No. 32 — August 18, 2000

Feature Article


Douglas Ostrom

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The spectacular economic performance of the United States in the late 1990s and in 2000 to date has raised the possibility that this country has given birth to a "New Economy." Although initially skeptical, economists in increasing numbers have become believers in this proposition. They have concluded that America's long-run growth potential has increased over the past 10 years. Many explanations of the causes of the New Economy are possible, but most analysts assign a significant role to new technologies, particularly those associated with computers and communications.

Japan's economy, by contrast, appears anything but "new." Growth there has slowed at the very time that it has accelerated in the United States. Moreover, demographic trends and other factors imply that Japan's long-term expansion potential will fall further in the early years of this century.

Cultural and economic forces combine to explain why a New Economy has surfaced in the United States and not in Japan. While these circumstances may slow the diffusion process in Japan, new economic structures already in place will push it forward. At the same time, electronic commerce and other key components of the New Economy will undermine Japanese insularity. As the world's second-largest economy slowly embraces these concepts, it might avoid the stagnation that otherwise would be likely over the next 25 years.

Americans will be among the winners from Japan's New Economy. Most obviously, they will benefit from one of their largest export markets becoming even bigger than anticipated. More importantly, the United States will reap some of the rewards of Japanese innovation, both from the goods and services that head eastward across the Pacific and from ideas that it can put to use in offices and factories.

The spread of the New Economy to Japan does mean, however, that the distinctive U.S.-Japan economic relationship that dates from the 19th century will continue. E-commerce will engender hostility and creativity alike on both sides, just as the arrival of Commodore Matthew C. Perry's "black ships" in Edo Bay did almost a century and a half ago. As in the past, the United States and Japan may be slow to recognize that the benefits of the changes are mutual and significant. This suggests the need for a continued political dialogue between the two nations.


A "New Economy" In The United States?

When Republican presidential nominee George W. Bush spoke of the "New Economy" in his acceptance speech at the GOP convention in early August, he joined the surprising consensus of economists, politicians and business leaders who believe that the American economy has changed fundamentally in the past decade. While some analysts might use the phrase simply to emphasize the role of new technologies in a few narrowly defined sectors without a judgment about their overall benefits, most imply that, whatever it is, the New Economy has generated unexpected economic growth. These individuals differ greatly, however, in their assessment of the New Economy's critical components.

At a minimum, the term implies that the relatively fast expansion of real gross domestic product in this country in recent years has its roots in something more important than a cyclical upturn. In that sense, growth is different now than in 1992, for example, when the United States experienced a big gain in GDP coming out of a recession. Of course, if the labor force were increasing fast enough or if consumers would forgo enough current consumption to increase investment, even the Old Economy would grow. There would be nothing "new" about these sources of expansion. The New Economy might best be described as a situation with the potential for a sustained improvement in economic performance that is not solely attributable either to the business cycle or to greater labor and capital inputs.

In economists' parlance, this formulation can be restated as a rise in multifactor productivity. Data from the Department of Labor's Bureau of Labor Statistics suggest that precisely this has happened in the United States (see Figure 1).1 The tail end of a long spurt of higher multifactor productivity occurred in the 1970-73 period. Otherwise, for more than two decades, the series showed no strong long-term trend, rising during times of recovery and dipping back to the level of the previous recession during downturns, as occurred in 1974, 1982 and 1991. The 1973-95 period has been called the era of "productivity slowdown" for the American economy. By 1997, however, multifactor productivity appeared to have escaped from the narrow range in which it had been trapped for so long, although only the next recession will tell for sure.

The continued robust expansion of GDP in the United States in both 1998 and 1999 and again in the first half of 2000 raises the strong likelihood that multifactor productivity rose as well. In fact, a related BLS series on labor productivity depicts just such a trend (see Figure 2). Labor productivity does not account for the possibility that workers are more efficient because they have more capital with which to work. Thus, it is a less-powerful indicator of a New Economy than is multifactor productivity. However, these statistics have the advantage of being available on a quarterly basis with little lag. Moreover, a comparison of Figure 1 and Figure 2 reveals a high correlation between the two yardsticks for the years for which both are available. Through the first half of 2000, the results of which are used to approximate the year as a whole, the uptick in multifactor productivity presumably was at least as great as that of labor productivity.

Some economists have paid particular attention to labor productivity in the period since 1995. At that time, the recovery, which began in 1991, was thought to be in its late stage, implying, as it had in the past, that productivity growth would slow. Indeed, it already had shown signs of deceleration in 1994 compared with 1992 and 1993. However, as Figure 2 indicates, productivity growth appears to have speeded up, especially after 1995. Most astonishingly, no slowdown is in sight. This surprise was the starting point, at least among academic economists, for their conversion into New Economy believers.

