subsidize their output. It was a war of one management against another. Profits were no consideration. Firms would fight until bankruptcy to gain market share. There was no truce. The war system produced economic war until one side was destroyed.

During the postwar era, however, firms were not given predetermined production quotas. Left to their own devices, the structure would produce many bankruptcies, higher unemployment, and excessively high concentration in each sector. Once the bureaucrats had identified the problem, a solution could be worked out. The solution was the creation of explicit or implicit cartels, usually administered by the trade associations (the former wartime control associations). A ranking of firms was established, and the guidance of the industry association ensured that firms would by and large leave the ranking unaltered; all the firms continued to compete, but just enough to keep the rankings intact.

Cartels Were Necessary

To many observers, cartels may appear to be a bad thing. However, the cartels and industry associations fulfilled a crucial function.26 Without them, excess competi-

{p. 31} tion would lead to economically wasteful excess production and dumping of goods below their production value. At the same time, the cartels and industry associations served the purpose of implementing the bureaucratic "guidance." The problem was that the Anti-Monopoly Law had rendered cartels and agreements illegal in many sectors, such as construction. If they had been made public, they would also have drawn criticism from abroad. Thus the bureaucrats tacitly tolerated illegal collusion to fix prices and market shares, the so-called dango, such as in the construction and public works sectors. Given Japan's economic system, they served the public interest, for collusion was aimed not at profits, but at maintaining marketshare rankings, while firms continued to compete for price and quality.

Despite the cartels and industry associations, however, the competition between firms remained so fierce that "excessive competition" was the biggest weakness of the mobilized economy set-up. Until the 1990s, it seemed to be the problem that Japanese firms produced too much, invested too much, competed too much, and grew too much.27

The Mobilized Postwar Economy

The militarization embraced people's daily lives: Western-style trousers had replaced the kimono during the war, and rationed food and consumption had standardized consumption patterns. The thought that consumption was bad and savings good had been hammered deeply into the psyche. What previously was an agricultural and traditional craftsmen's workforce had now concentrated in big cities and was employed in factories: "They put on industrial overalls and learned the life of bondage to the factory whistle."28 All this thanks to the war.

The wartime shift of labor to the heavy manufacturing sector and the shift of production capacity away from light industry, especially textiles, which dominated the prewar economy, laid the foundations for the rapid industrialization of heavy and chemical industries in the postwar era.29 The increase of technical schools from less than a dozen in the early 1930s to more than four hundred in 1945 was due to the science and engineering requirements of the military, which exempted these fields from military service. By the end of the war the number of engineering students had tripled compared with a decade earlier.30 Quality control had been a major concern of the military, which rigorously enforced norms and standards set by the Industrial Standardization Law of 1940.

The relationships forged during the war between banks and companies, large firms and their small suppliers, and bureaucrats and the industry associations provided the framework for postwar success. In the 1960s, more than 40 percent of the parts suppliers to Toyota had begun this relationship as wartime subcontractors.31

War technology was transferred to manufacturing consumer goods. Engineers and workers trained in this technology put their knowledge to making consumer goods. There are cases of machine-gun factories switching to sewing machine production. Optical weapons factories became exporters of cameras and binocu-

{p. 32} lars. Suppliers of military hardware, such as tanks, trucks, planes, and ships, became the postwar shipping, automobile and heavy industries giants. Upstart firms created and championed by the military during the war became postwar world leaders in their sector.

Exports, Not Bullets

The wartime ideology of the firm as family, fostered by the Industrial Patriotic Associations, was carried over unaltered to the postwar era.32 Lives remained regimented, with company exercises in the morning, military boot camps for new company employees, and army-style discipline and obedience to superiors. The ultimate goal of a soldier had also been transferred to the postwar corporate warriors - loyalty unto death, as documented by the stunning phenomenon of karoshi (death from overwork).33

Consumers and households were encouraged to withhold their purchasing power by saving, while firms were given funds to invest in the priority sectors. Their products had to be sold. In the early postwar years, the expansion of domestic demand was important for growth, based on enfranchised farmers and workers.34 By the early 1960s it became apparent that, given the high domestic savings, the markets had to be overseas. So instead of munitions, the priority industries were now export-oriented manufacturers.

Managers were the commanding officers, workers and salarimen the corporate soldiers. The bureaucracies of MoF, MITI, and the Bank of Japan were the economic general staff. All fought the total economic war against the world.

Exports were the bullets flying out, hitting world markets and often leaving deep wounds in other countries in the form of high unemployment. Imports were hits taken and had to be minimized. This was done with the wartime exchange rationing system, revived immediately after the war. Importers required import licenses for each item, which were granted only to producers in priority industries, such as the export industry. This system was used to impose extreme restrictions on automobile imports, tantamount to total import ban, while the infant domestic car industry was getting into gear. The more bullets were fired and the fewer hits taken, the likelier Japan was going to win the economic war it was fighting. A trade surplus meant victory. It seemed Japan was following the oft-quoted caricature of mercantilism, where trade surpluses had become an end, not a means to an end.

But the World Was Unprotected

The result could not fail to be even more successful than the war economy. Economically speaking, weapons are wasteful production, because they are consumed. The same factories now produced similarly high-value-added export goods, which now, however, earned foreign currency. The money could then be used to import other production factors, such as raw materials, or for reinvest-

{p. 33} ment. Thus instead of a steady drain on the system, as weapons production had been, exports would continuously strengthen Japan. The only limit would be the willingness of the world to put up with a country that was still at war with the world in economic terms - closed to imports and hence piling up trade surpluses as if they were war loot.

While domestically the bureaucrats and industry association leaders ensured that companies would be protected against the kamikaze-like market share expansion behavior, the rest of the world was not so lucky. The only place where the full thrust of Japan's totally mobilized growth-oriented economy was working unmitigated and without restraining cartels was the world market.

As the United States pushed the Western countries to welcome Japanese exports, the full force of Japan's war economy was unleashed onto the world. Ignoring profits and aiming at market share, Japanese exports soon dominated the steel and shipbuilding markets in the 1960s. European and U.S. firms, aiming at profitability, were soon driven out of business. The onslaught by Japanese carmakers followed. Subsidized by the underconsumption of the domestic population, they began to conquer world markets.35 Then, in the 1970s and 1980s, the entire U.S. consumer electronics industry was wiped out by Japan's militarized and mobilized exporters. As a consequence, unemployment rose in the United States and Europe.

U.S. economists were often puzzled by the fact that Japanese monopolization of many markets in the world did not lead to concerted price rises to exploit monopoly profits. Analysts still failed to see its intrinsically different organizational structure and dynamics as a scale-maximization machine. Profits were irrelevant for management.

Ensuring Access to World Markets

Before Japan could make these historic inroads into world markets, however, it had to ensure that the world would be open to its products. The major clubs of the postwar industrialized world community, the GATT (now WTO), and the OECD, guaranteed open markets for all its member countries. That is why Japan had been pushing for membership since the 1950s. There was only one catch: The membership rules said that only countries with market-oriented and open economic systems could join.

This provision was aimed at protecting the members from countries that might dump their products while keeping their own markets closed - countries just like Japan. European countries argued that Japan's application to join GATT should be refused until the country had deregulated