Discussion Paper No. 682

A COMMENT ON NISHIMURA,
NAKAJIMA, AND KIYOTA’S“DOES THE NATURAL SELECTION MECHANISMSTILL WORK IN SEVERE RECESSIONS?
EXAMINATION OF THE JAPANESE ECONOMY
IN THE 1990s”
Tae Okada
andCharles Yuji Horioka

January 2007

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

A Comment on Nishimura, Nakajima, and Kiyota’s “Does thenatural selection mechanism still work in severe recessions?
Examination of the Japanese economy in the 1990s”∗
Tae Okada
Graduate School of Economics, Osaka University, Osaka, JapanandCharles Yuji Horioka†
Institute of Social and Economic Research, Osaka University, Osaka, Japan, andNational Bureau of Economic Research, Cambridge, Massachusetts, USA
January 16, 2007

Abstract
Nishimura, Nakajima, and Kiyota (2005) analyze the entry/exit behavior patterns ofJapanese firms during the 1990s and find that relatively efficient (high total factor productivity (TFP)) firms exited while relatively inefficient (low TFP) firms survived during thebanking-crisis period of 1996-97. They conclude from this finding that the natural selection
mechanism (NSM) apparently malfunctions during severe recessions, but we offer a much
more plausible interpretation: the NSM continued to function effectively even during thisperiod, but aberrant banking practices (in particular, “forbearance lending” (“evergreening”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”) caused a shift
in the type of natural selection from “directional selection” to “disruptive selection,” withthe most efficient (highest TFP) firms as well as the least efficient (lowest TFP) firms being
favored and firms of intermediate efficiency and TFP being selected against.

JEL Classification: D21, D24, O47, L11
Keywords: Total factor productivity, Entry and exit, Natural selection, Directional selection,
Disruptive selection, Evolution, Banking crisis, Forbearance lending, Forcible withdrawal of loans,Reluctance to lend, Credit crunch, Recession, Japanese economy, and Japan∗ The authors are grateful to Kazuo Ogawa for his valuable advice.
† Address all correspondence to:Charles Yuji Horioka, Institute of Social and Economic Research, Osaka

University, 6-1, Mihogaoka, Ibaraki, Osaka 567-0047, JAPAN. Tel.: 81-6-6879-8586/8574. Fax: 81-6-6878-2766.
Email: horioka@iser.osaka-u.ac.jp1

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Introduction

Previous authors have found that the natural selection mechanism (hereafter NSM) of economic
Darwinism works well in normal times, but, in an important paper, Nishimura, Nakajima, andKiyota (2005) (hereafter NNK) analyze the entry/exit behavior patterns of Japanese firms during
the 1990s and show that this mechanism apparently did not function effectively during thesevere recession of the 1990s in Japan and that relatively efficient (high total factor productivity(hereafter TFP)) firms exited while relatively inefficient (low TFP) firms survived during thebanking-crisis period of 1996-97.
NNK’s analysis is carefully executed and we do not have any major quibbles with the analysis
itself, but we want to offer an alternative interpretation of their results. NNK conclude from theirfinding that the NSM apparently malfunctions during severe recessions, but we offer a much moreplausible interpretation that assumes that the NSM continued to function effectively even during
the banking-crisis period of 1996-97 but that there was a shift from one type of natural selectionto another as a result of a number of aberrant practices followed by banks.

2Did the NSM Continue to Function Effectively during
Japan’s Severe Recession?