Scholars naturally are skeptical about the existence of any phenomenon labeled "new," especially when it tends to cast politicians or other interested parties in a favorable light. The New Economy paradigm certainly was no exception. Massachusetts Institute of Technology professor Paul Krugman echoed the thinking of many academic economists when, in early 1998, he wrote:

What, then, is left of the New Economy? We have had a favorable turn in the business cycle, abetted by some temporary factors that have helped keep inflation down, and arguably also by shifts in the labor market that have reduced the bargaining power of workers and therefore allowed fuller employment without accelerating wage increases. The New Economy, in other words, looks a lot like the Old Economy. It has about the same long-run growth rate but can run at slightly lower unemployment. Things could be worse, but nothing fundamental has changed — the amount of good news is not enough to justify the triumphant rhetoric one now hears so often.2

Mr. Krugman and others invoked a 15-year-old rule of thumb to make their point that America in the late 1990s owed its superior economic performance to its position at a particularly favorable point in the business cycle. Known as Okun's Law, after Arthur Okun, a chairman of the Council of Economic Advisers in the Johnson administration (1963-1969), the rule of thumb posits that the economy will grow at 2.4 percent plus (or minus) the decline (or increase) in the unemployment rate. In other words, gains in GDP stem from better capacity utilization, as approximated by changes in joblessness.

Okun's Law seems far too simple to work, but it did — that is, until the late 1990s. From 1980 to 1995, calculations on the basis of the rule never differed from GDP by more than half a percentage point for more than one year in a row. In the 1996-99 period, however, such computations were out of synch with the expansion by between half a point and a full point each year. In short, Okun's Law — invoked to demonstrate that the New Economy plays by the Old Economy's rules — points to just the opposite conclusion. The long-run potential annual growth rate of the U.S. economy, stipulated by Mr. Okun to be 2.4 percent, now appears to be in the 3 percent range.

Mr. Krugman, for one, has changed his mind. After noting that his earlier objections to arguments concerning the existence of a New Economy were logically valid, he made the following observation:

But there is a twist in the story: however much their analytical arguments may have been logical nonsense, the new paradigmatics have reason to be vindicated by events. Over the past few years the U.S. economy has indeed grown much faster than conventional estimates of its potential with (at least by mid-1999) still little sign of serious inflation. … Perhaps we [academic economists] should have asked more carefully whether there was some reason why a new optimism had emerged among people closer to actual business experience.3

Today, the New Economy paradigm has found a remarkable degree of acceptance among economists whose long experience made them wary of the idea for years. Harvard University's Dale Jorgenson — for decades arguably the leading American expert on productivity growth, the key point of contention — was quoted recently in The Wall Street Journal as saying about a new study on U.S. productivity: "I've become an enlistee in the army of people touting the New Economy."4

Among policy-oriented economists, acceptance of the New Economy paradigm is equally widespread. The most distinguished convert in this group is none other than Federal Reserve Board Chairman Alan Greenspan. This July, he weighed in as follows:

The current economic expansion has not simply set a new record for longevity. More important, the recent period has been marked by a transformation to an economy that is more productive as competitive forces become increasingly intense and new technologies raise the efficiency of our businesses. With the rapid adoption of information technology, the share of output that is conceptual rather than physical continues to grow. While these tendencies were no doubt in train in the "old," pre-1990s economy, they accelerated over the past decade as a number of technologies with their roots in the cumulative innovations of the past half-century began to yield dramatic economic returns.5

Virtually to a person, these experts caution that the data still are sketchy, making conclusions tentative. Five years of productivity numbers are not much to go on, for example. A critical test of the theory will come once unemployment stops falling, as arithmetic suggests it must eventually. Still more important will be the next recession, which is viewed as inevitable. The New Economy paradigm implies that the downturn and accompanying rise in joblessness might be less painful than they would have been in the days of the Old Economy, but absent the actual experience, no one knows for sure.


What Caused The New Economy?

Confirming the existence of the New Economy is one thing. Determining how it came about is another. As might be expected, many claims to parentage of the New Economy have been made, some of which fly in the face of the productivity slowdown that extended from the mid-1970s through the early 1990s.

One theory, which has appeared repeatedly in the editorial pages of The Wall Street Journal, is that the origins of the New Economy go back to the administration of Ronald Reagan (1981-1989). In this view, the tax and regulatory policies put in place at the time bore fruit after a six-year incubation period. In support of this argument, the paper's editorial writers point out that the 1990-91 recession was unusually mild. In their thinking, its severity may have been reduced by the initial impact of the "Reagan revolution."

