It is a great honor to be chosen to deliver the Mansfield American-Pacific Lecture here in Tokyo and to follow in the path of such distinguished speakers as Charlene Barshefsky, Tom Friedman, Stephen Jay Gould, Tadashi Yamamoto, Haruo Shimada and Hiroshi Inose. I want to express my warmest thanks to the Mansfield Center for Pacific Affairs and the Keizai Koho Center.
Believe it or not, this is my first trip to Japan. It is embarrassing to admit this, but true. I arrived from China and Korea on Saturday. I spent the last two days in Kyoto, your ancient capital, viewing the cherry blossoms, visiting shrines, temples and palaces and, in general, preparing myself spiritually for this talk.
What a wonderful country! There is no nation in the world that has ever combined high aesthetic values, industriousness, discipline and imagination the way that Japan has done. You have truly achieved a miracle in the last half-century.
As a resident of New York, let me thank you for the compassionate and powerful response of the Japanese people after the horrifying terrorist attacks of September 11. These attacks inflicted profound wounds--not only on the American people but on civilization, decency and order. The U.S. will continue to respond forcefully to terrorism, but President Bush said from the start that we would not allow the attacks, or others, to disrupt our daily lives--our work and our affections.
I recently read--as I am sure many of you have also--a cover story in The Economist magazine, titled, "The Sadness of Japan." On this, my fourth day here, I can say that this nation does not appear--at least in the first impression of this sympathetic foreigner in the season of cherry blossoms--a sad place. But I do believe that deficient public policy is harming Japan unnecessarily. And that, certainly, is sad.
But it is only a small part of my message to you today. I am generally considered an optimist, and my message is optimistic. I will first describe the importance of sound corporate governance and what I call the democratization of finance--and I will try to show how those values, coupled with better public policy, can lead to a magnificent revival in the Japanese economy. There is no serious impediment to such a revival--not culture and not, ultimately, politics. If the U.S., learning from Japan, could fashion a managerial miracle in the past 20 years, Japan, learning from the U.S., can certainly fashion an economic renaissance.
But my story begins not in Japan, but in Texas....
A few years ago, an American economist named Kenneth Lay set out to create a new kind of energy company--one that would rely less on physical assets such as giant power plants and pipelines and more on trading skills. Lay’s company, Enron Corp., based in Houston, the hometown of George W. Bush, already owned 25,000 miles of pipelines and about a dozen natural gas plants, plus other hard assets like a water works in Britain. But Lay’s bold plan focused on bringing together buyers and sellers of electrical power in the new deregulated markets of the United States.
Lay’s plan captured the imagination of investors, including America’s most experienced. Janus, a highly regarded investment management firm based in Denver, eventually owned 5.6 percent of Enron’s shares. The sector fund specializing in energy for Fidelity Investments, the nation’s largest mutual fund house, made Enron its largest holding. Earnings per share grew from 9 cents in 1989 to $1.47 in 2000, and the stock price quadrupled in three years. Enron traded at a price-to-earnings ratio of 41, nearly three times the valuation of the typical energy company.
But as we all know now, Ken Lay’s plan failed--not so much because it was a bad business but because executives at Enron were caught promoting a massive deception.
Last year, a hedge fund manager named James Chanos, who makes his money mainly by shorting the shares of overpriced companies, began to spread the word that Enron’s books were not telling the whole story of its true condition. Eventually, the press caught on. In October, Enron shocked Wall Street with the announcement that it had lost $600 million in the third quarter. Three weeks later, the shock doubled when Enron announced it was restating earnings for the previous years, reducing profits by another $600 million. The company also admitted it faced immediate repayment of $700 million in debt. Further investigation found that, while Enron’s consolidated balance sheet showed $14 billion in loans, its actual debt, including entities off the balance sheet was closer to $40 billion.
Investors reacted with appropriate brutality. The company, which had once been valued in the market at $80 billion slid to a valuation of nearly zero by early December. Many of Enron’s loans, backed by stock, were called, and the company declared bankruptcy--the largest, in terms of assets, in U.S. history. Its accounting firm, Arthur Andersen, implicated in the deception, quickly lost some of its best clients, including Delta Airlines with a 53-year relationship to the firm. Andersen was later charged with obstruction of justice in the destruction of accounting documents, and it appears, at this time, that it will not survive as the fifth largest accounting firm in the world.
