What Japan Teaches Us About Industrial Policy
Industrial policy is back in vogue. On November 5, Senator Marco Rubio (R., Fla.) gave a speech at the Catholic University of America decrying the decline of American manufacturing. Rubio argued that shareholder primacy — whereby a corporation’s primary goal is to maximize value for its owners — caused the decline, and that American capitalism should instead focus on the “common good.” By this he meant that the federal government should promote high-paying, stable employment by investing in manufacturing.
Over the weekend, Sridhar Kota and Tom Mahoney sounded a similar tune in the Wall Street Journal. Kota and Mahoney, researchers at MForesight, a think tank dedicated to the study of advanced manufacturing, argued that outsourcing manufacturing jobs has led to a decline in innovation. “Once manufacturing departs from a country’s shores, engineering and production know-how leaves as well, and innovation ultimately follows,” they argue, citing increases in the foreign share of manufacturing research and development (R&D).
In concurrence with Rubio, Kota and Mahoney call for an “Industrial Policy 2.0,” which would boost domestic R&D and mandate that innovative hardware be manufactured domestically. This proposal echoes that of the Manhattan Institute’s Oren Cass, who has spent the past two years advocating a renewal of American manufacturing.
It’s not the first time Americans have worried about high-value-added manufacturing moving overseas. In the 1980s, Japan seemed poised to become the world’s economic leader. Between the mid-1950s and the early 1970s, Japan’s economic growth rate often exceeded 10 percent. Afterward, it settled at around 5 percent. This “Japanese miracle” was the result of highly skilled bureaucratic management. As Chalmers Johnson explains in MITI and the Japanese Miracle, in the 1960s and 1970s, Japan’s Ministry of International Trade and Industry funneled capital to highly productive manufacturing and machinery firms. Japanese manufacturing products from cars to consumer electronics became increasingly common fixtures of Western life, and the living standards of Japanese citizens improved dramatically.
Assuming that growth would last forever, investors piled into Japanese asset markets. At its peak, the Japanese equity market traded at four times the price-to-earnings ratio of the American market. Tokyo’s Imperial Palace alone was worth as much as all of the real estate in California. Then, in 1990, Japanese financial markets suddenly plummeted. Stocks lost 60 percent of their value, while commercial real estate’s value declined by 50 percent. It seemed Providence no longer smiled on the Land of the Rising Sun.
In large part, this was the result of the Bank of Japan’s faulty monetary policy. It didn’t help that the 1985 Plaza Accord devalued the dollar vis-à-vis the Japanese yen, leading Japanese monetary authorities to take forceful measures to prevent deflation, thereby driving up asset prices. Japan’s policies of lifetime employment and enterprise unionization also restricted the efficiency of its businesses, as did demographic headwinds. During the three decades since the asset bubble burst, Japan’s economy has been more or less stagnant. It’s a period economists have termed the “lost decades.”
Though the proximate cause of Japan’s decline remains a subject of debate, the duration of the country’s stagnation suggests its root problems are structural, not cyclical, the result of distortions caused by Japan’s industrial policy. In effect, the bureaucracy responsible for Japan’s miracle itself sowed the seeds for the lost decades. The country flooded productive firms with capital during the boom years, but proved unable to mobilize capital when those firms reached “steady state” and could no longer increase profits.
Any given product has limited demand. A firm that perfects a certain manufacturing process may grow to dominate a market. But thereafter, it will have to find new sources of competitive advantage in order to continue growing; if it doesn’t, it will fall behind its competitors. This is the underlying mechanism of creative destruction, wherein firms no longer generating value shutter, laying off their employees and defaulting on their financial obligations.
Under a state-directed model, political imperatives can render creative destruction intolerable. Thus, firms that are successful in one era due to government largesse tend to continue receiving benefits. Because Japan’s industrial policy was focused on maintaining employment and high growth, its bureaucracy could not afford to let state-aided enterprises fail. As a result, Japanese lenders rolled over non-performing corporate loans, creating so-called zombie corporations — companies on life support, miming the functions of productive businesses but in fact walking dead. As a result, Japan’s sclerotic state-run enterprises more or less failed to partake in the IT boom of the ’90s and ’00s.
China finds itself in a similar position today. Its investments in manufacturing and mining created an unprecedented boom, pulling nearly a billion people out of poverty. But many of the state-owned enterprises that drove that boom now operate at overcapacity, with high leverage and few growth opportunities in sight. China’s corporate-debt levels are among the highest in the world, and the country has experienced persistent industrial deflation due to its bloated iron and steel sectors. It remains to be seen whether China will escape the middle-income trap and develop a service-driven economy, but it is clear that Beijing’s industrial policy has reached its limits. At the same time that Rubio calls for decreasing shareholder rights in favor of the “common good,” China is trying to professionalize its financial markets in order to bring more accountability to its corporations, precisely because the lack of shareholder primacy has produced massive market distortions.
If an American Industrial Policy 2.0 worked, it might run into many of the same problems.
Suppose, for instance, domestic-content requirements and limits on foreign ownership provide a boon to domestic manufacturers, leading to higher manufacturing employment and an increase in American output. In this scenario, the U.S. begins to produce more high-tech devices, such as semiconductors and smartphones, as it re-shores innovative manufacturing.
What happens when those firms develop new products that require inputs not produced in the U.S.? How quickly will American suppliers be able to adjust?
What happens when lagging firms need to lay off workers? Will an industrial policy focused on reviving “well-paying, stable employment — especially for men with less formal education” allow such lay-offs?
And what happens when subsidized research facilities start underperforming? Will a manufacturing bureaucracy have the foresight to pull their funding and identify new researchers on the cutting edge?
If Japan’s experience is any indication, an American manufacturing bureaucracy would not be able to adjust to such scenarios. Instead, it would cement market wedges that would prove difficult to remove in the long run.