This reasoning, however, oversimplifies Reagan-era policies. Deregulation of the U.S. economy actually started at least five years before Mr. Reagan took office and continued in each successive administration. Moreover, the tax policies initiated by Mr. Reagan were partly reversed during his term in office and were further dismantled by subsequent administrations.

In fact, it is easier to make the case that the New Economy resulted more from the near obliteration of the Reagan White House's tax policies than from an extremely delayed response to their introduction. This assertion takes account of the fact that policy reversals not only began during Mr. Reagan's two terms but also have continued.

Globalization of the U.S. economy is another explanation sometimes offered. Economists like this argument because it dovetails with their belief that trade results in a more efficient use of resources, leading to higher levels of GDP over time. In the early 1990s, the United States entered into two important arrangements that produced greater internationalization: the North American Free Trade Agreement and the pact that resulted from the Uruguay Round of multilateral trade negotiations. Certainly, though, the two agreements, which were phased in starting in 1994 and 1995, respectively, had had little effect when the pickup in noncyclical productivity growth seemed to begin at mid-decade. Moreover, even the strongest advocates of liberalized trade estimate that the impact of these accords is less than the apparent increase in long-term GDP growth in the United States.

With many of these and other explanations found wanting, most analysts of the New Economy assign technology a big role. Of course, technical change is nothing new in economic advancement, but its impact has been particularly great in recent years, perhaps especially among those who communicate their ideas in writing. For instance, less than 20 years ago, virtually all Americans in professional positions generally either wrote articles, memos and other forms of communication in longhand or used a typewriter if they lacked a secretary. Today, not only are they able to use for this purpose computers at work, at home or on the beach, they can send their output around the world instantly without paying a per-message fee. Moreover, professionals can use the same computer to obtain research information, data, feedback and gossip far more easily than was possible even five years ago.

This revolution in white-collar office work may have gotten the attention of analysts, who are, after all, mainly writers, in ways perhaps that factory automation has not and led to a biased view of technological change. However, the changes on the shop floor also are dramatic. The same Internet that makes paperwork so different today has the potential to revolutionize inventory control, production schedules and business-to-business commerce generally.

Yet the question persists: Why are the results just becoming evident now? Well over a decade ago, Nobel laureate and productivity pioneer Robert Solow of MIT was attributed with saying that "[w]e see computers everywhere but in the productivity statistics." Indeed, although their arrival on virtually every desktop is fairly recent, computers have been around for years and logically should have been contributing to increased productivity in the 1980s, when, instead, the growth in output per person slowed.

This question has led many experts to pay renewed attention to a 1990 paper by Stanford University economist Paul A. David.6 He noted that the impact of earlier innovations — most notably, the electric dynamo in the initial years of the 20th century — was spread over several decades. Although the electric dynamo was enough of an advance to be widely adopted early on, the real benefits to productivity came from the secondary effects of having dynamos in place. For starters, factories could be built more cheaply once the original belt and shaft equipment no longer was in use, but this improvement might be delayed for decades as engineers who saw the technical possibilities did battle with cost accountants who (correctly) did not anticipate gains to the bottom line as long as the older machinery remained serviceable.

Mr. David pinpointed at least two important parallels between the electric dynamo and the computer. As he put it:

[E]ach forms the nodal elements of physically distributed (transmission) networks. Both occupy key positions in a web of strongly complementary technical relationships that give rise to "network externality" effects of various kinds and so make issues of compatibility standardization important for business strategy and public policy.7

Externalities imply that the diffusion of technology is hindered because early adopters are not adequately compensated for the benefits they create by, for example, adding to the size of the network. Mr. David wrote at a time when the Internet still was in its public infancy, yet his arguments seem particularly applicable to that innovation.

As if echoing Mr. David, a recent Organization for Economic Cooperation and Development study noted that:

The Internet has also been at the heart of a further deepening of ICT [information and communications technology] investment, by making possible a sharp increase in the quality and functionality of existing ICT equipment. It creates an environment that substantially lowers the entry barriers for electronic commerce, in part because it adheres to non-proprietary standards based on the existing communications infrastructure. The low cost of connecting to the Internet and its independence from specific equipment or operating systems mitigates the opportunity costs of being locked in to a particular technology and reduces the "switching costs" that accompanied the adoption of earlier forms of e-commerce.8

Mr. David's work and the OECD statement suggest that because of its design, the Internet may be contributing importantly to productivity gains.

