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Darkness Before the Dawn

Strategist Michael Porter tells why Japan's economic sun has set, and how it can rise again.
Edward Teach, CFO Magazine
May 1, 2001

Did you read the news from Japan today? Oh, boy. Two years after the end of its "lost decade," the Land of the Rising Sun remains stuck in an economic slump. Stocks have plunged to levels last seen in the mid- 1980s. Real estate values have been hammered, bankruptcies are rising, unemployment has reached postwar peaks. Falling consumer prices are raising fears of a deflationary spiral. In March, Finance Minister Kiichi Miyazawa made headlines around the world with his declaration that Japan's public finances were "very near collapsing." In April, ineffective Prime Minister Yoshiro Mori resigned, while the ruling Liberal Democratic Party struggled to bail out banks massively burdened with bad loans and bloated shareholdings. Once considered an unstoppable economic juggernaut, Japan now seems (with apologies to Richard Nixon) a pitiful, helpless giant.

But is it? Japan is still the world's second-largest economy, as well as the United States's second-largest trading partner. It boasts a sizable number of highly competitive, world-class companies--the Toyotas, Hondas, Sonys, and DoCoMos. Its technological sophistication rivals America's, and its workforce is admirably well educated. Japan's strengths, in short, are considerable, and it could in short, are considerable, and the country could soon right itself if its policy makers and corporate managers took bold, decisive action.

That, at least, is the opinion of Michael E. Porter, the C. Roland Christensen Professor of Business Administration at Harvard Business School and arguably the world's foremost authority on competitive strategy. Author of seminal books and articles on competition, the 53- year-old Porter has trained his analytic eye on Japan in his latest book, Can Japan Compete?, co-written with Hirotaka Takeuchi, a dean at Japan's Hitotsubashi University, and Mariko Sakakibara, a professor at UCLA and former deputy director at Japan's Ministry of International Trade and Industry. This compact book presents the results of a long and exhaustive analysis of Japanese industries--and unlike other investigators, Porter et al. studied Japan's failures as well as its successes. Japan, they conclude, is not a special case among nations, as was widely thought, but rather a country that has prospered in spite of its government's activist policies.

And if Japanese companies generally score high on best practice, most fail when it comes to strategy--as Porter began to realize some time ago. Japan, he points out, was 1 of the 10 nations covered in his 1990 classic, The Competitive Advantage of Nations. "During my research on that book, Japanese companies began to puzzle me," he told CFO articles editor Edward Teach during a recent interview in his Cambridge, Massachusetts, office. "They just didn't seem to do the sort of things I talked about in my older work on strategy." It was the "dissonance" between the Japanese case and his other work, says Porter, "that provoked me to start down the path of doing this book"--a book whose research took nearly eight years to complete, with the help of a team of graduate students.

Can Japan Compete?, which also offers detailed prescriptions for the country's competitive ills, was published first in Japan, in 2000. How was it received? "The sales are very high," says Porter. "CEOs in Japan are enormously supportive of this [the book's recommendations] as the way to go." Whether Japan's politicians decide to follow Michael Porter's advice, however, remains to be seen.

Japan's economy has been in the doldrums for years, and nothing the Japanese government does seems to help. What's wrong with Japan?
For the first few years of the economic slowdown, the assumption was that the cause was the financial bubble, and that if the government just worked through this bubble--pumping up the economy with public- works spending, lowering interest rates to zero--the problem would be solved. Clearly, this has not worked.

Our research shows that the system is the problem. The bubble is a symptom. Until Japan starts to dismantle the traditional government approach of intervention, subsidy, protection, and so on, nobody is going to have enough confidence to move ahead.

The system must have some merits. After all, it helped create the world's second-largest economy.
The received Japanese model has two parts. On the government side, Japanese industrial policy was viewed as a new approach to management of the economy. On the corporate side, the Japanese management system was seen as a new and better way of managing companies.

We actually found that the government's activist policies explained Japan's failures better than its successes. And while the Japanese management system did lead to success in many industries in the 1970s and 1980s, the system is incomplete. Japanese companies are far less profitable than their Western counterparts.

Japan's trade surpluses have been regarded as an index of economic vitality, but you write that they are really "a staggering disadvantage." Why?
The surpluses were produced by impediments to imports of a wide variety of goods and services that Japan should be importing, in the hopes of propping up local industries. The problem was that the protected industries were grossly inefficient.