NNK conclude that the NSM malfunctioned during the banking-crisis period of 1996-97, butthey use an unduly narrow concept of natural selection. In this section, we describe three typesof natural selection and argue that the NSM continued to function effectively even during the1996-97 period but that there was a shift from one type of natural selection to another.
In the theory of evolution, there are at least three types of natural selection: (1) “stabilizingselection” which acts against phenotypes at both extremes of the distribution and favors themultiplication of intermediate phenotypes, (2) “directional selection,” which acts against only
one extreme of phenotypes, causing a shift in the distribution toward the other extreme, and(3) “disruptive selection” (sometimes also called “diversifying selection”), which acts againstintermediate phenotypes, creating a bimodal distribution (see Darlington and Mather (1949)
and Mather (1953, 1955) for more details).
If we apply this taxonomy to the case of the Japanese economy of the 1990s, our interpretationis that, until 1995, the NSM functioned effectively in Japan and that the Japanese economy
exhibited “directional selection,” with natural selection favoring relatively efficient (high TFP)
firms. Thus, relatively inefficient (low TFP) firms exited and relatively efficient (high TFP) firms
survived, as shown by NNK.
However, during the banking-crisis period of 1996-97, banks engaged in both “forbearance2

lending” (“evergreening”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”(these two practices are collectively referred to as “credit crunch”), and this caused natural
selection to favor firms at both extremes. This caused a shift in the type of natural selection from“directional selection” to “disruptive selection,” but the NSM continued to function effectively
even during this period. In what follows, we describe in more detail the aforementioned banking
practices and how they led to a shift in the type of natural selection (see Kobayashi, Saita, andSekine (2002), Ogawa (2003), and Peek and Rosengren (2005) for more details).
“Forbearance lending” (“evergreening”) refers to the practice of banks continuing to lend toless efficient (low TFP) firms to keep them afloat and to thereby avoid the need to declare existingloans to theses firms as non-performing. Banks engaged in this practice during the banking-crisis
period of 1996-97 because the severe recession and the concomitant collapse of asset prices led
to a proliferation of non-performing loans and myopic bank managers wanted to delay writing
off those loans until they had retired and received the full amount of their lump-sum retirementallowances, and because the Bank for International Settlements (hereafter BIS) regulations on
the capital adequacy of banks introduced in 1993 required banks to meet certain risk-based
capital ratios, which created a further incentive for banks to keep non-performing loans off theirbooks. And this practice of “forbearance lending” (“evergreening”) caused relatively inefficient(low TFP) firms to be favored.
However, banks also engaged in the “forcible withdrawal of loans” and/or the “reluctanceto lend,” which refers to the practice of banks’ calling in loans to more efficient (high TFP)
firms and/or reducing their lending to such firms. Banks engaged in these practices during thebanking-crisis period of 1996-97 because the recession and the concomitant collapse of asset prices
had reduced bank capital, because banks had to reduce lending to satisfy the newly introduced
BIS regulations on the capital adequacy of banks, and because banks had to find some way of
securing the funds needed to engage in “forbearance lending” (“evergreening”) to less efficient(low TFP) firms. And the “forcible withdrawal of funds” and/or the “reluctance to lend” acted
against firms of intermediate efficiency and TFP and forced some of them to exit.
Finally, the most efficient (highest TFP) firms presumably did not have loans outstanding
to begin with, and even if they did, they could repay those loans without having to exit, andmoreover, they did not require additional loans to survive. Thus, their survival was not at all
threatened by the “forcible withdrawal of loans” and/or the “reluctance to lend.”Thus, the NSM continued to function effectively even during the banking-crisis period of
1996-97, but aberrant banking practices (viz., the combination of “forbearance lending” (“evergreening”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”) caused natural
selection to favor both the most efficient (highest TFP) and least efficient (lowest TFP) firms
and to act against firms of intermediate efficiency and TFP, which in turn caused a shift in the3

type of natural selection from “directional selection” to “disruptive selection.” This interpretation can explain NNK’s finding that relatively efficient (high TFP) firms exited while relativelyinefficient (low TFP) firms survived during the banking-crisis period of 1996-97 just as well as
their interpretation that the NSM malfunctions during severe recessions. Moreover, our interpretation seems more plausible than NNK’s own interpretation of their findings because they do notprovide a convincing explanation of why a severe recession would ipso facto cause a breakdown of
the NSM. Indeed, NNK (p. 74) themselves assert that the combination of “forbearance lending”
and the “forcible withdrawal of loans” is a possible explanation of their finding.