Those who have decomposed the increases in multifactor and labor productivity have found, in contrast to Mr. Solow's earlier observation, that the role of computers is important. Research to be published this year9 suggests several conclusions about U.S. productivity growth in the late 1990s:

  • Technical advances in computer production have boosted productivity overall simply because the industry is a key part of the economy.
  • These productivity hikes have led to increasingly cheaper computers, creating more widespread diffusion. The resultant deepening of capital (more capital per unit of labor) has boosted both labor and multifactor productivity in other durable goods industries.
  • Other industries have benefited from capital-deepening and the gain in labor productivity that stems from lower computer prices and wider computer usage. Experts disagree, however, as to whether multifactor productivity has risen or fallen in those industries. As in the past, experts also are sharply divided about the extent of productivity gains in services industries — banking, for one — that long have been important users of computers.
  • Opinion differs, too, on whether the Internet will take its place beside the undeniably great inventions of the past century or so. Some experts believe that it represents mostly a better way of doing things that already were possible, such as purchasing airline tickets. In this view, the convenience of being able to buy a plane ticket on-line is nothing compared with the invention of the airplane itself or even the proliferation of jets. Others argue that the Internet has or will lead to sweeping organizational changes, which, from the standpoint of economic efficiency, mostly will be of a beneficial nature.


The Situation In Japan

By all accounts, these trends are much less apparent in Japan. Labor productivity, at least in manufacturing, grew faster in Japan than in the United States up to 1990 or thereabouts, after which it generally declined or stagnated along with the economy (see Figure 3). Recent Japanese data clearly are dominated by the business cycle, which alternated between sharp declines and generally weak recoveries from 1991 through the first six months of 2000.

This grim history suggests that the question regarding the New Economy and Japan is different from the one that American policymakers and researchers have addressed. The issue is not whether productivity growth has picked up — it has not — but whether such a development could be part of the solution to Japan's chronic economic difficulties. It probably will be, although the process will involve enough pain along the way that decisionmakers and other influentials may try to sabotage it.

The fact that Americans and Japanese even are asking such questions is itself revealing. Democratic presidential candidate Al Gore long has had the reputation of a champion of the Internet, if not its biggest public booster. As a University of Tokyo professor recently pointed out, part of the impetus for Mr. Gore as a senator and then as vice president to push the construction of an "information superhighway" to link schools and hospitals was a reaction to a 1990 Nippon Telegraph and Telephone Corp. announcement that it would build a nationwide fiber-optic network in Japan by 2015.10

A decade ago, many Americans certainly held the view that the Japanese would wield their technology — already believed to be superior to that of the United States — to their competitive advantage. More generally, Japan was judged at that time to have avoided the productivity slowdown said to have afflicted the United States since the mid-1970s.

The subsequent decade destroyed both perceptions completely, in part because the original view regarding Japan's technological superiority now is seen as having been an exaggeration and also because the Japanese economy has performed so badly since 1990. Whether productivity has risen slowly because GDP growth has been weak or vice versa can be debated, but most of Japan's economic problems have little to do with technology.11 The banking crisis of the late 1990s, for example, stemmed more from regulatory changes and weak oversight than from outmoded technology. Even in this industry, however, American conventional wisdom has moved over 10 years from the belief that Japanese banks bested their American counterparts in technology and management to the view that Japanese financial institutions of all types are hopelessly backward in these respects.

Many problems said to have caused Japan's stunted economic performance also slowed productivity growth. For instance, to the extent that companies failed to maximize the rate of return on investments, they wasted capital. Over time, that practice weakened the banks from which firms borrowed, contributing to the banking crisis and to lower productivity gains because what lending did occur was done for the wrong purposes. Moreover, the result — a credit crunch that led to less lending — not only limited economic output by curbing aggregate demand, but it also slowed the installation of equipment that might have laid the groundwork for faster productivity growth. Even in the absence of a credit crunch, corporate Japan would have been reluctant to adopt risky, forward-looking technologies in the face of weak overall demand.

These factors just scratch the surface in terms of the stated reasons for Japan's poor productivity record in the 1990s. For example, its labor force probably is less flexible than the U.S. one (but not compared to those of most European countries). While Japan's venture capital market has grown, it is still tiny next to America's and is dominated by conservative institutions. Japan's educational system is said to emphasize rote learning to the exclusion of more creative ways of thinking.12 These three conditions alone could be enough to dampen the ability of dot-com start-ups and other Internet-related entrepreneurial businesses to attract capital and workers of the right type.

These supply-side constraints are bad enough, but a shortage of demand at current prices may be another problem. Some new technologies simply are too costly in Japan, in part because of regulation. Adjusted for purchasing power parities, Internet access at peak times in 1999 was calculated by the OECD to be 46.5 percent more expensive in Japan than in the United States and 73.7 percent higher than in Canada, although it was cheaper than in France, Germany, Italy and the United Kingdom.13 Observers on both sides of the Pacific have long complained about the high fees charged other carriers to connect to NTT's local networks (see JEI Report No. 28B, July 21, 2000), one of the reasons for Japan's steep Internet costs.

