Japan Rethinks Reform

Japan's "shareholder revolution" does not seem in line for a counter-revolution any time soon.

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"The Koizumi reforms" was one of the portmanteau concepts most commonly bandied about in Japanese political debates in the summer of 2009 as the parties geared up for the August election. Japan had in fact embarked on its neo-liberal agenda of deregulation and privatization well before the charismatic Mr. Koizumi laconically offered his "no gain without pain" recipes, but it was pushed with most enthusiasm during his premiership from 2001 to 2006.

Today, his successor as prime minister, Taro Aso, sings a different tune. He promises "a clean break with excessive market-fundamentalism". Yukio Hatoyama, the leader of the opposition Democratic Party with a strong likelihood of becoming the next prime minister, blames market fundamentalism for destroying local communities.  Both of them deplore the privatization of the post office, the crown jewel of Koizumi's program, even though Aso has to claim that he went along with it as a cabinet minister only under extreme pressure.  In a striking illustration of the changing mood, one of Japan's most vocal advocates of neo-liberal reforms and writer of deregulation blue-prints for earlier prime ministers, the economist Iwao Nakatani, has produced a bombshell best-seller recantation.  The belief in the sovereign virtues of market competition, he acquired so enthusiastically in his graduate student days at Harvard was nothing, he said, but a simplistic illusion. It led in effect to great inequalities and much misery; above all to the abandonment of precious Japanese cultural values of cooperation, mutual concern and egalitarianism.

So it is no longer with promises for structural reform that the parties compete. As they look forward apprehensively to the post-slump future in their election manifestos, the ruling Liberal Democrats and the opposition Japan Democratic Party are primarily competing on welfare, with plans to combat unemployment, to help agriculture and small business, to halt the decline in fertility and the increase in inequality, and to cure poverty (the OECD's poverty rate index shows that Japan has now beaten Mexico and Turkey to second place behind the United States). "Small government", a key slogan of the structural reformers, is nowhere in sight.

But there is one structural reform of the last decade which neither party shows any signs of seeking to undo.  Corporation law, corporate governance and management make no appearance in either manifesto.  The "shareholder revolution" of the last decade seems firmly and incontestably established. 

The much-touted virtues of Japanese management

No one would have predicted this twenty-years ago, when the unique virtues of the "Japanese management system" were a favorite theme for patriotic publicists, and when the end of the cold war - the capitalism vs. planned economy war - set off, in the Anglophone social science world, the "different types of capitalism" debate. In those debates Japan figured, along with Germany, as a comprehensive alternative to the textbook-standard Anglo-Saxon model, an alternative which the courses on Japanese management that proliferated in American business schools frequently presented as superior.  

Instead of efficient markets, relying on the invisible hand to guide the purest individual self-seeking to the greater good, what the Japanese had was the self-restraint to enter into long-term commitments which could override short-term opportunities to maximize profit. Lifetime employment, long-term and not purely contractual business relations between manufacturers and their suppliers and customers, and a sense of the enterprise as a focus of community sentiment were the chief "cultural" ingredients. And the chief outcomes, which proponents said gave Japanese firms an edge over their American counterparts, were: collegiate management, relationship banking rather than market finance,  cooperative industrial relations, willing shop-floor engagement in productivity improvement efforts, a collective pride in quality, and a willingness to sacrifice short-term profit for long-term investment, research and development.

Business magazines in the 1980s frequently published the results of surveys comparing what Japanese and American managers claimed to be their objectives. American managers gave pride of place to returns on equity and maintaining their share prices. For Japanese managers those came well down the list, after market share in product markets, raising employee wages and maintaining the firm's reputation.

The secret: shareholders hardly counted

How could Japanese managers be thus indifferent to shareholder pressure for profits, given that company law gave shareholder rights the same priority as in the Anglo-Saxon countries - unlike in Germany, where the parallel rights of employees were enshrined in co-determination laws? The answer is: not in the way that American managers were generally shielded from investor pressure in the 1960s, because of the wide dispersion of shareholdings which Berle and Means recorded, and writers like Galbraith celebrated. Rather, it was because of ownership concentration in friendly hands.

