Stand up & fight.

LAST JULY, the President summed up what he said was his basic negotiating approach with these words to students at Tokyo's Waseda University, "What the United States seeks--let me be clear-- is not managed trade or so-called trade by the numbers, but better results from better rules of trade."

Yet, last week the U.S.-Japan trade "framework" talks broke down with the Administration advocating the very managed trade--market-share targets in areas such as autos and medical equipment, telecommunications, and insurance--the President had earlier opposed. Mr. Clinton has given in to the temptation of placing more faith in the visible hands of Japanese bureaucrats than in the invisible hands of the free market.

Now, as retaliation in the form of restrictions on Japanese access to the American market looms, the U.S. may pay for his mistake through higher prices for Japanese goods and a deterioration in relations with one of our more vital strategic partners. And the "results oriented" approach of the Administration--even if accepted by Japan--would likely manage more American business out of than into trade with Japan anyway.

The changing political situation in Japan, if played right, could mean the substantive market opening the U.S. has sought for decades. Relying on the Japanese bureaucracy--whose major preoccupation the last forty years has been Keeping foreign trade and investment out of Japan--to "manage access" for the U.S. is naive. Doing so in the midst of a popular movement in Japan against that bureaucracy is tantamount to supporting the Soviet nomenklatura during perestroika.

If the Administration really wants to solve the "Japan problem" for American business once and for all, it should adopt a policy that targets the removal of regulatory, administrative, and structural barriers to free trade in Japan. The key to opening Japan is to get the Japanese government out of the day-to-day workings of the economy, not to expand its powers of intervention in hopes of increasing our market share. In a new round of negotiations the Clinton team should forget about trade by the numbers and insist that the Japanese government lay out a clear schedule for sweeping deregulation and structural harmonization. Then it should carefully monitor progress to ensure that--unlike in the past--talk is backed by action.

Japan's economy is riddled with regulations and procedures that both stifle imports and discourage domestic entrepreneurship. At last count there were over 11,000 government licensing and authorization processes affecting business activities in Japan. Almost all of these are subject to the nontransparent "administrative guidance" of the Japanese bureaucracy, whose power to restrain innovations that might "disrupt the market order" is legendary--especially when the innovator is a foreign company.

Even MITI Minister Hiroshi Kumagai agrees that excessive economic regulation in Japan largely explains why market-opening attempts in the past have proved futile. On his first day on the job in August he startled the Japanese press by bluntly announcing, "It's natural for the U.S. and Europe to think that Japan is strange. Our tariffs may be low but collusive practices and excess regulation effectively close the market."

Calling Adam Smith

IN CAPITALISM the fundamental freedom of capital flow is of obvious importance. But in Japan the freedom of capital flow is drastically restricted. This hurts consumers by giving them very low returns on their savings. At the same time it allows producers to continue making and marketing goods even in the face of sustained low net profitability and sub-standard returns on investment. Thus, financial protectionism is the key to what Western analysts have mis-termed the "Japanese style of capitalism" (which hardly constitutes what Adam Smith would call capitalism at all).

As Masasuke Ide, a senior researcher at Nomura Research Institute in Tokyo, writes in a recent paper, "It is often claimed that Japanese companies adopt a low-return strategy in the short run to drive out competitors so that they can obtain market dominance and leap to high profitability in the long run. This is not the case. Japanese companies do not have to aim at higher profitability even after they have won and gained market share. Rather, they force competitors to come down to Japanese profitability levels."

Ide believes that financial deregulation would prove to be the unmaking of the whole keiretsu system of insider cross-shareholding and cross-purchase agreements between large companies that is often cited as an impediment to greater foreign access to the Japanese market. In his words, "If financial institutions have to start seeking higher returns for depositors and investors, that will make it difficult for them to keep supporting the low-return strategy of their traditional corporate group partners." The problem is that to effect the type of substantive--not merely superficial--financial deregulation needed to end this system, the U.S. will have to aim at the heart of the closely protected powers of the Japanese Ministry of Finance (MOF).

Exemplifying the way the MOF uses its regulatory powers to make markets defy gravity are its so-called "Price Keeping Operations" (PKO). Since the massively overvalued Tokyo stock market started to tumble two and a half years ago, the MOF has taken a series of unprecedented steps to keep it from heading further south. Most obviously, it has done things like limit new issues, severely re-regulate futures and arbitrage trading, and even change the (already infamously distorted) accounting rules so that companies do not have to report losses fully in their mid-term earnings statements. It has also covertly channeled perhaps as much as 16 trillion yen from Japanese consumer deposits in the postal savings system directly into the financial system through its power to "supervise" the trusts that manage postal savings-fund investment.

