Why Did Japan Stop Growing?

Takeo Hoshi
School of International Relations and Pacific Studies, University of California, San Diego,
NBER, and TCER
andAnil Kashyap
Booth School of Business, University of Chicago, NBER, and Federal Reserve Bank of Chicago
January 21, 2011

* This report is prepared for the National Institute for Research Advancement (NIRA). We
thank NIRA for financial support as well as the comments on an earlier draft by Jiro Ushio,
Reiko Kanda, and Tetsuo Ota. Research assistance was provided by Jess Diamond, Daisuke
Fujii, Eigo Kato, Satoshi Kimura, Norimasa Kudo, Kyohhei Matsuyama, Kazunari Nakajima,
Yuki Nonomura, and Kunitaka Ueno. We benefited from conversations with Takero Doi, Robert
Feldman, Kyoji Fukao, Yuji Genda, Yoshihisa Godo, Masako Ii, Takatoshi Ito, Kazumasa Iwata,
Richard Jerram and Ulrike Schaede.

Table of Contents
1. Introduction ................................................................................................................................. 2
2. End of Rapid Economic Growth ................................................................................................ 6
3. Aging and economic growth ...................................................................................................... 9
4. Japan’s Export-led growth ....................................................................................................... 10
5. Growth Impediment #1: Zombie lending and depressed restructuring ................................... 12
6. Growth Impediment #2: Government Regulatory Restrictions ............................................... 17
7. Growth Impediment #3: Macroeconomic Policy Mistakes ................................................... 22
8. Evaluating Koizumi Reform .................................................................................................... 30
9. Conclusions .............................................................................................................................. 34
References ..................................................................................................................................... 39
Figures........................................................................................................................................... 42
Tables ............................................................................................................................................ 62

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1. Introduction
The Japanese economy has been stagnating for almost two decades. Some recent researchsuggests that at the end of the 1990s the economy fell into a deeper paralysis that differed fromprevious “normal” recessions (Hamada, Kashyap, and Weinstein, 2011). By the middle of the
2000s a recovery seemed to have taken hold, but with the global financial crisis of 2008 Japan
has slipped back into recession and deflation. The governments after the onset of the global
financial crisis (one led by the Liberal Democratic Party and two led by the Democratic Party ofJapan) have proposed various policies to restore economic growth, mainly through fiscal
stimulus, but, overall, they have been ineffective.
Rather than focusing on the immediate growth challenges associated with the fallout fromthe global recession, we take a long-term view. The Japanese stagnation did not start in 2008.
The problem goes back at least to the collapse of stock and land prices in the early 1990s, and wetrace the major causes of stagnation to the failure of Japan to adjust to various challenges thatemerged starting as far back as the 1970s.
Prior to the 1970s, the Japanese economy enjoyed a very rapid pace of economic growth.
But, during the 1970s important factors that supported this rapid growth started to disappear.
First, Japan was catching up with more advanced economies such as the U.S. Thus, Japan could
no longer grow just by imitating or importing new technologies from the advanced economies.
The practices and economic institutions that worked well during the catch-up phase were not sowell-suited for a more mature economy.
Second, financial globalization and the collapse of the fixed exchange rate regime meantthat by the end of the 1970s that Japan could not rely on an undervalued currency to boost its

2

exports. Japan had to rearrange its production system and other economic institutions to copewith globalization.
Third, Japan’s population structure was shifting and becoming increasingly elderly. The
aging meant slower growth of the labor force. The aging and the declining fertility also reduced
the domestic saving that supported economic expansion during the rapid economic growth period.
The end of catch-up phase, globalization, and the rapid aging together created a major
challenge to the Japanese economy. Japan has yet to successfully meet these challenges.
Worse, there were some subsequent policy mistakes, which turned stagnation into
paralysis in the late 1990s. For example, regulatory forbearance on problems in the banking
sector created the situation where zombie banks were supporting zombie firms, which hurt
growth by stifling the process of creative destruction (Caballero, Hoshi, and Kashyap, 2008).
Mistakes in monetary policy created prolonged deflation and entrenched deflationary
expectations. Fiscal policy allocated too much money to ineffective spending programs andcreated a massive debt build up that now will require wrenching adjustment.
Although the Japanese economy started to recover in the mid 2000s under the reformminded Koizumi government, the global financial crisis in 2008 put it back into recession.
Looking back, the “recovery” of Japan was not robust, and Japan needs to change its policy
direction for sustained growth to emerge.
There have been a lot of discussion and research into the causes and remedies for Japan’s
stagnation, often called the “lost decade.” This paper differs from many of those attempts intaking a longer horizon.1 We see the challenge that the Japanese economy faces as comparable
in magnitude to those at past historical turning points, including the opening of the country in the1

Our analysis builds on a few recent studies that also take a longer term perspective such as include Blomström,
Corbett, Hayashi, and Kashyap (2003), Ito, Patrick, and Weinstein (2005) and the ESRI Project led by Koichi
Hamada, Anil Kashyap, and David Weinstein (2010)3

mid-19th century, the turmoil in the 1920s, and the devastation after World War II. How Japan
confronts the challenge is likely to influence its future for several decades.
One important reason why Japan has not successfully responded to the challenges is thatthe status quo has been mostly satisfactory. Thanks to the rapid economic growth in most of the
post-war period, Japan is a rich country now. Therefore, except for a few very severe crises,
there has been little pressure to confront these issues. Without a clear vision on what Japan
could achieve, it is hard to grasp what Japan is losing. One important goal of this paper is tocome up with a clear view of what is possible for Japan in rest of the 21st century.
The paper is organized as follows. In Sections 2 through 4, we start by identifying thechallenges that Japan faced after the rapid economic growth era. Section 2 points out that a
slowdown in economic growth was an inevitable consequence of a successful catch up. As
Japan’s GDP per capita rose, the growth rate fell. The end of the catch up phase, however, is not
the whole story. We show that some advanced countries such as the U.S., Canada, and the U.K.
continued to grow at the rate higher than Japan even after they reached a similarly high level of
GDP per capita. Hence, the right question is what can Japan do to grow like the U.S., Canada
and the U.K?
Section 3 identifies rapid aging as one factor that made Japan’s adjustment to the end of
rapid economic growth more challenging compared to many other advanced economies. Not
only were the effects of aging more pronounced in Japan, but the aging effects started tomanifest at the same time as the catch up phase of economic growth ended. In addition, thesustainability of the export oriented nature of Japan’s growth posed another serious challenge.

4Section 4 reviews this hurdle and shows that Japan needs to change from an exportoriented growth economy that uses imported technologies to try to catch-up to one focusing on
its domestic market and own innovation.
Sections 5 through 7 identify three important impediments that have interfered withJapan’s adaptation to the new environment. Section 5 shows that protection of incumbent firms(and their workers) against macroeconomic shocks in the 1990s stifled the competitive processof creative destruction that is essential for innovation and productivity growth in a matureeconomy. The section is mainly based on the work by Caballero, Hoshi, and Kashyap (2008).
Section 6 examines the role of various government regulations in further reducing the
productivity growth, especially in non-manufacturing industries. Finally, Section 7 discusses
problems and growth reducing consequences of the monetary, fiscal and banking policies thatwere implemented to respond to macroeconomic shocks in the 1990s.
There was a period recently when Japan had a reform minded government andexperienced a brief recovery of economic growth. The government, led by Prime Minister
Junichiro Koizumi, started several economic reforms that appeared to steer the Japanese
economy in the right direction. Section 8 is devoted to an analysis of several major reforms that
the Koizumi government tried. A detailed discussion of major reform programs are in the
Appendix.
Section 9 concludes by summarizing the findings and drawing lessons that Japanesepolicy makers should learn in order to restore economic growth. We close with a brief
evaluation of the New Growth Strategy, which is the current government’s attempt to do that.

52. End of Rapid Economic Growth
For many years the Japanese economy grew very rapidly. From the mid 1950s to mid
1970s, the average growth rate of the real GDP was around 10% per year, but growth then began
slowing. Figure 1, using data based on the 1968 System of National Accounts, shows the real
growth rates from 1955 to 2000. The figure clearly shows a first slowdown in the mid 1970s andthen a second, more pronounced drop during the 1990s. Figure 2, using the current vintage ofnational accounts data, shows real GDP growth rates from 1981 to 2009. Although the growth
seems to have returned briefly in the mid 2000s, Japan stopped growing again after the global
financial crisis of 2008-2009. The purpose of this report is to explain the stagnation that began
in the 1990s and deduce what policies might help reverse it.
Economists have demonstrated that long term growth patterns are generally welldescribed by the so-called “neoclassical” model of growth. This model focuses on the supply
side of the economy and we will use it to organize our discussion of potential causes of theslowdown. To quantify these alternatives, consider the simplest version of the neoclassicalmodel:Y = AF ( K , L )(1)where Y is the level of output, K is the amount of capital input, and L is the amount of labor
input in the economy as a whole and A denotes the level of technology.2 Written this way, themodel presumes technological progress raises output by making both labor and capital moreproductive (rather than favoring capital or labor).