Most of the big firms had a large share of their equity held on a long-term basis by "stable shareholders". Some were (mutual) insurance companies with which they had on-going business relations which were much more important for those partners than the profits from their shareholdings. Others were reciprocal cross-shareholdings with their banks and with friendly suppliers and customers, especially those from the same enterprise group to which they were bound by historical ties.  (Hostile takeovers were practically unthinkable and even mergers took place only with difficulty; merging communities and seniority promotion systems always gave trouble.)

Shareholders were in fact treated as if they were creditors, and dividends were a kind of fixed charge, a standard percentage of the face value of their shares. Managers sought profits, of course, but more as free cash for investment than as a means of keeping shareholders happy. How far they would allow increases in pay to eat into potential profits was primarily a ‘jam today or jam tomorrow' question. And the jam in question was their own jam as well as that of their subordinates. The enterprise was a quasi-community; the top managers were its elders, so that when the annual bargaining round with the company union had settled a percentage increase, that was roughly the percentage by which managers upped their own salaries.   Thus, their pay increases kept pace with those of people on the shop floor. A Ministry of Finance statistical series for the 2000 largest firms gives detailed figures for the pay, bonuses and non-statutory welfare payments of directors and ordinary employees separately. From 1975 to 1999 that ratio hardly varied from 2.5 to 1.

That same statistical series puts numbers to the shareholder-as-mere-creditor feature. In the recession that followed the Plaza Agreement in 1985, dividends fell the next year by less than 0.1 percent. In the four boom years leading up to the massive asset bubble that followed they increased by only 2%.  And this was at a time when wages and directors' emoluments went up by 19% and 22% respectively.

The new normality

The picture today is very different.  Forget, for the moment, the wild swings of the past year, from the growing panic after the Lehman shock and the wholesale canceling of export orders, to the near despair of the spring 2009 panic when average large-corporation profit margins (operating profit on sales) plunged to a disastrous minus 0.3%, to the tentative sighs of relief as the second quarter figures uncertainly suggest that the worst has passed. Through all these ups and downs, the institutions, instinctive behaviors and mind-sets of managers have been rather different from those of their predecessors twenty years earlier.

They have been ‘Anglo-Saxonised'. It is not market share, but the price of their shares in the stock market that has become their central measure of how well they are doing. The former executive of a large Japanese steel firm remarked: "Of course the share price is important; you let it go down and you are the target for a raider; you get it up and you can get equity finance.  When I took over the chief financial job (in 1993), I was concerned about our share price, but nobody else on the board seemed to be, I was the one then who took care of investor relations.  Not nowadays. Now it's the job of the president. He is the one to go off to Wall Street and the City. He's always having to prepare for meetings with the analysts."  And there are a lot of the latter about in Tokyo. The Security Analysts Association of Japan, had a mere 1,000 members when it first instituted its professional examination in 1981.  As of mid-August 2009, it boasts 22,577 members, all of them, except 80 survivors of those pre-qualification days, possessors of a full diploma.

Structural reform through legislation is one reason for the change, beginning in 1993 with the simplification and cheapening of shareholder representative suits. (This was under strong official American pressure in the so-called Structural Reform talks of 1989-90, but from then on the indigenous reform movement needed little outside prompting.) It proceeded to the legalization of many hitherto forbidden practices, always with the US as a model - creation of holding companies, remuneration through stock options, buy-backs of one's own shares, and using shares rather than cash to pay for corporate acquisitions. A complete revamping of corporate law in 2002 consolidated these changes and offered the choice of an American-style board structure dominated by external directors. A mark-to-market accounting system was enforced and tax legislation promoted a shift from defined benefit to defined contribution pension systems - both measures intended to help in the accurate valuation of companies for investors and corporate raiders. Labor market legislation vastly extending the scope for temporary work contracts, especially in manufacturing, gave companies the option of reducing their core "committed" labor force and cutting labor costs.