3Conclusion

To summarize, in an important paper, NNK analyze the entry/exit behavior patterns of Japanesefirms during the 1990s and show that relatively efficient (high TFP) firms exited while relatively
inefficient (low TFP) firms survived in Japan during the banking-crisis period of 1996-97. NNK
conclude from this finding that the natural selection mechanism (NSM) apparently malfunctions
during severe recessions, but we have offered a much more plausible interpretation. Our alternative interpretation is that the NSM continued to function effectively even during this period butthat aberrant banking practices during this period (in particular, “forbearance lending” (“evergreening”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”) caused a shift
in the type of natural selection from “directional selection” to “disruptive selection,” with themost efficient (highest TFP) firms as well as the least efficient (lowest TFP) firms being favoredand firms of intermediate efficiency and TFP being selected against. Thus, it was not that theNSM malfunctioned but rather that aberrant banking practices caused a shift from one type ofnatural selection to another.
Moreover, the shift from one type of natural selection to another during the banking-crisis
period of 1996-97 was induced not by the severe recession itself but by the aberrant banking
practices precipitated in part by the severe recession and the concomitant collapse of asset prices
and in part by other factors such as moral hazard on the part of myopic bank managers andthe introduction of BIS regulations on the capital adequacy of banks in 1993. It was this unique
confluence of factors that produced the aberrant banking practices, and it was the aberrantbanking practices rather than the severe recession itself that caused the shift in the type ofnatural selection. Therefore, it is not appropriate to draw sweeping generalizations from thefindings of NNK about the applicability of the NSM during severe recessions. It is quite possiblethat not only does the NSM continue to function effectively during severe recessions in othercountries and/or time periods but that there is no shift from directional selection to disruptiveselection.

4NNK deserve a great deal of credit for their meticulous analysis that sheds light on how theentry/exit behavior patterns of firms changed during the banking-crisis period of 1996-97, but webelieve that our interpretation of their findings (that the NSM continued to function effectively
but that it changed from one type of natural selection to another) is more plausible than theirown interpretation (that natural selection malfunctioned). It thus appears that natural selection
is still very much alive and well, even in Japan and even during severe recessions.

References[1] Darlington, Cyril Dean, and Mather, Keith (1949), The Elements of Genetics. London: Allenand Unwin.
[2] Kobayashi, Keiichiro; Saita, Yumi; and Sekine, Toshitaka (2002), “Iwayuru ‘Oigashi’ ni tsuite(On So-called Evergreening),” Working Paper 02-2, Research Department, Bank of Japan (inJapanese).
[3] Mather, Kenneth (1953), “The Genetical Structure of Populations,” Symposia of the Society
for Experimental Biology, vol. 7, pp. 66-95.
[4] Mather, Kenneth (1955), “Polymorphism as an Outcome of Disruptive Selection,” Evolution,
vol. 9, pp. 52-61.
[5] Nishimura, Kiyohiko G.; Nakajima, Takanobu; and Kiyota, Kozo (2005), “Does the NaturalSelection Mechanism Still Work in Severe Recessions? Examination of the Japanese Economy
in the 1990s,” Journal of Economic Behavior and Organization, vol. 58, pp. 53-78.
[6] Ogawa, Kazuo (2003), Daifukyou no Keizai Bunseki: Nihon Keizai Chouki Teimei no Kaimei(An Economic Analysis of Severe Recessions: Shedding Light on the Long-term Stagnationof the Japanese Economy). Tokyo: Nihon Keizai Shinbunsha (in Japanese).
[7] Peek, Joe, and Rosengren, Eric S. (2005), “Unnatural Selection: Perverse Incentives and theMisallocation of Credit in Japan,” American Economic Review, vol. 95, pp. 1144-1166.

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