Lecture 4: The Postwar Arc of Japanese Economic, Financial and
Political Development in Phases and Key Economic and Political
Institutions in Japan
1945 – June 1950: Postwar disruptions, monetary growth
deficits, hyperinflation, and the Dodge Line – establish base for
June 1950 – 1970: High Growth Period (HGP)
1970 – 1975: High or “Wild” Inflation, BOJ policy error, and
shift toward political “independence” – difference between de
jure and de facto independence
1975 – 1985: High Point of the Japanese Economy and
Institutions – World Attention Directed Toward Japan
1985 – 1990: “Bubble economy”, growing stress within the
financial system and BOJ policy error – U.S. repeats the pattern
15 years later
1990 – 2001: “Burst of the bubble economy”, economic and
financial distress, and potential for second lost decade – this
period itself is divided into phases that represents the beginning
of a shift from the “old” to the “new” financial and supervision
regime and central bank policy. More broadly, this period
represents the beginning of shift from the “old” set of economic
and political institutions to a “new” set of institutions. Intense
economic, financial and political distress characterizes the
1990s. – “Japan’s Lost Decade”
2001-2006: Possibility of a “second” Lost Decade, continued
financial and economic distress, but political distress declines
with Koizumi. Koizumi initiates more aggressive reform and
concentrates political leadership and power in the PM office.
Shift of power away from bureaucracy to PM. Transition to a
new set of economic and political institutions: economic
“recovery”: and, according to BOJ deflation process over, but
continued challenges to Japan.
2006-present: Return to political distress – one new PM per
year on average, economy slows and declines, deflation returns,
but nonetheless, Japan absorbs the financial shock of 2008/2009
relatively well. Earthquake, tsunami and nuclear shock have
adverse, but unknown impacts on Japan; the world; and in
particular, the U.S.
Economic and Political Institutions
Japan emerged from WWII in 1945 as a devastated nation
The pre-war economic and political institutions had embodied
Japan’s view of how the world functioned and had served Japan
up to WW II, but were found wanting in the postwar
This was an especially difficult attitudinal change on Japan’s
part considering the overall impressive performance of the
Japanese economy since the start of modernization in the 1870s
or 1880s depending on how one dates the start of modernization.
The focus here is to outline Japan’s set of political and
economic institutions and the social contract they established
between the government and the public as they existed in the
1970s – at the end of the lectures, we can determine the extent
to which they have changed in the past three decades.
Importance: (1) Specific characteristics of the economic and
political institutions led Japan to adopt a flawed response to the
new economic, political, and technology forces that emerged in
the 1970s. Japan’s “bubble” economy in the second half of the
1980s and the “lost decade and a half” of the 1990s and first
few years of the new century can be traced to an unwillingness
to depart from key elements of the old regime. (2)
Juxtaposition of the newly evolving economic and political
institutions in the first decade of the new century with the old
set of institutions provides a perspective on how much Japan
has changed and how a new social contract is emerging.
Economic and Political Institutions: Is Japan Special?
Two perspectives: (1) Narrow sense of existing to allocate limited
resources among competing ends (economic institutions) and to
determine social rankings of different social policies based on
individual rankings (political institutions). This is the “one size fits
all” view and in the extreme, is the Marxian view the means of
production defines culture, attitudes, religion, and even political
institutions. (2) Institutions are viewed as the outcome of a complex
set of forces summarized by a country’s history and cultural and that
each country’s set of institutions cannot be understood independent of
the culture and history of that country. This is the “one size fits only
one country” view and in the extreme, is the Hegelian view that ideas
and concepts determine the means of production and political
In Japan’s case the second perspective has tended to dominate
Japanese economic and political institutions are “special” and
“different” and not easily understood by standard analytical tools
derived from Western thinking.
This adherence to “specialness” has been one reason Japan in the
1980s failed to learn important lessons from the financial disruptions
in many industrialized economies.
Both perspectives are important; however, the first perspective is
fundamentally more important. There are identifiable characteristics
of Japanese society incorporated into its economic and political
institutions, however. Japanese society has a tendency toward risk
aversion, stability, and an aversion toward change.
Two points are important to bear in mind. First, separating Japan’s
institutions into economic and political does not imply an absence of
feedback relationships. The bifurcation is a pedagogical device.
Second, of all the economic and political institutions in Japan it is
important to keep mind only the financial system that responded to the
forces of change in the late 1970s and early 1980s and even with
respect to financial system redesign, reform was limited.
