The Snowball Effect And Economic Reform

A response to Tobias Harris

Political analyst Tobias Harris wrote a very thoughtful assessment of my book on his blog, including a discussion of the political hurdles to implementing pro-entrepreneurship reforms. The concluding Part V of the book focuses on how to overcome them. I’ll summarize my argument below.

            Meanwhile, Brad Glosserman, a security expert, wrote a review in Japan Times (behind a paywall) which captures the spirit of the book.

            After a lengthy summary of the book, Tobias wrote:

While it is hard to argue with [Katz’] vision for a new Japanese capitalism, it is less clear how it is achievable. Katz says it comes down to political leadership: “The main hurdle... is not a lack of feasible solutions; it is getting Japan’s political leadership to implement them.”...But individual politicians may matter less than the socio-political coalitions they lead – and every LDP leader has had to grapple with an electoral coalition skewed towards economic incumbents and the over-represented countryside...

The firms that would be forced out of business have organizations that speak on their behalf, representatives who listen closely to their concerns, and employees, customers, and neighbors who may be reluctant to endorse creative destruction – even if it means Japan’s future prosperity is harmed as a result. How many votes can a start-up that does not yet exist deliver for an ambitious politician? As Katz admits, it may be more realistic to start with smaller reforms with “little budgetary or political cost”...It is not inconceivable that small changes that create more space for start-ups could snowball into broader social, political, and economic changes.

My response:

Depending on what questions you ask, you’ll get different answers. If you ask why things are as they are, you’ll focus on only certain facets of the overall picture, and you’ll “connect the dots” by showing how these facets combine to make the status quo self-reinforcing. On the other hand, all business and political “models”—no matter how effective—eventually become obsolete due to changes in the economy, society, technology, and demographics. The self-reinforcing features of a system can then also become self-undermining, and tension arises between the two opposing impacts. Consequently, tension also arises between current ways of doing things and emerging alternatives. If you investigate that tension, seeking levers of change, you’ll notice additional “dots,” and connect them via a different conceptual lens.

            I started by asking myself: could I find indigenous socio-economic trends that could resurrect the kind of entrepreneurship that helped drive Japan’s post-WWII “economic miracle”? They had to be indigenous because, while countries can learn from others, one cannot simply graft foreign practices onto a society.

            Fortunately, I found several powerful pro-entrepreneurship trends that belie Japan’s appearance of stasis. Yet, such trends are unlikely to reach critical mass unless they are amplified by government policies. I looked for a realistic scenario inducing the government to reverse itself and genuinely promote entrepreneurship. Kishida never went beyond hollow promises.

A Self-Undermining Status Quo

While leadership is pivotal, I’m not just calling on political leaders to act differently. To me, that’s like saying: if cows had wings, they could fly. The question is what forces would lead political leaders to act differently, would give rise to a different set of leaders—perhaps in a different political party—with different ideas, and would create a different sort of socio-economic-political coalition with a different policy profile? Certainly, it’s an uphill climb. The forces of resistance are powerful, abetted by inertia, a “better the devil we know” mindset, and the rigidity of a one-party democracy. It’s impossible to know which side will win. Nonetheless, the chances of reform are the greatest they have been in a generation due to underlying societal-economic-technological shifts.

            The most fundamental self-undermining feature of the current situation is this: the very policies used by the LDP to shore up its socio-political base have decimated growth. That has created a situation in which you cannot aid one constituency in the LDP's “big tent” without hurting another. Aging greatly exacerbates these political fissures.

            It’s harder to maintain support for the elderly when social security and health care spending per senior has been cut by the government by more than a fifth since the mid-1990s. And yet, other generations are hurt when the consumption tax is hiked to support the elderly. Meanwhile, Tokyo spends the second-to-lowest share of GDP in the OECD on education, which squeezes consumer spending power on other things. In 2017, Shinjiro Koizumi, a possible future Prime Minister, declared: “You’re willing to spend up to four million yen to provide a bigger monthly pension to the elderly, and then you say there’s no money for the young people? There’s something wrong with this picture.”

            The protection of farmers forces urbanites to spend a larger share of income on food than elsewhere. This was more tolerable when wages were rising. However, subsidizing business via corporate tax cuts and the promotion of low-paid non-regular workers has led to falling real wages for much of the workforce and stagnant wages for the regulars.

            The LDP rules today mainly because the opposition is so feckless that many of those who don’t like the LDP just stay home. But the LDP has to fear that, if it cannot restore good growth, one day it will lose the elections again, as in 2009, or it will split, as in 1993. Already, former Prime Minister Suga has said the LDP could lose control of the government unless it dumps Kishida. While the immediate catalyst is a financial scandal, as in 1993, deeper stresses intensify the rage at corruption. So, the LDP needs to restore good growth. Yet, it cannot do so unless revived entrepreneurship is part of the picture. Some in the LDP recognize this.