2

We also make the standard technical assumptions that the function F(·) is assumed to be homogeneous of degree
one and the marginal product of each input is positive but declining with respect to the level.
6

If we also assume that capital and labor are each paid their marginal product (as would be
the case if neither had any market power), one can show that the growth rate of output can be
decomposed into three parts.
% ΔY = % ΔA + α % ΔK + (1 − α )% ΔL(2)

where %Δ is the operator to take the percentage change of the variable (for example, %ΔY
denotes the growth rate of output in percentage points) and α is the share of profits (income tocapital) in total national income (and correspondingly 1-α is the share of labor income). This
representation attributes output growth as coming from three sources: increases in capital (thesecond term of the right hand side of the equation), increases in labor (the third term), and/orfrom technological progress (the first term).
One can rearrange (2) to describe output per (quality adjusted) labor input term as arisingfrom either increases in the ratio of capital to labor or from technological progress:⎛Y ⎞⎛K⎞% Δ ⎜ ⎟ = % ΔA + α % Δ ⎜ ⎟
⎝L⎠
⎝L⎠

(3)

Since the marginal product of capital declines as the capital intensity (K/L) increases, the second
term in (3) naturally falls as the economy grows. This observation also implies that countries
that are initially poor can grow very quickly by having high rates of capital growth, but more
importantly it tells us that eventually growth will be governed by technological progress (i.e.
pure productivity improvements). Historically technological progress among rich countries has
been somewhat similar, which means that countries have a tendency to converge to a common
rate of technological progress. Part of what explains Japan’s slowdown is the transition frombeing a poor economy that was catching up with other advanced countries through strong
investment to becoming a rich country whose growth was limited by productivity improvements.

7

To see this clearly Figure 3 shows the trend GDP per capita for G7 countries measured inyear 2000 US dollars (converted using the purchasing power parity) from 1970 to 2005. The
trend estimates were calculated using a standard statistical method developed by Hodrick andPrescott (1997).3 Figure 4 shows the growth rate of the trend compared to the level of the trend.
This presentation allows us to compare the growth rates across countries when each reached agiven standard of living.
The figure shows that most of the countries experienced slowdown of growth as the real
GDP per capita moves from the mid $10,000s to the low $20,000s. Compared with the other G7
countries, Japan continued to have a higher growth rate even when the GDP per capita crossed
the $20,000 level, but then the growth rate declined much more rapidly than elsewhere.
The figure also shows that the countries do not converge to a single rate of growth.
Instead, as per-capita income broached roughly $25,000 we see the countries split into threegroups. First, the U.S., the U.K., and Canada seem to be converging to a steady state growth rateof around 1.7%. Second, France, Germany, and Japan seem to be converging to the growth rateof about 1.0%. Finally, the growth rate has continued to fall and seems to be approaching zerofor Italy. These differences, if sustained, are extremely important. When per-capita incomesgrow at 1.7 percent per year, incomes double in 41 years. In contrast, when the growth rate is 1
percent, then it takes 69 years for income to double.
But Japan’s path is also interesting. Trend growth rate declined very rapidly once GDP
per capita reached a little over $20,000 (around 1990) and for a time looked as if it was on the
Italian trajectory. But in the early 2000s growth recovered slightly so that Japan seems to havesettled in with France and Germany.

3

Specifically we set the smoothing parameter in their algorithm to 400.
8

The figure motivates several questions that we analyze in the rest of the report. Whataccounts for the sharp growth deceleration? What happened in the 2000s to reverse Japan’s
freefall? What can Japan do to match the higher long-term growth rate that the U.S., the U.K.
and Canada seem to enjoy?

3. Aging and economic growth
One factor that may explain the rapid decline of trend growth rate compared to othercountries is aging of the population. Figure 5 shows the proportion of the old (65 years old or
above) to the total population for G7 countries. Japan had relatively low share of elderly people
during the 1960s and the 1970s, but the ratio subsequently increased very rapidly. By 2022, 30
percent of all Japanese citizens will be aged 65 or older, which is nearly twice the percentage inthe U.S.
The neo-classical growth model implies that the long-term growth rates of per capita
GDP declines when the aging proceeds rapidly. Note that the decomposition in equation (3) iswritten in per worker terms and the labor input (hours) is adjusted for distribution of different
worker skill levels. Thus, letting N be the total population, equation (3) can be re-written as:⎛Y L ⎞⎛K⎞⎛L⎞%Δ ⎜⎟ = % ΔA + %αΔ ⎜ ⎟ + %Δ ⎜ ⎟
⎝L N⎠
⎝L⎠
⎝N⎠

(4)

This formulation highlights the fact that as aging leads workers to retire or cut back on hours
worked, per-capita growth necessarily declines because the last term in the equation becomes
negative.
In addition to the effect of reducing labor participation and declining hours, the rate ofquality improvement of labor may also suffer from aging if the skill improvement of old workers
9tends to be lower than that for young workers. Sommer (2009) shows peak earnings occur inJapan as workers reached their late 40s. He also shows that in contrast to the U.S., earnings drop
noticeably shortly after that stage, so that by the time the workers reach their late 50s, they are
earning roughly 30% below the peak level.

4. Japan’s Export­led growth
The neoclassical model assumes that as long as goods are produced efficiently there will
be a buyer, so we can abstract from demand in estimating long term growth. But if demandstagnates, the expanded productive capacity resulting from technological progress will not be
used effectively and will be wasted. The demand side problems have been evident in Japan for
more than 15 years. One clear symbol of this is the persistent deflation that has prevailed since
the mid 1990s. Given its depressed domestic demand, Japan has relied heavily on selling toforeigners.
Table 1 shows the contributions of external demand to the economic growth and theaverage ratios of exports on GDP for G7 countries for the period from 1995 to 2009. Japan’s has
the highest dependence on external demand. This is especially surprising because Japan’s
exports relative to GDP are small. Thus, Japan has had an odd combination of output being
produced to satisfy external demand, while demand in the large domestic market has stagnated.
The reliance on the external demand is a legacy from the rapid economic growth period.
Under the Breton Woods System of exchange rates, Japan benefited from a fixed andundervalued currency that made exports extremely competitive. The combination of a young,skilled workforce with a stable, undervalued exchange rate delivered high growth. The collapseof the Breton Woods regime in the early 1970s put an end to this strategy. The economic success10

of Japan and emergence of competing export-oriented economies in East Asia changed thecompetitive environment for the Japanese exporters.
As Rajan (2010, Chapter 2) argues, an export-oriented growth strategy backed by close
relationships between a country’s government, banks, and industrial firms has been a successful
formula for poor countries to become much richer. Japan and other Asian economies, including
China, used this strategy to grow successfully. When the developing economy is small
compared with the rest of the world, it can continue to depend on external demand. But as the
economy grows larger, depending too much on external demand becomes increasingly difficult.
Another problem of the export-oriented strategy is the absence of market forces in
guiding the allocation of resources. Rajan (2010) points out that protecting domestic firms
against market forces so that they can develop organizational capacities may make sense during
the catch-up phase of growth when a country can grow just by importing new technology andaccumulate capital. As the economy matures, however, a well functioning market to sort out
efficient from inefficient production arrangements becomes essential. The problem with anexport-oriented strategy is that it tends to suppress the market mechanism which usually creates
acute problems in the non-manufacturing sector, particularly the service sector, where there is no
discipline from international competition.
Table 2 compares the experience of Japan with the recent growth experience of China.
For Japan, export led growth was no longer enough to lift the economy (China is likely to face asimilar problem in the near future). Going forward Japan needs to rely on vibrant domestic
markets and we next review some of the problems in domestic markets that have impeded
growth.

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5. Growth Impediment #1: Zombie lending and depressed restructuring
One of the big problems that emerged in the 1990s was the rise of what Caballero, Hoshi,
and Kashyap (2008) call zombie firms. A zombie firm can be defined as an unproductive andunprofitable firm that should exit the market place but stays in business with help from its
creditors or the government. By continuing to operate and hanging onto the workers that should
be reallocated to more productive firms, zombie firms impede the efficiency of the economy.
Healthy firms are able to grow less quickly, and over time if the zombies’ presence becomeslarge enough, productivity growth falls.
Zombies were spawned in the aftermath of the collapse of asset prices in the early 1990s
and subsequent recession. The large loan losses during this period left many banks with very
little capital. The banks, therefore, faced two options: recognize the losses, and try to raise
capital and find new customers, or deny the problems and continue to roll over loans while
hoping for improvement. Most banks, encouraged by the government to support existing firms,
took the latter option.
Caballero et al. (2008) explain how the presence of zombies discourages healthy andproductive firms from entering new markets or expanding their operations. In particular,
because the stronger firms would be forced to compete with the subsidized weak firms to sell
products, hire workers or borrow money, the zombies depress activity. Only the non-zombies
with highest productivity and profitability are able to survive competition with zombies. As aresult, the productivity of the industry (and the whole economy) suffers when there are many
zombie firms.
Identifying zombies is challenging since banks have no incentive to confess that they are
keeping customers on life support with subsidized credit. To come up with a quantitative12