Access fees appear to be a critical determinant of how widespread Internet use is. Another OECD study found a very strong relationship between the cost of Internet access and the number of companies per capita hosting Web sites. The only exceptions appeared to be very rich or very poor countries. This comparison put Finland first and Hungary last in terms of inexpensive Internet access in a survey of 30 countries. Finland was second only to the United States, a richer country, in the per capita number of Internet hosts, while relatively poor Turkey and Mexico had fewer hosts per capita despite lower fees than Hungary. Japan ranked 17th both in price and in usage. In other words, cost and income together explained the number of Internet hosts almost perfectly.14

For decades, Japanese sociologists have emphasized the importance of cultivating personal alliances and face-to-face contacts in the nation's corporate world. Similarly, American executives long have complained about the many hours required to get a business relationship off the ground in Japan. These cultural preferences may have slowed the adoption of such innovations as e-mail, which may substitute for direct dealings.

The existence of keiretsu (corporate groupings) in Japan raises similar issues. Although the situation is in flux, most observers believe that firms have at least a weak preference to buy or sell to other members of their group.15 To the extent that these tendencies are immutable, then the speed permitted by on-line business-to-business dealings and e-mail is wasted and such tools are not likely to be embraced. Conversely, the Internet could speed the demise of keiretsu.

Of course, all cultures resist change, but Japan may be extreme in this regard, at least in the business community. Its executives are older than their American counterparts and are more likely to be saddled with a certain insularity bred by having spent their working lives with one firm. Conversely, the "baby bust" that began in the 1970s has dramatically reduced the ranks of young workers and will continue to do so for at least another 20 years.16 Finally, Japan has few foreign-born, foreign-educated or ethnic minorities. (Japanese Internet pioneer Masayoshi Son — who was born of Korean parents in Japan and received an undergraduate degree from the University of California at Berkeley before leading Softbank Corp. to prominence in the on-line world at home as company president — is the exception that proves the rule.) Not a few analysts, including experts at the OECD, have pointed to America's openness to expatriates as one key to its successful development of high technology industries.17

Whatever the reality 10 years ago and regardless of the reason, experts agree that Japan has slipped badly in the adoption of some cutting-edge technologies. Not only is the extent of Internet proliferation much less in Japan than in the United States, it also is by certain accounts not as high as in some other Asian countries, most of which have the smaller per capita incomes that normally would be predictive of lower usage.18 Mr. Son has pointed out that Japan has 20 million on-line users, while South Korea has 16 million, giving that nation a much higher rate of diffusion.19 Japan's neighbor has less than half its population and slightly more than half its per capita income on a purchasing power parity basis. Most experts, Softbank's president included, put Japan about three years behind the United States in terms of Internet use.

Mr. Son is among those who argue that the United States is widening its lead over Japan. The OECD would appear to agree. It notes that the number of secure servers in the United States doubled between February 1999 and March 2000, roughly three times faster than what happened in Japan. The European Union's roughly 60 percent rate of growth was greater than Japan's but less than this country's.20


What Can Japan Do?

If one thing is obvious from even a perusal of the Japanese press, it is that opinion leaders know that information technology is a problem for Japan's economy. Not for nothing was IT the theme of the summit of the leaders of the Group of Seven industrial nations plus Russia that Tokyo hosted on Okinawa in July.

Can Japan ever catch up to the United States? Of course it can — if it learns from the errors of the past. The first such mistake is the reluctance to do what it takes to get the macroeconomy moving again. Absent expanding markets and the prospect of profits, businesses will not invest in new technologies or anything else, even when equipment wears out. Sufficiently fast growth will lead firms to install new capacity that incorporates state-of-the-art technologies top to bottom and pushes productivity ahead faster.

Many Japanese experts have noted that business spending on communications equipment and computers has been a powerful macroeconomic factor in the United States in recent years. According to the latest Economic Report of the President, such outlays accounted for between 21 percent and 31 percent of the increase in American GDP between 1995 and 1998.21 This implies that corporate investment in communications equipment and computers boosted aggregate output by at least 1 point in both 1997 and 1998.

To date, capital spending on communications hardware and computers has been a much-less-powerful factor in Japan's economy. In 1996, when GDP surged 4.4 percent in real terms, such expenditures may have accounted for 1.1 point — or one-quarter — of that growth, but in the years since, their contribution has been no more than half as large.

Although most analysts believe that Japanese companies still have excess capacity — something that would appear to limit the potential for significant increases in capital spending — the reality might be quite different.22 In many cases, the excess capacity dates to the "bubble" period that ended 10 years ago, making much of the installed plant and equipment uneconomic and a prime candidate for the scrap heap. In this case, the rate of return on additional cutting-edge equipment could be high, inducing corporate investment in it and thereby contributing significantly to the growth of aggregate demand.

