Since 1990, gross domestic product per capita—the single most important measure of a country’s economic health and standard of living—has grown by a meager 0.6 percent annually in Japan, compared with 1.7 percent annually in the United States. As a result, the gap in GDP per capita between Japan and the United States widened from 10 percent in 1990 to over 20 percent in 1999 (Exhibit 1). Japan’s unemployment rate rose from 2.3 percent in 1990 to 4.9 percent in 2000. In mid-1998, the unemployment rate surpassed that of the United States. Japan’s government, once lauded for its masterful management of the economy, has only exacerbated these problems with futile attempts at a Keynesian stimulus. The country’s debt-to-GDP ratio grew from 60 percent in 1990 to nearly 120 percent in 1999—twice the level of the United States and Germany. In short, the past decade has seen the Japanese economy go from model to muddle.

Yet, as the failed government programs show, the real causes of Japan’s decline are not well understood. In fact, there is a real lack of detailed information about the performance of the Japanese economy at the micro level. To fill this information gap and to measure performance at the level of individual companies and industries, the McKinsey Global Institute recently completed a year-long study of the Japanese economy.¹ The resulting detailed understanding of that economy not only provides unique insights into the causes of Japan’s spectacular decline but also lays the groundwork for policies that would reverse the slide and cause Japan to grow again.

Overall, we found that Japan’s once-vaunted workforce is actually 31 percent less productive than that of the United States. The country’s capital productivity is worse still, trailing that of the United States by 39 percent (Exhibit 2). These aggregate numbers, telling as they are, hide the true explanation for Japan’s woeful performance. Surprisingly, we found that the Japanese economy was never as strong as it appeared to be during its glory days. In fact, today’s woeful economic performance is not so much a reversal of fortune as a revelation of the hollowness of Japan’s success in the 1980s. Even then, Japan suffered from a "dual economy": a small group of world-beating exporters that everyone knew about and a large group of laggardly locals hidden from public view. The performance of the locals was so poor that it swamped the excellence of the high-profile exporters.

Today, the dual economy remains. The world-beating portion—autos, steel, machine tools, and consumer electronics—is thriving, bettering any and all competitors’ productivity by 20 percent. Yet these Toyotas and Sonys, accounting for only about 10 percent of all economic activity in Japan, are the exception and not the rule. The remaining 90 percent of economic activity takes place in companies that do not export products, instead providing domestic manufacturing and services. Save for national origins, these companies share nothing with Toyota. They are subscale, poorly managed, antiquated, insulated from competition, and woefully unproductive. The productivity of this portion of the Japanese economy stands at a mere 63 percent of US levels (Exhibit 3). This is the source of Japan’s ills, and the Japanese economy will not rebound until the performance of these companies begins to turn around.

Why is productivity so low?

To understand why the productivity of the domestic sectors is low, we studied four of the largest: retailing, health care, and housing construction (in the service sector) and food processing (in the manufacturing sector). Together, these four sectors account for 18 percent of Japan’s GDP and 22 percent of employment. Their productivity averaged only 56 percent of US productivity (Exhibit 4).

Unfortunately, the four sectors, with their subscale operations and poor product and service offerings, typify Japan’s domestic economy. In retailing, for example, tiny, archaic mom-and-pop stores still account for 55 percent of employment, compared with 19 percent in the United States and 26 percent in France (Exhibit 5). Located in shotengai, or town centers, these stores are usually family owned and employ two or three family members. Because the stores lack the buying power and merchandising savvy of larger retailers, prices are high while product ranges and service levels are poor. In fact, some stores sell the same set of products year after year.

Similarly, the food-processing industry has six times as many establishments per capita as does its US counterpart, and each establishment produces only one-tenth of the value added (Exhibit 6). These plants are far too small to automate their operations. Packaging and processing are generally done by hand. Processors, despite their small size, go to great lengths to produce a huge variety of products to meet consumer tastes.

However, in an unfortunate reversal of Henry Ford—who made only black cars that everybody wanted—Japanese companies produce a huge variety of products that hardly anyone wants. One midsize milk producer, for example, had seven separate storage tanks, one for the milk from each of the small regions it served. At great cost and complexity, it processed each regional batch separately into a distinct line of dairy products for the region where the milk originated. Yet the producers have no evidence that consumers from the different regions even notice subtle distinctions in taste or that consumers wouldn’t prefer lower prices resulting from consolidated operations.