measure Caballero et al. (2008) attempt to estimate what expected credit costs should be andlook for firms that are being charged less than what would be expected. Importantly,
measurement is also hampered because specific lending arrangements between banks andborrowers are not disclosed. Hence, they give all firms the benefit of the doubt and assume thatthey are able to get funding at the most favorable possible rates; effectively they assume thatevery firm is as credit-worthy as the strongest companies in the economy. For example, if thehighest rated firms are able to borrow at a 0.5 percent interest rate in the commercial paper
market, then Caballero et al. (2008) assume that this rate would be available to all commercial
paper borrowers. By making similar assumptions for each type of borrowing they construct thelowest possible amount of interest payments that a firm could reasonably be expected to pay.
Zombies are defined as those firms which somehow manage to pay less than the lower bound.
Figure 6, taken from Caballero et al. (2008), shows two estimates of the prevalence ofzombie firms in the Japanese economy. The top panel shows the proportion of zombies
measured based on simply on the number of firms, while the bottom panel looks at zombie
prevalence by comparing total assets residing in zombies to total assets in all firms. Bothmeasures show that the zombie firms increased rapidly during the 1990s when Japan entered arecession following the collapse of the so-called “bubble economy”. The proportion of zombies
stayed high into the early 2000s.
Figure 7 shows the cross-industry breakdown of the zombies (based on the asset
percentage definition). One striking observation is that the zombies were much more pervasivein the domestic parts of the economy: in manufacturing, which accounts for virtually all exports,
the percentages are low, while in the service sectors the zombie percentages are much higher.
One possible explanation is that the manufacturing sector is continuously subject to global

13

competition so that banks would realize that propping a firm up was potentially very expensive.
In contrast most of the service sector firms face limited foreign competition. Also the averagefirm size is much smaller for non-manufacturing firms and these small and medium sizedenterprises have historically been very active politically in lobbying politicians for favors.
Regardless of whether this conjecture about the explanation for the cross-industry differences iscorrect, if zombies are a problem it looks like they will affect non-manufacturing industries
much more than manufacturing.
The central hypothesis offered by Caballero et al. is that the zombies impede the healthyfirms. To test this proposition one needs a benchmark for what the healthy firms would doabsent the presence of zombies. Caballero et al. use regression analysis to construct thebenchmark and look for distortions in the behavior of the healthy firms that can attributed tocompeting with zombies. They consider three different regression specifications which are
estimated for a panel of publicly listed companies in Japan. The specifications are:Activityijt =δ1′D t +δ 2′D j +β nonzijt +χ Z jt +ϕ nonzijt *Z jt +ε ijt(5)Activityijt =δ3′D jt +β nonzijt +ϕ nonzijt *Z jt +w ijt(6)

Activityijt =δ3′D jt +β nonzijt +ϕ nonzijt *Z jt +θ sijt +vijt(7)

The proxies for economic “activity” that are to be explained are either investment in fixed assets,
employment growth, or the total factor productivity growth.4 These specifications differ
depending on the implied forecast for what would happen in the absence of zombies. The
simplest, baseline specification (5) regresses an activity variable on an indicator variable thatallows for different values for each year and industry (Dt and Dj respectively). This amounts toproposing that knowing the year and the industry is an adequate summary for what investment,
4

The subscripts i, j, and t denote an individual firm, an industry, and a year respectively.
14

employment or productivity would be. In addition, this specification (and all the others) allows
for different estimates of activity for zombies and non-zombies. The non-zombie dummy
variable (nonz) takes the value 1 when the firm is not considered to be a zombie in that year.
Activity is also presumed to depend on the proportion of the assets in the industry held byzombies (Z). The final “interaction” term in the equation (nonz times Z) captures the possibility
that non-zombie firms behave differently when their industry has many zombies than when few
zombies are present.
For investment and employment growth regressions, the zombie hypothesis predicts theinteraction coefficient to be negative. As the number of zombies increases in the industry,healthy firms cut back their investment and employment growth. For TFP growth, the zombie
hypothesis makes the opposite prediction, that the coefficient be positive. To successfullycompete with zombie firms, non-zombies are required to have extra high productivity. Thus, ineach case the regressions can be read as asking the question what happens to activity for nonzombies when it has to confront additional zombies over and above what we already would
expect based on average activity for the whole economy in a given year and for the average
performance in the industry.
Notice that most standard theories of industry dynamics would make opposite predictions
to the zombie hypothesis. For example, if a firm’s competitors are weak, standard theories
would suggest that this would be a good time to hire more workers or to invest in moreequipment to steal market share. Likewise, a firm with poor productivity growth would be
expected to survive more often when its competitors are weak.
Specifications (6) and (7) are estimated to allow for more complicated counter-factual
scenarios. Specification (6) includes a dummy variable for each industry-year combination15

instead of the year-specific dummies and the industry-specific dummies. This allows us toaccount for any factor that influenced all the firms in an industry in a specific year. Although
this makes it impossible for us to estimate the impact of the increase in the zombie index (whichis measured at industry level) on individual firms in general, it is still possible to estimate its
differential impact on the non-zombies.
Specification (7) introduces the firm specific sales growth in addition to the year-industry
combination specific dummies. This is an attempt to control for differences in profitability atfirm level. In other words, besides holding fixed the conditions for all firms in a given industry
in a given year, this equation also accounts for the average activity of a firm with a given level ofsales growth.
Table 3 again from Caballero et al. (2008), reports the regression results. The first threecolumns show the coefficient estimates and their standard errors (in parentheses) for
specification (5). The middle three columns are for specification (6), and the last three columns
are for (7). In all of the specifications, the sign of the interaction coefficient are as predicted by
the zombie hypothesis and in most cases the coefficient is statistically significantly different
from zero. Thus, the regressions suggest that an increase of zombie firms hurt the non-zombies
in the same industry and reduces the investment and the employment growth of those otherwise
healthy firms. More zombie firms also increase the productivity gap between the non-zombies
and the zombies, because the non-zombies have to be extra profitable in order to survive.
We next explore the cross-industry impact of the zombies. The productivity growth of anindustry where there are many zombies is expected to be low not only because there are many
unproductive zombies, but also because the zombies prevent the entry of new productive firms.
Figure 8, again taken from Caballero et al. (2008) plots the total factor productivity growth from16

1990 to 2000 against the change in the (asset weighted) zombie index from the 1980s to the1990s in the industry. As expected the industries that experienced large increases in zombies had
low productivity growth.
Taking this one step further, Figure 9 compares the total factor productivity for the
manufacturing sector to that for the parts of non-manufacturing sector which are considered tohave suffered from the zombie problem. For this calculation non-manufacturing are those
operating in construction, retail & wholesale trade, real estate, agriculture, finance & insurance,and hotels & restaurants. The shaded areas of the graph show recessions according to thebusiness cycle dating by the Cabinet Office of the Japanese government.
The figure shows that both manufacturing and non-manufacturing industries increased
their total factor productivity during the 1980s. During this period manufacturing out-performed
non-manufacturing, but their patterns were relatively similar. In the 1990s, divergence occurs.
The manufacturing industry’s productivity suffered during the recessions but grew during therecoveries. In contrast, the productivity for non-manufacturing has been flat since the early
1990s.

6. Growth Impediment #2: Government Regulatory Restrictions
Another growth impediment is the heavy government regulation in some sectors.
Protection of industries often stifles competition and has a similar effect to permitting zombies.
For example, entry restrictions raise profits of incumbent firms but reduce overall productivity
growth by discouraging the entry of new firms. There are also cases where government
interference can interact with the zombie problem. For example, Tett (2003) recounts
discussions held between the government and the new owners of the Shinsei bank (the successor

17

to Long-Term Credit Bank, LTCB, which had failed and was auctioned by the government) overlending policies. When LTCB was up for sale one of the conditions imposed on bidders was acommitment to continue to support small borrowers. Tett reports that the new bank owners
believed that many of these borrowers were not credit-worthy but nonetheless were pressured by
the government to continue lending.
While systematically documenting any effects of informal pressure such as that describedby Tett is difficult, there are a variety of testable implications of the conjecture that regulation
stifled growth. Most directly, if government regulation is an important impediment, we shouldfind that more heavily regulated industries tend to have lower productivity growth. We should
also expect to find that industries with more restrictions allow inefficient incumbents to operate
longer than otherwise. Moreover deregulation should correct some of these problems, so
deregulated industries should show productivity growth.
The existing literature has some suggestive evidence for these predictions about the
distorting effects of regulation. Nakanishi and Inui (2008) use the data from the JIP (Japan
Industrial Productivity) database to examine the relation between regulation and total factor
productivity at the industry level. The index for regulation in the JIP database is constructedfrom Kyoninka-tō Genkō Hyō (Present State of Administrative Clearance) (published by the
Ministry of Internal Affairs and Communication, Administrative Evaluation Bureau), which
provides 0-1 indicators if a very narrowly defined industry is subject to some administrative
clearance. This assessment is given for 519 sub-industries, and then the data are aggregated to
108 industries by calculating the weighted average (based on the value added) of the underlying
sub-industries. (Fukao et al. 2008, pp.109-110). For the sample period from 1970 to 2002,
Nakanishi and Inui (2008) find more heavily regulated industries have lower total factor