The Enron scandal shocked the U.S. public and, after visiting China, Korea and Japan in the past 10 days, I can conclude that it shocked much of the Asian public as well. But the aftermath has not been what was predicted in the U.S. press. While the media expected an "erosion of confidence" among investors, in fact in January and February net inflows of new money by small investors into U.S. stock mutual funds totaled a healthy $24 billion. January, the month when Congress began holding its Enron hearings, was the best month for stock mutual fund purchases in a year and a half. Meanwhile, during the first quarter, the Dow Jones Industrial Average rose about 4 percent, and price-to-earnings ratios remained high--in the range of 25--evidence of general investor confidence.
The response of investors was rational and discriminating. They killed Enron, but they remained in the stock market. Should this response have been surprising?
I don’t think so. The U.S. economy and the U.S. stock market have suffered numerous shocks over the past 20 years. To name a few: the 1987 crash, when shares fell 23 percent in one day, the Gulf War and 1990-91 recession, the Mexican financial crisis, the Asian crisis, the Russian default, the failure of the Long-Term Capital Management, the tripling of oil prices in 2000-01, the terror attacks and recession of last year. And now, Enron--the failure of the company with the 7th-highest revenues in the U.S., a company that won Fortune magazine’s award for most innovative firm five years in a row.
The Enron story provides us with an important lesson: The U.S. financial system’s stability, displayed in the Enron case and many others, is based on essential principles of strong corporate governance and transparency and rooted in high levels of democratization: Equity assets are broadly held and equity capital broadly dispersed. Large institutions, including the federal government, therefore, have little ability to manipulate stock prices. This system, unfortunately, stands in contrast to that of Japan, where corporate governance and transparency are relatively weak, stock is not broadly held by the public, capital is often allocated for political purposes, sick firms are frequently kept alive rather than letting what Schumpeter called "creative destruction" take its course, and the government sometimes intervenes directly in the market.
The U.S. financial system if far from perfect, but it rests on such a broad and democratic and resilient base that it absorbs shocks and bounces back. In fact, the scar tissue from wounds like the Enron failure make it stronger. Immediately, we saw investors toughening their standards, marking down the prices of companies with too much debt or with questionable--even if legal--accounting practices, including Tyco (the Bermuda-based conglomerate), AES (a large utility manager) and WorldCom (the large telecom firm). As Alan Greenspan, the Federal Reserve chairman, put it, "Corporate reputation is fortunately re-emerging out of the ashes as a significant corporate value."
In my travels in Asia recently, I have heard opponents of free markets use Enron as evidence of the severe deficiencies of the U.S. system. One Korean commentator said that Enron is proof that Korea would face another currency crisis if it follows IMF prescriptions to open its economy--which it has been doing magnificently, by the way--in the U.S. style. Last week, Moody’s raised Korea’s credit rating two notches, and its stock market has been the world’s best performer (aside from Russia) in the past year. Better corporate governance practices, introduced after the 1997-98 financial meltdown, have worked in Korea. But the critics persist. Of course, many of these critics resent a free-market system because it deprives THEM of the power to shape the economy. Others are simply fearful of what a system that lacks controls will lead. They fear the unknown.
This fear is a major problem for Japan--whose central planners insist on trying to create a knowable future. Indeed, the most notable fact about the U.S. economy over the past two decades--a time in which deregulation has come rapidly and the idea of free-market solutions has been broadly embraced by both parties--the most notable fact is stability. GDP, Inflation, interest rates, unemployment: all the major economic statistics have shown a remarkable lack of volatility. Since 1982, the U.S. economy has suffered a GDP decline in only one calendar year, and that was a fall of 0.5 percent.
Again, this is not to say that shocks and dislocations are absent in the system. To the contrary, the system ABSORBS shocks. The mechanisms for this absorption are: a free labor market, where the surface appears calm but underneath there is turmoil as workers lose and gain jobs; a vigilant monetary authority that is largely immune to ideological constraints and reacts quickly to a timely flow of information, correcting its mistakes when necessary; and, finally, democratized financial markets that allocate capital with amazing speed and assurance.
