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[edit] Chapter 7: The Big-Firm Wealthy Economies: Preventing Retreat or Stagnation

In 1979, Ezra Vogel, a professor at the Harvard Business School, published a highly acclaimed book, Japan as Number One. The book, and its compelling title, seemed to capture the fears of the country during the traumatic decades of the 1970s and 1980s, which were punctuated with the deepest U.S. recessions of the postwar era, followed by a recovery accompanied by (then) historically large federal budget and trade deficits, both in absolute terms and relative to GDP. A good portion of the U.S. trade deficit was with Japan, whose companies and their owners used their export earnings to invest in new manufacturing plants in the United States and, in some cases, to buy “trophy” real estate, such as the Pebble Beach Golf Course and Rockefeller Center in New York. Many politicians, and many American citizens, feared that Japan would soon displace America as the leading economic power in the world.

Readers of Vogel’s book, of course, now know that these fears proved to be without foundation. A decade after the book was published, the Japanese stock market, where share prices had soared, came plummeting back to earth with a massive thud. Japanese banks, which had expanded largely on the back of the rising prices of the shares they held, lent too much money to many ill-founded projects and borrowers and eventually experienced the worst losses of any banking system on record. At one point in the 1990s, it is conceivable that had the assets and liabilities of the country’s largest banks been “marked to market,” all of them would have been insolvent in economic terms. The sluggish response of Japan’s political leaders to the banking crisis contributed to that country’s deep economic funk, which lasted for more than a decade and from which recovery is still incomplete. So shaken was the confidence of Japanese consumers and businesses that even the extraordinary fiscal and monetary stimulus applied by the Japanese government and central bank did not seem to work. Only by the time we began writing this book, in 2005, was Japan’s economy showing any signs of recovery.

After Japan fell from its economic pedestal in the late 1980s, similar fears were soon expressed in some quarters in the United States about what was projected to be the next great economic challenge: that posed by Western Europe (especially by the countries on the Continent). Lester Thurow, former dean of MIT’s Sloan School of Management, penned a best-selling book in the early 1990s, Head to Head, in which he forecast, among other things, that the Western Europe economies, fueled by the strengthening and expansion of the European Union (EU) and the likelihood (then) of a common European currency, could soon overtake the United States. In fact, the common currency, the Euro, became a reality in 2002, and the EU itself has enlarged from its initial fifteen member countries to more than twenty today, but the economic “threat” from the continental economies never materialized. Throughout the 1990s and well into the first decade of the twenty-first century, Western European economies have grown less rapidly than that of the United States, while unemployment rates have hovered near or in some cases above double digits. Throughout Western Europe one hears calls by political leaders for fundamental economic transformation aimed at catching up to the United States, though without some of the undesirable features of the U.S. economy (such as greater income inequality).

Readers of this book today, particularly those in America who by now have become accustomed to warnings about the economic threat posed by China, India, and the more advanced Southeast Asian economies (such as Singapore and Taiwan), would do well to remember that the previous alarms about both Japan and Western Europe proved to be off the mark. Furthermore, as we will discuss in our concluding chapter, although the underlying premise behind these alarms—that Americans are somehow engaged in an “economic war” with other countries—may have its political uses in accelerating the adoption of policies that are conducive to economic growth, the military analogy is fundamentally misplaced. The global economy is not a “zero-sum game” where some countries “win” and others must “lose.” The objective for any country is to do its best to improve living standards of its own citizens, and this objective can be furthered if other countries grow as well.

In fact, the economies of Japan and Western Europe have achieved remarkable success on this score, literally rising from the ashes of World War II to approach the per capita income of the world’s leading economic power, the United States. Indeed, by some measures—such as quality of life, access to health care, and amount of leisure—average standards of living in continental Europe, in particular, arguably exceed those in America.

Nonetheless, when measured in economic terms—such as output or income per capita—the economies of Japan and Western Europe (excepting Ireland and the United Kingdom) have grown more slowly in recent years than that of the United States, as shown in table 12. No longer does it appear that either economy will soon overtake the per capita income level of the United States, as Americans feared and perhaps Japanese or Europeans anticipated as recently as the 1980s or early 1990s.

Indeed, analysts from around the world, including the United States, worry about the long-term prospects for the economies of continental Europe and Japan. Both parts of the world face daunting demographic challenges, arguably more difficult than those the United States must confront in this century. The possible future stagnation of continental European and Japanese economies clearly is not in anyone’s interest. Not only have both regions historically been major contributors to global growth and purchasers of goods and services from the United States and other countries, but economic stagnation can lead to untoward political consequences. A less economically confident Europe or Japan is more likely to be protectionist, anti-American, and less likely or able to meet the requirements of future global security, environmental, health, and economic challenges.

Accordingly, a number of economists in recent years, both outside and inside Europe and Japan, have called upon European and Japanese leaders to adopt radical and immediate change to make their economies more flexible and productive, that is, to undergo the more up-to-date equivalent of the “shock therapy” that was urged upon the former Soviet republics and Eastern Europe after the fall of the Berlin Wall in 1989. Although we are broadly sympathetic with the need for major changes, we have a somewhat different perspective on their nature and the pace at which they can or should be carried out and will devote this chapter to explaining how and why. A quick preview of our argument follows.

First, the standard prescriptions for improved economic performance in both Japan and continental Europe, which look very much like the “Washington Consensus” prescriptions for developing countries, lack a central organizing principle. Precisely what kind of capitalism do the proponents of the standard prescriptions envision for these other countries? Our answer to this question, again not surprising to readers who have made it this far, is that continental Europe and Japan, as perhaps the leading exemplars of big-firm capitalism, need a healthy dose of what we have called “innovative entrepreneurship.” Although some large firms in these parts of the world have been truly innovative—Toyota in Japan or Nokia in Europe, to take two examples—the United States experience teaches that the most reliable source of radical innovation (and that is what is required to step up growth) is to be found among new, vibrant firms that do not have a vested interest in preserving their current markets. Ironically, the European and Japanese economies were built by entrepreneurs and still have many smaller firms, indeed so small in some cases (Italy being a prime example) that they are unable to take advantage of economies of scale necessary to match the low prices coming out of China and other low-cost producing nations or find it difficult to grow.^[1] Nonetheless, the industrial makeup of these economies is far more stable—and stagnant—than that of the United States where the names of companies in any list of “top” enterprises changes from decade to decade. Thus, we find it fair and useful, though admittedly convenient, to characterize the continental European and Japanese economies as leading exemplars of big-firm capitalism and to suggest that only by renewing the innovative entrepreneurial spirit that once helped build these economies can each reasonably expect to grow more rapidly in the future.

Second, and of equal importance, any reform program aimed at enhancing growth over the long run must take account of fundamental political realities in both parts of the world: that abrupt, radical change is unlikely to be embraced by the majority of voters or, even if initially embraced, is not likely, given current realities, to be maintained for a sustained period. Instead, if any reform package is to have a chance at producing an enduring and constructive impact, it probably must be incremental in nature. The model we suggest here draws on the way in which China has gradually embraced capitalism, as opposed to Russia’s sudden turn from central planning to something akin to Wild West capitalism.

[edit] The Need for Growth

In chapter 2 we made the case for economic growth, aiming largely at American readers. But the arguments we laid out there apply with equal force to all countries, their governments, and their citizens. As the output of economies grows, so do average standards of living, something that all surely want.

Figure 5. Population over Age Sixty-five as Ratio of Total Population. Source: OECD Factbook 2005: Economic, Environmental, and Social Statistics. Paris: OECD, August 2005.

Economic growth is also useful, if not essential, if countries want to make good on their costly promises to their citizens: promises to pay for their health care, their retirement, to cushion the economic pain of unemployment, and so forth. While European governments have promised their citizens more protection than those of most other countries, including Japan, these two parts of the world share a common demographic challenge—population aging—that will be far easier to meet with faster growing economies. Figure 5 should make this clear. As recently as 1995, the share of the population represented by those over sixty-five was pretty much the same—roughly within two percentage points of 15 percent—in Western Europe, Japan, and the United States. By 2005, however, the share of the elderly in Japan had soared to 20 percent, while the share in the United States remained flat at 13 percent. By 2020, all rich countries will have aged to the point where the share of the elderly will be approaching 30 percent in Japan, 20–25 percent in Western Europe, and 17 percent in the United States. By 2030, it is predicted that there will be only one worker for every retiree in Italy, and a ratio of 1.3 workers to each retiree in Germany (Baily and Kirkegaard, 2005, 16). Feeding, clothing, and caring for retirees will therefore require a very large and increasing share of what employed persons produce in total.