There are, in fact, two Japans. One is the highly competitive Japan, the country familiar to Westerners. It consists of relatively few export industries for an economy as large as Japan's, such as cars and consumer electronics. Government has played a surprisingly small role in the success of these industries. The other Japan consists of a far greater number of uncompetitive industries, such as agriculture, chemicals, consumer packaged goods, and many types of services; and inefficient domestic industries, such as transportation, construction, and energy. Many are protected by trade barriers and other government policies. The more Japan protects, the more the economy becomes bifurcated.

Protectionism drives up the Japanese cost of living. What is less well understood is that it also drives up the cost of doing business, and harms the competitiveness of the rest of the economy. Construction costs are too high. Logistics costs are too high.

So what do Japanese companies do? When they expand capacity, they don't expand in Japan, but overseas. So you see large Japanese investment in Malaysia, Singapore, China, and elsewhere in the world. Investment in Japan has been stagnant, because the economic sense of further capacity in Japan was compromised.

There is a growing recognition that these problems are structural, not financial. But there has been a lack of political will, as well as governmental consensus, to go forward.

Let's talk about the Japanese management model. What's right, and what's wrong, with the model?
What's right is the concept that a company has to continually improve cost and quality. It has to incorporate every new technology and new idea that advances best practice. That's what I call improving operational effectiveness.

These are ideas such as total quality management, continuous improvement, and just-in-time.
Yes. All those are best practices, better ways of organizing production, reducing defects, improving efficiency, and so forth. Japanese companies taught the world how important these approaches were. The problem is that when you are competing on operational effectiveness, it's very hard to sustain an advantage, because everybody, of course, tries to imitate. The Hewlett-Packards and the Motorolas studied very carefully what the Japanese companies did, and they started implementing those practices themselves.

In two respects, American companies surpassed the Japanese. One was to more aggressively deploy information technology. Japanese companies were chronically slow in incorporating information technology, and they remain behind.

The other way that American companies surpassed Japanese best practice was in understanding the customer and segmenting markets.

What's wrong with the Japanese management model?
Japanese companies are weak at strategy. In fact, most companies don't have strategies. Essentially, they are competing on best practice.

Isn't pursuing market share a strategy?
Market share isn't a strategy. Market share might be a good thing to have, but not necessarily. In some industries, having the largest market share is the least profitable position, because of powerful large customers or the presence of substitutes.

How do you define strategy?
I define strategy as the choice of a unique mix of value, or unique value proposition. "Choice" doesn't mean that you have figured out the universally best way to compete that your competitors should imitate. Choice is where you make trade-offs. Where you decide, for example, that you are going to become incredibly good at manufacturing computers to order that are essentially marketed over the phone and over the Internet. Customers that want intensive service, to be able to go to a showroom or a retail center, are not served. That is a trade-off: in order to deliver one kind of value, you have to give up delivering other kinds of value.

The sign of a strategy is that a company sets limits--it is not trying to offer everything to everybody. Japanese companies, with very few exceptions, don't have strategies in that sense of the word. They try to maximize market share and grow as rapidly as they can. That leads them to enter every product segment, offer every feature and service, and imitate relentlessly anything that their rivals offer.

Why does that happen?
The first reason it happens is the goal structure. There is little corporate-governance pressure--the board in Japan has no outsiders, and shareholders have little power--so Japanese companies never had to earn high returns. As long as they made an acceptable profit and weren't on the verge of bankruptcy, that was OK.

But aiding and abetting that lack of strategy are two other conditions. One is a style of decision-making in which everybody has an equal say. If there is no clear leader and nobody to decide, then a company ends up doing everything.

The final condition is the keiretsu structure. A keiretsu is a group of companies bound by ownership interest. If you are owned by a family of other companies, there are pressures to serve sister-company needs. If you have to serve all their needs, and if your keiretsu has 100 companies, it's hard to have a strategy.

A strength of the Japanese system is that it leads to a very long time horizon. Companies don't worry about shareholders, takeovers, or being acquired. But a long time horizon is problematic unless companies also must worry about profitability. Without profit pressures, companies pursue 20-year investment strategies to enter businesses in which they have no chance of succeeding.

Which Japanese companies have strategies, and why?
Some examples are Sony, Honda, Nidec, and Shimano. The Sonys and the Hondas are mavericks. They have strong CEOs. They don't care about fitting in, and they don't see themselves as part of the Japanese corporate structure. Such companies tend to be the ones that have a strategy.