The health care industry mimics the dual nature of the Japanese economy as a whole, with a small number of state-of-the-art hospitals and a huge number of local ones that provide outmoded medical care. Because demand for the services of the state-of-the-art hospitals is so high, they commonly force patients to wait hours and hours for routine care. When patients finally see doctors, the visits are rushed and cursory because of the huge volume of patients each doctor must see. Meanwhile, the remaining hospitals—which serve only their immediate locales—extend patient stays well beyond any reasonable standard in an effort to raise their occupancy rates, thereby shoring up their faltering economics. In both cases, patients get poor treatment, and productivity suffers.

Finally, residential construction is still dominated by small, self-employed carpenters. Using traditional methods of construction and hand tools, these carpenters achieve only 30 percent of the average US productivity level because they lack project-management skills and don’t work from standardized designs. Japanese consumers ultimately pay for this inefficiency in high prices and the small variety of housing options the market provides.

A dearth of domestic competition

In a more open economy, this poor performance would provide an open door for more able competitors to enter and drive all these inefficient domestic players out of business. Yet the Japanese economy is far from open. In fact, it is rife with protection for the inefficient players, and competition is nearly nonexistent. In a misguided effort to protect jobs and maintain stability, the government subsidizes the inefficient players and blocks the entry of competitors.

A sea of subsidies

In retailing, for example, the tiny mom-and-pop stores remain in business because the government has lavished subsidy after subsidy upon them. They have been given guaranteed loans of over $40 billion with almost no credit evaluation. The government has also given these shops an additional $10 billion in rent subsidies, grants to buy computers, and infrastructure programs for the shopping districts where the mom-and-pop stores are located. In addition, the Japanese tax code provides large incentives that keep owners of small stores from liquidating them and selling the valuable land on which they sit.

So too in health care, where the government—in an effort to keep hospitals from closing—simply reimburses institutions for any length of stay by a patient, regardless of whether there is a medical justification for it. As a result, patient stays far exceed levels for other countries in the developed world (Exhibit 7). In addition, Japan has a startling overcapacity of hospital beds in its health care system: fully three times as many beds per capita as the United States, which has far higher levels of disease and injury.

New competitors: "Keep out"

In addition to shortening the track for old-fashioned businesses, the Japanese government puts ankle weights on any new entrants—Japanese or not. Zoning laws make large-scale residential real-estate development nearly impossible. In retail, the Large-Scale Retail Location Law limits the entry of large-scale stores by requiring the development of stores of over 1,000 square meters to be approved by local committees that include owners of mom-and-pop stores who would be put out of business by the new competition. Although the criteria for exclusion have shifted to environmental and planning concerns, a similar shift in the United Kingdom allowed mom-and-pop stores to go on blocking their large retail competitors.

Besides the direct effects on the retail sector, the resulting lack of large-scale food retailers slows down the growth of large food processors. These players are not only more productive than the existing subscale players but also would bypass food wholesalers, thereby reducing the cost of the entire food chain. Outmoded food processors are also protected by high tariffs. Pork prices, for example, are set by a government-owned body. Tariffs are levied at the differential between the import price and the domestic-controlled one, so that all imported pork is priced at the same level as domestic pork. As a result, there is no price competition among Japanese processors or between them and imports. Similar tariffs exist for other meats and for vegetables.

The government bureaucracy has had a similar, if unintended, effect in health care, where new and innovative treatments are either slow to reach the market or don’t make it at all. For example, five of the global top-ten selling drugs (including Prozac and Lipitor) are currently not available for purchase in Japan. By the time laparoscopic cholecystectomy²—a huge innovation and a key driver of productivity in the treatment of gallstones—gained approval for reimbursement in Japan, it was already commonplace in the United States and in Europe.

No information 5 no competition

Further squelching competition is the paucity of price and quality information available to consumers. Robbed of the ability to comparison-shop, consumers cannot reward the best competitor with their business. This again serves as a prop to the unproductive, entrenched local players. While there are examples of price transparency in Japan—the Ministry of International Trade and Industry’s successful standardization of the machine tool industry allowed Japanese producers to become the world’s most productive—they are the exception and not the rule.