Population aging in these societies will have certain unavoidable implications. As the share of the population over sixty-five increases, the ratio of those working to those not working—and receiving pension and health care benefits in retirement—will steadily fall. Only if workers become increasingly productive, that is, only if economic output per employed person grows, will workers experience the rising living standards their parents enjoyed, unless of course retirement benefits are cut, which is highly unlikely as elderly citizens comprise an ever larger share of voting publics. More than generational warfare is at stake. If wages do not continue to rise, then those most able to leave—those with the skills necessary to prosper in an increasingly global and technological economy—will do so, making it more difficult for the economies they leave to support aging populations. Indeed, many of continental Europe’s “best and brightest” have already crossed the English Channel to work in the more thriving economies of Great Britain and Ireland, or the Atlantic Ocean to reach the United States (to the extent they are able to do so given the more restrictive immigration policies pursued since the September 11 terrorist attacks).^[2]

In principle, Japan and Western Europe would find it much easier to manage their aging challenge if they adopted substantially more liberal immigration policies, but this, too, is highly unlikely. Japan has a long history of not accepting immigrants, and for cultural reasons it is not likely to change course despite the growing fiscal pressures implied by its rapidly aging population. Meanwhile, many European countries already face considerable difficulties in absorbing their existing immigrant populations, which, as shown in table 13, are substantial in a number of nations, and which in some countries constitute a greater share of the populations than is the case in the United States, which is widely known for its welcoming attitude toward immigrants. But as the 2005 riots among Islamic immigrants living in France and the ongoing tensions between the native and immigrant Islamic populations in historically tolerant Netherlands illustrate, many European countries have had a hard time fully accepting into the economic, political mainstreams of their societies immigrants who are often less skilled and hold different religious beliefs. As a result, immigrants typically suffer much higher unemployment rates and earn lower wages than natives, who already have their own substantial unemployment problems (Great Britain and Ireland excepted).

For these reasons, therefore, neither Japan nor the European countries are likely to be able to reduce significantly the financial burdens of their aging populations by accepting more immigrants. Both regions must find a way to grow more rapidly in the years ahead or else face wrenching generational warfare over the generosity of retirement benefits. In some ways, this challenge will be more difficult for the countries to meet at this time than following World War II, when both parts of the world were flat on their backs and citizens worked hard simply to survive. Furthermore, the nations then were too poor to support a broad economic safety net—for those no longer working or those still in the labor force who were looking for work. Today, however, residents of both Western Europe and Japan are largely comfortable economically—at least the healthy majority who have jobs—and they perceive no immediate crisis, even though many of their children cannot locate suitable employment. The central question both parts of the world face is how soon their citizenry will wake up and realize the magnitude of the economic challenge before them and whether, when they do, a crisis already will be at hand.

[edit] Entrepreneurship and the Transformation toward Big-Firm Capitalism

One of our central themes in this chapter is that both the countries of continental Europe and Japan have drifted too far in the direction of what we call “big-firm” capitalism and are now sorely in need of the kind of innovative entrepreneurship that has sparked a reawakening of their European cousins across the English Channel and the remarkable resurgence over the past decade in productivity growth in the United States. But the capitalisms of both regions of the world were not always so dominated by large firms. In the nineteenth century and into the early twentieth century, the companies that are now synonymous with big-firm capitalism—Daimler Benz in Germany, Fiat in Italy, Toyota and Mitsubishi in Japan, to name just a few—were, after all, started by entrepreneurs.

And it is not just the entrepreneurs who championed entrepreneurship. Intellectual leaders, at least in Europe, also praised the virtues of individualism and enterprise, thereby providing important role models for entrepreneurial thought in the United States. For example, as Edmund Phelps has pointed out, as early as the eighteenth century, the French economist Jean-Baptiste Say (the father of “Say’s law,” that “supply creates its own demand”) extolled the importance of entrepreneurs in constantly reinventing economies. Similar, and perhaps even better known, are the writings of British political economist Adam Smith, who first explained how supposedly self-interested businessmen, actually entrepreneurs in his day, were forced by market pressures to serve the broader social interest by focusing on what they did best.

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. (emphasis added) (Smith, 1976, 351)

Despite this thought leadership, both Europe (including Great Britain) and Japan moved away from their entrepreneurial roots toward a very different sort of capitalism, one that focused on not only preserving large firms, but also actively promoting them through various forms of state guidance: subsidies, implicit or explicit directions to banks to support particular enterprises, and other kinds of state assistance (although there has been an active debate among academics for some time over the importance of these measures for growth). In Japan, this big-firm capitalism took the form of zaibatsus, or financial-industrial conglomerates, in which the countries’ largest banks both loaned money to and invested in the equity of that country’s emerging large enterprises. In Europe, too, banks took equity positions in large borrowers, but neither the firms nor the banks called all the shots. As Columbia University’s Edmund Phelps has explained, a “corporatist” economic model evolved in the early decades of the twentieth century in continental Europe, South America, and East Asia, one in which property may have been privately owned but the fundamental decisions about how national savings were to be allocated were made by social consensus—including firms, labor unions, banks, and, we would add, government. (Phelps, 2006). This corporatist model was (and is) similar to the iron triangle of “big firms, big labor, and big government,” minus the banks, so well described for the United States in the first two decades following World War II by the late John Kenneth Galbraith in his then-best-selling work The New Industrial State (a description that no longer fits the U.S. economy, as we have argued at various points in this book).

The corporatist model, especially the active involvement of organized labor in firm governance, flowered after World War II, especially in Germany, the home of “codetermination,” or the practice of labor representatives sitting on corporate boards (often along with bank representatives). Before the war, labor unions struggled to gain the right to strike, both in Europe and in the United States. For a time, formal labor participation in firm governance in the postwar era was viewed favorably, even in the United States, as an important instrument for gaining labor’s cooperation in productivity and quality improvements in firms while avoiding strikes. In more recent times, however, labor’s involvement seems to have acted as a brake on innovation, especially changes that lead to job loss. To this extent, labor board representatives have a clear conflict of interest, since their main objective—protecting existing jobs—is not coincident with the central objective of the firm, which is to maximize its current and future profitability.

So how did this come to pass? That is, how and why did Japan and continental Europe seemingly move away from their entrepreneurial roots to embrace something very different? This is a complicated question and we clearly do not pretend to be able to answer it fully, but we do have some thoughts that are relevant to the answer. Furthermore, we believe it is important to understand the answer to this question both when analyzing why the two parts of the world later experienced significant slowdowns in their rates of growth and when thinking about ways in which growth may be accelerated in the future.

For one thing, there was no populist revolt—as there was in the United States, in the form of antitrust legislation—in either Europe or Japan against the emergence of large firms that may have dominated particular markets. To be sure, both parts of the world later adopted antitrust laws, and in the past two decades, in particular, European authorities (operating through the European Union) have become especially aggressive in this area. But until these recent developments, European and Japanese authorities have tolerated, and arguably encouraged, the growth of large enterprises.

In the postwar era, this attitude has been easy to understand. Coming out of the war, both the Japanese and European economies (and societies) were devastated. Once-large firms literally had to be resurrected at a time when American companies dominated the global arena. It would have seemed self-defeating for governments in either Japan or Europe to handicap their fledgling enterprises through antitrust constraints. A similar rationale would have applied to the prewar years as well, especially in the two decades following World War I, when Germany was flat on its back and Japan was only emerging as an economic force. Later, in the 1930s, with the world mired in depression, the last thing policy makers in either part of the world would have worried about would have been the consequences of allowing their large firms, which then were struggling to survive, to grow too large. The only remaining puzzle is why neither Japan nor Europe adopted some form of antitrust policy before World War I. Our educated guess is that in this period, the United States itself was just beginning to experiment with antitrust enforcement; indeed, the United States Congress did not prohibit anticompetitive mergers until 1914. The only antitrust law before that time, the Sherman Antitrust Act of 1890, prohibited restraints of trade and acts of monopolization, and prosecutions under this law, though notable (against the steel, oil, and tobacco industries), still were not yet significant in number.

Second, the financial systems in both Japan and Europe were especially conducive to the emergence and growth of big-firm capitalism. In both economies, banks have long been the dominant source of financing for business, and not just any banks—very large banks. Indeed, in Japan, following World War II, certain “main banks” developed in and around Tokyo, and government (through the Ministry of Finance) fostered their growth. As this occurred, banks assumed far greater importance in financing businesses than they had before the war, when the capital markets, both in the form of bonds and stocks, provided most business financing, even for medium-size firms (Hoshi and Kashyap, 2001).^[3] In Europe, governments themselves owned some banks (as has been true in many developing economies). Furthermore, in both economies, banks were permitted to own equity in companies, which typically often borrowed money from the same institutions. In addition, these so-called universal banks were permitted to engage in a wide range of other financial activities, including the underwriting of securities and insurance.

