Adapting the Japanese Model

Timothy C. Collins

The following remarks were made by Timothy C. Collins to the 2000 annual meeting of the Trilateral Commission in Tokyo. Timothy C. Collins is Chief Executive Officer and Senior Managing Director of Ripplewood Holdings.

Unique Problems Require Unique Remedies
This session is about the one constant in our lives—change. But I have to admit our topic, “Changing Models of Capitalism,” is much too ambitious for me. Unfortunately, I have a very granular perspective and can only address this topic from my own narrow point of view. Our business in the U.S. is one where we have successfully used private capital as a catalyst for strategic change. We have spent the last two and a half years developing an approach to investing in Japan. This approach imports some of the private equity techniques from the U.S. and adapts them to the unique aspects of the Japanese market.

Now, from my limited perspective, let me give you my basic, simple conclusion about change in Japan: Don’t throw out the baby with the bath water. That is, let’s not forget that many habits, policies, and practices came about for good reasons, many of which are still or may again be valid. Change is good, but not every change that worked in a particular situation is appropriate in another environment or time. As an American, I am proud of our economic resurgence. We have made extraordinary progress over the last two decades. Our own past economic success is quite remarkable and probably, as in most things, full of very fruitful happenstance. However, one cannot take a template developed in one time and place and apply it without amendment to starkly different conditions.

In any case, the favored economic paradigm seems to shift from day to day. Let me quote to you from a book written in ’82 by Robert Reich, a former U.S. Secretary of Labor, and his colleague, Ira Magaziner: “Rampant inflation and high unemployment are symptoms of economic stagnation. Our standard of living is no longer rising.” Why was this the case? At the time Reich and Magaziner concluded that it was the U.S.’ increasing integration into the world economy and its failure to maintain international competitiveness. More specifically, they said, “…many U.S. companies have not kept pace in recent years with changes in the international competitive environment. Our systems for evaluating investment decisions have not sufficiently considered the competitive evolution of businesses. Our accounting systems have given managers incorrect signals. Our systems for measuring total product costs have misallocated manufacturing and distribution overheads....” This sounds, in many ways, strangely familiar. But even more interesting than the diagnosis of the ills was the prescription for a cure. After enumerating all of the conventional policies and practices, Reich and Magaziner concluded these policies will not bring about prosperity. Prosperity can be only achieved by means of an industrial policy carefully geared to international competition, that is, a set of policies similar to those in Sweden—where Magaziner had worked—and in Germany and Japan.

Obviously, in 1982, they were not alone in their view. The conventional wisdom, far and wide, was that the short-term, earnings-driven management style of U.S. companies could not hope to succeed against the longer-term perspectives of enterprises aided by thoughtful government intervention and industrial competition. During the ’80s, a time when Mitsubishi Estate took over Rockefeller Center and Matsushita purchased MCA, pundits throughout the United States repeated the refrain that Japan and Germany were destined to be the economic models for the world and the United States was destined to be a low-pay service economy unable to compete or maintain its standard of living unless it applied the Japanese approach directly to the U.S. economy. However, to paraphrase Mark Twain, rumors of the economic death of the U.S. were grossly exaggerated.

The route to the current robust economic health in the U.S. was not achieved by adopting the policies or practices without modification from any other economy, however robust at the time. As any doctor would warn, it never makes sense to take a pill prescribed for another patient. Japan can and will benefit from the U.S. experience, but it will certainly find its own way. We can already see the signs that a new economic model is emerging in Japan. Most importantly, thinking is evolving. I will discuss some of the structural changes that I see Japan pursuing and suggest some changes that it may be well-advised to pursue. But to provide some context, I would like to briefly discuss the key factors that were, in my view, antecedents to Japan’s current economic malaise.

Antecedents to Structural Change in Japan and the United States
The current system is carrying the weight of policies and practices that made enormous sense in the immediate post-World War II period. Japan was severely short of two key economic inputs—capital and skilled labor. These two factors were the principal constraints to growth. The economy grew by taking market share in new markets while relying on low-cost debt to fund growth. And because the economy relied on such low-cost debt, Japan became the most leveraged developed economy in the world. Also, during this period of extraordinary growth, most enterprises were competing in terms of size of revenues or assets and their ability to recruit and employ a talented technical workforce. Unfortunately, the policies that made so much sense for so long created an environment in which an unnaturally low cost of capital and hoarding of people created enterprises that operated with a dangerous combination: high fixed costs and high fixed charge payments. Projects that had projected returns of 4 or 5 percent were in many cases, ultimately, money-losers. Further, the real-estate bubble exaggerated the misallocation of resources to projects with no hope of earning their cost of capital. When the bubble burst, the old saying, “an asset is not always an asset, but a liability is always a liability,” took on new meaning. The bursting of the bubble coincided with the new competitive realities in what were once key growth sectors, like the automotive and steel sectors.

However, rather than serve as a vindication for the U.S. model of capitalism, the Japanese experience should provide a cautionary example because the U.S. economy may be now misallocating capital in a very different way. A huge proportion of American financial and human resources is streaming away from established industrial companies into the so-called “new economy” companies characterized by high growth and high risk. By many accounts, excessive exuberance in the capital markets is attracting resources beyond any rational justification. The Nobel Prize-winning economist Franco Modigliani stated that the current bubble prices are inherently unstable and, as he puts it, a bubble by its nature will burst.