Second, Tokyo needs to commit to full-throttled deregulation in traditional industries, a policy proposal that predates the spread of the Internet. Regulatory reform would have major benefits even without the prospect of a New Economy. For starters, it could bring Japan up to the U.S. productivity level in 1995 before output per person surged here. This accomplishment alone would mean the difference between a projected shrinkage of GDP over the next 20 years and modest expansion. If all Japan did was deregulate, its productivity growth rate might exceed that of the United States, which, after all, has no catching up with itself to do.

The third component of a catch-up plan for Japan involves active encouragement of IT activities. If, as Mr. David and others have argued, network effects determine efficiencies, then support from Tokyo for the development of communications and computer networks is appropriate. However, the thrust of such policies would differ from the big, government-backed computer projects of the 1970s and 1980s, which may have led Japanese industry into some technological dead ends.

The envisioned programs would be modest in scope, like tackling such seemingly mundane issues as the elimination of the per-minute cost of telephone calls during an Internet connection, as has been done in the United States. This initiative may appear irrational, but it actually reflects the low incremental cost of establishing a connection as well as the positive externality created by the network. Another change would be restructuring Japan's 5 percent consumption tax, which, in contrast to analogous state sales taxes in the United States, is assessed on business-to-consumer e-commerce. Such a move would encourage Internet use and possibly the growth of the business-to-business e-commerce that, according to some experts, will be the biggest payoff from the Internet.

One lesson from the American experience is that a considerable portion of labor productivity growth occurs as firms invest increased amounts in computers in response to their steadily falling prices. Such an effect could be even more important in Japan because boosting worker productivity will be critical in coming decades as the labor force shrinks. The U.S. example implies that strategies favoring domestic suppliers could be counterproductive because they would reduce the overall use of computers.

If Tokyo makes the right moves and avoids potential pitfalls, the results could be amazing. Japan could reap unusually large gains to the extent that it suffers uniquely high inefficiencies. For one thing, many experts consider Japan's distribution costs high by international standards. B2B e-commerce reduces these costs through a wider search for competitive suppliers, more effective inventory management and the like. In some cases, the burden of regulation can be reduced. U.S. dairy producers and users recently set up a B2B Web site precisely because the combination of a perishable product (milk) and regulated prices rendered distribution difficult. In effect, the B2B venture will substitute for the price mechanism in signaling shortages and surpluses in a timely manner. Japanese firms should have many similar opportunities.

B2B transactions in cyberspace raise the possibility that the important economic role of Mitsubishi Corp. and Japan's other big trading companies might diminish. These firms, which act as business go-betweens, presumably exist because they serve some useful function. Their absence, with few exceptions, in other countries despite markets that would permit their evolution suggests that trading companies meet needs that are almost unique to Japan. If B2B e-commerce proves superior to what trading companies offer in the way of facilitating business, it might reasonably be concluded that the potential gains from trading in cyberspace are greater for Japan than for other nations.

Experts debate the extent to which Japanese markets are closed to outsiders.23 E-commerce would seem an ideal mechanism for both businesses and consumers eager to get the best deal to go directly to foreign suppliers without the latter having to make the significant investment required for a bricks-and-mortar presence. Indeed, Recreational Equipment, Inc., the Seattle outdoor equipment retailer that recently opened its first outlet in Japan, reported in August that sales from its Japanese Web site were expanding by an incredible 50 percent a month.

Some evidence points to barriers even in e-commerce, however. Many Japanese consumers are averse to using credit cards, which have facilitated business-to-consumer e-commerce elsewhere, in part because credit-card expenses for buyers and sellers are much steeper in Japan than in other industrialized countries. For whatever reason, the Ministry of International Trade and Industry found that in the year through March 31, 2000, goods prices on the Web were 46 percent higher for Japanese consumers than for their American counterparts. Little wonder, then, that, although Japan's economy in 1999 was roughly half as large as America's, its B2C on-line transactions were only 6 percent as big.

Over time, the appeal of the Internet could force the elimination of noncompetitive practices in Japan. For example, an on-line merchant's potential rivals are almost unlimited in number, implying that competition is far more likely to drive margins to the minimum on the Web than on Main Street. Moreover, in some instances, Web merchants or B2B e-commerce relationships might slip through a regulatory loophole. If cyberspace vendors gain an advantage vis-a-vis sellers that must comply with rules of one sort or another, then the latter may be able to persuasively argue for relief. In other words, e-commerce might lead to deregulation in the bricks-and-mortar world, with broad benefits for the economy.