The Japanese and European financial systems heavily favored wellestablished companies rather than start-ups or fledgling enterprises for two reasons. Banks naturally were more interested in lending to larger companies whose shares they had bought and could potentially trade. At the same time, securities markets developed more slowly in Japan and Europe than in the United States, an outcome that may have been an unintended consequence of advanced banking institutions in the former countries, which were not nearly as prevalent in the latter. In particular, it is possible, if not likely, that securities markets developed more quickly and more deeply in the United States precisely because commercial banks were prohibited from underwriting securities under the Glass-Steagall Act of 1933, enacted in the midst of the Depression. This prohibition ironically protected investment banks (that do underwrite stocks and bonds) from competition for more than six decades before Congress effectively repealed Glass-Steagall in 1999 (by enacting the Gramm-Leach-Bliley Financial Modernization Act), during which time several of these institutions (notably, Goldman Sachs, Morgan Stanley, and Merrill Lynch) grew into financial powerhouses. The same thing did not occur in Europe very likely because the large universal banks there already had easier ways to finance the activities of their large firm customers—simply by lending to them— than by underwriting their securities.

It is more difficult to explain the slower development of securities markets in Japan, where Glass-Steagall was imposed by the United States after World War II and therefore should have given a similar impetus to the development of strong investment banks and securities markets in Japan as it did in the United States. That this did not occur seems attributable to at least two factors. One is the poor condition of the Japanese economy coming out of the war. A second factor is that because the pattern of crossshareholdings of commercial companies and banks that existed before the war continued thereafter, large Japanese corporate borrowers had little incentive to turn to securities markets for financing.

In any event, the slower development of securities markets in Japan and Europe, relative to the United States, biased the financing of companies in the former economies, both before and after World War II, toward large enterprises. Securities markets represent an alternative source of funds for enterprises and thus afford more opportunities for new entrants to support their growth, which can often come at the expense of established firms. In addition, securities markets offer a means of “exit” for venture capitalists, who played an important role in the early stage financing of many hightechnology companies in the United States in the 1980s and 1990s (Gompers and Lerner, 1999). That is, investors in a start-up company that reaches a certain level of maturity and profitability can exit from that firm by simply selling their shares in the securities market. Other economies where securities markets are not as well developed have not been as successful in fostering the formation and growth of innovative companies, which inevitably has meant a larger role for more established firms.

Finally, big-firm capitalism was especially in vogue in both Europe and Japan after World War II for the reason already hinted at: governments there presumably thought this was the only way for their economies to compete with the powerful, emerging global companies from the United States. By the mid-1960s, for example, some Europeans voiced fears about the continuing and seemingly inevitable growth of U.S.-based multinational companies (Servan-Schrieber, 1968), much as Americans later (in the 1980s) came to fear what then seemed to be the juggernauts from Japan. Indeed, the European Commission, now the European Union, was born in the 1950s in part to counter the economic power of the United States. European governments also have encouraged the growth of national champions in certain industries (Airbus in airplane manufacturing being a prime example) more or less explicitly to counterbalance the rise of American companies.

A good case can be made that for its time, at least through the first two or three decades of the postwar era, big-firm capitalism served a useful purpose, though we will never know definitively whether the European and Japanese economies would have advanced more rapidly with a different mix of more entrepreneurial firms. As we discussed in chapter 4, large firms, with the ability to mobilize large pools of capital and labor, have an inherent advantage in mass-producing others’ innovations or in imitating products and services developed elsewhere. Because they literally were starting over, firms in both economies were well positioned after the war to do little more than imitate or adopt American technology, either through licensing, joint ventures, or simply basic observation. And that is exactly what they did until a number of the more successful enterprises introduced incremental and in some cases radical innovations that outpaced their American counterparts. The development of fuel-efficient, reliable cars in Japan is one example. In Germany’s case, Daimler Benz already had the expertise before the war in manufacturing high-quality automobiles, and this advantage continued after the war.

But a capitalist system that is good at imitation is not necessarily well suited for more radical (or even less-than-radical) innovation. By definition, innovation is a departure from what currently exists. Large firms are generally not enthusiastic about departing from what they are already making money at, and so radical, disruptive innovation is far more likely to come from newer companies. In particular, innovation has difficulty flowering in an environment where everyone needs consensus. There are exceptions to the rule, of course—Toyota and Honda perhaps are the leading examples. The problem is the rule, the subject we take up next.

[edit] Eurosclerosis and Japanese Stagnation

If imitation is the best form of flattery, then imitation has much to recommend it. From the ashes of World War II, continental Europe grew through the next four decades, to the point where by the mid-1980s, per capita incomes in the core European countries were roughly 80–90 percent of the United States level. Japan’s growth was even more impressive, reaching a similar level but starting from a lower point. Yet what happens when one runs out of things to imitate? That is essentially the problem that confronted both Europe and Japan at the end of the twentieth century. Since 1990, per capita incomes of European countries and Japan have slipped relative to the United States, as evidenced by slower rates of per capita GDP growth in these countries compared to America (see table 12). Slower growth has translated into persistently higher unemployment in regions of the world where unemployment rates traditionally had been lower than in the United States. For the past several decades, continental Europe has been plagued by unemployment rates that have hovered at or above double digits. In Japan, where unemployment rates of 2 percent or less had become the norm, the unemployment rate has held stubbornly in the 4–5 percent range for much of the past fifteen years.

Slow growth and high unemployment in Europe even has acquired a name: “Eurosclerosis.” In theory, the closer integration of the European Union—in particular, the harmonization of different national rules so that goods and people can easily cross borders within the Union—was supposed to jump start European growth in the 1990s (Hufbauer, 1992). A similar growth spurt was widely expected following the decision by most of the EU countries in the early part of this decade to adopt a single currency, the Euro, which was supposed to make it easier for firms and consumers throughout Europe to trade with each other by eliminating the toll extracted in the form of currency conversion fees and uncertainty about the values of the former national currencies. In addition, a truly common European market was supposed to enable European firms to realize economies of scale, the better to compete on the world stage. In combination, these effects should have accelerated growth.

In all likelihood they did, but any growth-enhancing effects of the move toward a single European market ran into strong headwinds from other forces (which we discuss shortly). Table 12 shows the result: while growth throughout continental Europe has continued, it has not accelerated or met the level of the United States, let alone the optimistic expectations of those who have backed closer European economic integration throughout the past two decades.

Economic problems in Japan are equally if not better known. Until 1989, Japan’s postwar record of economic growth was stellar, the envy of the world. Then came the crash of that country’s stock and real estate markets, the bursting of the so-called bubble economy, and with it the rest of the Japanese economy. From 1989 forward, Japan’s GDP grew very slowly (see table 12), while its stock market languished and its banking system fell into disarray, requiring huge infusions of government funds to remain afloat. During the past fifteen years, Japanese authorities have tried an extraordinary combination of monetary and fiscal stimulus to raise GDP; the Bank of Japan has lowered short-term interest rates essentially to zero, and the government has variously pushed tax cuts and spending programs that have generated annual deficits of 5 percent of GDP or more, very high by Japanese (or any other country’s) standards. Until 2005 or so, this extraordinary combination of fiscal stimulus had little effect, as Japanese consumers continued to save high fractions of their incomes (no doubt fearing worse times ahead, collectively a self-fulfilling strategy) and Japanese firms were reluctant to invest.

Clearly, in Japan’s case, something structural in that country’s economy has stunted growth, since it is difficult to imagine that any stronger macroeconomic stimulus could reasonably have been provided or, if so, that it would have more effect (Lincoln, 2001). Continental Europe, too, has structural problems, although restrictive macroeconomic policy there also has limited growth.^[4] Indeed, the leaders of European governments essentially admitted their economic problems by embracing, at least in principle, a broad-ranged reform effort in the Lisbon agenda of the European Commission announced in April 2000.

So what are these “structural difficulties” and are they similar or substantially different between the two economies? Let’s review some of the commonly mentioned obstacles and the evidence relating to them.

[edit] Taxes and High Social Welfare Spending

One barrier to growth in Europe that some Americans (and Europeans) point to is the substantially higher taxes in Europe. There is a reason for this, of course, and that is because continental (and Nordic) European countries typically have much more extensive government “safety net” programs—universal health insurance, child care, and unemployment programs—than are found in other rich countries. Indeed, the safety net programs are cited by some observers as making life too comfortable for Europeans, contributing to the fewer hours they work and ostensibly dampening incentives for them to start new businesses.

Whatever readers may think about these two subjects (and we suspect opinions will vary significantly)—taxes and the welfare states they support— the evidence is slim that they are major contributing factors to slow productivity growth, although generous unemployment programs, in particular, almost certainly do contribute to the persistently high unemployment rates in continental Europe (Phelps, 2006). If taxes and welfare-state programs were significant barriers to more rapid growth in Europe, then how does one explain the slowdown in productivity growth in Japan, where taxes are among the lowest (relative to GDP) of any of the rich OECD countries? Furthermore, throughout most of the postwar era, European countries have ranked at the top of the OECD’s list of tax revenues, as shares of GDP, and yet Europe grew rapidly until the 1980s. If tax burdens were significant impediments to long-term productivity growth, their effects would have been evident much earlier.^[5]

As for the welfare-state arguments, with the exception of unemployment insurance benefits, one would think that a generous government safety net—the support of health care and childcare, in particular—would promote rather than detract from growth. For example, if workers know that their health care costs are covered independent of their employment circumstances, then they should be more willing to establish their own firms than if, as in the United States, their health insurance is tied to their current jobs. While this effect may be at work and perhaps is reflected in the rates of self-employment in continental Europe that are higher than they might otherwise be, a strong government safety net nonetheless does not appear to have driven many Europeans to be innovative entrepreneurs.