Thus despite increasingly bad economic news and political uncertainty, the average price-earnings ratio of shares on the "bust" Tokyo exchange remains over 60, more than twice that of those listed on the booming New York Exchange. From the standpoint of the Finance Ministry, then, the PKOs have been a great success. However, what is thought to be good for Japan is not always good for the world around it. For in its attempt to impose artificial "equilibrium" on Japan's financial markets, the MOF has fomented massive disequilibrium in the country's trade and current-account balances, which threatens to undermine the stability of the U.S.-Japan relationship and indeed of the entire international trade system.

PKOs distort trade with Japan in two immediate ways. For one, they buoy up the cost of direct investment in Japan when overall costs should be falling. As a result PKOs foster what Japan expert David Asher, author of last year's House Wednesday Group report on U.S.-Japan trade, calls "cost protectionism"---effectively precluding American companies from entering Japanese markets.

The impact of "cost protectionism" is clearly reflected in the Japanese government's foreign direct investment (FDI) statistics. Japan has twenty times more money outside its borders than foreign countries have invested in Japan. A1though FDI in the U.S. and the European Community averages over $1,600 per capita, accumulated long-term FDI in Japan is less than $97 per capita. The net effect of artificially high asset costs on flows of investment into Japan is to suppress imports from foreign sources.

Direct investment to establish distribution, sales, and service infrastructure is critical for any company wishing to penetrate an overseas market. In the U.S. more than 16 per cent of all economic activity is linked to foreign companies; the numbers for France, Britain, Germany, and Canada are even higher. In Japan the figure is 1.1 per cent, lower even than it was in 1963.

The second major effect of PKOs is to subsidize the efforts of Japanese companies to limit market-share losses in sectors where they are especially uncompetitive. For example, given their superior products, American companies like Apple, Digital, and Compaq should be dominating the PC market in Japan as they do elsewhere. Yet, despite their having developed the necessary Japanese-language software and made large direct investments in Japan, their market penetration is restrained by "unforeseen factors." The main invisible factor is that rivals like NEC, Fujitsu, and Toshiba are effectively shielded from having to back out of unprofitable PC markets by the government, which is propping up their stock values.

Understanding how PKOs support the weak bottom line of Japanese industry today helps explain a number of phenomena that have perplexed business economists. For one thing, PKOs at least partially account for why the total number of firms in the top ranks of each Japanese manufacturing sector and sub-sector has not declined much despite the dismal state of the economy. Basically, companies have been protected from having to face up to the costs of their bad business decisions during the bubble of the late 1980s. Also, PKOs explain why manufactured export volumes have not significantly dropped off even though only 3 to 4 per cent of all Japanese exports have been profitable since the yen went above the 125-tothe-dollar level. It is truly as though, in the words of Japan's top trade negotiator and senior MOF official Eisuke Sakakibara, "Japan has surpassed capitalism." But that's not something to brag about--it is exactly the problem in Japan's trade relations today.

Thought Experiment

WHAT MIGHT happen if the Japanese government did not regularly intervene in the financial system, and real--not fictitious-market clearing occurred? American companies soon would find it affordable to invest in Japan in order to take advantage of Japanese corporate weakness (as Japanese companies have exploited that of industries in the U.S.). And Japanese companies, rather than continuing to produce (and export) at a loss, would have to cut back on labor, shut factories, drop out of unprofitable market areas, and even start to buy better-made, lower-cost foreign parts and equipment. The "convoy system" (gosou sendan) of big Japanese keiretsu firms would crumble and the fabric of the nation's cost-protection system would unravel. With this "creative destruction" a whole new age of fair access for foreigners would begin.

The bottom line is that reciprocity in Japanese market regulation could translate into gains for American labor and for the American economy as a whole that would be so substantial that managed-trade protectionists would be left on the sidelines to blush. Economists generally agree that every $1 billion in increased U.S. exports produces about 20,000 jobs here at home. Every $1 billion of U.S. imports that are replaced by goods made in America produces about the same number of new jobs. The result would be tens of thousands of new jobs in high-wage, cutting-edge manufacturing and service sectors.

So, rather than stumbling down the same trade-by-the-numbers path, the U.S. trade team should reread Clinton's speech last July. There, he proposed a agenda for U.S. policy that resonated with the spirit of reform in Japan, calling on the Japanese people to accept the logic of reciprocal market deregulation to create a higher standard of living for themselves and better relations with Americans.

Although there are different types of capitalism in the world, there are also different types of protectionism. Japan falls more into the latter category than the former. Balancing U.S.Japan trade relations requires a policy framework that addresses Japanese regulatory policies as protectionist and anti-capitalist. Our companies are not inherently at a disadvantage. In most sectors they are world leaders--everywhere but in Japan. To succeed in Japan we do not need affirmative action. All we need is something the Japanese government openly says it supports--free trade.