The Financial System
Japanese financial system institutions as they existed in the 1970s can
best be understood from three perspectives. First, the evolution of the
financial system from 1868 to WWII; second, the financial system as
of the 1970s; and third, the influence Japan’s financial system had on
financial systems throughout much of Asia.
The first and third point has already been discussed.
The financial system of the 1970s reflected a continuation of pre-war
trends. The financial system remained an instrument of industrial
policy, based on bank finance, government played a significant role in
the allocation of funds, and the system remained internationally
isolated. The Allied Occupation did have some impact: - Glass-
Steagall and disbanded the prewar zaibatsu which had limited the role
of banks in corporate governance; however, corporations reestablished
the zaibatsu system in the form of the less rigid keiretsu or company
group structure organized around a financial institution, usually one of
the large city banks.
Four important changes in the postwar period: (1) government banks,
enterprises, and corporations were established and became important
components of the FILP. (2) Financial system became more bank-
focused, specialized and concentrated. The private banking system
consisted of a small number of very large banks (city banks, foreign
exchange bank, long-term credit banks, and trust banks), larger
number of regional banks, and a very large number of specialized
credit cooperatives. City banks and regional banks focused on short-
term business loans while long-term credit and trust banks focused on
longer-term loans. There were also a large number of small
specialized credit cooperatives. (3) Third, the shift toward bank
finance was completed so that by 1975 securities markets played no
meaningful role in the flow of funds. (4) The financial system came
under the direct control of the government via a system of credit
allocation policies, interest rate restrictions, limited competition
between financial institutions, restrictions on foreign financial
institutions, and restrictions on the inflow and outflow of capital. As
of 1975 Japan’s financial system was the most regulated, isolated, and
administratively controlled financial system of the industrialized
Japanese corporations were not responsive to shareholders. Despite
the capitalization of the Tokyo Stock market in the pre-transition
period equities were primarily used to solidify relationships between
corporations within a company grouping and/or the main bank in the
company group. The relationship between the large corporations was
defined by the keiretsu or bank system and cross-shareholding by
Enhancing the value of equity and paying dividends to equity holders
had very low priority relative to supporting the members of the
keiretsu. Equity was more a solidifying factor rather than a means to
raise capital from investors that imposed a responsibility on the
corporation to be responsive to those investors.
Borrowing from banks was the main source of funding.
Cross-holding of equity permitted stable long-term relationships with
group companies, prevented hostile takeovers, and provided for
shared business risks.
However, this set of corporate governance institutions denied
Japanese corporations an effective monitoring mechanism on their
decisions and activities normally provided by outside shareholders
and the market.
Labor Market Institutions
Lifetime Employment: In practice lifetime employment was a
somewhat elastic institution not rigidly followed throughout Japan.
About 25 percent of the workforce most of which was concentrated in
the export sector. Public employees had lifetime employment,
including national and local government workers, teachers, police
officers, and firefighters. The number of employees operating under
an explicit lifetime employment benefit understates the institution of
lifetime employment, however. Even for employees who were not
given lifetime employment, the implicit understanding was employees
would keep their jobs in the absence of extremely poor performance,
criminal actions, or antisocial behavior.
Wage Coordination and Restraint: In 1975, corporations and labor
unions established an informal, but highly institutionalized system of
wage coordination and wage restraint. Wage coordination eliminated
labor disputes because wages were essentially set for the entire
economy once every spring and the bonus system was used to make
adjustments at the end of the year to ensure that previously set wages
were consistent with economic performance.
Unions did not have significant power. Union membership was low
and formal union organizations were not centralized.
Company Welfare: Mixture of residualism and a conservative
ideology. It is residual because the Japanese government’s welfare
spending was and continues to be minimal among the OECD
countries. Japan’s formal welfare system is based strictly on means-
tests because of the traditional belief the family is the main support for
the aged and poor. Strong social stigma attached to receiving welfare
also limits government welfare in Japan. The company welfare
system provided welfare benefits for company employees, and
government was responsible for those not covered by the system.
Dualistic structure of welfare recipients: Government employees and
employees of big corporations were entitled to generous company
welfare while small business employees and the self-employed
received much less welfare support and were forced to rely on
minimal government welfare.
Life Expectation View: Japan’s labor-corporate system supported a
life expectation for the average Japanese. Husbands were expected to
provide for their family and wives served as homemakers taking care
of the children. Men devoted themselves to their companies and the
companies provided income and welfare for their employees’ entire
family. A highly meritocratic nature of Japanese society also
informed married parents that as long as their children studied hard
and attended good universities, their children would have a
comfortable life as they matured.