[edit] Culture

Perhaps, then, the absence of innovative entrepreneurship in both continental Europe and Japan reflects a different cultural mindset than is found in other countries—not just the United States, but in India, China, and Israel, among others. For example, given the poor economic conditions from which Japan emerged in the first several decades after the war, it is possible that widespread lifetime employment opportunities available in large firms (and in the government), coupled with the related housing and other social benefits of working for large companies, over time created a cultural bias favoring employment by others rather than independent entrepreneurial activity, and that this attitude has been handed down to successive generations. Such an outcome appears to be reflected in the new business formation rate in Japan, which over the past quarter century, has ranged between a third to a half that of the United States (Cox and Koo, 2006). Furthermore, because the government does not provide as extensive retirement benefits as are found in other rich economies, many of those who reach the age of sixty or thereabouts and thus no longer work for large companies turn to self-employment, typically ownership of small retail establishments, as a means of providing for retirement. Thus, a culture of “replicative entrepreneurship” has developed in the postwar era that has nothing to do with what we have called “innovative entrepreneurship.” To sum it up, a reasonably good case seems to exist for the proposition that Japanese culture does not support innovative entrepreneurship— by the young and middle-aged workers, or by those who supposedly are in retirement but in fact are engaged only in replicative entrepreneurship.

A different sort of cultural attitude against innovative entrepreneurship seems to have pervaded Europe. There, too, the trauma of the postwar years may have driven a generation of workers to embrace the comfort and seeming employment stability of working for larger firms and to transmit that attitude to their offspring. The problem that many young European adults now face, however, is that large firms have not been hiring in recent years, in large part because it is extremely difficult under the law for these firms to fire any new employees who turn out to be incompetent or irresponsible. In principle, one would think that the harsh economic environment would encourage many younger workers to seek entrepreneurial careers. But as Edmund Phelps has suggested to us, a generation of parents has sheltered its children (now adults) from having to earn money in their teen years, whether in school or over the summers, and this may have dulled their entrepreneurial drive and instincts. The risk aversion that is so inconsistent with entrepreneurship is perhaps most pronounced in France, where surveys in 2006 reported that most young French wanted civil service jobs for the apparent lifetime security they offered.

One other cultural attitude, shared among Japanese and Europeans, is an apparent hostility toward extreme income inequality (though not to inherited wealth). It is commonly observed, for example, that the differential between the pay of typical workers and senior executives at American companies is much wider, and growing more so, than in either Japan or Europe. In one sense, the narrower income disparities in the latter two economies may work to their economic benefit, since workers are more likely to see themselves in the same economic boat as their managers if their pay is more closely aligned, and thus be more likely to think of productivity improvements on their own (something for which Japanese companies are rightly famous) or to accept those introduced by management. But any such beneficial effect of narrow pay differentials, assuming it to exist, may also be more than offset by the hostility that those narrower differentials may generate toward entrepreneurs who earn extraordinary profits from their successful undertakings. Corporate legal theorist Professor Mark Roe of Columbia University has observed that Europeans, as individuals and through their elected officials, look askance on highly profitable ventures and presumably those who profit from them (Roe, 2002). From what we know about the consensus-driven culture in Japan, we suspect that similar attitudes can be found there as well.

[edit] Policies Underpinning Culture

As appealing as these cultural explanations for the absence of innovative entrepreneurship in continental Europe and Japan may be, it is important, in our view, to realize that certain policies underpin or, at the very least, have helped to shape these attitudes. The British and Irish experience, if nothing else, demonstrates that supposed “cultural attitudes” can sometimes be altered much more quickly than is sometimes surmised, particularly with the help of appropriate changes in government policies. As recently as 1980, both these economies were the laggards of Europe, especially Ireland, whose per capita income then was roughly half that of the Continent. Yet through major policy reforms—privatization of stateowned companies and freer product and labor markets in the United Kingdom, and substantially lower corporate income taxes, a well-educated labor force, and inducements for foreign direct investment in the case in Ireland—both economies grew much more rapidly in the ensuing twentyfive years than their continental counterparts. In the process, it has become much more socially acceptable, indeed desirable, to make money, not just by working for someone else but also on one’s own.

Indeed, a quick look at both the Japanese and European economies reveals how certain policies have contributed to whatever cultural bias may exist against innovative entrepreneurship. For example, in Japan, tax policies permitting companies to deduct the costs of housing provided to their employees on the one hand reward employee loyalty, but on the other strongly discourage workers from going out on their own until they are forced to retire (much of the same can be said of U.S. tax policies that have allowed employers to deduct the cost of health care insurance provided to their employees). In addition, Ministry of Finance “guidance” that has supported the Japanese main banking system indirectly penalizes entrepreneurship by ensuring that banks finance large, existing enterprises rather than start-ups. Without access to formal financing to grow their enterprises, Japanese citizens who might otherwise want to start the next Toyota, Honda, or Mitsubishi are discouraged or effectively prevented from doing so. The increasing concentration of the Japanese financial system, especially its main banks, which Ministry of Finance authorities have encouraged in the wake of Japan’s post-bubble banking problems, has further biased the banks toward lending funds to large enterprises rather than to less-well-established newcomers. This effect may have been partially offset by the unwinding of the banks’ shareholding positions in their large borrowers, but the historical lending patterns favoring the funding of large companies still appear to remain the same.

Would-be European entrepreneurs also complain about a lack of access to capital, though the role of government policy on this issue is less clear. European governments do not guide private banks’ lending decisions, but complaints about the lack of access to bank capital are more common than in the United States (European Commission, 2002). But in an age when credit card financing is widely available and is used in developed economies to finance start-ups, and many start-ups themselves do not seem to require much capital, it is not clear how significant a constraint access to capital really is, any longer, to the launching of at least some new enterprises (Hurst and Lusardi, 2004). For ventures that are more capitalintensive, however, the absence of early stage or “seed” capital is a problem that Europeans, and the French in particular, have raised as a significant barrier to innovative entrepreneurship. Later we suggest that to the extent that financing is a problem, it is closely related to other policies that inhibit growth of new enterprises in Europe.

Another policy-driven barrier to entrepreneurship is the cost and red tape entailed in business registration. The data presented in table 14 suggest that although the costs of registering a business are low in some European countries, in others they remain sizeable. Also it is much more difficult to hire and fire workers throughout Europe than in the United States. If it is difficult to start and, perhaps more important, to grow new companies, it should not be surprising to find that Europeans are less prone to engage in entrepreneurship than Americans.

In short, although cultural attitudes may now be discouraging wouldbe entrepreneurs from launching enterprises in both Japan and Europe, which helps to entrench the dominance of large firms in both economies, it is vital to realize that past policies have contributed to these attitudes while independently reinforcing big-firm capitalism in each of these areas of the world.

[edit] Eurosclerosis, Japanese Stagnation, and Big-Firm Capitalism

The recent decades of relatively slow growth in Europe and Japan attest to the weaknesses of big-firm capitalism (see chapter 4). One tendency of large firms, especially if guided or assisted by the state, is either to overinvest or to invest in the wrong projects. Japan’s experience provides a striking example. Through much of the 1980s when Japanese companies were investing at a rapid rate, and the share of investment in Japan’s GDP was well above that of the United States, there were many calls in the United States for U.S. companies to think longer term and for policy to encourage them to do so. It was said that the supposed obsession of U.S. stock analysts and investors on companies’ short-term profits was leading U.S. firms to ignore the long term, and allegedly the strongest proof supporting this argument (or complaint) was the high investment rate in Japan. Some believed that Japanese companies were able to take a long-term view and to invest as much as they were doing because of their close relationships to their main banks through the ownership stakes enjoyed by these banks, which also supposedly had a long time horizon (encouraged by “administrative guidance” from government officials who ensured that they were doing the right thing).

In retrospect, these fears and the policy arguments that flowed from them look seriously mistaken. If anything, the cozy alliance between Japan’s banks and its leading big-firm borrowers led the latter to invest too much and in the wrong ventures. All this became apparent when the bubbles in the Japanese stock and real estate markets burst, leaving Japanese companies that had invested so heavily with excess capacity. Japan’s economic problems were compounded by the complicity of the large banks in this outcome. Because the banks could count a portion of their unrealized gains on their company shareholdings toward their shareholder capital, the banks looked much stronger than they actually were. In turn, the banks were eager to make loans to their borrowers, many of whom collateralized the loans with inflated property values. When the property boom turned to bust, property collateral values fell, as did demand for the products that the firms were producing. Furthermore, the sharp drop in stock prices wiped out much or all of the unrealized gains in the company shares held by the banks, which forced a sharp reduction of the banks’ capital and thus their ability to lend. In combination, all these things—the bursting of the property and stock market bubbles and the downturn in demand— meant that the Japanese banks were in deep trouble on two accounts: their capital base had dwindled and their borrowers had difficulty repaying their loans. Meanwhile, many borrowers were stuck with excess capacity.

