A Note on the Japanese Trade Policy and Economic Development
Secrets behind an Economic Miracle
Three Key Messages
* Japan achieved a miraculous economic development to become one of the richest countries in the world, although the World War II almost killed the Japanese economy.
* The Japanese economic development was generally supported by the expansion of international trade, especially exports of manufacturing goods.
* The secrets behind the miracle lie in very effective economic and trade policies backed by powerful and impartial civil service.
The World War II gave a devastating impact on the Japanese economy. When the war ended in 1945, the production index of Japan was only one-fifth of the prewar peak, and international trade was severely restricted. Most major cities were destroyed by American bombing, and people were suffering from shortages in food, energy, and other essential goods. The situation facing Japan then was probably worse than those of many developing countries today. However, the Japanese economy quickly took off, supported by the dramatic growth of exports. In 1968, just twenty years after the devastating war, the Japanese gross national product became the third-largest in the world, next only to the USA and the USSR.
The purpose of this short note is to investigate why Japan succeeded in emerging as one of the richest countries in the world for such a short period of time. I put an emphasis on the role of effective trade policy in Japan. As I argue below, while, at least until recently, Japanese market was heavily restricted from foreign imports, trade policies were employed that provided Japanese producers with incentive to export, i.e., Japanese exporters were never disadvantaged relative to the domestic market because of effective economic and trade policies. One of the essential ingredients of the Japanese success was extremely efficient and impartial civil service which designed and enforced economic and trade policies which made Japan an economic superpower quickly. Although such an efficient and clean civil service may be a long cry for some (or many) developing countries today, the following discussion of the Japanese experiences would give some insights into how to achieve an economic growth led by the expansion of international trade.
From Fatal Patient to Superstar
Before going into the Japanese trade policy per se, I will quickly summarize the economic growth and trade expansion of Japan after the World War II, in order to give non-Japanese readers some background facts of the Japanese economy.
Dramatic Economic Growth
During the World War II, most major cities in Japan, including Tokyo, Osaka, Hiroshima, Nagasaki, and Kobe, to name a few, were almost completely destroyed by carpet bombing of the Allied (or U.S.) forces. As a result, eighty percent of the production capacity of the Japanese Economy was lost. However, thanks to very effective industry policies and trade policies, Japan quickly recovered and has shown a miraculous economic development. (See Figure 1 for real GDP of Japan)
The first priority of the government is to increase production capacity in order to feed large population, including eight million discharged soldiers. In 1946, the government announced the Priority Production System (PPS) to reconstruct the Japanese industry. The PPS tried to start reconstruction process by concentrating available resources on two critical industries, coal and steel1. The recovery plan was called “inclined production process”: almost entire production of coal was put in steel industry, and almost entire production of steel was put in coal industry. The process was to be repeated until the two vital industries revived.
Thanks to the direct government regulation in the 1940s and early 1950s, the Japanese economy began to show a sign of strong recovery, and continued double-digit growth rate until the Nixon Shock in 1971. (See Figure 2 for annual growth rate of the Japanese real GDP) As shown in Figure 2, the growth rate of the Japanese economy in a few years after 1948 (only three years after the end of the devastating war!) was around twenty percent. In 1949-1951, Korean War gave an economic stimulus to the Japanese economy. Due to special procurements for the Korean War, the Japanese exports tripled in two years, and the production increased by seventy percent in the same period. In 1951, the occupation by the Allied Forces ended, and Japan became an independent nation. In December 1960, Prime Minister Ikeda announced the famous “Income Doubling Plan.” Under the plan, the government took various policies to double per capita income in Japan in ten years. The policies include: (i) modernization of agricultural sector; (ii) modernization of small and medium sized companies; and (iii) expansion of exports.
Table 1 shows GDP and per capital GDP of selected OECD countries since 1950. As the table shows, in 1950, the GDP per capita of Japan was less than seven percent of
that of the United States. But, the speed of catch-up was remarkable, and the Japanese per capita income has exceeded that of the Unites States since 19902.
Heavy Reliance on International Trade
The land of Japan is very small (about one-fiftieth of Russia) although population of the two countries are not very different (1.5 trillion for Russia vs. 1.2 trillion for Japan). Japan is very poor in natural resources. So, Japan has to import a large amount of food, energy, and raw materials to support its population, and in order to earn foreign exchange to pay for the imports Japan has to export a large amount of goods, mostly manufactured goods. The pattern of the Japanese trade is often called ‘processing trade’, because it produces goods by processing imported raw materials. Therefore, the government put a great emphasis on expansion of exports. Due to the aggressive trade policies discussed in more detail in the next section, Japan emerged as one of the largest exporting countries which accumulate huge trade surplus.
Figure 3 shows the share of the Japanese exports in the world exports.
As I said in the above, the Japanese export at the end of the World War II was almost nil, but it has to import huge amount of food end energy. Instead of relying on foreign aid heavily, Japanese government put an emphasis on the increase in exports of manufacturing goods (textiles and clothing at first, and TVs and cars in more recent years). As a result, the share of the Japanese exports in world exports increased in reaps and bounds to become almost 10 percent in the middle of 1980s, when Japan faced various trade conflicts with the United States and other advanced countries.