18

productivity growth. Their statistical estimates imply that TFP growth increases by 1.1% peryear when an industry switches from having each sub-industry regulated industry to having none
regulated.
Cabinet Office (2006) uses another index for regulation that is based on not only theexistence of regulation but also how “strong” the regulation is (both in content and in the legal
basis of the restrictions). Their index builds on basic information in Kyoninka-tō Genkō Hyō(Present State of Administrative Clearance), but groups regulations into 4 categories according
to the content of the regulation. Category A regulations require explicit approval or licenses toengage in certain business areas or offer new products. Category B regulations compel the firms
to prove periodically that they satisfy certain standards for products and business. Category C
regulations ask firms to report certain business information to the regulatory agencies. Category
D regulations are other minor regulations (e.g., periodically required training programs). In
addition to these four categories, Cabinet Office (2006) also counts the number of regulatory
reforms that opened up new business areas or new products each year. When such deregulation
occurred, the new business area or product was considered to have been banned before thederegulation although the ban is not listed in Kyoninka-tō Genkō Hyō. Such implicit ban iscoded as a regulation in Category S.
The regulations are also categorized according to the legal bases. If a deregulation isderived from a formal Act, it is classified as Level 4. If it is defined by a government ordinance,
it is Level 3. If it is by a ministerial ordinance, it gets Level 2. If it is just a notice, it is coded as
Level 1.
The weighted sum of the regulations is calculated, using highest weight for Category S
regulation and then Category A regulation, and so on. The index is normalized to 1.0 for 1995 in19each industry, so one cannot compare the extent of regulation across industries. Once again theycorrelate productivity from the JIP database with the regulation proxy. The Cabinet Office findsthat industrial TFP growth from 1995 to 2002 is negatively related with the regulation index in
2002. Thus, the result suggests that deregulated industries (lower value for the regulation index
in 2002) tend to have high productivity growth. The result is statistically significant for nonmanufacturing industries. For manufacturing industries, the result is not statistically significant,but the sign of the coefficient suggests the direction of the effect is the same.
We extend the Cabinet Office analysis by using more recent estimates of the industrial
TFP growth rates contained in JIP Database 2009(http://www.rieti.go.jp/en/database/JIP2009/index.html). This allows us to correlate the TFP
growth from 1995 to 2005 to the regulation index in 2005. We also consider an alternative
regulation index that only considers Category A regulations to be relevant.5
Figure 10 shows the time series of the average regulation index for manufacturing andnon-manufacturing. The coverage of “non-manufacturing” here is the same as that for Figure 9(construction, retail & wholesale trade, real estate, agriculture, finance & insurance, and hotels &restaurants). The regulation index for each industry is weighted by the value added of theindustry and averaged. Note that the index is normalized to be 1 in 1995, so unfortunately wecannot compare the levels of the index across the sectors – although we strongly suspect that
manufacturing was already much more deregulated than non-manufacturing in 1995. We cancompare the speed and the extent of the deregulation from 1995 to 2005.
The regulation index for the manufacturing sector fell to about 0.4 by 2005, while the one
for non-manufacturing stood at around 0.6 in 2005. Thus, over the decade, there was more

5

We thank Tomohiko Inui, Hidehiro Iwaki, and Fumihira Nishizaki at the Cabinet Office for sharing their data on
regulations.
20deregulation (relative to the initial level in 1995) in the manufacturing sector. The more striking
difference is found in the time series pattern of deregulation. While the deregulation for the
manufacturing sector proceeded steadily, the deregulation for the non-manufacturing sector
moved quickly during the 1990s (more quickly than in the manufacturing sector) but then stalled.
In the 2000s, the average regulation index for the non-manufacturing sector actually increased
noticeably. Overall, the graph suggests that the deregulation efforts (to the extent they arecaptured by this index) slowed down in the 2000s for the non-manufacturing sector.
Figure 11 plots the TFP growth rate from 1995 to 2005 against the value of the regulationindex in 2005 for each sector. The TFP growth does not seem to be correlated with theregulation index for either sector. The slopes of the simple regression lines are not significantly
different from zero.
Figure 12 and 13 repeats the same analysis for an alternative regulation index that counts
only the Category A regulations. Figure 12 again shows that the deregulation for nonmanufacturing industries has been much slower than for manufacturing industries. In fact, theregulation index for non-manufacturing trended upward from 1995 to 2005. Compared with theoriginal regulation index in Cabinet Office (2006), the alternative index excludes (1) new
business areas or products opened up during 1995-2005 and (2) deregulation of less important
restrictions in categories B through D. Since allowing new business areas or new products were
often associated with new regulations concerning those areas or the products, it is possible forthe number of Category A regulations to increase even when the firms in the industry gain more
discretion. The gap between manufacturing and non-manufacturing, however, is striking. Even
with the potential upward bias, the index shows steady deregulation in the manufacturing sector.

21

In the non-manufacturing sector as aggregate, this index does not show any evidence of
deregulation.
The Figure 13a for manufacturing is very similar to Figure 11a. We do not find acorrelation between deregulation and productivity growth. For non-manufacturing, however,relatively more deregulated industries experienced higher productivity growth – although thiscorrelation is not statistically significant.
Overall the results here are broadly consistent with the results of Cabinet Office (2006).
But, the updated figures imply that deregulation in non-manufacturing seems to have stalled
during the 2000s. When we focus on Category A regulations, we do not see any trend of
deregulation for non-manufacturing. The lack of deregulation in the non-manufacturing seems
like another potential cause of stagnation.

7. Growth Impediment #3: Macroeconomic Policy Mistakes
There are three broad areas of economy-wide economic policy where Japan made major
mistakes. The first was with respect to financial supervisions and regulation. The zombie
problem was at its core caused by lax (and/or) misguided oversight of the banking system. The
zombies only continued to exist because impaired banks were allowed to continue extending
credit to them. Normally, healthy banks have no incentive to roll over loans to deadbeat
borrowers. But the Japanese government was not interested in being forthcoming about the sizeof its banking problems. Hoshi and Kashyap (1999) pointed out that the major Japanese banks
were substantially under-capitalized, yet the government neither chose to force the banks to raise
capital nor did they allow stronger foreign banks to buy the bad banks. Instead there were many

22

examples such as the ones documented by Tett (2003) where the government insisted that thebanks keep lending to zombies.
Eventually, as we discuss below, the program designed by Minister of Financial Affairs
Heizo Takenaka succeeded in forcing major banks to get rid of their non-performing loans.
Around that same time, the activities of the Industrial Revitalization Corporation of Japan andother turnaround funds contributed to the restructuring of many firms. There is no good reason
that these steps could not have been taken sooner, which would have promoted an earlier
recovery.
Had the bank support to the zombies been withdrawn sooner, some of the zombies could
have been restructured and regained profitability (provided that there was financial support tofacilitate the reorganization.) For these firms it would have been wise to encourage restructuring
rather than liquidation – but even in these cases, it would have been likely that many workers
would have been released. For other zombies, closure would have been the best outcome.
Given that the fallout from tackling the zombie problem would have involved massive
labor turnover, it would have been advisable to have a strong social safety net in place. This isespecially important for Japan where the lifetime employment was the norm and the market for
mid-career workers has been underdeveloped. But Japan has historically had a weak social
safety net. For example, Figure 14 shows data from the Organization for Economic Cooperation
and Development on public expenditure on active labor market policies in 2001. Japan had thefourth lowest spending of the 23 OECD countries for which data were available. The social
safety net was not significantly improved even after Takenaka’s reform. This lack of a strong
safety net may have contributed to the political backlash against several major economic reforms
that started under the Koizumi government.

23

Fiscal policy more broadly was poorly used during the stagnation period. Between 1992
and 2007 (before the global financial crisis had taken hold), net government debt as a share of
GDP rose from under 20% to about 80%; since 2007 the debt skyrocketed to over 120 percent of
GDP. So over the whole period of slow growth, the country was consistently running substantial
budget deficits. As Figure 15 shows, Japan’s budget position over the last 20 years has moved
from amongst the best of the developed countries to the worst.
Doi, Hoshi and Okimoto (2010) (DHO) examine the time series pattern of deficits andgovernment debt (including both central government and local governments as well as the social
security funds) to assess the long-term implications of Japan’s fiscal trajectory. They start byasking how much tax revenue will be needed to avoid defaulting given the likely path of
expenditures and transfers and the existing level of debt. Broda and Weinstein (2005), looking at
data through 2003, had asked a similar question and reached a relatively benign answer: taxes
would need to be increased but depending on the assumed path of expenditures and transfers,
only to levels that already were observed in the U.S. or Europe.
DHO find that the level of required taxes now appears to be much higher. In the last
several years there have been three important changes. First, there are updated data on
demographics that allow for more accurate projected aging costs. Second, there are revised, andmore realistic, projections about other future spending obligations of the government. Finally,
and most importantly, the initial level of debt used for the calculation is higher reflecting the
sharp increase in recent years. Once these revisions are taken into account, the necessary level oftaxes rises sharply, so that in the baseline scenario government revenue would need to jump byalmost 10 percent of GDP immediately to stabilize the debt to GDP ratio at the (already high)current level by 2100.