The Japanese government compounded these problems by failing to take prompt action to shore up the banks and force them to restructure their loans (and quickly recognize their losses). Instead, Japanese financial officials appeared to take their cue from U.S. financial policy makers during the 1980s, who when confronted with the insolvency of several thousand savings institutions engaged in “regulatory forbearance,” hoping that economic conditions would improve sufficiently rapidly so that the officials would be spared from taking more aggressive action. Japan’s regulators failed to enforce their own capital standards and allowed the troubled banks (and there were many of them) to continue lending to troubled borrowers by simply rolling over (or extending the maturity of) previously extended debt. This went on for more than a decade, not only delaying adjustment by many of Japan’s leading companies to new economic realities, but depriving worthy borrowers of funds for expansion. Eventually, Japanese policy makers bit the bullet and injected government funds into the banks to help restore their capital positions, but unlike American policy makers—who ultimately allowed many financial institutions to close— Japanese regulators tended to force the merger of troubled financial companies with each other. (There were a few exceptions to this policy, and in one notable case, the failure of Long-Term Credit Bank, the regulators allowed an American company to buy the institution.)

As a net result of this failure to recognize reality, Japan’s economic recovery was delayed, perhaps for years, and its economy was denied the benefit of companies that might have formed and grown had they had access to the capital that was instead channeled to troubled companies that were artificially propped up. Japanese taxpayers will be paying a heavy price—perhaps the equivalent of several hundred billions of dollars—for the years of delay in cleaning up the country’s banking system (Hoshi and Kashyap, 2004). The government’s fumbling also contributed to a loss of confidence by Japanese citizens in their political system, which more than likely made them less willing to spend, thus contributing to persistently high private savings rates, which counteracted much of the macroeconomic stimulus that Japan’s fiscal and monetary authorities attempted to provide throughout this period. The persistent pattern of cross-shareholdings between the large banks and their customers, although it gradually began to unwind in the 1990s, also contributed to the sluggish reaction of the banks’ to their borrowers’ financial difficulties. So did the fact that mutual life insurers have been among the largest shareholders of the large commercial banks. Because mutual life insurers have no stockholders, only policy holders, they had weak incentives to bring pressure to bear on the banks to improve their performance (Fukao, 2004), which they could have done had they more aggressively cut their losses on existing loans and sought out more opportunities to lend to other firms. In short, the Japanese capitalist system, built around large companies and their banks— that, for a time, seemed primed to promote investment and growth among the economy’s largest, most successful firms—contained the seeds of its own malaise, which did not become evident until the firms (and their financial backers) discovered that opportunities for imitation and incremental innovation had been exhausted.

Continental Europe, too, has suffered from problems related to bigfirm capitalism, but these have a different origin and do not relate to the excessive investment that eventually led to the bursting of Japan’s assetmarket bubbles. But as in Japan, government policy shares in the blame, and in the future, change in policy will be required to correct the problem. A shorthand summary of Europe’s economic problems is that the continental economies are simply too rigid and do not facilitate or adapt well to change. This rigidity is reinforced by government policies that are inconsistent with the last of our four preconditions for successful entrepreneurial capitalism: “keeping the winners on their toes.” Indeed, a number of continental European policies do the opposite, inhibiting entry by new firms (through restrictive zoning rules and in some countries excessive costs for registration of new businesses); subsidizing certain national champions, which tilts the competitive playing field toward the chosen firm(s) and away from potentially more efficient competitors; imposing various industry-specific regulations ostensibly for other purposes but with the net effect of sheltering existing firms from competition (as, for example, the German requirements relating to the water used in local beer production); and maintaining various sorts of tariff and nontariff barriers that thwart global competitors from enhancing competitive pressure on local firms (Baily and Kirkegaard, 2005).

European labor regulations also contribute to economic rigidity. In many European economies, layoffs and firings at all but the smallest firms are subject routinely to regulatory or court review. This system not only deters both existing and new firms from hiring new workers (see the ratings in table 14), thus dampening the demand for labor and raising the unemployment rate, but it indirectly works to the relative advantage of larger firms since it helps to insulate them from competition that otherwise new, rapidly growing enterprises would provide. Indeed, one significant finding of a study of OECD economies is that successful start-up enterprises in the United States add workers at a much faster rate than those in Europe (OECD, 2003). Certainly, the major reason for this must be the more restrictive labor rules in Europe. To make matters worse, generous unemployment compensation and health and disability programs that can provide payments to unemployed workers for extended periods dampen the supply of workers who are actively looking for work at any one time. Although this effect may lower the measured unemployment rate by reducing the measured labor force—which includes only those already working and unemployed individuals who are actively looking for work—it dampens total economic output and its growth.

Accordingly, contrary to what one would expect in a dynamic economy, where good firms grow and poorly performing firms do not, in several European countries the very opposite has been the case. As one study has documented, in these countries the companies in the bottom quartile of performance—the least productive firms—have grown more rapidly than the best-performing companies. As the study authors conclude, “the United States eliminates its least productive companies; the EU does not,” a result they attribute to the oppressive combination of excessive product and labor market regulation and zoning rules that inhibit entry by more innovative firms (Baily and Farrell, 2006b).

[edit] The European Postwar Miracle: Can It Happen Again, and If So, How?

To their credit, European and Japanese political leaders and highlevel bureaucrats are very much aware of their economies’ structural difficulties and have announced plans to address them. In Europe, the Lisbon agenda is the principal reform vehicle, with an announced objective no less sweeping than to make the EU into the “most competitive and dynamic knowledge-based economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion.” The European Council (an official body of the EU) has recognized that this will require a “radical transformation of the (European) economy” in order to create 20 million new jobs by 2010.^[6] To accomplish this, the Council has proposed reforms that, in principle, would reenergize the continent’s large firms while encouraging significantly more entrepreneurship.

As for Japan, as of this writing, Prime Minister Koizumi has been among the most vociferous champions of radical reform. Koizumi successfully ran for reelection in 2005 on a platform that, among other things, called for privatizing Japan’s largest financial institution, its Postal Savings System. This would build on prior reform efforts that have helped to make Japan’s economy somewhat more flexible and enhanced incentives for innovative activity. Among them: modestly lower taxes, lower barriers to imports, some crackdown on bribery of government officials, and some progress in lowering the costs off starting a business (Cox and Koo, 2006, 5).

Perhaps by local standards the Lisbon agenda and Koizumi’s reform plans are radical, but they fall far short of what many American—and, indeed, some European and Japanese—observers have been advocating for some time. Typically, advocates of these more radical reform packages or suggestions urge that the various components be adopted simultaneously. In that sense, the recommended plans are roughly equivalent, at least in terms of ambition, in their expressed commitment to the “shock therapy” that a number of Western economists urged upon the former states of the Soviet Union and Eastern Europe after the fall of the Berlin Wall, on the conjecture that one can cross a chasm only in one large jump not in many incremental steps.

For example, with respect to reform in Europe, the former chairman of President Clinton’s Council of Economic Advisers, Martin Baily, has outlined (with colleagues) a series of ambitious reforms that would go far beyond anything the European Council or EU member states have so envisioned (Baily and Kirkegaard, 2005; Baily and Farrell, 2006b). We focus on these proposals not so much because we endorse each and every one of them (though we are sympathetic to them) but because they are illustrative of the kinds of policy suggestions that a number of analysts, inside and outside the EU and including such official bodies as the OECD, have been urging upon Europe for some time.

The proposals, which are listed in table 15, fall into three broad categories. The first two are structural (aimed at enhancing productivity growth and the flexibility of European labor markets) and the third is macroeconomic (to allow greater flexibility of fiscal and monetary policy during economic downturns). Although the specific measures highlighted in table 15 may look very much American in character, the kind that could be found in any “Washington Consensus” set of reform proposals for less developed countries, Baily and colleagues argue, persuasively in our view, that the proposals are based on well-analyzed economic principles and represent what would work best to rejuvenate the European economies. That many of the proposals seem to draw on the American experience is not accidental, however, since U.S. economic performance over the past decade has been extraordinary (though the American economy can stand some improvement and faces its own set of significant challenges in the future).

Baily and his colleagues also argue, again persuasively in our view, that several reform proposals advanced by the European Council pursuant to the Lisbon agenda are not high priority items (because of their distant connection to productivity growth) and may even be counterproductive. These include tax reform to reduce the high marginal income tax rate on upper-income taxpayers (in light of evidence that these rates, as high as they are, are not as detrimental to growth in output and employment as high marginal rates on low- and middle-income workers, which do discourage labor force participation); large-scale public infrastructure spending (given the lack of evidence that more spending here would add significantly to long-term growth); or significant increases in training and education of labor (to which Baily and his colleagues give low priority in light of the already relatively high skills of European workers).

