Another big scandal is rocking corporate Japan. This time it’s Kobe Steel, a major producer, which has confessed to faking data on the quality of its materials. Everything from bullet trains to cars to US-made airliners could be affected. It’s doubtful that the scandal will wreak lasting damage on Japan’s reputation for top-notch manufacturing quality -- after all, every country’s industrial giants suffer this sort of debacle from time to time. But Kobe Steel does show that Japanese companies need better corporate governance. Along with recent accounting scandals and another cover-up at Toyota Motor, as well as falsified data at air bag maker Takata, the incident shows that Japanese companies need to work harder to catch these problems earlier, instead of just apologizing after it’s too late.

But preventing scandals and disasters isn’t the only reason Japan needs to improve corporate governance -- it also needs to boost productivity. With an aging, shrinking population, and with women already having joined the workforce en masse, Japan’s best bet to keep its economy growing is to push its companies to update their management practices. And the best people to force Japanese managers to shape up are investors and independent directors.

This is the conclusion of some recent research by economists Naoshi Ikeda, Kotaro Inoue and Sho Watanabe of the Tokyo Institute of Technology. The researchers set out to test what they call the quiet-life hypothesis -- the idea that without shareholder pressure, managers will tend to avoid big decisions and content themselves with managing stable corporate empires, letting their companies stagnate.

The quiet-life hypothesis is an old idea, going back all the way to the great economist John Hicks in the 1930s. Herbert Simon, perhaps the first economist to win the Nobel Prize for behavioral economics, called it “satisficing,” to distinguish it from the rational, machine-like optimizing behavior encountered in many economic models. When an industry is less competitive -- because of government regulation, network effects, brand loyalty or a bunch of other factors -- managers can get away with ruling their empires instead of pushing for profitability.

Ikeda et al. finds that a lot of this is going on in modern corporate Japan. Many Japanese companies engage in cross-shareholding, where corporations own each other’s stock. This practice allows a sort of unofficial deal to take place -- you don’t push us too hard, and we won’t push you. Japanese companies also don’t have a lot of independent directors on their board -- frequently, managers themselves are the ones in control.

Ikeda et al. find that companies with more cross-shareholding spend less on both capital investment and research and development. They also engage in less corporate restructuring. Capital expenditure and R&D indicate a desire for growth and expansion into new markets, while restructuring indicates a push for efficiency. Japanese managers who are protected from shareholder pressure tend not to do either of these things, suggesting they’re leading a quiet, comfortable, inefficient life. Bolstering that notion is Ikeda et al.’s finding that the presence of independent directors on a company’s board is correlated with more investment, R&D and restructuring.

In other words, to improve Japanese companies’ dynamism, growth, and efficiency -- and, probably, to reduce the incidence of scandals -- the country needs to unleash shareholders against hidebound management.

Japan’s government realizes that this is a priority. Under the administration of Prime Minister Shinzo Abe, Japan’s Financial Services Agency introduced a new corporate governance code two years ago. Rates of compliance have been surprisingly high. Progress on getting independent directors onto Japanese boards has been especially encouraging.

In the past two years, Japan has gone from a majority of companies having not even one independent director to four out of five having two or more. That’s a stunning change, and a testimony to the power of the Japanese bureaucracy to influence the country’s big companies when it wants to.

But the question remains whether the new independent directors will have the same kind of salutary effect that Ikeda et al. found in their paper. It might be the case that the companies that had independent directors in the past tended to be those who were also interested in efficiency for other reasons.

Realizing this danger, the Financial Services Agency also introduced a stewardship code that aims to teach investors the art of pushing companies to do better. In other words, Japan now features government bureaucrats trying to teach capitalists how to fight for higher profit. It sounds a bit crazy, but so far the headline results are encouraging.

Of course, it will take years to know how much of this profit growth is merely an artifact of a strong global economy. Meanwhile, the bureaucrats aren’t resting on their laurels. The FSA is trying to nudge companies to expand more into new markets, and to offer buyouts and early retirement to senior managers in order to let younger leaders take the corporate reins. And they’re bringing in industry consultants and academic experts to make sure they themselves don’t succumb to bureaucratic tunnel vision. Meanwhile, private equity, relatively unmolested by government meddling, is now taking a larger role in helping Japan Inc. restructure.

So policymakers are trying to do the right things to shake up corporate Japan. Rising profits and the increasing prevalence of independent directors are signs that things just might be working. Let’s hope scandals like the one at Kobe Steel represent the last gasps of an old order.


By Noah Smith

Noah Smith is a Bloomberg View columnist. -- Ed.


(Bloomberg)