24

DHO then examines how the primary budget balance or the tax rate responded to changes
in the debt to GDP ratio in the past 30 years. If the government tends to tighten fiscal policy
when the debt to GDP ratio increases, this kind of policy can limit the debt problem. Put
differently, the government does not have to be in the deficit reducing mode all the time, if theefforts made to reduce debt are sufficiently aggressive at certain times. If the deficit reducing
mode is entered frequently enough, the fiscal policy can be sustainable. DHO conduct several
different tests, but they yield the conclusion that the tax and spending policies observed in thelast 30 years are unsustainable. Japan would need to substantially and rapidly raise revenues toavoid defaulting, but such a policy change is highly unlikely given the observed policies from thelast 30 years. It would take an unprecedented commitment by the government to stabilize thedebt.
Coincident with the increased spending by the government has been a reduction in
investment by the private sector. Figure 16 shows the shares of GDP for the private sector grossfixed capital formation (the broadest measure of private investment in the economy) and public
spending. The investment share has trended down steadily since the early 1990s. Importantly,
this is not just due to the bulge in investment share that accompanied the boom during the socalled “bubble years”. By 1993, the share of the private sector investment was back to the levelfrom the early 1980s, at 20 percent. Since that time the share has dropped further to its current
level of about 16 percent. As our growth accounting calculations indicate this does not bodewell for growth.
In addition, there is a striking negative correlation between the government’s share of
GDP and the share of private investment. During the “lost decade”, 1993 to 2002, thecorrelation is -0.8, and over the whole sample it is -0.7. Obviously, we cannot conclude that the25

government spending increases caused investment declines based on this simple picture alone.
There is no doubt that some of the spending increases were initiated because of weak state ofprivate spending, including investment. But over the period of 20 years the pure reverse
causality explanation for the correlation becomes less plausible.
Probably the clearest way to see the problems with spending is to look closely at its
timing and composition. For example, in 1996, the Hashimoto government believed that theeconomy had recovered from the post bubble recession and it was time for fiscal consolidation tocontain the growth of government debt. The fiscal policy was tightened, and the economy
returned to a recession. Contemporaneous commentary on this decision was generally favorable,with many observers lauding the move. For instance, the International Monetary Fund Executive
Board in July 1997 wrote the “Directors endorsed the fiscal correction measures enacted in the1997 budget as a step in the right direction, given the large budget deficit and to prevent a further
increase in the already high level of public indebtedness. Looking ahead, Directors welcomed thegovernment’s announcement of plans for medium-term fiscal consolidation and proposals forspending restraint in next year’s budget.”6 While in hindsight many criticize this decision, we
think it was defensible.
On the other hand, the resources marshaled to clean up the banking problems were
woefully inadequate. As Hoshi and Kashyap (2009) describe, by the early 1990s Japan’s
specialized housing lenders, the jusen, were widely recognized to be bankrupt. But Ministry of
Finance and many politicians insisted that they could be rationalized without taxpayer support.
When the legislation to clean them up finally passed in 1996, the public was outraged and thegovernment was nearly toppled – even though the total amount of public funds was tiny (¥0.68
trillion). Having witnessed the public reaction to the jusen rescue, neither the elected officials
6

See IMF press information notice 97/19, http://www.imf.org/external/np/sec/pn/1997/pn9719.htm .
26

nor the government bureaucrats were anxious to admit the scope of the banking problems for the
major banks and to allocate the necessary funds to reorganize them. The dithering anddissembling about the true size banking problems were a critical factor in exacerbating thezombie problems.
In addition, the delay meant that government spending overall was high from 1999 to
2002, which likely made it harder to get a handle on the deficits. The Koizumi fiscal
consolidation stands out as the only period of sustained reductions in spending over the lasttwenty years. With the onset of the global recession, budget deficit has reappeared and spendingis on the rise again.
Perhaps more importantly, the deficit spending that did occur was poorly chosen. Most of
the spending went into public works that ceased to be very productive by the 1990s. Doi and
Ihori (2009, Chapter 3) estimate the marginal productivity of public capital in five categories(roads, harbors, and airports; railways; postal services, telephone and telegraph; agriculturerelated pubic capital and fishing ports; and flood control and forest conservation). They find themarginal productivities in all these categories of public investment declined after the end of therapid economic growth period. The marginal productivity had become especially low for thethree out of five groups (roads, harbors, and airports; agriculture-related pubic capital and fishingports; and flood control and forest conservation) by the early 1990s.
Figure 17 shows the percentage of public spending devoted to each category from 1992
to 2003, along with the Doi-Ihori estimate of investment efficiency in 1991. More resources werepoured into the areas where productivity was already low. Total spending on the three categories
of infrastructure totaled 213 trillion yen between 1992 and 2003 and amounted to 89% of the27total public investment during this period. 7 Given the unsustainable fiscal position that Japanfinds itself in now, this kind of nearly useless spending will have to stop.
Monetary policy is the third major leg of government policy that has been mismanaged
for much of the 1990s and 2000s. The path of the interest rate target is shown in Figure 18. The
figure shows that starting in July 1991 the Bank of Japan began cutting its interest rate target,
lowering it by nearly 3 percent between July 1991 and July 1992 (recall that the peak for real
GDP growth came in the 2nd quarter of 1990). By mid 1995 Japan had reduced its target to 50
basis points.
Starting with an influential paper prepared by the Federal Reserve Staff in 2002, Ahearne
et al., it has become fashionable to argue at the Bank of Japan was slow to respond to economic
developments. Indeed, speeches by senior Federal Reserve officials routinely assert that thecritical lesson from Japan’s experience with prolonged deflation is that the BOJ was too slow intrying to stop deflation; see for example Kohn (2006).
As we explain just below, Japanese monetary policymakers committed several errors, but
we believe that the criticism of the early 1990s reflects serious hindsight bias. There are two
ways to see why monetary policy in the early 1990s in Japan does not look irresponsibly tight.
First, as Ahearne et al. (2002) document quite convincingly, neither the Federal Reserve staff
forecasts, the IMF staff forecasts, nor the consensus private sector forecasts anticipated the
deflation that ultimately appeared in Japan. Indeed, we are unaware of any credible analysts thatin real time were criticizing the Bank of Japan for being too slow to cut interest rates.
Second, financial market prices also reflected the belief that deflation was unlikely.
While short-term interest rates were below 0.5 percent by the second half of 1995, longer term
safe interest rates such as the 10 year rate remained above two percent. So given that deflation
7

We thank Takero Doi for providing us with the data.
28

was not forecasted, the implied real interest rates by mid 1995 were already negative. By thelatter part of the decade, it may be the case that real interest rates in Japan were substantiallyhigher than would be desired, but does not appear to be the case through 1995.
Taken over the subsequent 15 years, however, the policy does seem inappropriate. One
indication is that despite the BOJ having an unambiguous mandate of delivering price stability
and having announced a preferred target level of around one percent inflation, the bank has failed
to hit that target. As of 2010 nominal GDP was lower than nominal GDP in 1994. Over a time
period this long, there is no good reason why a central bank should consistently miss its target in
one direction. We agree with the criticisms by Ito and Mishkin (2006) who describe the weakefforts by the BOJ to end deflation and the premature tightening of monetary policy on several
occasions. These mistakes were more important than the interest rate decisions made between
1992 and 1995.
The persistently tight monetary policy has had two modestly bad effects on the economy.
First, by having interest rates near zero for so long, the job of detecting zombies was made moredifficult. If inflation had been consistently positive and interest rates consistently higher thefirms which could not repay their loans would have been easier to spot. But virtually any firm
can make payments of a few basis points.
Second, at least for the last half of the 1990s when deflation was expected, the policy led
to higher real interest rates than circumstances warranted. By 1998 there was plenty of evidence
that the economy was in dire condition and yet the Bank of Japan did not try to drive real interest
rates negative. One of Ben Bernanke’s most memorable speeches was the scolding he delivered
to the Bank of Japan in 2003 listing the many ways in which the Bank of Japan could havepursued a looser policy.

29

We share the conventional view that over long periods monetary policy does not havereal effects. So we are not asserting that a purely monetary fix could have made a big differencein preventing the stagnation of the economy. Rather, it seems that there was no good reason to
pursue the policy that was chosen and perhaps a looser policy would have helped marginally.