Contrary to the popular belief, the expansion of exports was accompanied by the expansion of imports in Japan. In fact, the Japanese trade balance was generally in deficit until late 1960s (See Table 2). As Japanese manufacturing sector grew, the amount of imports of energy and raw materials increased, too. Also, as the Japanese workers became richer, the import of foreign consumption goods increased.
Some Secrets behind the Miracle
(1) Export Incentive under Import Restrictions – A puzzle
The strong performance of the Japanese exports discussed above gives us a puzzle, in view of the fact that, at least in early years of economic development after the WWII, Japanese imports were heavily restricted in order to protect domestic producers. In addition to agricultural products (like rice and meat) and service sectors (like banking), manufacturing sector was also protected in early years based on the infant industry argument. While Japanese cars flood the markets all of the world today, in early years even automobile imports (and inflow of foreign direct investment by U.S. automakers) were severely restricted lest strong multinationals like GM and Ford killed weak Japanese companies like Toyota and Nissan.
The economic theory tells us that, when domestic market is insulated from the foreign competition, domestic price of a good is higher than international price, which tend to discourage domestic producers from exporting to the foreign markets. Suppose that the domestic price of a pound of beef is 20 dollars which is substantially higher than the international price (5 dollars) of the same kind of beef because Japan imposes various tariffs and non-tariff barriers. In such a case, Japanese farmers sell their beef in Japan for 20 dollars, instead of exporting it for 5 dollars.
Actually, however, the Japanese producers of manufacturing goods, e.g., textiles, TVs, and cars, made every effort to export their products to the world, although the domestic prices of their products were sometimes higher than those in the export market due to import restrictions. Why?
In what follows, I will discuss several factors behind the puzzle, including export support programs (finance and tax system), foreign exchange rate, scale economies, and ‘export contest’ supported by clean and able civil service.
Various Support programs for Exports
As mentioned above, Japan is very poor in natural resources and arable land is limited. So, Japan has to rely on exports to earn foreign exchange to pay for the imports of food and energy. In order to encourage producers to export, various incentives were provided. The followings are only a partial listing of export support program which contributed a great deal to the take-off of the Japanese economy.
(i) Export-promoting tax system
(a) Special deduction of export income
In 1953, the Japanese income tax law was revised: exporters were allowed to deduct certain percentage of export income from their total income, which gave producers an incentive to export, because the same value of sales in the foreign market brought more after-tax income than the value of sales in the domestic market. However, this program constituted a violation of the GATT provision and was abolished in 1963.
(b) Import tariff refund
When the Japanese producers imported raw materials and intermediate goods to produce export goods, import tariffs paid on the input were refunded to producers at the time of export. The GATT provision allows government to pay such import tariff refund as long as the amount of refund does not exceed tariffs actually paid.
(ii) Export-promoting financing
(a) Pre-shipment export bill discount
When producer A in Japan exports goods to importer B in, say, the United States, the transaction is usually settled in the form that importer B issues a payment bill (similar to a check) to producer A in Japan. Producer A brings the bill to a foreign exchange bank in Japan to receive money for his already exported goods. Normally, the cash transaction is made after producer A completed the shipment of the exported goods. However, in order to encourage exports, the Bank of Japan rediscounted the bills at very low interest rate before actual shipment is made. So, the foreign exchange bank (Bank of Tokyo) also discounted the pre-shipment export bill at low interest rate. The pre-shipment export bill discount at low interest rate means a low interest loan to exporters to finance the production, purchase, and transportation of goods for export. The pre-shipment export bill discount was abolished in 1972, when Japanese producers obtained international competitiveness.
(b) Japan Export-Import Bank
In 1951, the Japan Export-Import Bank was established to provide medium and long-term loans to shipbuilders and producers of plants (or mini-factories) whose major markets were those in foreign countries. The scope of its activities was greatly expanded to include financing imports of raw materials and intermediate goods, development of natural resources in foreign countries, and foreign direct investment. In 1979, the amount of loan outstanding for exports, imports, and investment were 2.6 trillion yen (about 26 billion dollars), 700 billion yen, and 900 billion yen, respectively. In 1999, the Japan Export-Import Bank was integrated into Japan Bank for International Cooperation (JBIC), whose major responsibility is to aid developing countries.
(3) Favorable foreign exchange rate
Foreign exchange policy also contributed to the expansion of Japanese exports at least until 1971, because Japanese yen was generally undervalued in the 1960s. When yen was undervalued, the dollar price of Japanese products is cheaper to consumers in the importing country than otherwise. In 1949, the foreign exchange rate of the Japanese yen was set at 360 yen to a U.S. dollar, and the same exchange rate was maintained until August 1971. Until the last moment when major industrialized countries abandoned fixed exchange rate system itself, the Japanese government succeeded in avoiding revaluation of the Japanese yen, in order to promote exports. Of course, I do not argue that developing countries now should maintain undervaluation of their currencies, because such a policy makes eventual adjustment more drastic and painful one. But, Japan was very lucky. By the time of the necessary adjustment, Japanese producers like Toyota and Panasonic to name a few had become very strong in the international market.