Eventually, efficiencies associated with the Internet and related communications and computer technologies could change how companies are organized and managed. Firms make decisions about what to supply, whether to outsource and how much to diversify based in part on the internal-versus-external costs of the transactions involved, all of which are affected by the new technologies. Even if a firm typically produced a component in-house because it was less expensive to do so, the existence of B2B Web sites could change that. A large firm that long has profited from its ability to offer customers a full line of products could see that advantage disappear as buyers become able to do business inexpensively with a large number of vendors electronically. Businesses that have no other advantages and that are — as is typical of diversified corporations — inherently uncompetitive in some lines could be forced by the new technologies to focus on a few core competencies.

While such changes are underway in all countries, they might be especially important in Japan. Observers long have noted, for example, that Japanese electronics manufacturers, if not the nation's automotive makers, are more diversified than their American and European counterparts.24 Moreover, established companies in Japan are most likely to dominate new market segments, as they did personal computers in the 1980s and early 1990s, while start-ups have fared far better in this country.25

If business patterns in Japan are the result of high transaction costs that not only create advantages for big, mainstream firms but that also offset their slow response times and other bureaucratic handicaps, then the new technologies could change the face of corporate Japan as smaller, more focused firms gain competitiveness. In certain market segments, however, economies of scale could become more important, creating a countervailing tendency. In any event, the proposed changes would represent movements toward greater efficiency. Replicated on a national scale, they would lead to increased potential output.

In short, the move to cyberspace and the wider use of related technologies could have an enormous impact in Japan both directly and indirectly by changing the way business is done, even for those who have never touched a computer. Yet the potential effects should not be overestimated. For one thing, those companies disadvantaged by the new technologies will fight them. Diversified manufacturers, for example, have been accused for years of forcing customers to buy their full line of products even when other suppliers, some of them foreign, are highly competitive in specific segments. The Web will create more such situations, sometimes with the same unfortunate results. Other companies, faced with a loss of business, will look to their allies in government for a helping hand, possibly slowing the diffusion of the new technologies.

Even if Japan enthusiastically embraces the Web and all the other new or emerging technologies, it will not return to the rapid growth of the early 1970s or even to the slower rise in GDP that occurred in the 1980s. A shrinking labor force increasingly will depress potential economic expansion. Even in the United States, the benefits of the New Economy mean perhaps an extra point of growth a year.

Despite these caveats, the next 10 years are likely to be much better for Japan than the past decade. The nation would benefit enormously if it merely were to attain the 1995 level of U.S. productivity and much more if it could hitch itself to the New Economy. The coming shrinkage of the labor force could be minimized by greater participation by women or by older workers.

Figure 4 sorts out the factors likely to be decisive in Japan's long-term economic prospects. The shrinking labor force and the difficulty of eking out productivity gains under existing arrangements will create unprecedented challenges in coming years. Actual and future GDP growth as projected by the Japan Economic Research Center, a well-respected Tokyo forecaster, shows a steady slowdown that becomes a contraction later in this decade under a business-as-usual scenario. However, merely catching up over a 25-year period to the 1995 level of U.S. productivity in those industries, mostly services, in which Japan lags would be enough to keep the world's second-largest economy expanding throughout this time. Movement to a New Economy, in which the gains beginning this year are as great as they have been in the United States, would boost potential growth close to 3 percent annually, although demographic factors still would exert downward pressure on the economy's performance.

Cynics would say that Tokyo never will make the hard choices that would put the economy on its theoretical expansion path. They might be right. Certainly, the slow pace of deregulation during the 1990s is not encouraging. However, the New Economy American-style, which Tokyo has put under a microscope as much as Washington has, provides a road map for the government and, in turn, a way to avoid what otherwise would be economic stagnation at best. If the public sector clears the way, corporate Japan can proceed quickly, as outlined above. If policymakers resist, the economy still will be restructured but more slowly, goaded in that direction by consumers, business buyers eager to make money and rivals trying to avoid a competitive disadvantage.

Even the possibility of a modest improvement in productivity growth in Japan is welcome news, not just for it but for the global economy as well. Obviously, a more prosperous Japan means a bigger market for American and other foreign companies, but the stakes are much higher than that. In the long run, nations profit from sharing expertise. In this case, Japan will borrow technologies developed elsewhere. These will provide both it and its trading partners direct benefits, some in the form of better goods and services and others via improvements that become available abroad.

For more than 100 years, Japan repeatedly has gone down this road with the United States, with benefits — not always appreciated — for both sides. In the past two decades, for example, American firms have gained from corporate Japan's just-in-time inventory methods. With the development of the New Economy, the United States somewhat unexpectedly blazed yet another new roadway. Even Japan's halfhearted conversion to this economic model would be better than its current standpat strategy. More importantly, Japan's economic performance in coming decades would exceed what was expected just a few years ago.