The residential-construction industry suffers from a lack of both price and product quality information. The Japanese government, unlike that of other developed countries, does not release price information on housing sales. The lack of price information allows builders to sell overpriced, feature-laden houses to consumers who have no objective way of determining if they are a good value, in part because housing construction materials and methods have never been standardized, as they were in the United States in the 1920s and ’30s. Compounding the problem is the fact that in the absence of information, many consumers associate low cost with low quality. In addition, the secondary housing market—which acts as a substitute for new houses and also provides useful price information—is severely underdeveloped because of disincentives in the tax code and the absence of a standardized appraisal system for sales of existing houses (Exhibit 8). As a result, price comparisons—an essential factor in US housing markets—play a minor role in their Japanese counterparts.

Similarly, in health care, the rigorous third-party appraisals offered by the US Joint Commission on Accreditation of Healthcare Organizations (JCAHO) and other bodies are completely unavailable in Japan. As a result, patients simply crowd into subsidized hospitals that have better equipment, without any idea of whether they actually offer better care. The long waiting times and low service levels in these hospitals result in some of the lowest patient-satisfaction levels in the developed world (Exhibit 9). Yet if better hospitals existed or old hospitals improved, consumers would have no way of finding this out and modifying their behavior.

Conventional wisdom is amiss

Contrary to what many people believe, the banking crisis and idiosyncratic consumer tastes were not important in explaining Japan’s poor performance. The banking crisis and the resulting government support to banks have promoted continued lending to bad-debt retail conglomerates. However, they account for only 2 percent of employment in the retail sector, which is dominated by unproductive mom-and-pop stores that remain in business because of the exit and entry barriers mentioned above, not because of the banking crisis.

That idiosyncratic consumer behavior in Japan hampers productivity is also a myth. Japanese consumers, on those few occasions when they are given the chance, react en masse to low-priced goods from productive retailers such as Toys "R" Us and Japan’s own Uniqlo. When Uniqlo, for example, put its fleece jackets on sale for 50 percent off and launched a focused marketing campaign to sell them, eight million jackets moved in one season. The problem is that entry and exit barriers prevent such productive retailers from expanding. Moreover, the prevalence of under-the-table payments to get better treatment from doctors and hospitals is a clear indication that Japanese consumers are willing to pay more for higher-quality services in health care.

Can Japan turn around?

If the impediments to competition are removed, our analyses suggest that productivity can grow by as much as 4.7 percent a year for the next ten years. Assuming that the workforce will decline by 0.5 percent a year because of the aging of Japan’s population, GDP per capita will then increase by a robust 4 percent a year.

How can GDP per capita grow at such a rapid rate? The ineffectiveness of the local economy in meeting consumer needs has created tremendous pent-up demand. The GDP will boom because reform will cause the Japanese to consume more of many products. Japanese consumption levels are much lower than those of the United States, for example: Americans consume 60 percent more clothes, twice as much at restaurants and hotels, and about 2.5 times more cars, books, and magazines. Furthermore, the reforms will cause capital productivity—and thus the return on savings—to rise. And, like the people of the United States, the Japanese will be able to consume more because their savings will be earning higher interest.

Our work demonstrates the important point that productivity improvements will not create long-term unemployment. GDP growth will therefore come with far less social dislocation than is commonly feared. To be sure, in the first years after the reforms are enacted, there will be a period when job losses are not yet matched by job creation. During this period, the government may have to increase unemployment benefits, which now stand at about US levels.

But this period will be short-lived (two to three years) because of a potential boom in underdeveloped consumer sectors such as health care. While retailing, food processing, and housing construction will experience job losses, our case study shows that the health care sector can create over one million jobs even after inefficiencies are removed. These jobs can come into existence as a result of staffing up to deliver higher service levels, new treatments, and care for the aging population. All told, we believe that the Japanese economy will be able to absorb a 50 percent increase in productivity over ten years with no increase in unemployment.

Despite the poor economic performance of the Japanese economy over the past decade and the failure of recent economic policy, we believe that Japan can turn itself around if the government begins a systematic program of reform aimed at increasing competition in all of the country’s local markets. While the Japanese economy will never regain the false luster it had during the years of the bubble economy, it does have the potential to return to a position of leadership and influence in the global economy.