Academic theories are attractive-especially to academics. When the theory is simple, contrarian, and championed by eminent Tokyo University and Harvard professors, it is almost irresistible. However, when it fails to make sense of reality, it quickly loses its appeal. So, despite the temptation to embrace Professor Miwa and Professor Ramseyer's ("M&R") new theory of Japanese corporate governance,1 that finds decades of research to have constructed "a myth," I resist.2
The story painted by M&R is enchanting in its simplicity and universality. In their world:
Whether in the United States or in Japan, firms raise funds in competitive capital markets, and buy and sell in competitive labor, service, and product markets. Whether here or there, in order to survive, they will need good governance schemes.... The scheme they pick will vary from firm to firm. The fact that they will pick the optimal scheme or die will not.3
It all sounds logical, because it is-unless unique and perverse institutional incentives, and not free-market forces, drive corporate governance.4 In which case, the incentives for "bad governance" and "suboptimal schemes" may be greater than those for "good governance" and "optimal schemes." Perverse it is, but mythical it is not.
The simple fact that taints M&R's conclusions is that Japan-indeed, every country-is unique and that uniqueness matters in corporate governance. Japan's-again, every country's-unique institutional framework provides incentives that drive the decisions of corporate executives.5 The market in Japan-again, every country's market-is uniquely imperfect in the face of exogenous institutional forces. In theory, economic efficiency guides the "invisible hand" to wash away differences between disparate corporate governance systems. In practice, however, institutional forces combine with imperfect markets to create a plethora of unique incentives-some of which lead firms to take suboptimal inefficient actions that M&R's theory, which is based on the supremacy of free-market forces (as opposed to institutional incentives), would not predict.6
The reason why M&R's free-market theory fails, and unique institutional incentives matter, is simple. Hardnosed executives-whether downing shots of shochu in Shinjuku or whiskey in Manhattan-do not worry about their firms being economically efficient or optimally governed in the abstract sense. Firm survival, and not even profit, is key.7
What M&R miss in their analysis is that Japanese firms, in their unique environment, are often driven by perverse institutional incentives to select schemes that may be beneficial to firm survival but may not be optimally efficient.8 The consequence of firms responding to such incentives and picking suboptimal schemes is not, as M&R predict above, that they will die. While some may die, others may simply get "sick" and later be bailed out by the government, while a few others may thrive on the perverse incentives. Whatever the result, one thing holds true: firms will adopt inefficient suboptimal schemes when the incentives to do so are greater than the incentives for alternative actions.
This is the perverse story of Japanese banks in the lost decade.9 As a result of being mired in nonperforming loans arising from poor lending decisions in the 1980s, banks were on the verge of collapse. Many spent the lost decade treading terribly close to having insufficient healthy capital to continue banking operations. According to American precedent, unhealthy banks tighten lending, causing a "capital crunch."1 Unhealthy banks definitely do not increase loans to risky clients. American precedent may apply to America, but it does not apply to Japan.11
American precedent and M&R's theory go hand in hand. In M&R's world, sophisticated banks with billions of dollars at stake do not spend good money after bad-especially when there is little hope of recovering part of the bad. …