8. Evaluating Koizumi Reform
In considering the impacts of government regulation on the (lack of) growth in Japan, wepay particular attention to the experience in the early 2000s. From April 2001 to September
2006, under the leadership of Prime Minister Junichiro Koizumi, Japan embarked on several
economic reforms, which included deregulation attempts in several industries. As we saw inFigure 4, this coincides with the period when the decline in the Japan’s long-term growth rate
seems to have halted.
In this section, we evaluate the role of several economic reforms attempted by the
Koizumi government. As the key components of the Koizumi reform, we consider the following
six high profile reforms:(1). Financial system reform(2). Postal Privatization(3). Labor reform(4). Promotion of FTAs and agricultural reform(5). Deregulation through special zones(6). Local public finance reform (“Trinity” reform)
For each of these six reform areas, we ask several questions. First, how would the reform
restore the growth of Japan? Second, what was the goal of the reform? Was it stated clearly30

with some clear targets? Third, did the reform achieve the stated goal? Fourth, was the reformcompleted? If not, why was the reform aborted? Fifth, did the reform have any unintended
consequences?
Table 4 summarizes our answers to these questions. Here we go through our evaluationof each reform briefly. More detailed discussion of each of the six reforms is found in the
Appendix.
The financial system reform carried out by the Minister Heizo Takenaka started in
September of 2002. The Takenaka plan targeted the reduction of non-performing loans at majorbanks by half in two years. The Takenaka plan consisted of six parts, which forced the banks todisclose the amount of non-performing loans and deal with those. The plan included the optionof using business improvement orders for non-compliance. The plan successfully achieved thetarget. The major banks reduced the amount of non-performing loans by more than a half in two
years. Although the reform did not solve the problem of Japanese banks to find viable businessmodels for the future, it at least restored health of the financial system. By forcing the banks to
get rid of non-performing loans and encouraging restructuring of troubled firms through theIndustrial Revitalization Corporation of Japan (IRCJ), the reform also helped the recovery of thereal economy.
The Koizumi government also initiated the privatization of various special public
corporations and agencies, including postal services. Although these were called privatization,
the reform just restructured the organizations into government-owned joint stock companies andspecified a schedule for divesture of government shares in the future. For example, the postal
privatization planned the divesture of the government shares in the postal savings and the postal
life insurance to start after the listing of the new entities on the stock market in 2010 and to be31complete within five years. This meant that true privatization had not started when Mr. Koizumi
left the office. When the Democratic Party of Japan (DPJ) won the power in late 2009, thedivesture plan was suspended and the privatization process stopped.
The Koizumi government embarked on the reform of the labor market to make it more
flexible. The most often discussed component is the revision of the Dispatched Workers Act in2003. Dispatched workers are those hired by one firm (a work agency) and temporarily placed atanother firm. The reform allowed more variety in the arrangements for worker dispatching thanallowed in the previous version of the law and most notably allowed worker dispatch to
production jobs in manufacturing. This revision is often criticized as the one that substantiallyexpanded the group of workers with unstable and low paid employment. The data reveals that
there was a surge in the use of dispatching after the 2003 reform. But, even for workers
dispatched in manufacturing, there was a practice of using subcontracting to shell companies tohire de facto temporary workers before the 2003 reform. The reform was rather an attempt toformally regulate the employment contracts under this “fake subcontracting” arrangement. Afterthe Koizumi government, there have been attempts to re-regulate worker dispatching.
The Koizumi government tried to change the prevailing agricultural policy as well. The
low productivity of agriculture often hindered government efforts to expand the network of thefree trade areas. The Koizumi government tried to improve the productivity of Japanese
agriculture to cope with globalization of the economy. The traditional support of agriculture
used subsidies to all farmers including small and old farms. This policy was replaced by support
for larger scale farming. It is not clear if the productivity of the agricultural sector improved nor
if the policy enhanced large scale farming at all, but it did certainly weaken the farmers’ political32

support for the LDP. After Mr. Koizumi stepped down, the agricultural policy switched back totrying to protect small farmers.
One method that the Koizumi government used to promote deregulation was creation of
special zones. The government allowed local governments to set up special local economic
zones where some aspects of regulation are relaxed. They are designed to set up example cases
to show the benefits of deregulation. Another objective was to promote local economies throughlocal initiatives. Many special zones were established but only few of them had sizable impact.
Worse, many local promotion zones ended up diverting business from other areas. After the
Koizumi government, creation of special zones slowed down.
Local governments in Japan traditionally relied on the central government for financial
support through the local allocation tax grants and the state subsidies. Typically less than half ofthe expenditures by local governments are financed by the local taxes. To reduce the local
governments’ dependence on the central government, which faced the mounting problem ofgovernment debt, the government implemented the so called “Trinity Reform”. The reform
called for achieving the financial autonomy of local governments through reduction of local
allocation tax grants, reduction of state subsidies, and transfer of tax resources to local
governments. The reform succeeded in reducing the grants and subsidies substantially, andshifted some income tax revenues from the central government to local governments. In net, thereform did not reduce the deficit at the central government very much. For many local
governments, however, the reductions in the grants and subsidies far exceeded the increase in tax
revenues, because the increase in local tax revenues was concentrated in a few rich localities.
Many local governments also saw cuts in the amount of Emergency Fiscal Measure Bonds thatthat they were allowed to issue. These bonds were supposed to be repaid using future local

33

allocation tax grants, so these cuts added fiscal stress at many local governments. After Mr.
Koizumi stepped down, local governments lobbied for transferring more central government
revenues to the local governments, essentially restoring the flow of subsidies and transfers.
Reviewing the reform experience under the Koizumi government, we make several
observations. First, only the financial system reform was fully implemented and successful.
Second, many reform attempts were not specifically targeted to raise growth. Third, somereforms, such as privatization, specified deadlines too far in the future and, hence, weresusceptible to reversal. Fourth, measuring progress was often difficult since there were often no
numeric targets for the reforms. Finally, in many cases, the reforms are still incomplete today
not because the reforms are infeasible but because the policy was reversed by the governmentsthat followed Koizumi.
The review gives us a set of clear lessons for further deregulation to be successful. It is
important to focus on sectors (or distortions) that are important for growth and target those. This
strategy improves the chances that the gains will be meaningful. It also makes it easier toexplain the importance of the reform to the public and measure the progress towards the goal. It
is also important to have clear targets (preferably numerical) that can be achieved in a few years,
not in a few decades.

9. Conclusions
Our report shows that it is now very clear why Japan stopped growing. Some of theslowdown was natural. Japan moved from being a relatively poor economy after World War II
to one of the richest in the world. The easy catch up phase of growth could not go on
indefinitely and invariably brought a reduction in growth.

34

The transition to growing as a mature economy requires all countries to change and Japanencountered two specific challenges in making this transition. First, the structure of its
population was shifting. Instead of having a young, growing work force, it had to confront onolder, declining work force. The aging lowered the growth potential.
Second, Japan’s economy had been organized to produce goods for export, withproduction for the domestic market being an after-thought. Productivity growth in nonmanufacturing lagged that in the manufacturing sector. A more balanced and richer economy
requires a well functioning non-manufacturing sector.
Once asset prices collapsed in the early 1990s, the weaknesses in the non-manufacturingsector became more apparent. Japan compounded the losses from the asset price drop with threesignificant policy errors. First, the government delayed dealing with the losses in the banking
system that accompanied the asset price drop. Weak banks operated for too long by
misallocating credit to obscure their problems. By rolling over loans to zombie firms, the banks
distorted competition, keeping the zombies in business and reducing the rewards to strong firms
from expanding their presence. Over time this reduced productivity growth. These problems
were most pronounced in the non-manufacturing sector where the trouble could be more easily
disguised. Only during the Koizumi administration was real progress made in confronting thebanking problems.
Regulation, or more precisely the lack of deregulation, exacerbated the zombie problems.
In the non-manufacturing sector, the industries that had the most deregulation grew fastest. On
average starting in the late 1990s regulatory barriers to new entrants were actually increased.
Finally, monetary and fiscal policy performed poorly. The Bank of Japan consistently
undershot its inflation objective. The government pursued massive fiscal stimulus during the35

1990s and 2000s, so much so that Japan went from having the best debt position amongst
advanced economies to the worst. Japan’s current mix of spending and taxing cannot besustained without reneging on the future promised transfers (through the national pension systemor the national healthcare system), producing very high inflation (that would reduce the realvalue of debt), or defaulting outright on its debt.
Worse still, much of the spending that took place was misguided. Most of the public
work projects undertaken were directed in areas that had long ago ceased to be productive.
Hence, the payoff from the spending binge will not be high.
Japan now finds itself growing at about the rate found in Germany and France andsubstantially below the trends in Canada, the U.S. and the U.K. If Japan wants to raise its
growth rate, much will have to change. It is encouraging to note that all of these countries
experienced growth slowdowns in the past, from which they have recovered. And likewise, thepast failures in Japan point to what needs to be done to reverse course.
First, and foremost, the priority should be on policies that plausibly raise productivity
growth. Policies that remove regulation to protect inefficient incumbents in many areas of theeconomy are an appropriate place to start. To the extent this will involve more labor reallocation,
it would be wise to set aside money for protecting displaced workers’ incomes and training them
to be redeployed. That kind of spending will be far more productive than continued public
works projects of the type undertaken throughout most of the 1990s and 2000s. Reducing thesize of the government’s claim on the economy will leave more room for private investment andlessen the need to raise taxes; although tax increases are inevitable, and they should be designed
to minimize distortions.