Those capital markets depend on accurate information and on strong corporate governance. When those essential elements in place, investors trust both the caretakers of the assets they are purchasing and the intermediaries who help them make their transfers. One result of better corporate governance has been a decline in the equity risk premium--the extra return that investors demand over benchmark government bonds in order to compensate for the uncertainty of stocks. My 1999 book, "Dow 36,000," written with the economist Kevin Hassett, offered the theory that this declining equity risk premium was the reason for the rise in the Dow Jones Industrial Average from 777 in August 1982 to over 10,000. The decline, Dr. Hassett and I expect, will continue until stocks become fully priced at a Dow of around 36,000. Current high levels of valuation--seen in price-to-earnings ratios in the mid-20s, even during an economic slowdown--are evidence, we believe, of this declining risk premium in the United States.
What do I mean by corporate governance? A corporate structure that enshrines certain values: transparency and consistency of accounting rules; an independent board of directors; voting protections for minority shareholders; and a lack of barriers to takeovers. A way to summarize these factors is that they align the interests of management with the interests of shareholders. This alignment is stronger in the U.S. than in any other country, and it is one reason that U.S. stocks have such high relative valuations.
There is a wealth of academic evidence that shows that strong corporate governance is rewarded in the marketplace. A recent study by Gompers, Ishii and Metrick for the National Bureau of Economic Research, for example, found that "firms with weaker shareholder rights earned significantly lower returns, were valued lower, had poorer operating performance." A strategy of investing in firms with the best corporate governance and shorting those with the worst produced returns that were 8.5 percent better annually than a strategy of investing in the market as a whole, the researchers found.
And the power of good corporate governance is not limited to U.S. stocks. A study last year by CLSA Global Emerging Markets, a Hong Kong subsidiary of Credit Lyonnais, looked at 495 companies in emerging-market countries, examining them for 57 corporate governance factors. "Corporate governance pays," the study concluded. Over the five preceding years, the average returns for companies in the top fourth of the study were, in the aggregate, more than twice as great as for the 100 largest companies surveyed.
Finally, just look at the Enron case. Before any government investigation or indictment, investors concluded that Enron was guilty of violating corporate-governance norms of truthful disclosure. Investors pronounced the sentence: capital punishment. They have done this time and again, most recently with Cendant and Sunbeam in the U.S.--and suspicions about companies like Tyco have driven down share prices dramatically.
Market forces, then, signal companies that corporate governance is a desirable value. It is difficult for some observers, from a perspective that emphasizes central planning, to understand this process. Outside Beijing last week, for example, Dr. Hassett and I addressed a group of 300 Chinese who had been selected by their government as outside directors for Chinese firms. They were attending training sessions at a national accounting university. One member of the audience asked me about laws in the U.S. on independent or outside directors. How many are required at a company? She asked. She was baffled when I told her there were no such laws, but that investors often looked skeptically at companies with too many inside directors and devalued their stock. Market discipline, in this case, works very well.
But, of course, market discipline is not everything. Every nation needs strict policing of fraud and insider trading, with an aggressive securities agency enforcing the rules. In the wake of Enron, however, rules changes should be minor--and it appears that President Bush and Congress are reacting, admirably, with restraint. The American expression goes, "If it ain’t broke, don’t fix it.".
But in Japan, corporate governance is still broke. In 2001, PricewaterhouseCoopers issued what it calls an "opacity index," which ranks countries on corporate governance criteria. Opacity, says the study, "increases the cost of capital due to lack of clear, accurate formal and widely accepted practices." Low scores are best, and the U.S. received a score of 36; Britain, 38; Singapore, 29; Chile, 36. But Japan’s score was 60--worse than countries such as Peru (58), Mexico (48) and Greece (57). PWC also calculated that investors suffered a risk premium of 629 basis points over U.S. benchmark levels for this high opacity.
The barriers to strong corporate governance in Japan remain: a lack of transparency in much accounting; difficulty in effecting takeovers; a lack of accountability when things go wrong; a system of interlocking ownership that renders clarity for outsiders nearly impossible; and, in general, the lack of alignment between the interests of shareholders and management.
Without clear signals about what is happening within a company, small investors, especially, won’t be willing to entrust their cash to the company’s managers. It is these investors, together with stock analysts, the financial press and professional short-sellers that enforce discipline on companies, rewarding those with good performance and penalizing those with bad.