The other class of companies that are more likely to have strategies are those not based in Tokyo or Osaka. Companies in the big establishment business centers got dragged into the system. But if companies were based in Kyoto, Nagoya, or someplace off the beaten track, they often were far more focused. They had a distinctive positioning.

There is still a lot to learn from Japanese companies. All the efforts to study the Japanese quality system, and just-in-time, were valid. But that's not the whole job of management. Indeed, competing on operational effectiveness can become a very destructive kind of competition--a zero-sum game, where everybody is trying to do the same thing and profitability is eroded. The big message of our book for Japan, and also a big message in general, is that ultimately you have to have a true strategy if you are going to be successful.

How do you change the Japanese management model? It won't be easy, especially given the interlocking share ownership of the keiretsu.
Change is already occurring. It's being driven by a number of things--by economic pressures, by foreign investors, and by a new generation of CEOs. The keiretsu system will decline as cross-holdings among companies are sold off. The problem is that, in most Japanese companies, change is still very slow, timid, and measured. The big barrier is that Japanese companies really avoid laying off people.

The tradition of lifetime employment won't change easily.
Lifetime employment is a problem. But companies are finding ways around it; they are offering severance packages, for instance. So it is starting to happen.

If government would demonstrate a sense of leadership, that would speed up the corporate restructuring. I think companies are nervous that there is nobody driving the bus, and they are risk averse as a result.

What steps should the government take to revive Japan's economy?
First, the government needs to stand up and legitimize the need for substantial changes. Almost more important than what government does is to have a true reform plan.

A major step needs to be the restructuring of bank loan portfolios. A lot of emotional and psychological energy, as well as real economic difficulties, is being caused by the debt problems in the banks. The focus is on the past and preserving the fragile status quo, rather than on the future.

The contrast between the United States and Japan is striking. We faced a series of issues at the turn of the 1990s. A huge budget deficit, the savings-and-loan crisis, a meltdown in real estate. But the wonderful thing about the United States is that we adjust. The system adjusts. People go bankrupt, there are workouts, loans get renegotiated, and we move on. But Japan hasn't been able to move on.

Beyond bank debt, there is a whole series of reforms that need to be carried out. Japan needs to rewrite its competition laws, enact stricter antitrust enforcement, end cartels, start rooting out the protectionism that remains. There also needs to be substantial deregulation in parts of the economy.

This is not to say that Japan should look exactly like the U.S. There are enormous strengths in Japan.

For example?
Their public education system. Despite the fact that Japanese wring their hands about public education, their system is much better than ours. They need to build on that.

Japan has real strengths in terms of technology. They are a very technologically sophisticated nation, but innovation has been blunted by some of the same consensus decision-making and incentive issues that have blunted competitiveness in general. Also, Japan has the opportunity to prosper by confronting some of its demographic changes earlier than other countries.

It has an aging, and shrinking, population.
Yes, but Japan has successfully handled such challenges before. Think of its ability to make compact, multifunctional, energy-efficient products. Americans were used to having lots of space, and cheap energy; Japan didn't have those. It confronted that challenge earlier than other countries did, and it paid off in competitiveness. Japan has similar opportunities today in the area of demographics and aging. It also has a secret weapon: women. Women in Japan have not yet entered the workforce in any substantial way.

How long will it take Japan to get out of what looks like a deflationary spiral?
Be careful about using the word "deflation." In Japan, housing prices are going down. Food prices are going down. The prices of goods are going down. Is that bad? No.

Japan had grossly overinflated prices because of its flawed system. I don't see this kind of deflation as unhealthy. In fact, I think it is fundamentally healthy. If the cost of doing business and the cost of living in Japan go down, people are going to end up investing more and buying more. This is the only way to get the economy growing again.

How long will it take to turn the economy around? I would think that if everything went right, we could see within a year or two a significant change in the sentiment in Japan, and momentum in the positive direction. If everything goes wrong, it will be a slow, three- to-five-year process. I see enough change under way that I am confident that Japan is now on a different track.

Ultimately, a resurgent Japan would be good for the United States. We are now living in an era--slightly tempered by the economic downturn- -where too many Americans think we've got everything right. The U.S. has gotten a lot of things right, but there is substantial inequality-- which is unsustainable. We also have a weak education system, are not graduating enough scientists and engineers to replace those who are retiring, and are not investing in basic science and technology.

So, we have some real issues in the United States. And a good thing about having renewed competition from Japan would be to once again motivate us to address our weaknesses--rather than just pat ourselves on the back.

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