This is not to say that the internet will not change the world and create enormous value for its winners, just a caution against the excesses in the capital markets. The current wealth effect driving consumption in the U.S. could become a reverse wealth effect stopping consumer spending in its tracks and whipsawing the market. Consider how many American investors have never experienced a down market. How many American workers could see their retirement assets evaporate and then, how many would foreswear investing, drying up venture capital and IPO markets? Risk-taking and entrepreneurship could be seriously dampened. Business school graduates who flock to internet start-ups for a job with extraordinary wealth potential could suddenly find themselves in search of a job with security. Bear in mind how heavily leveraged the U.S. economy is with private-sector debt equaling more than 130 percent of GDP. It’s true that the rise in debt has been more than equaled by a rise in assets, but debts are fixed in value, assets aren’t. Once again, a debt is a debt, but an asset is not necessarily an asset.

The contrast between the antecedents to the current stagnation in Japan and those prevailing twenty years ago in the U.S. is as clear as the differences between the Japanese and American bubbles. In the United States, despite the pleadings by many to follow the path trod by others, the catalyst for economic revitalization included tax cuts, tight monetary policy, deregulation, and significant corporate down-sizing under pressure from corporate raiders and increasing shareholder activism. A little good luck in the birth of new information-driven enterprises surely helped. But it’s important to keep in mind that the historic background of Japan’s economic problem is strikingly different. The United States suffered from decades of bitter labor–management relations and a slide in investment and R&D in manufacturing that led to low-quality processes and products. Japanese companies, by contrast, use leading edge processes to make world-class products at state-of-the-art plants with relatively harmonious labor relations. As one Japanese executive told us, the good news about Japanese companies is that they are run by engineers, and the bad news is that they are run by engineers.

If the U.S. experience were to be copied directly, what would be the unintended consequences? They would include worker backlash, reversal of public confidence, disrupted supplier relationships, and pressures to create a large government safety net with the costly and stifling bureaucracy that goes with it. In an economy where greater entrepreneurship and risk capital are needed, fewer would be willing to take risks. In an economy where increased consumer spending is needed, consumers would be less inclined to spend. But that does not foreclose change. Government, business, and other stakeholders have shown a growing willingness to adapt principles that have worked elsewhere to Japan’s unique circumstances. And clearly the example of new economy models like SoftBank are among the brightest lights on the horizon.

Government Has Set the Course, Entrepreneurs Should Now Take the Lead
Government’s role has been pivotal. Economies, especially the financial sector, operate on the basis of confidence. Prime Minister Obuchi has done much to inspire confidence. He and his cabinet have shown understanding of the West, as well as the uniqueness of domestic circumstances. They have maintained a steady pace of reform including the “big bang” legalizing and facilitating stock option plans and providing autonomy for the Bank of Japan. The law requiring companies to convert to consolidated accounting standards will provide transparency, exposing losses that used to be buried in subsidiaries’ financial books. Firms that used to hide their problems will now have to face them.

Government has set the course, and in my opinion the next round must be led by the corporate sector entrepreneurs and investors. They are being looked to for leadership and inviting foreign direct investment, which is crucial to help produce strategies that are conducive to global competitiveness. (The value of foreign direct investment has skyrocketed, however from a very low base.) A Council on Foreign Relations study last year reported that most foreign businesses unequivocally state that the opportunities they find in Japan are better now than they have ever been. How enthusiastically foreign direct investment is embraced depends largely on how it is managed. People in Japan are anxious to know, Will foreign management or partners pursue capitalism based on patience and compassion? Corporate policies like those practiced by Nissan and Renault offer tremendous encouragement. As I understand it, the Nissan revival plan relies heavily on natural attrition for employment reductions. Also, the Long-Term Credit Bank is committed to building its place as a cooperative partner in the Japanese economy. We have purchased a bank intact and are retaining and retraining the workforce. And we are hoping to re-list on the Tokyo stock market.

There are other positive signs in the Japanese economy. Information technology expenditures have grown, similar to the kind of spending that foreshadowed huge U.S. productivity increases a decade ago. Entrepreneurs are growing. Japan’s budding new economy is spawning a creative hub in Bit Valley. The internet can have an even more catalytic effect in Japan than the United States or Europe because of its ability to minimize distribution costs, long an excessive burden on the national economy. But no one should think that the task of reconstruction is almost complete. The key goal must be to enhance profitability and return on invested capital in the corporate sector, and increase the efficiency of allocation of resources, both tangible and human. This can not be achieved by MITI, the Diet, or the banking system. It can be achieved by an industrial company (that in the past always priced to maximize market share) deciding that it can increase the price of spare parts, maintain the price of new equipment, and retain market share, while increasing return on invested capital. It can be achieved by a vertically integrated automotive manufacturer outsourcing component manufacturing to foundries, or frame assembly to someone who can leverage their capacity and run it twelve months of the year at 90 percent capacity, rather than six months at 90 percent capacity and six months at 30 percent capacity. It can be achieved by a company investing in financial systems to continually analyze business operations and thus reduce working capital—something they didn’t feel the need to invest in when capital was virtually free. It will require changes in corporate governance, where shareholders can have a greater influence over management. I also believe that Japan will find a role for venture capital and other forms of private equity, which were so important as a catalyst for change in the U.S.

The challenge in Japan is not nearly as great as the one facing the United States in the ’70s and ’80s. Outdated industrial infrastructure and counterproductive labor relations required a much bigger fix in the U.S. than will be required in Japan, where in many cases new pricing strategies, working capital management, and lower overhead can dramatically increase the viability of key enterprises. I am confident that the Japanese economy will again have its day in the sun. Given the unique nature of every nation, no economy can be the right model for the world, but the Japanese economy is, in its own way, finding the right model for Japan.