36

Table 5 presents a summary of the “New Growth Strategy” of current government.8
Given the vast number of proposed projects, a full assessment is beyond the scope of this report.
But, using the framework we have developed, it is possible to make four broad points about thecurrent plan.
First, many of the strategies represent old fashioned industrial policies, whereby someindustries or activities are given subsidies. This policy had mixed success during Japan’s catchup period, but there is no evidence that it works well for mature economies (see Beason and
Weinstein (1996) and Pinkovskiy (2009)). These policies are susceptible to lobbying so thatfunds are allocated for political rather than economic reasons and so these findings are notsurprising. Moreover, the goal of an industrial policy is often to provide temporary protection to
an industry so that it will become competitive without government help. If the industry fails to
become competitive, however, it is hard for the government to pull the support and the protection
can turn permanent, further dulling the incentives of the private sector to be competitive.
The New Growth Strategy identifies some seemingly promising areas such as “green”
industries and health care/long-term care industries. Even for these areas, however, one stillneeds to ask why those areas are not developing already without government help. What are theexternalities that the government tries to solve? There may be government regulation and otherstructural reason why the private sector is not eager to invest in these areas. In that case,removing the regulatory barriers will be more effective than giving subsidies or tax breaks.
A second observation is that many of the strategies are export-oriented (e.g., promoting
medical tourism into Japan, exporting infrastructure projects to the rest of Asia, strengthening

8

This is based on two announcements by the Cabinet: “New Growth Strategy – Strong Economy, Robust Public
Finances, & Strong Social Security System” (June 18, 2010)(http://www.npu.go.jp/policy/policy04/pdf/20100618_shinseityou_gaiyou_eigo.pdf) and “On the New Growth
Strategy” (June 18, 2010) (http://www.kantei.go.jp/foreign/kan/topics/sinseichou01_e.pdf).
37intellectual property right (of Japanese firms), etc.). Continuing to rely on external demandrather than developing domestic markets has been a perpetual problem for Japan for at least
twenty years. Given the limits on what Japan can afford to spend on, this seems like acounterproductive way to use public money.
Third, the strategy embraces the idea of special zones similar to the ones started by
Koizumi, but with an emphasis is on tourism where the effectiveness of the zones werequestionable. The upside on these policies is low.
Finally, there are few examples of policies that aim to remove regulations that impede
growth. For example, increasing acceptance of high-skilled foreign workers would increase theamount of quality adjusted labor and help growth. Promoting free trade areas with morecountries will improve competitive pressure on the domestic industries and force them to grow.
Increasing imports will also make consumers better off by giving them more choices. Creating anational ID system would make it possible to improve the efficiency of the tax collection and thesocial security system. Focusing on more reforms like this would be great improvement relative
to past policies.
Japan needs to change direction if it wants to grow. The path that will work is wellunderstood. The main question is whether the political courage to shift to the policies that could
work exists and will be utilized.

38

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Conference.
Doi, Takero and Toshihiro Ihori (2009) The Public Sector in Japan. Cheltenham, UK: Edward
Elgar Publishing.

39

Fukao, Kyoji, Tsutomu Miyagawa, Hyeog Ug Kwon, Tomohiko Inui, Sumio Hamagata, Keisuke
Orii, Joji Tokui, Tatsuji Makino, Yoko Takahashi, Keiko Ito, Yasuo Nakanishi,
Toshiyuki Matsuura, Yukako Murakami, and YoungGak Kim (2008) “JIP Database no
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Miyagawa (Eds.) Seisansei to Nihon no Kizai Seichō (Productivity and Japanese
Economic Growth). Tokyo, Japan: University of Tokyo Press, pp. 49-125.
Hamada, Koichi, Anil K Kashyap, and David E. Weinstein (2011) “Introduction” in Koichi
Hamada, Anil K Kashyap, and David E. Weinstein (Eds.) Japan’s Bubble, Deflation, andLong-term Stagnation. Cambridge, MA: MIT Press, forthcoming.
Hodrick, Robert, and Edward C. Prescott (1997) "Postwar U.S. Business Cycles: An EmpiricalInvestigation," Journal of Money, Credit, and Banking, Vol. 29 (1), pp. 1–16.
Hoshi, Takeo and Anil K Kashyap (1999) “The Japanese Banking Crisis: Where did it Come
From and How will it End?” in Ben S Bernanke and Julio J Rotemberg (Eds.) NBER
Macroeconomics Annual 1999, pp.129-201.
Hoshi, Takeo and Anil K Kashyap (2009) “Will the US bank recapitalization succeed? Eightlessons from Japan,” NBER Working Paper, No. 14401.
Hoshi, Takeo and Anil K Kashyap (2010) “Will the U.S. Bank Recapitalization Succeed? Eight
Lessons from Japan,” Journal of Financial Economics, Vol. 97, pp. 398-417.
Ito, Takatoshi and Frederic S. Mishkin (2006) “Two Decades of Japanese Monetary Policy andthe Deflation Problem,” In Takatoshi Ito and Andrew K. Rose (Eds.) Monetary Policy
with Very Low Inflation in the Pacific Rim. Chicago: University of Chicago Press, pp.
131-93.

40

Ito, Takatoshi, Hugh Patrick, and David E. Weinstein (2005) (Eds.) Reviving Japan’s Economy.
Cambridge, MA: MIT Press.
Kohn, Donald L. (2006) “Monetary policy and asset prices” speech delivered at "Monetary
Policy: A Journey from Theory to Practice," a European Central Bank Colloquium heldin honor of Otmar Issing, Frankfurt, Germany.
Nakanishi, Yasuo, and Tomohiko Inui (2008) “Kisei Kanwa to Sangyo no Performance”(Deregulation and Industrial Performance) in Kyoji Fukao and Tsutomu Miyagawa (Eds.)
Seisansei to Nihon no Kizai Seichō (Productivity and Japanese Economic Growth).
Tokyo, Japan: University of Tokyo Press, pp. 203-220.
Pinkovskiy, Maxim (2009) “Growth, Productivity, and Policy Instruments During the Lost
Decade: A Replication of Beason and Weinstein (1996) for the Period 1992-1998”,
Consilience - The Journal of Sustainable Development.
http://journals.cdrs.columbia.edu/consilience/index.php/consilience/article/view/9
Rajan, Raghuram G. (2010) Fault Lines: How Hidden Fractures Still Threaten the World
Economy. Princeton, NJ: Princeton University Press.
Sommer, Martin (2009) “Why are Japanese Wages So Stagnant?” International Monetary
Funding Working Paper 09/97.
Tett, Gillian (2003) Saving the Sun: A Wall Street Gamble to Rescue Japan from its TrillionDollar Meltdown. New York, NY: HarperCollins.

41

Figures
Figure 1: Japan’s GDP Growth Rate: 1956-2000
16
14
12
56-73 Average (9.2%)

10
8
6
4

74-90 Average (3.8%)

2

91-2000 Average (1.3%)

0-2

Source: Japanese Cabinet Office, 1968 System of National Accounts

42

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

1958

1956

-4

Figure 2: Japan’s Recent GDP Growth (% from a year ago)
10
8
6
4
2
0
-2
-4
-6
-8
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009

-10

Year

Source: http://www.esri.cao.go.jp/en/sna

43

Figure 3: GDP per capita in the G7 Countries(per capita PPP expressed in year 2000 USD)

40,00035,00030,00025,00020,00015,00010,000
1970

1975

1980

USA
Germany

1985

1990

UK
France

1995

2000

Japan
Canada

44

2005
Italy

Figure 4: Trend Growth In the G7 Countries: 1971-2009(Measured for per capita PPP GDP expressed in year 2000 USD)

4.5%
4.0%
3.5%

Trend Growth

3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
$10,000$20,000$30,000$40,000

Trend Level
USA
Germany

UK
FranceJapan
CanadaItaly

45

Figure 5: The Proportion of the Elderly in Various Countries (65 years old and above) (%)
40
35
30
25
20
15
10

1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
2020
2023
2026
2029
2032
2035
2038
2041
2044
2047
2050

5

United States

United Kingdom

Japan

Italy

46

Germany

FranceCanadaFigure 6: Aggregate prevalence of zombies
R a w P e rc e n ta g e
40
35
30
25
(% ) 2 0
15
10
5
0
1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

1997

1999

2001

Asset-weighted Percentage
18
16
14
12
10
(%)
8
6
4
2
0
1981

1983

1985

1987

1989

1991

1993

1995

Note: The sample is listed firms in manufacturing, construction, real estate, retail and wholesale (other than the nine largest general
trading companies), and services

47

60

40
40

0

0
`

20

Real Estate

20
0Manufacturing

`

0

`

48

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

All Firms

20
0

Trade

60
60
60

40
40
40

20
0
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

20
`

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

60

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

20

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Figure 7: Cross-industry incidence of zombies

60
Construction

40`

Services`Figure 8: Zombie Incidence and Productivity Growth

Zombies and TFP Growth
10%

TFP growth 1990-2000

8%
6%
4%
2%
0%
-2%

y = -0.3993x + 0.0336

-4%
-6%
0%

5%

10%

15%

20%

25%

Change in the zombie index: 81-92 average to 93-02 average

Note: Estimates for TFP Growth are from Tsutomu Miyagawa, Yukiko Ito, and Nobuyuki Harada (2004) “The IT Revolution and
Productivity Growth in Japan,” Journal of the Japanese and International Economies, 18(3), 362-389.