Over the years, analysts in the United States and elsewhere have called for similar reforms in Japan, but with some differences from the list in table 15. For example, labor markets in Japan, too, are inflexible, but this is not so much because of extensive government protections that inhibit firms from shedding workers if they need to, but because large Japanese companies have a practice of not hiring laterally, instead taking on workers at a young age and keeping them until they retire. This system of lifetime employment has changed modestly over the past decade on account of Japan’s economic difficulties but remains largely intact, especially at the larger Japanese companies. Below, we offer one modest policy suggestion that might crack this system and encourage more Japanese to take the entrepreneurial plunge.

In addition, although the country’s main banks have been gradually unwinding their shareholdings in nonfinancial companies (typically their borrowers), this process has a long way to go, but it could be accelerated by government officials through “administrative guidance” (without the need for formal regulation or legislation). Although there is some hope that this is already occurring,^[7] until it happens on a wider scale, the Japanese banking system still will be heavily biased toward lending to the country’s largest companies rather than to prospective or new, high-growth enterprises. If the Japanese Postal Savings Bank is successfully privatized, this will gradually free up capital that would have gone into the bank, allowing it to find its way toward other ventures, with potentially some amount for newer companies. But this, too, will take some time, since even the prime minister’s proposal would not fully privatize the system for another ten years. Fortunately, one item in table 15—more macroeconomic flexibility— is not relevant to Japan. As we have already noted, the Japanese government and its central bank have tried every trick in the book to promote economic expansion in the country, and only after more than a decade of such stimulus has it appeared that this policy is finally having some success.

It may seem ideal for governments in continental Europe and Japan to embrace these reforms fully and introduce them as rapidly as possible—or, in other words, to adopt a “shock therapy” approach to economic reform. But we believe the chance that this will happen is remote. The vast majority of adults in continental Europe and Japan are employed, earning more than they probably ever expected to, believe that they will continue working at their current jobs (if they are in large firms) until they retire, and are expecting to have a comfortable retirement largely paid for by governments their taxes have financed. Under these circumstances, it is not hard to understand why there seems to be so little support for any set of reforms that may threaten these expectations, even if in some not-so-distant future governments find it difficult to meet their financial obligations and even though in the current environment the children of financially comfortable parents cannot find substantial, well-paying work in their home countries.

Several recent events and trends can be understood when seen in this light. In 2005, French voters rejected the EU constitution in part, in our view, out of fear that a stronger EU could mean faster economic and political reform in France (and elsewhere), something a majority of voters did not seem to welcome. Several months later, German voters refused to give Angela Merkel’s Christian Democratic Union a majority in their parliamentary elections of September 2005, very likely because they, too, feared too much economic disruption from the economic changes—especially those that would have loosened German labor markets—Merkel had promised or at least hinted at during the campaign. As a result of the vote, Merkel was forced to cobble together a multiparty coalition that has so far evidenced little appetite for Merkel’s pre-election economic reform proposals. Indeed, by spring 2006, Merkel had become one of the most popular leaders in Europe in large part because she had rejected her pre-election platform (Walker, 2006b).

The reaction against any move toward freer labor markets in France has been even more negative. In early 2006, Prime Minister Villepen, in an effort to reduce persistently high unemployment rates among French youth, proposed a law that would allow employers to hire and fire at will workers under the age of twenty-six. The proposal sparked a wave of protest marches and even riots, which forced the French government to back down (and to propose instead a weak substitute, a subsidy to employers to hire younger workers). From where we safely sit—on the other side of the Atlantic Ocean—the hostile public reaction to any efforts to liberalize labor protections for any class of existing workers in the core countries of continental Europe appears to be even stronger than the opposition to “off-shoring” that has arisen in the United States (and which appears to have abated somewhat since the 2004 presidential election).

At this point, perhaps some critics, in rebuttal, may point out the willingness of Great Britain and Ireland to embrace significant reforms during the past two decades, which clearly have helped rejuvenate both economies, a prospect that once would have seemed fanciful. If these economies could pull themselves out of much deeper economic holes than those in which continental Europe and Japan now find themselves, why can’t the latter economies embrace a set of radical reforms—even something akin to shock therapy? Or critics may point to the example of Denmark, which has scaled back its labor protections but introduced generous systems of retraining to take their place.

Our answer is that it is precisely because Europe and Japan are comparatively much better off than were Great Britain or Ireland several decades ago that their citizens are unlikely any time soon to see the need for their governments to adopt the economic equivalent of shock therapy. For example, as of the late 1970s, Great Britain stood as a prime example of state-guided and big-firm capitalism that had grown stale and fallen from economic grace, from a position of economic leadership among European countries following World War II to a highly visible laggard several decades later. Ireland, meanwhile, was widely looked on as one of the “poor men” of Europe. In neither country were the majority of voters happy about their circumstances, and thus they were more than willing to vote for political leaders who would implement radical, even disruptive, reforms that held some promise of igniting faster growth.

And that is exactly what each country got, although the details of the reform packages differed between the countries. In Great Britain, the form of shock therapy ushered in by Margaret Thatcher and her Conservative party colleagues in the Parliament consisted largely of privatizing stateowned companies and curtailing labor regulation, measures that led to major restructuring of British industry and subsequent productivity improvements. Over time, these changes, cemented during Tony Blair’s tenure as prime minister, led to sharply lower unemployment and faster growth in an economy that many observers in Europe and elsewhere had written off. Ireland’s reform process started earlier, with the introduction of free, universal primary education in 1968, and in the 1980s, the slashing of corporate taxes to the lowest level in Europe, just 12.5 percent. Ireland’s political leaders also negotiated a new “social partnership” with the country’s labor unions, which effectively capped wage increases while curtailing worker protections that had the effect of discouraging firms from firing and, therefore, from hiring workers. All of these reforms helped Ireland attract what eventually turned out to be a flood of foreign multinational companies, first in the computer industry (Intel, Dell, Hewlett-Packard, Microsoft, among others), and later in the financial services industry. The result was the “Irish miracle,” or the most rapid growth rate in Europe, and one that has exceeded even the extraordinary growth performance of the United States (see table 12).

Although today they are comparatively much better off than either Great Britain and Ireland was several decades ago, and thus unlikely to embrace the kind of shock therapy that the latter economies were able to implement, the economies of continental Europe and Japan still can accelerate their growth through a less radical, more incremental strategy—one that not only has a chance of being adopted but being sustained.

[edit] Toward Innovative Entrepreneurship—At the Margin

Now that they are at or close to the technological frontier, both continental Europe and Japan have no choice, if they want to grow faster (as they should for reasons already outlined), except to foster more innovation. It is possible, of course, that through some combination of luck and good policy, existing large firms or perhaps foreign multinationals (large firms from abroad) will advance innovation to some degree. Yet as we have seen, large firms typically are better known for their incremental advances than for their radical breakthroughs. If the latter is what European and Japanese policy makers want, their top priority should be to promote the formation and growth of innovative enterprises.

On the surface, it might appear that European leaders have recognized this in their Lisbon agenda. In particular, the European Commission in 2003 issued a Green Paper on Entrepreneurship, which outlined a series of ways to promote small- and medium-sized enterprises, or SMEs. Japanese government officials also, from time to time, give a nod to the importance of SME growth.

But the very term “small- and medium-sized enterprises,” or its acronym SME, reveals a fundamental confusion about the meaning of “entrepreneurship.” There is a world of difference between what we have called “replicative” entrepreneurs and “innovative” entrepreneurs. Although replicative entrepreneurship offers those who undertake it a financial means of support, it is only through innovative entrepreneurship—commercial activities that embody some new product or service, or method of production or delivery—that societies advance their technological frontiers and thus their standards of living.

This distinction explains why self-employment data, for example, can be highly misleading, at worst, or of little use, at best, in assessing how successful economies are in promoting innovative entrepreneurship. As shown in table 16, Europe and Japan have plenty of self-employed individuals. In some European countries, the share of self-employed in the workforce exceeds that of the United States. But even more so than in the United States, we suspect (for there is no hard evidence, given the paucity of the data) that the vast proportion of the so-called self-employed entrepreneurs in Europe and Japan are replicative, owning small retail establishments or service firms. The challenge that continental Europe and Japan face is to find a way to spawn and grow their next Nokias or Toyotas or the next innovative, high-growth companies that can revolutionize their economies in the same way that Microsoft, Intel, Cisco, eBay, and Amazon and the rash of biotech companies are doing for the United States. Although the European Green Paper frequently mentions “fast-growing” or “innovative” firms, its recommendations are aimed broadly at promoting new enterprises generically and give no special emphasis to innovative entrepreneurship in particular. We are aware of no official Japanese document or government initiative that does this either.

Although it clearly is not easy to create and then foster the growth of innovative, new companies, the challenge in one sense does not require the political boldness of any reform package aimed at prodding large firms and their workers to make fundamental changes. By its nature, a reform program that is designed to promote something new must work at the margin rather than directly challenge existing vested interests. This should make significant reform more feasible and sustainable politically. The trick, as discussed in chapter 6, is for governments in Europe and Japan to remove barriers to new, potentially high-growth companies without directly challenging the way existing large firms do business or any protections their workers may now have.