(4) Export Contest3
In order to encourage export, the Japanese government set up ‘export contest’ among firms to combine the benefits of competition and cooperation. Although contest-based competition is more difficult to manage than market-based competition, various forms of export contests played crucial role in export expansion in the 1950s and 1960s. There are three prerequisites for successful contest: rewards, rules, and referees. Rewards must be substantial enough to elicit broad participation and energetic competition. Rules must be clear-cut so that contestants know which behavior will be rewarded. And impartial referees are crucial. In Japan, preferential access to credit and foreign exchange were very attractive rewards. Rules centered on economic performance, primarily a well-understood imperative to export. Referees, the government officials who have designed and supervised the contests were generally competent and impartial.
(5) Powerful and Impartial Civil Service
According to the Japanese Constitution, the basic principle of the government is separation of three powers, i.e., parliament (called Diet in Japan), cabinet, and judiciary should check each other and maintain the balance of power among the three branches of the government. However, in Japan, bureaucrats are extremely powerful, and most laws and policies are designed and implemented by bureaucrats. Although the Diet is supposed to enact laws, in reality almost all bills are prepared by bureaucrats and the Diet just ratifies the bill to make the law. As far as the laws on industrial policies and export policies are concerned, most laws were prepared by the bureaucracy in the famous MITI (Ministry of International Trade and Industry), which is now called METI (Ministry of Economy, Trade and Industry). Political appointees in each ministry are only minister and parliamentary vice minister, which are replaced almost every year and have very little, if any, power in policy making. The real head of the ministry is administrative vice minister, who are promoted to that poison after some thirty years of civil service in that ministry. Moreover, MITI also regulated firms by an informal method, called ‘administrative guidance’. It is supposed to be voluntary whether not firms follow the administrative guidance, because it is not a law but just guidance by the Ministry. In reality, however, the administrative guidance is strictly enforced by stick and carrot.
The above description of the Japanese bureaucracy --- an independent force that controls generous incentives and issues vague guidelines --- is not unlike that of bureaucracies in other economies that engage in corruption and malfeasance on a vast scale. However, the powerful bureaucracy in Japan was backed by reputable civil service system and efficient education system. First of all, elementary and middle-level education is free of charge and open to everyone, and almost 100 percent of people acquire education. As for higher level education, unlike in the United States, national universities, which include University of Tokyo, are much more prestigious than private universities in Japan. Until recently, tuition of these prestigious national universities is just nominal4. Graduates of the prestigious national universities become leaders of the society, including the top of the powerful bureaucracy. In other words, a son of very poor family could, and often did, enter a prestigious national university, if he is smart enough to pass the extremely competitive entrance exam. And if he studies hard at the university to pass another extremely difficult ‘class I’ exam5, he is almost guaranteed to become high-ranking civil servant, including the administrative vice minister, de facto top of the ministry. Thus, recruitment and promotion in the powerful bureaucracy is strictly based on merit in Japan. For those bureaucrats, corruption is fatal. The industry policies and export expansion policies are backed by the very competent and clean civil service.
(6) Scale economies
Japan put an emphasis on export of manufactured goods, especially of cars and other machinery goods. When producing machinery goods, a firm has to put in a large amount of money to build the factory. For example, in order to produce one unit of car, Toyota has to put in, say millions of dollars, to build an assembly plant. But, in order to produce the next car, necessary input may be just steel and plastics and so force, which may cost only, say, several hundred dollars. If this is the case, the more cars Toyota produces, the less is the average cost of each unit of cars. In economic jargon, it is called scale economies because large scale production economizes production cost. Under the scale economies, producers have incentive to produce more. In other words, Toyota does not face a choice whether it produces cars for domestic market or foreign market. Toyota may as well produce cars for both domestic market and foreign market in order to increase the number of cars produced (or, in order to decrease average cost of auto production). Since major items of the Japanese exports was machinery goods, which is produced under the technology of scale economies, producers were not penalized by increasing their production for exports on top of their production for domestic market.
(7) A Caveat – weak and inefficient agricultural sector
So far, I have discussed some success stories of the economic development of Japan. However, one caveat is in order to make a balanced argument. The above success stories only apply to manufacturing sector, such as cars and VCRs. The agricultural sector of Japan has been heavily protected from foreign competition. For example, until the completion of the Uruguay Round in 1995, Japan had imposed almost total ban on the import of rice, a staple food for the Japanese. Even after 1995, when it comes to international trade of rice, the Japanese government has taken utmost effort to resist the WTO principle. As a result, the price of rice in Japan is several times higher than international price. And, there are no sign of hope to make Japanese agriculture sector more competitive in the international market. The current situation of Japanese agriculture shows how bad excessive protection can be (huge loss to consumers and the continuation of very inefficient production). Banking and distribution industries are other examples to show the loss of competitiveness due to prolonged protection, although there is some sings of hope in these industries.
Junichi Goto (1990), Labor in International Trade Theory: A New Perspective on Japanese-American Issues, The Johns Hopkins University Press, Baltimore and London,
The World Bank (1993), The East Asian Miracle: Economic Growth and Public Policy, Oxford University Press, London