49

Figure 9: Total Factor Productivity by Industry, 1980 – 2006
(1995≡100)

110

100

90

80

70

60
80

82

84

86

88

90

92

MANUFACTURING

94

96

98

00

02

04

Nonmanufacturing

50

06

Figure 10: Weighted Average of the Regulation Index from Cabinet Office (2006)

51

Figure 11: Cabinet Office (2006) Regulation Index and TFP growth
A. Manufacturing Sector

52

B. Non-manufacturing

53

Figure 12: Weighted Average of Regulation Index: Alternative Index Using Regulations in Category A only54

Figure 13: Alternative Regulation Index and TFP Growth
A. Manufacturing Sector

55

B. Non-manufacturing sector

56Figure 14: Public Expenditure on Active Labor Market Policies in 2001 (% of GDP)

2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0

57

Figure 15: Net Government Debt of selected OECD Countries (% of GDP)
140
120
100
80
60
40
20
0
19921993199419951996199719981999200020012002200320042005200620072008200920102011
CanadaFranceGermany

Greece

Italy

Japan

United Kingdom

United States

Source: OECD Economic Outlook 87 database. Annex Table 33.

58

Figure 16: Private Sector Gross Fixed Capital Formation and Total Government Spending Relative to GDP
0.30

0.25

0.20

0.15

0.10
80

82

84

86

88

90

92
G_Y

94

96

98

00

I_Y

Source: http://www.esri.cao.go.jp/en/sna/qe103-2/gdemenu_ea.html

59

02

04

06

08

Figure 17: Distribution of Public Spending

Marginal Productivity in 1991 (estimates in
Doi and Ihori 2009)

Public Investment Share and Marginal Productivity
1.2

Postal service, telephone and telegraph
1.0

Railways
0.8

0.6

Agriculture‐related public capital and fishing ports
0.4

Roads, harbors and airports

Erosions of flood control and conservation of forests

0.2

0.0
0%

10%

20%

30%

40%

Share of public investment, 1992‐2003

60

50%

60%

Figure 18: Japanese Policy Interest Rate, 1990 to 201061

Tables

Table 1: Importance of External Demand Across Countries, 1995 to 2009

Country

Contribution of External Demand to
GDP Growth: 1995 to 2009

Average Share of Exports in GDP:
1995 to 2009

USA

-4.4%

10.8%

UK

-4.9%

27.3%

Japan

26.6%

12.5%

Italy

-7.4%

26.1%

Germany

19.9%

35.6%

France

-7.2%

25.9%

Canada

-7.3%

38.7%

62

Table 2: China and Japan

Japan 1955-1971

Growth in
Output per Worker
8.05%

Contribution from
Capital per Worker
3.04%

Contribution from
TFP
5.02%

Japan 1970s

3.74%

1.74%

2.00%

Japan 1980s

3.23%

2.98%

0.26%

Japan 1992-2002

0.59%

0.06%

0.53%

Japan 2003-2007

2.14%

0.73%

1.41%

China 1998-2007

9.79%

5.21%

4.58%

Source: Accounting for China’s Growth by Loren Brandt and Xiaodong Zhu, IZA DP No. 4764, Feburary 2010 and authors'calculations

63

Table 3: Impact of Zombie Firms on the Investment, Employment and Productivity of Non-Zombies

Dependent Variable

I/K

ΔLog E

Log Sales– ⅔ Log E– ⅓ Log K

I/K

ΔLog E

Log Sales– ⅔ Log E– ⅓ Log K

I/K

ΔLog E

Log Sales– ⅔ Log E– ⅓ Log K

Non-Zombie Dummy

0.0256(0.0056)0.00109(0.001751)

0.0139(0.0135)0.0248(0.0057)

0.0002(0.0018)

0.0119(0.0137)

0.0238(0.0056)0.0001(0.0017)0.0150(0.0136)

Industry Zombie %-0.1370(0.0376)-0.0454(0.0116)-0.3418(0.0922)

Non-Zombie *Industry Zombie%-0.0885(0.0330)-0.0232(0.0102)

0.2183(0.0756)-0.0852(0.0333)-0.0188(0.0102)0.2315(0.0767)-0.0716(0.0321)-0.0128(0.0098)

0.1980(0.0770)0.3490(0.0176)0.1404(0.0073)0.3123(0.0256)

Sales growth
Industry dummies
included?

Yes

Yes

No

Yes

Year dummies
included?

Yes

Industry*year
dummies included?

No

No

No

No
Yes

No

Yes

No

No

No
No

Yes

No
No

Yes

No

No
No

Yes

Yes

Yes
Yes

Number of obs.

22,39622,42923,09022,39622,42923,09022,39422,42822,847R2

0.05370.08950.35990.06170.10070.35900.11250.17940.370564

Table 4: Major Koizumi Administration Reforms
Reform area
1. Financial system
reform

2. Postal Privatization

3. Labor reform(Revision of the
Dispatched Workers Act)
4. Promotion of FTAs
and agricultural reform

5. Deregulation throughspecial zones
6. Local public financereform (“Trinity” reform)

Would the reform help
restoring growth?
Yes. By forcing banks
to restructure zombie
firms. Healthy financial
system supports
investment.
Yes. By releasing thepostal savings to be used
more efficiently in theprivate sector.

What was the statedgoal?
Reduce the NPLs atmajor banks to a halfof March 2002 level
by March 2005

Did the reform achieve
the stated goal?
Yes.

Has the reformcompleted?
Almost. Resona Bank,
which received public
capital injection, is still
government owned.

Unintended consequences

Privatize the postal
servicesTechnically yes, buteffectively no.

Deterioration of qualityof services

Maybe. More flexible
labor market reduces thecost of economic
restructuring, thereby
productivity growth.
Yes. By increasing
productivity ofagriculture. FTAs help
maintaining markets forJapanese industrial
products.
Maybe. If growthenhancing deregulation
can spread beyond thezones
Maybe. If increased
financial autonomy oflocal governments leads
to reduction of wastefulspending.

Increase theflexibility of labormarket and thediversity of jobs

Not clear.

No. Divesture ofgovernment owned
shares did not start andnow stopped
indefinitely.
No. Trend of
reregulation after
Koizumi.

Promote large scale
farming that isinternationallycompetitiveNo.

No. Agricultural policy
has been reversed since
Koizumi left.

Trade diversion rather
than trade expansion

Promotion of local
economy;experiment with
deregulation
Reduce the annualtransfers to local
governments by ¥4trillion by FY2006.
Local governments
find their revenues toreplace this.

Varies.

Still continuing. In
some cases, nationwide
implementation of
deregulation.
Reform period (2003 to2006) ended. Gradualroll back after Koizumi
government.

Special zones simply
divert demand away fromthe neighboring regions

Partially. The reduction
was successful, butmany local governments
failed to find newrevenue sources.
Backlash after Koizumi.

65

Credit crunch

Increase of poorly paid
workers with insecure
employment

Severe expenditure cutsin some localities.

Table 5: Japan’s Latest Growth Strategy (June 18, 2010)
Targets
1. Achieve nominal and real growth in excess of 3% and 2% respectively
2. Positive inflation in consumer prices in fiscal 2011
3. Lower the unemployment rate to 3%-4% range as early as possible
There are 7 strategic areas and 21 national strategic projects
1. Green innovation
a. Expand the renewable energy market by introducing “feed-in tariff” system for electricity
b. Designate future cities
c. Promote domestic timber utilization
2. Life innovation
a. Create consortiums to promote new medical careb. Set up medical care visa and accept foreign patience
3. Asiaa. Market infrastructure projects to Asian countries
b. Reduction of corporate tax rates; introduction of tax incentives for foreign investment into Japanc. Globalization of university education; increasing acceptance of high-skilled foreign workers
d. Roadmap for winning the global standard setting race; strengthening intellectual property protectione. Economic partnership through free trade areas
4. Tourism and local revitalization
a. Designate special zones; open skies policyb. Ease tourist visa requirementsc. Expand the existing housing and remodeling markets
d. Open public facilities to private sector promote projects using private sector funds
5. Science, technology and information technology
a. Develop intensive industry-academia-government cooperation in technology
b. Promote utilization of information technologies; introduce a national ID system66

c. Enhance government related R&D investment
6. Employment and human resources
a. Integrate kindergartens and nursery schools
b. Introduce “career grading” system and “personal support” system
c. Implement efforts to build public service supported by the people; reform taxation on donation and NPOs
7. Financial services
a. Create an integrated exchange for securities and commodities

67