An Alternative In The Wings

Socio-coalitions, and policy frameworks associated with them, don’t collapse just because they create bad results. There has to be some alternative waiting in the wings. Today, we are seeing the ingredients for a different socio-economic coalition and policy framework emerging on a scale that did not exist as recently as 10-15 years ago. Among them are generational changes in attitudes and technological shifts that alter the balance of power in society.

            For example, the greater willingness of “the best and brightest” in their 20s, 30s, and even 40s to found and/or work for a startup—including women frustrated by promotion and wage discrimination—has enabled new firms to recruit mid-career veterans with indispensable technical and managerial skills. E-commerce has enabled tens of thousands of small and medium enterprises (SMEs) to bypass the traditional incumbent-dominated distribution system and thereby access customers. A big dearth of digital skills among the giant incumbents has made the latter dependent on partnering with new firms that have mastered such skills. Toyota now has more independent software firms as first-tier suppliers than hardware parts makers. This technological dependence has caused splits among assorted big corporations, and even within individual companies, on whether new high-growth companies are a bane or a boon to them.

How the Snowball Effect Can Create Change

How can pro-entrepreneur bureaucrats, businesspeople, academics, and politicians use these trends to effect reforms? Here I took a lesson from Deng Xiaoping: sequencing is everything. Pro-entrepreneurship forces have to start with measures that have a small political and economic cost but can create visible improvements that, in a snowball effect, generate support for further measures.

            In Japan’s case, it means fighting for small changes that increase the number of high-growth new companies. As the number of such firms grows along with the number of employees—of whom some will have personal connections with policymakers—that increases their political clout. They gain access to bureaucrats and politicians. Some bureaucrats have even left their Ministries to join startups. They become a constituency to which politicians must pay attention. They can then use their increased weight to push for further pro-entrepreneur measures in a virtuous cycle. The book details how some smart bureaucrats have been trying to do this for years. The difference today is a new political-economic context for such efforts. Kishida may have been “all rhetoric, little action” when he promised 100,000 new startups by 2027 but there is a reason that he felt it necessary to put the issue on the public agenda. Others can exploit this opportunity.

            Let’s look at a few examples in the field of finance. Would-be entrepreneurial firms cannot grow, or often even survive, unless they start big enough. And that is hard to do without access to external finance. Therefore, only the small fraction of people with money (or access to it) as well as brains and ambition can create high-growth firms. Those with vision and drive but little money cannot do so.

            Kishida established a tax break for “angels,” i.e. for middle-class people to invest in startups. But it was designed so poorly that it won’t work. The key problem is that people are required to invest in an individual startup, and most of those fail. That’s way too risky. By contrast, an extremely successful tax break program in France had people invest in an angel fund, which is like a mutual fund in the stock market. While most startups fail, angel funds show high returns because the few ventures that succeed do extremely well. Tokyo could tweak the program to stipulate investments in funds by defying the ideologues in the Finance Ministry’s Tax Bureau or the LDP's Tax Commission.

            Even companies not in high-tech need to do R&D, which is why most governments subsidize it. Japan does so exclusively through a tax credit on the firm’s income. But only firms that are already profitable can benefit from such a credit and it takes years for most startups to become profitable. Governments solve that problem by having a “carry forward” of 20 years or more. So, once a firm becomes profitable, it can use the tax credit. Japan only had a 1-year tax credit and the Abe administration eliminated that in the name of deficit reduction. So only 8% of aid to R&D goes to small and medium enterprises, the worst ratio in the OECD.

            Many startups are strapped for revenue in their early years and banks are loath to lend when they need expansion capital. To deal with this, the government has, by law, stated that 3% of all national government procurement should be set aside for purchases from companies under ten years old. But the government has never even reached 1%. By contrast, nearly half goes to all SMEs, no matter how old or moribund.

            These are many more potential initial steps. Even the LDP could pass such things if a strong Prime Minister insisted upon it, especially if he were backed by some important large firms. The process would go faster and be more likely to succeed if the opposition could seriously threaten LDP rule, even more so if parties alternated in power.

Fighting Fatalism

One final point. One of the biggest obstacles to reform is public fatalism arising from repeated disappointment. Three times in this century the public voted massively for politicians promising reform; Koizumi in 2001 and 2005; the DPJ in 2009, and Abe in 2012. Each time their hopes were dashed. Shikata ga nai (it can’t be helped) rules the roost. Showing that real reform is economically and politically possible is part of the process of building public support. Helping that process was the aim of this book.

On some days on amazon.co.jp