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Economy, No.19  Mar. 24, 2014

Economics for winning: Be skeptical about commonly accepted viewsViewing something that is commonly accepted from a different angle will lead to discovery

Q: What are the criteria for the government to rescue a corporation?
A: When market failure is greater than failure by the government
There are pros and cons to the government rescue of TEPCO and JAL. It is time to explain the economics behind the permissible scope for public rescue of private corporations.
OHASHI Hiroshi, Professor, University of Tokyo

OHASHI Hiroshi, Professor, University of Tokyo

There is mounting concern in Japan and abroad about the rights and wrongs of governments contributing to corporate turnarounds. Overseas, the turnaround of General Motors (GM), the U.S. corporation that was temporarily nationalized in the wake of the collapse of Lehman Brothers, has attracted attention. Recently, we have also seen rising concern about state-owned corporations in China and other emerging countries buying and selling Western corporations, or dumping exports. In Japan, opinion is divided about the measures taken to support the process of turning around JAL, which relisted on the stock market in 2012, and as of now, the debate has not been resolved.

Broadly speaking, in economics, there are two approaches to governments using public money to turn around corporations that are inferior in competitive terms (or should go bankrupt and be withdrawn from the market). Approach (A) holds that it is not advisable to use public funds because it erodes the basis for fair competition between competitors and props up corporations that properly should have been weeded out, preventing new ones from entering the market. If we believe that the principle of the survival of the fittest through market competition engenders corporate dynamism and gets the economy growing, then this approach holds that public money, which intervenes and distorts the process of the survival of the fittest, should not be applied in any shape or form. 

Tokyo International Airport

Too big to fail

On the other hand, approach (B) holds that the market does not always function logically and correctly as suggested by approach (A), and since markets can also fail, public money should be used at such times.

Suppose, for example, that the impact of a financial crisis abroad, such as the Lehman Brothers bankruptcy, causes a dramatic decline in total demand without any warning. At such times, even excellent corporations may become embroiled in the bankruptcy of client corporations and even though by rights they should not go bankrupt, the knock-on effects may push them over to the brink.

If they can prevent chain-reaction bankruptcies by rescuing client corporations in order to avoid such market failures, governments can at least stop a temporary drop in demand from developing into long-term economic damage. Surely, the economic foundation for using public money based on the logic that large corporations are “too big to fail” is found in the market dysfunction described here. The reason is that large corporations have all too many affiliated partners and the size of a market failure would immediately escalate.

Approach (B) only states that there are cases where public funding is justifiable, but does not say that it can always be justified. The reason is that just like markets can fail, government support can also fail. One example is the public funds paid out to housing finance corporations (the so-called jusen) that became insolvent in the 1980s and 1990s. Approximately 680 billion yen of taxpayers’ money was pumped into companies with poor cost awareness. It was a breeding ground created by political intervention and collusion between the public and private sectors. It was certainly a failure of the government.

When we summarize the above approaches, the economic foundation for justifying support by public funds is not found in the magnitude of the merits of support. Rather, public support is justified when a comparison of the demerits of allowing a market to fail and failure by the government despite the use of public funds, suggests that the demerits of the former are greater. In short, we could say that it depends on the severity of the impact of market failure.

Since the context and format where market failure occurs vary greatly depending on the specifics of individual cases, the starting point for each case is to first evaluate the extent of the adverse effects caused by a dysfunctional market. 

Two rules

If possible, it would be advisable from the viewpoint of transparency and accountability to develop indicators for degrees of market failure and to establish an approach to evaluation whereby public money would be made available in cases where a certain threshold is exceeded, but unfortunately, at the moment, even the most advanced economics do not have indicators with such a degree of reliability. Therefore, it is difficult to conduct a rigorous debate about the permissible scope for public funding support, but it should be possible to gain some rough insights by applying the two rules described below to the suitability of using public money.

