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Friday, October 01, 2004

Allowing Failure

    Posted by Adam Crouch

The Economist has a lengthy feature on one of the big things holding back Japan's recovery: a distinct lack of failure.

That's right, a lack of failure. A key insight of Economics is that in order to facilitate success, you have to allow failure. If people/firms do not have to pay the consequences for their actions, they won't have the proper incentives to behave as they should. They will continue their destructive behavior, and drag others down with them. The result is that resources that could be used in a productive manner are instead used to sate the inefficiency addiction.

An excellent example of this phenomenon is Japan's banking sector:
For more than a decade after a financial crisis in 1989 plunged once-booming Japan into a long period of slow growth, weak companies and wobbly banks clung to each other in mutual defiance of reality. Troubled borrowers needed the banks to overlook their problems and keep open the flow of money; the banks, too short of capital to admit that their loans had soured, obliged. Over time, this led to the emergence of so-called "zombie" companies that are competitively dead, but, sustained by their banks, continue to walk the Earth and give healthier firms nightmares. And zombies are most prevalent in the service sectors of the economy, especially construction, property and wholesale and retail distribution.
It is hard to think of a single non-manufacturing sector in which Japan excels. High domestic transport costs hinder distribution, travel and tourism. A lack of competition in energy and telecoms keeps business costs high. Professional services, such as law and accountancy, remain hidebound. Health care, a crucial sector for a country that is ageing rapidly, has shamefully low levels of productivity by international standards. Consumers of many basic services, from finance to fitness, routinely encounter inefficiency and inconvenience. Above all, says Richard Jerram of Macquarie Securities, Japan conspicuously lacks "that American feeling that if you don't want to do it yourself, you can pay somebody to do it for you."
In retailing, property, construction and other zombie-laden sectors, it is the losers that have held the upper hand, forcing the winners to follow their lead. Recent research by Alan Ahearne of America's Federal Reserve and Naoki Shinada of the Development Bank of Japan found that productivity growth in the 1990s was exceptionally low in sectors that had lots of firms with non-performing loans. Even more damagingly, resources consistently flowed in the wrong direction within those sectors, with the least efficient firms gaining market share at the expense of healthier ones.

Research by Anil Kashyap of the University of Chicago's business school and others suggests that misdirected investment is the main culprit. In one poor-performing sector after another, the firms with the most bad loans increased their investments at the expense of healthier competitors. The zombies' twisted relationship with Japan's broken banks is clearly at the centre of this problem. Mr Kashyap shrewdly likens competing with zombies to trying to make money in a sector dominated by state-run firms. The zombies have been propped up by banks that were in turn given unjustified leeway by accommodating regulators. The bill will one day land on taxpayers' doorsteps.

And here's the ultimate irony:

Such distorted competition has hurt Japan's service sectors in countless ways. Perhaps most important, the tendency to prop up weak firms has held back investments in information technology, one of the best ways in which service firms can boost productivity (see chart 1). Some of the most successful retailers in Japan over the past few years have been convenience-store operators such as Seven-Eleven Japan (owned by Ito-Yokado) and Lawsons, which make far better use of IT than the country's supermarkets and department stores. Last year Wal-Mart took a stake in Seiyu, another troubled retailer, since when it has invested heavily in IT. Around 130 of Seiyu's 400 stores now have advanced inventory and point-of-sale tracking systems. Employees no longer have to run to the back room to print out lists of goods that are in stock.

That's right... this problem is so bad, it was has managed to hold back Japanese companies from investing in technology. The Japanese, of all people.

The idea that enabling failure is necessary to enable success has wide-ranging implications. From education to labor laws regarding firing to tariffs and subsidies to "protect" particular companies/industries.

Notice any parallels between the Japanese service sector and the American airline industry?

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