This belief was supported by Japan’s rapid economic growth in the
1960s and 1970s.
The LDP dominated Japanese politics from 1955 when it achieved a
majority position in both houses of the Diet until 1993 when it lost the
majority in the Lower House (the LDP had lost the majority in the
Upper House in 1989). The LDP controlled the government for 38
years without interruption despite Japan’s democracy with periodic,
free elections that are usually expected to create alternation of parties
in power. The so-called “1955 System” Why?
First, individual LDP politicians created and maintained large
networks of supporters called koenkai (supporters’ associations).
Japan’s multimember district (MMD) system allowed a candidate to
win a seat with a smaller percentage of votes than under the single-
member district (SMD) system.
Second, the LDP specialized in clietelistic distributive politics to
maintain electoral support - “pork barrel” politics. In this regard, the
LDP was very strong in rural areas, and conducted large-scale
redistribution of wealth from urban areas to rural areas in the form of
government subsidies to local governments and industries, public
works projects, and subsidies to farmers.
Third, the extensive system of 24,000 post offices and the FILP
budget supported by postal deposits and life insurance premiums were
used by the LDP to ensure support at the local level. Local post
offices frequently and actively campaigned for LDP politicians who in
turn promised to support the PSS and the FILP budget. The FILP
system was a major instrument for pork barrel spending and hence,
Fourth and perhaps the most important, Japan’s economic
performance contributed to the power of the LDP. Voters were
reluctant to seriously consider non-LDP alternatives despite the
numerous corruption and money scandals that frequently plagued the
In Japan, the bureaucracy has traditionally exerted greater influence in
policy making than found in other democracies. The Allied
Occupation purged many political leaders but left the bureaucracy
intact because they knew the Japanese bureaucracy was competent
and was needed it to manage the war-torn country. In the first few
years after the end of the war the bureaucracy virtually dominated
policy formulation and implementation.
When the LDP began to dominate Japanese politics after 1955,
politicians still found themselves dependent on the established and
well-entrenched bureaucracy. The bureaucracy in Japan as of the
1970s was powerful, highly respected and because there were few
shifts in the policy agenda, the bureaucracy assumed the role of
managing the economy.
How controlled Japan? The answer depends on policy issues and
time-periods; however, for all practical considerations, until the 1990s
bureaucrats probably played the major role in managing the economy.
The bureaucracy’s importance in the 1990s began to wane and one of
the most significant changes in Japan’s transition has been a gradual
loss of power by the bureaucrats vis-à-vis politicians.
Constrained Policy Making Power of the Prime Minister
Japan’s parliamentary system is almost identical to that of the United
Kingdom; however, the British system concentrates policy making
power in the prime minister and creates executive dominance.
The opposite occurred in postwar Japan. Japan’s system generated
weak and dependent Prime Ministers because a set of formal and
informal rules and practices created multiple veto players with whom
the Prime Minister had to contend with in their pursuit of their own
policy. Four factors combined to limit the power of Japan’s Prime
First, the Prime Minister is normally the LDP president. The majority
factions had the power to replace the Prime Minister if they wished to
Second, the LDP was an effective gate keeper in the flow of Japanese
policy making legislation.
Third, the prime minister not only had to deal with the LDP as a veto
play, but was forced to deal with the other two elements of the iron
triangle – the bureaucracy and client businesses and groups.
An important component of the iron triangle was the practice of
amakudari or “descending from heaven” - a major feature of Japan’s
political institutions and the “old boys” system of mutual support.
Hence, any decision made by the bureaucracy or politicians would be
constrained by post-retirement amakudari benefits.
The iron triangle elevated the bureaucracy and LDP clients as
effective veto players weakening the power of the Prime Minister.
Fourth, veto players for prime ministerial policy initiatives are not
limited to the LDP, bureaucrats, and client industries and groups. A
combination of formal and informal rules and practices of the Diet
equipped the minority opposition parties with the ability to block LDP
Thus, the prime minister faces multiple veto players in Japan and as a
result generally was not able to exercise the same powers as the prime
minister in the British system.
The Iron Triangle in Sum
These three political institutions in pre-1980 Japan – dominance of the
LDP, the bureaucracy, and the absence of strong leadership by the
Prime Minister – formed the basis of the iron triangle. The LDP
politicians, the bureaucracy, and their client industries and firms
formed an iron triangle that determined policy formulation and
implementation in postwar Japan. The triangle was strengthened and
solidified by favor-sharing and amakudari.
See diagram in Cargill/Sakamoto (p. 53)