To its credit, the European Commission has recognized the need for certain of these reforms for continental Europe (we know of no officially endorsed set of recommendations for Japan). For one thing, the EC’s Green Paper rightly recommends that member states further reduce the costs and administrative delays in registering new businesses and adopt more streamlined bankruptcy procedures (which, as we discussed in chapter 5, can help to promote entrepreneurship by reducing the risks of failure). The Green Paper is also right to call for more entrepreneurship education in technical schools and universities. Here, especially, both Europe and Japan can take a page from the American playbook, where universitybased entrepreneurship programs have flowered in the last two decades, in part from efforts by the Kauffman Foundation (with which each of the current authors is affiliated) to promote entrepreneurship across college campuses and not just within business schools, where the subject has been traditionally taught.^[8] Although this is easier said than done, since there is a shortage of effective teachers of entrepreneurial skills even in the United States, universities in both Europe and Japan may find it especially promising, at least for some initial period, to promote entrepreneurship through joint ventures with American universities that are doing this effectively (just as many universities around the world are doing in other fields) and through programs that might place home country students in internships with entrepreneurial companies in the United States. Assuming the right incentives are in place in their home countries after they finish—and this is a critical subject—there is potentially an ample supply of prospectively highly innovative entrepreneurs in both Europe and Japan. We say this because both parts of the world have excellent primary and secondary educational systems that consistently turn out students that are well trained in such technical subjects as mathematics, computer science, and basic science, fields that are essential for innovative entrepreneurs to know and master in an increasingly technologically sophisticated global economy.

The EC’s Green Paper also identifies the lack of access to capital as a significant barrier to entrepreneurial activity and recommends that governments launch or augment resources to provide seed funds, especially equity, to SMEs. In particular, the paper lauds the Finnish public program for providing micro-loans to its entrepreneurs and thus seems implicitly to endorse that concept for other governments, as well as government guarantees of micro-loans.

The EC’s complaint about the shortage of risk financing for entrepreneurs has some validity, since banks in Europe have not traditionally funded entrepreneurs nor is there yet much of a venture capital industry in Europe, let alone anything that could be called angel investing. The same observations apply to Japan. We are skeptical, however, of the solutions to this problem outlined in the EC’s Green Paper, for Europe and Japan. We know of no evidence that governments anywhere—including state governments in the United States that have established venture funds—can systematically and over sustained periods outperform private venture capital or private investors generally. Indeed, because there is always a danger that politics can infect the management of government funds, it is possible, if not likely, that such funds will underperform; that is, they will not yield returns that cover the government’s own (low) cost of capital.

In principle, one way to minimize this risk is for government venture funds to invest only on a matching basis with the private sector. For example, the Advanced Technology Program administered by the Commerce Department in the United States in the past has provided funding only for those technology-related ventures that have also attracted private money. There is some evidence that this approach has been successful (National Research Council, 2001). A similar story apparently can be told about government- funded venture capital efforts in Israel (see chapter 6). But even with a private matching requirement, it is still difficult to know whether the ventures funded by the government would have attracted other private funding had the government money not been available.

Meanwhile, the notion that more broadly based micro-lending will provide a significant stimulus to innovative entrepreneurs is fanciful. Microloans typically are made in small amounts, of $1,000 or less in developing countries and not much more in developed economies. While small loans may be enough to empower their borrowers to earn a decent living and, in the best of cases, to expand to the point of employing a few other workers, the enterprises they fund are not likely to become high-growth firms that lead to broader-based productivity gains for society as a whole. As we discussed in the last chapter, micro-lending may help to cure poverty, but it is not the promising source of funding for truly innovative entrepreneurs.

How then can the capital access problem be solved, and are there any other significant barriers to innovative entrepreneurship in continental Europe and Japan that must be overcome? In our view, the same answers help address both questions.

To some extent, the fact that until recently wealthy individuals in Europe and Japan have not invested to a significant degree in start-up enterprises, either through venture capital firms or as angel investors, reflects the culture in both societies. There is a strong tradition of family enterprise in both economies, and if family businesses generate profits, family members are likely to keep their money for any new venture “in the family.” This pattern is one that is difficult for government policy makers to change, at least directly. In principle, governments could provide tax benefits for third-party equity investments in start-up companies, but given the cultural traditions in both Europe and Japan, we are not certain that this would work. It might backfire by providing incentives for tax avoidance analogous to various tax shelters in the United States that over the years have drained the United States Treasury without contributing to overall economic growth.

In fact, there is some evidence that the private equity markets, fueled by inflows of funds from foreign investors, may be moving on their own to address the capital access issue, at least in Europe. In 2005, approximately $73 billion (60 billion Euros) was committed to private equity. Although most of these funds were targeted toward buyouts of existing European firms, this development is a good sign that some new blood—via capital infusions—is being poured into Europe’s larger firms. Indeed, the roughly $15 billion (12 billion Euros) invested in true venture funds, where the money is more likely to be targeted toward start-ups or early stage companies, represents a 44 percent increase over the year before, clearly an encouraging result.^[9]

One set of policies might boost these figures further by lifting one of the largest, if not the largest, barriers to the formation and growth of innovative entrepreneurial ventures: the legal and institutional hurdles that prevent all but the smallest firms (which some countries have exempted) from laying off or firing employees they no longer need or who are not performing satisfactorily. As we already noted, excessively strict protection of existing workers inhibits employers from hiring new workers. This effect is especially important, in our view, in explaining the shortage of new, rapidly growing companies in Europe. Why go to the trouble of forming a potentially innovative enterprise, let alone fund such a firm, if in the future when the firm needs more employees, it will become locked in to keeping them, regardless of their performance or changes in the market for the firm’s goods or services? Indeed, we suspect one reason highly successful new European ventures like Skype (which pioneered Internet-based telephone calling) sell out to other companies rather than expand internally is that, especially in a rapidly changing technological environment, their founders don’t want to incur the essentially fixed costs of a permanent workforce, unable to make an easy transition to other tasks and duties if market demands require it. Fear of the same future might also help explain why would-be European entrepreneurs (like Pierre Omidyar, one of the founders of eBay) move abroad—to the United States or across the English Channel to either Great Britain or Ireland—to start their companies rather than building them in their home countries.

The labor issue is different in Japan but no less of an important reason why venture capital has not taken off in that country. Again, as we have noted, large Japanese companies have traditionally used a system of lifetime employment, which strongly discourages existing employees, even those with potentially innovative ideas, from leaving to starting new ventures. If the undertaking fails, the former employee not only will be unable to rejoin his (or her) firm, but also will find it difficult, if not impossible, to gain similar employment at other firms. The same system also makes it very difficult for the rare entrepreneur to find suitable employees or partners to assist them in the venture. Knowing all this, why would potential sources of finance be interested in funding such ventures?

We do not believe, therefore, that culture, however important it may appear to be in contributing to the persistence of any practice or pattern, is immutable. To the contrary, changes in government policies—more labor flexibility for firms in Europe and perhaps innovative incentives for Japanese firms to allow or encourage workers to pursue entrepreneurial ventures—can, over time, lead to changes in attitudes of potential entrepreneurs and their potential financial backers. In particular, if more individuals are freed up to pursue their entrepreneurial dreams, and if some of these ventures prove successful, other would-be entrepreneurs and those who might fund them will see that it is possible make their dreams, too, come true.

We believe that such a virtuous cycle can be launched in part by drawing on recent developments in Europe and other parts of the world in an unlikely arena: philanthropy. Until very recently, the formation of foundations devoted to charitable purposes was, for all intents and purposes, an exclusively American phenomenon. With few exceptions, wealthy individuals in Europe or Japan bequeathed their wealth to their families rather than giving much of it during their lifetimes or through bequests at death to foundations. This supposedly “cultural” pattern has been changing, however, especially in Europe, as wealthy individuals there now see how their American counterparts are behaving (“Business of Giving,” 2006). If the “culture” of giving away money can change, then so can the “culture” of investing it, for a profit.

How specifically can this virtuous cycle of innovative firm formation be launched in Europe and Japan? Our answer here is similar to the advice we provided in the last chapter for developing (and more advanced) countries wedded to state guidance: reform at the margin. Thus, in the case of continental Europe, in addition to the measures we have already favorably mentioned, European countries could exempt new enterprises—those legally formed after a certain date—entirely (or nearly so) from the current labor protections that apply to other firms. We suggest an exemption based on date rather than size, which is already present in the laws of a number of European countries, because a size threshold not only creates a “notch” at the threshold but also, for reasons just noted, a strong barrier to the formation of potential high-growth enterprises in the first place. Indeed, the EC’s Green Paper on Entrepreneurship mistakenly suggests a lighter regulatory touch for small firms in general. But this is the wrong criterion. If a lighter touch is called for in any other regulatory sphere (beyond labor)—and we hold open the possibility it might be—it should be based on date, namely, one carved only for new firms, which would provide much stronger incentives for their formation than any special treatment based on size.