The stability of the U.S. system owes a great deal to small investors, who, time and again, have refused to panic in the face of severe market shocks, including, most recently, the NASDAQ collapse, the terror attacks of Sept. 11, and the Enron failure. Despite these traumas, small investors have continued to add to their stock accounts.
More than half of all American families now own shares, either directly or through mutual funds--up from 15 percent in 1965 and 20 percent in 1990. One reason is the rise of 401(k) plans--defined contribution pension plans that allow individual workers to own their own retirement assets and to allocate them as they wish, staying invested until age 59 ½. Another reason is that Americans have become less risk-averse as they have learned the special nature of stock market risk: that shares are very volatile in the short term but not so volatile in the long term. For example, U.S. stocks--represented by the Standard & Poor’s 500 Index -- have lost money in 22 of the last 76 calendar year periods, but they have never lost money in any 15-year period and have lost money only twice out of the past 66 overlapping 10-year periods.
Democratization works in the other direction as well. Capital flows from small investors through mutual funds and other intermediaries to entrepreneurs. Currently, stock funds hold more than $3 trillion in assets. More and more young companies have also gained listing on the NASDAQ exchange, including firms that in the past would be considered "pre-IPO" (that is, too young for a proper Initial Public Offering), without any earnings but with a good idea and a decent business plan. Some of these companies have failed, but other pre-IPOs have been hugely successful, including Dell Computer and America Online. Venture capital no longer comes solely from venture capitalists.
Japan, by contrast, has low levels of citizen shareholding--8 percent is the most recent figure I have seen. It lacks the institutional infrastructure for democratized finance. Huge sums are poured into Postal Savings accounts and bank deposits, and, with a debt to GDP ratio of 130 percent, government borrowing sops us substantial capital.
I don’t have to tell you about the deficiencies of the current economic state of this great country. For the past decade, stagnation has haunted Japan. Your current recession is now in its 17th month, with rates of unemployment unseen in a half-century. This stagnation hurts not just the people of Japan but those of developing Asia, the U.S. and the rest of the world. In 2001, Japan was the only industrialized country with a GDP that declined. In 2002, according to a recent poll of economists, it is the only industrialized country where GDP is expected to decline.
I am not here to lecture you on what is wrong with your economy. I think you know that already. My late colleague at the American Enterprise Institute, economist Herb Stein, once made this famous statement: "Any trend that cannot be sustained, will end." The trend of decline in Japan cannot be sustained--for social and political reasons, if no other--and it will end. David Malpass, chief international strategist for Bear Stearns in New York--and a longtime critic of Japanese policy--wrote last week, "Our view is that Japan has a severe, but isolated, problem--bad monetary policy--that will not last forever." Yes, deflation is a plague, but it could end tomorrow if the government announced serious inflation targets. Japan’s stagnation can end quickly, and I think it will.
That does not mean, however, that Japan’s economy will reach its full potential. It cannot if it lacks strong corporate governance and democratized markets.
This is the time to lay the foundation. Japan has wisely and courageously moved to limit to 10 million yen the government guarantee on interest-bearing bank deposits. This move already has had the effect of directly, through market forces, deposits toward stronger banks, and ultimately it will move tens of trillions of yen from savings into equities--Japanese and foreign--which is where this long-term money belongs.
Ultimately, families build wealth, not by lending money to banks or governments. Not by owning bars of gold. Not by stashing yen under the mattress. Ultimately, families everywhere build wealth by becoming partners in successful businesses. A stock market in a strong economy offers that opportunity. It allows the democratic participation of every family, and it spreads capital democratically to the best businesses.
Some people will say that Japan and the U.S. differ culturally--that Japan inherently lacks what Lord Keynes called "animal spirits" and that the Japanese have an unhealthy aversion to risk--entrepreneurial and financial. I do not believe that for a second.
It was not long ago that Americans were looking to Japan for managerial leadership. It was a time when critics said that, culturally, the U.S. lacked the discipline and technological skill to manage firms with the success of the Japanese. We have learned a great deal. U.S. companies are better managed than ever. And the critics were proved wrong. Similarly, Japan can learn from the U.S., building and adapting its own institutions. There are no cultural impediments--nowhere in the world (not in China, Korea, India, Nicaragua or Greece)--to sensible corporate governance and democratized finance. No less in Japan.
James K. Glassman is a resident fellow at AEI.