Rules for measuring the suitability of using public funds

1 Will public funding for a limited time produce lasting effects?

2 Will public funding create a positive spillover effect that cannot be attained on the market?

The first rule is whether public funding made available on condition that it will be discontinued after, for example, three years will permanently turn the corporation around. As seen in the field of trade and tariffs, protective policies introduced for a limited time are extended time and again, and are sometimes even ended without achieving any of the goals established at the outset. The intent of this rule is to try to limit the impact of failure by governments.

The second rule is whether the use of public money can have other positive economic synergy in addition to corporate turnaround. If a “Yes” can be expected for either one, using public money is worth considering.

If we look for example at the effect of the Act to Facilitate Financing for SMEs in light of these rules, support for SMEs temporarily struggling to find financing due to the impact of the Great East Japan Earthquake can be justified from the viewpoint of Rule 1. On the other hand, there is a concern that widening the scope of the Act to include entrepreneurs who did not suffer any damage in the earthquake disaster is just so much hot air.

Public funding for venture companies and other SME startups is also important from the perspective of accelerating training for inexperienced entrepreneurs and the supply of money for high-risk, high-return investment in Japan. Both Rule 2 and the ripple effect on the economy would be significant.

Although I have used the example of the Act to Facilitate Financing for SMEs, sweeping generalizations about overall policy make it difficult to tell what is right and what is wrong, so it would be appropriate to make assessments by type of corporation. For example, as might be expected, venture companies have generally not been established long and financing through capital stock would probably be preferable to short-term interest-bearing debt. Therefore, it would be good to discuss whether public funding to increase capitalization or issues of preferential stock would not be a more effective policy than the Act to Facilitate Financing for SMEs where young SMEs are concerned. Conversely, when considering the facilitation of financing, we can perhaps ask if the problem is not that SMEs have been lumped together as a target for policy without classifying them according to type.

The problem of reorganizing the management of TEPCO is also an important case for this article. As far as the TEPCO problem is concerned, the range of stakeholders is broad and we should be wary of hasty debates, but we should also bear in mind the economic approaches based on the abovementioned rules while discussing the issues. For example, so far public money has been used for compensation payments to victims or to deal with the contaminated water, but in light of Rule 1, we need to ask whether avoiding legal liquidation and providing more support while the company remains nationalized will have a lasting effect on business stabilization, a stable and low-priced supply of power, or stimulate innovation following reforms to the systems.

Further, in this article I have mainly discussed public funding while bearing in mind corporate turnaround. However, public funding also includes aspects such as support for global development and strategic market creation through structural reform. It is also possible to evaluate such aspects by adopting the rules outlined above.  

Excessive expectations are taboo

Amid accelerating competitiveness in the global economy, an extraordinary session of the Diet is debating the Industrial Competitiveness Enhancement Act, and the expectations for policies to secure international competitiveness are mounting mainly in the industrial sector. If we look back, a sense of impending crisis in relation to the decline in international competitiveness was prevalent in the industrial sector in the 1960s and 1970s when liberalization of trade and currencies were moving forward. However, we know that at the time the business sector led by Ishizaka Taizo, the chairman of Keidanren (the Japanese Business Federation), rejected policy support arguing that the independence and freedom of corporations was the source that would revitalize the Japanese economy.

Even though the format for corporate governance has changed, the drawing term of economic indicators have shortened, and it is difficult to compare a time half a century ago with the present day, there are probably no big differences between now and then in the sense that the source for creating vitality in the Japanese economy is in the minds of the entrepreneurs. In short, pinning one’s hopes on excessive expectations of public funding support is as taboo today as it was in the past.

Translated from “Tsusetsu wo Utagae: ‘Shijo no Shippai’ ga ’Seifu no Shippai’ yori Okiitoki (Be skeptical about commonly accepted views: When market failure is greater than failure by the government),” Weekly Economist, October 29 2013, pp.30-32 (Courtesy of Mainichi Shimbunsha). [2013]