The political-economic rationale for exempting new firms from the current onerous labor protections is straightforward: it does not threaten workers at existing firms while benefiting only entrepreneurs and the workers they hire at their new firms. Of course, there is a danger that workers at current firms would nonetheless view such a reform as the proverbial “camel’s nose under the tent,” opening up the possibility that existing enterprises might form new enterprises or, more boldly, close down and reform themselves entirely simply to take advantage of the exemption. From a purely economic point of view, we would not be concerned about this possibility; to the contrary, it could be a desirable way of leading to much more rapid reform of European economies on a much larger scale. But practically, any reform that could be so easily expanded in this fashion could morph into the radical shock therapy whose political viability we questioned in the first place. For this reason, protections probably would have to be written into any laws creating regulatory exemption for new firms to prevent existing firms from moving part or all of their operations into new entities solely to take advantage of the exemption (although it may be possible politically to preserve the ability of existing companies to form new subsidiaries or affiliates that employed additional workers to take advantage of any labor exemption).

It may be useful and necessary to go even further to ease European workers’ anxiety that changes at the margin will affect them. Denmark provides one role model. It permits firms to hire and fire without significant hurdles and also puts strict limits on its (high) unemployment compensation benefits, but at the same time the government shares in the cost of retraining and subsidizes the wages of workers who take new jobs. According to at least one media account, this system appears to account for the fact that Denmark’s unemployment rate is about half that of its European neighbors, and the reported rates of anxiety about job security are far below those found in its European counterparts (Walker, 2006a). A related approach is the concept of wage insurance. Under this system, governments would compensate displaced workers for a limited period (perhaps two years) for some portion of any loss in income if they take a new job that pays less than the old one. Indeed, to its credit, Germany has adopted a limited version of wage insurance for older workers (as has the United States, but only for those who can prove they were displaced by foreign imports) and reduced the term of unemployment compensation payments instead.^[10]

Promoting innovative entrepreneurship may be more difficult for Japan, where formal labor protections are not the main problem but where the difficulty stems from the system of lifetime employment. The government could begin to change this without directly challenging the employment system itself. Specifically, the government could give Japanese companies tax credits or other tax-related incentives for investments in enterprises founded by their employees. The reason for limiting the credits to employee- initiated ventures is that otherwise companies could “game” the tax system simply by creating new entities and thereby reap tax credits in the process. Indeed, to avoid this result, it may be necessary to limit the eligibility for any tax credits to companies where the employees who form the new enterprises own at least a minimum percentage of the equity of their companies.

Finally, some might think that European and Japanese universities could play a stronger role in facilitating the launching of entrepreneurial enterprises, as Cambridge University appears to be doing with some success in the United Kingdom. In particular, some of the suggestions we advance in this regard for the United States in the next chapter, in principle at least, would seem to be applicable to Europe and Japan (if not elsewhere). This may well be true, but we are reluctant at this point to bet too much on this possibility. As a gross overgeneralization that nonetheless we believe to be true, faculty at universities in Europe and Japan do not have a history of pursuing entrepreneurial ventures or of conducting research that could be readily commercialized.^[11] More broadly, in some European countries (France, for example), university faculty collaboration with industry is frowned upon and thus not attempted. Instead, commercially relevant R&D is typically found only within large firms, which is one reason we have labeled these economies as leading exemplars of big-firm capitalism.

If, however, innovative entrepreneurship takes hold in either or both of these economies in the future, it is possible that university faculty gradually will take a different attitude. Should this occur, then the kinds of policies we advocate in the next chapter for facilitating the commercialization of university-based innovations in United States universities would indeed become relevant for Europe and Japan.

In any event, without more aggressive steps to promote the growth and formation of new enterprises, such ambitious Lisbon agenda goals as a substantial increase in the level of R&D spending throughout Europe, perhaps to 3 percent of GDP, have little chance of being realized, as one recent European “experts” report has recognized.^[12] R&D spending is an input into the innovation process, not an output. Firms are the agents for translating R&D into commercially successful products and services. So far, already high R&D spending in some European countries has failed to generate large social gains precisely because the overall environment has not been conducive to new firm formation and growth (Henrekson and Rosenberg, 2001). This must be changed or else more resources thrown into research and development are likely to be wasted.

[edit] Concluding Comments

The economies discussed in this chapter are generally examples of big-firm capitalism. For this form of capitalism, growth has two basic requirements: elimination of obstacles to the entry of new firms created by innovative entrepreneurs, and creation of incentives for large firms to engage energetically in innovative activity. Little has been said here about measures that can help to achieve the second objective as this subject is addressed in some detail in chapter 8 with respect to the United States. The lessons outlined there, for the most part, apply with equal force to Europe and Japan.

In this chapter we have focused on the other and comparably critical task, the stimulation of innovative entrepreneurship in the countries of Europe and Japan whose regimes are examples of big-firm capitalism. We do not know, and indeed find it difficult to predict, whether and to what extent the incremental suggestions we have proposed for fostering innovative entrepreneurship in continental Europe and Japan actually would work, but we see little downside in trying. If the measures are not effective, they will at least set the stage for more aggressive policy steps. The pessimists may hold that this will not work because there is an anti-entrepreneurial culture in Europe that cannot be easily changed. For reasons that should be clear by now, we are not of this view, or at least not yet.

The central problem with our recommendations, if there is any problem, is that there is no immediate crisis in the economies of either Japan or continental Europe that would call for such measures. It is one thing, for example, for the leaders of continental European governments to declare their intention to reform their economies through such a process as the Lisbon agenda. It is quite another, as recent European elections attest, for substantial reforms to be welcomed by voters and then implemented. One possible ray of hope is that citizens in the medium- and lower-income EU countries, such as Spain and the Eastern European countries, feel a stronger need for their countries to catch up to the living standards of the continental core—France, Germany, and Italy—and because of this reform will proceed faster at the fringes. As it does, voters in the core countries, out of envy, may be shaken into supporting more aggressive reforms.

The Chinese approach to reform—do it at the margin without transparently threatening existing interests—should nonetheless provide reformers in Europe and Japan with the best and most immediate source of hope. Young voters in each economy are the obvious potential beneficiaries of reforms that lead to more entrepreneurial success and hence economic growth. Our advice to leaders in these countries is to sell the reforms to them, while assuring their parents that the reforms will not immediately threaten their own interests. Indeed, such steps are the best hope for providing for their children’s welfare while also ensuring that health and retirement benefits promised to them by their governments can be paid for out of the resulting future growth.

[edit] Notes

1. ↑ Thus, one OECD study has found that although new firm entrants in the United States tend to be smaller than in Europe, after the initial start-up phase, successful U.S. firms grow more rapidly than their European counterparts, which tend to remain small (Scarpetta et al., 2002).
2. ↑ Table 12 illustrates that the populations of both Ireland and Great Britain also will age rapidly in the years ahead, but the fiscal burdens of this trend will be much less pronounced than in the other countries because retirement benefits are not as generous in Ireland and Great Britain as they are elsewhere. Of course, this may leave elderly citizens, on average, to face more difficult economic circumstances in these countries than in those with more ample government retirement programs.
3. ↑ Hoshi and Kashyap attribute much of the increased importance of banks in financing Japanese businesses to their role in reorganizing many of the firms that were deeply in debt as a result of the war.
4. ↑ In particular, fiscal stimulus has been limited to no more than 3 percent of GDP, the upper ceiling for central government deficits under the European Union’s “Stability Pact” that European countries adopting the Euro have had to sign; and monetary growth has been limited by the new European Central bank, which has adopted the strong anti-inflation tradition of the Bundesbank, the German central bank.
5. ↑ This is not to dismiss the role of high marginal tax rates for low- and middle-income workers, which probably do diminish incentives for these workers to participate in the labor force. See Baily and Kirkegaard, 2005, 14, 19 (who at the same time also do not find evidence that high marginal tax rates for upper-income workers are a significant barrier to output or employment growth).
6. ↑ For an overview of the Lisbon agenda and related information, see http://www.europa.eu.int/comm/lisbon_strategy/index_en.html.
7. ↑ The Economist of January 7, 2006, reported, for example, that as of early 2006, several large Japanese banks were looking to lend to small- and medium-sized enterprises (SMEs) because, as in America, larger companies increasingly are raising funds in the capital markets.
8. ↑ In particular, by 2007, the foundation will have funded two rounds of competitively determined awards to multiple universities to further this goal.
9. ↑ These data are preliminary figures provided by the European Venture Capital Association and can be found at http://www.evca.com/images/attachments/tmpl_8_art_190_att_935.pdf.
10. ↑ This idea was promoted through work done at the Brookings Institution. See Burtless and Schaefer, 2002.
11. ↑ For a thorough analysis of some of the problems besetting universities in Europe and other countries, see Weber and Duderstadt, eds., 2006.
12. ↑ See Independent Expert Group on R&D, 2006.

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