Jason Russell provided research assistance.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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1aa Department of Labor, Bureau of Labor Statistics, "Multifactor productivity in the business sector." Available at Return to Text

2aa Paul Krugman, "The American Economy: Beautiful or Boastful?" Foreign Affairs, May/June 1998, p. 40. Return to Text

3aa Paul Krugman, "Can America Stay on Top?" Journal of Economic Perspectives, Winter 2000, p. 170. Return to Text

4aa Steve Liesman, "Further Gains in Productivity Are Predicted," The Wall Street Journal, August 1, 2000, pp. A2 and A6. See also "Productivity on Stilts," The Economist, June 10, 2000, p. 86, and additional information relating to that article available at http:// Return to Text

5aa Remarks by Alan Greenspan, Federal Reserve Board, "Structural Change in the New Economy," before the 92nd Annual Meeting, National Governors' Association, State College, Pennsylvania, July 11, 2000. Available at speeches/2000/20000711.htm. Return to Text

6aa Paul A. David, "The Dynamo and the Computer: A Historical Perspective on the Modern Productivity Paradox," American Economic Review: Papers and Proceedings of the Hundred and Second Annual Meeting of the American Economic Association, May 1990, pp. 355-361. Return to Text

7aa Ibid., p. 356. Return to Text

8aa Organization for Economic Cooperation and Development, "A New Economy? The Changing Role of Innovation and Information Technology in Growth: Executive Summary," p. 8. Available at http://www. PDF. Return to Text

9aa See, among others, Robert J. Gordon, Does the "New Economy" Measure up to the Great Inventions of the Past? (Working Paper W7833) (Cambridge, Massachusetts: National Bureau of Economic Research, August 2000). Available at pdf. Return to Text

10aa Kasunori Ishiguro, "Hikari-fuaiba-mo Seibi Isoke (The urgency of setting up a fiber-optic network)," Nihon Keizai Shimbun (American edition), July 30, 2000, p. 14. According to Mr. Ishiguro, the network, to be known as the Visual Intelligent and Personal Communications Service, has not been "adequately implemented." Return to Text

11aa See Arthur J. Alexander, "What Happened To Japan's Economy In The 1990s?" JEI Report No. 27A, July 14, 2000. Return to Text

12aa In a recent interview, Masayoshi Son, head of Softbank Corp. and arguably Japan's most visible symbol of the New Economy, described the creative problem as one of young Japanese having to learn to use both the left and the right sides of their brain. See Masayoshi Son, "Kisei Kanwa-no Jikko (Only Through Actually Relaxing Regulations)," Nihon Keizai Shimbun (American edition), July 9, 2000, p. 18. Return to Text

13aa Cited by Council of Economic Advisers, Economic Report of the President (Washington, D.C.: Government Printing Office, 2000), p. 111. Return to Text

14aa Organization for Economic Cooperation and Development, Is There a New Economy?: First Report on the OECD Growth Project (Paris: 2000), p. 17. Available at Return to Text

15aa Douglas Ostrom, "The Keiretsu System: Cracking Or Crumbling?" JEI Report No. 14A, April 7, 2000. Return to Text

16aa Douglas Ostrom, "Babies Grow Up: The Changing Demographics Of The Japanese Labor Force," JEI Report No. 32A, August 23, 1996. Return to Text

17aa OECD ("A New Economy?"), op. cit., p. 4. Return to Text

18aa See Marc Castellano, "Japan: Leading Or Following Asia Into The Information Age," JEI Report No. 30A, August 4, 2000, especially p. 7. Return to Text

19aa Nihon Keizai Shimbun (July 9, 2000), op. cit. Return to Text

20aa OECD ("A New Economy?"), op. cit., p.  8. Return to Text

21aa Council of Economic Advisers, op. cit., pp. 104-105. Return to Text

22aa Dai-Ichi Kangyo Research Institute recently estimated excess capacity at ¥50 trillion ($454.5 billion at ¥110=$1.00). See "Stock Adjustment and IT-Related Demand Spur Capital Investments," DKR Economic Report, April 15, 2000, p. 8. Return to Text

23aa See Douglas Ostrom, "Japan's Imports In The 1990s: The Impact Of Recession And The Asian Crisis," JEI Report No. 37A, October 2, 1998, especially pp. 4-6. Return to Text

24aa U.S. Congress, Office of Technology Assessment, International Competitiveness in Electronics (Washington, D.C.: Government Printing Office, 1983), pp. 154 and 158. Return to Text

25aa Douglas Ostrom, "The Search For New Corporate Superstars: Japanese Firm Mobility In The 1990s," JEI Report No. 12A, March 26, 1999, especially pp. 4-5. Return to Text

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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