The post-bubble stagnation of the 1990s also prompted change, especially the financial crisis of 1997.  It came just at the time that the American economy took off, thus sharpening  the contrast between the vigor of American free-market capitalism and the stagnation of Japanese "organized" pseudo-capitalism, and reinforcing the argument that "we must be more like them".  The banks had to sell off much of the equity which had made them protective "stable shareholders".  Financial difficulties and a change of mood forced the unwinding of many more of the reciprocal cross-holdings.

Nothing, in fact, more clearly symbolizes the shift in the dominant ideology accompanying, and reinforcing, these changes than the media's treatment of cross-holdings. They used to be seen as a means of letting managers get on with the substantive direction of the company, undistracted by bids and counter-bids. The media and the whole of corporate Japan rallied round to defeat an attempted hostile take-over by the American arbitrageur Boone Pickens in 1989. Now, attempts to rebuild cross-holdings are condemned as the actions of lazy, timorous, incompetent managers seeking to escape "the discipline of the market."

It is understandable that shareholders want to exercise discipline in a way that they used never to do. Until 1990 they were reasonably content to be ignored and treated as creditors. It was the seemingly endless capital gains, not dividends, that they were after. Now with the stock market still at a quarter of 1990 levels their pressure for high dividends and more share buy-backs has intensified. And shareholders today are increasingly organized, foreign, institutional shareholders. Foreigners held 5% of Japanese shares in 1990, never less than 25% this century. Institutional Shareholders Services, and the Japanese Pension Fund Association vigorously press for higher dividends at shareholder meetings with organized votes against reappointment of directors. Even more crucial in making the share price the centre of managers' attention is the arrival in Japan of a number of private equity funds, ready to pounce on cheap firms with a lot of unrealized assets that they can squeeze with a threatened take-over.

Takeover battles and ideological battles

Nothing, in fact, has done more to bring shareholder sovereignty into focus than the controversies which have arisen over these attempts and the court cases to which they have given rise. They have pitted solid traditional management - usually technically efficient but hoarders of resources against a rainy day to secure the future of their employees - against raiders who promise to realize sleeping assets and give shareholders the benefit of what is, after all, their property. Sympathies are divided. The business magazines, which once filled their pages with articles by ex-Marxist Keynesian economists from the universities, are now dominated by MBA  Japanese with English titles like Cheefu Ekonomisuto at Tokyo-Mitsubishi or Sutoratejisuto (Strategist) at Merrill-Lynch. They are wholly in sympathy with the raiders who are finally teaching managers what maximization and financial efficiency mean.

Less articulate, but more deeply felt, are the sympathies of those who side with management. They draw on what might be called a widely shared "productivist bias."  The Japanese have a special pair of antonyms, "making things" as opposed to "making money". Belief in the moral superiority of the former goes back to Han dynasty Confucianism when society was first structured as the "four orders" and farmers and artisans were ranked, in nobility and moral worth, above mere merchants.

There have been no prominent court cases to set off such controversy in the last year, and it is hard to guess how, in the long run, the balance has been changed by that year's traumatic events. On the one hand the "productivists" should gain strength from the revelations of moral turpitude in the Anglo-Saxon finance industry which brought on the world crisis. On the other, there are many who complain that it is Japan's reliance on its strength in "making things", i.e., its dependence on exports, that has made it one of the worst-hit economies, in spite of the fact that its banks were relatively circumspect in dealing with risky financial products and blameless for the crisis.

Underlying trends of change

Two crucial long-term trends underlie these changes. First, seniority promotion has brought to positions of influence what I rudely call ‘the brain-washed generation' - the high-flyers sent by ministries and companies to the United States for MBAs and PhDs in the 1970s and 1980s. These true believers in agency theory and shareholder value have become the dominant voice in ministries and boardrooms, backed up by the media and by the economists and corporation law experts who sit on government committees.

The second trend is the enfeeblement of the unions. We are now nearly half a century away from the days of a militant class-conscious union movement.  But the enterprise unions which became the norm formerly combined full cooperation in production matters with vigorous bargaining in the annual "spring struggle" for a share in productivity gains. Now, even that legacy of militancy has gone. After nearly two decades of deflation, they have allowed individual performance pay systems to overshadow collectively bargained wage scales and in firms like Canon, even the ritual of an annual collective wage bargaining has been discontinued. Labor costs continue to contract as the wages of regular workers stagnate, welfare benefits are cut, and regular workers are replaced by cheaper temporaries. Meanwhile managerial pay which once kept step with that of other employees, is now increasingly linked to profits, to how well they have served their shareholders. That 2.5 to 1 ratio of directors' to employee emoluments is now well over 5 to 1. Still a far cry from the American 300 /400 to 1, but moving in that direction.

Emerging resistance?  Should shareholders be worried?

To be sure, prominent managers still give speeches about the importance of all stakeholders, not just shareholders. The old firm-as-community ideology still has a residual hold. And in one crucial respect Japanese firms are still distinct. They are still run by long-term, usually lifetime, employees, who have come up through the seniority/merit promotion system.  Management is still collegiate. The charismatic qualities which get you the fastest promotion and a good chance of becoming the CEO should not be too flamboyant and self-assertive. For all the concern to please shareholders, "the firm" is still important to top managers. They care about its future and are anxious that nothing should happen "on their watch" to jeopardize that future.

And they still are very much in control. It has become the fashion (a fashion which some firms like Toyota have resisted) to appoint a number of external directors to the board. But, almost invariably, they are appointed as "wise men" (now, occasionally "wise women"), sources of useful counsel or providers of useful networking links, not, as in the United States, as powerful watch-dogs of the shareholder interest.

Given these residual institutional features; given the strong residual sentiment in support of managerial rather than financial capitalism (see the discussion above about takeovers and the "productivist bias"); given also the world-wide backlash against the finance industry, with Sarkozy in France announcing the death of Anglo-Saxon capitalism, and the German Minister of Finance, promising to restrict the activities of "locust" hedge funds in order to preserve the virtues of  German co-determination; and given also the concern with poverty and inequality and all the denunciations of market fundamentalism, symbolized by the Nakatani best-seller and reflected in the party manifestos - given all this, one would have expected that there would by now be some articulate movement in Japan to shift the balance between employee sovereignty and shareholder sovereignty back a bit in favour of employees and other stakeholders.

And the place to start would surely be the takeover rules which put the fate of management teams into the hands of quick-profit-seeking shareholders. These are the bit of the corporate governance system which is ultimately the main source of shareholder sovereignty; it is these rules which, over the last decade, have been the main trigger for controversy between the "productivists" and the shareholder value-ists.

But there is no sign of any such articulate movement emerging.  The only genuinely left-wing party, the dwindling Communist Party, draws some support from small business but has practically zero connections with the corporate sector and its unions.  Members of the extinct union-dominated Social Democratic Party have been absorbed into the Democratic Party which has a good chance of winning the August 30 election, but their influence within it is small. Some ex-union MPs, together with some ex-bankers within the party, have in fact created a party working group which has drafted a new Corporation Law. It is mostly about ensuring greater transparency in the interests of shareholders but it does contain one possibly radical suggestion - the appointment of an employee representative to the Audit Committee. The Audit Committee, which it is now compulsory for all firms to have, must have a majority of external members. Its name, kansayakkai is also the standard translation for the German aufsichtsrat, the supervisory board. It is in fact a relic of the Japanese nineteenth century corporation law modelled on the German. But it has nothing like the powers of control over management enjoyed by the German body.

The appointment of an employee representative might have some symbolic effect at least, but the measure is unlikely to reach the statute book. There are far more politicians in the Democratic Party with friendly (and revenue-generating) ties to the finance industry than to the unions.  The intention to enact such a measure did not figure among the 55 separate policy initiatives which were enumerated in the party's manifesto.

Japan's "shareholder revolution" does not seem in line for a counter-revolution any time soon.

Ronald Dore is an Associate of the Centre for Economic Performance at the London School of Economics and the author of numerous studies of Japanese, German and Anglo-Saxon capitalism.