Will Technology Leave Japan Behind?

More investment in innovation will be needed to propel the economy into the future

Perhaps in another time and another place, things would have turned out differently for Japanese Internet startups. As the market took off around 1994, entrepreneurs launched 2,000 such ventures, confident that the technology-driven forces sweeping through the American economy soon would engulf Japan. They also figured that demand for software, high-speed computer networks, and Net-related offerings would explode. And Japanese investors would continue to pump funds into Internet-services firms.

Four years later, half of those ventures have vanished. And one survivor, Joichi Ito, president of Digital Garage, a search-agent vendor, has a darker view of Japan's prospects in the Information Age. The nation's debt-soaked banks--the source of 45% of Japan's venture capital--aren't in the mood to lend to risky startups. Nor are established high-tech giants willing to nurture small firms that could become competition. With Japan caught in the grip of a recession, deep structural problems, and a long bear market, Ito has postponed plans to list his company on Tokyo's over-the-counter market. Instead, he's looking for a Silicon Valley partner to take a big equity stake. "I think a lot of Internet startups are going to look to the U.S. for cash," he says.

Digital Garage--and plenty of others--may well succeed. But that raises the question: Why do entrepreneurs such as Ito face so many obstacles when it comes to trying out new ideas? Sure, Japan is home to world-class multinationals, a highly educated workforce, and the world's biggest stash of savings. Yet it fails miserably at freeing up those resources for promising startups, providing incentives for managers to challenge old certainties, or marshaling Japan's considerable research and development spending into breakthrough products and industries. If the future belongs to economies driven by innovation and knowledge, where does that leave Japan?

The problems run deeper than the banking crisis that has grabbed headlines of late. If Japan is to regain its edge, its entire economic model will need rethinking. For decades, well-trained bureaucrats have funneled capital to export-oriented industries. It worked brilliantly during Japan's postwar catch-up phase. Not so in this decade--since 1992, Japan's average annual growth has barely topped 1%.

SLOW TO CHANGE. True, Japan has a world-class manufacturing sector, accounting for 24% of the nation's output, vs. 13% in the U.S. Nobody can design and roll cars off assembly lines better than Toyota Motor Corp. The majority of the economy, though, doesn't nearly match up. The productivity of Japan's banks, brokerages, retailers, and other services is two-thirds, on average, of their counterparts in the U.S., according to the McKinsey Global Institute.

These sectors have scarcely started the transition to the Information Age, where flexibility and speed matter. One reason is that they tend to be heavily regulated, subsidized, and protected from the forces of a cost-competitive global economy. Another is that Japan's consensus-leaning, top-down management style is slow to embrace technologies that would transfer decision-making to middle managers. That's changing, but not fast enough. "The fundamental reason why Japan is weak in information technology is because of its 1940s-era economic system," says Yukio Noguchi, a professor at the University of Tokyo's Research Center for Advanced Science & Technology.

Moreover, fostering startups in leading-edge businesses has only recently become a priority in Japan. Bureaucrats can readily cite the latest statistics for car production or silk-cocoon yields. But there's precious little tracking or promotion of the entrepreneurial sector. Only now, with high tech fueling impressive growth in the U.S., are Japanese policymakers and economists starting to take notice.

Bureaucrats at the Ministry of International Trade & Industry (MITI), who for years have coddled the manufacturing sector, have begun drafting new policies, in hopes of spurring the creation of high-tech ventures. At the urging of Stanford University economist Masahiko Aoki, who is coaching MITI officials in his capacity as head of the Research Institute of International Trade & Industry, MITI this year scrapped regulations that ban the creation of holding companies. Aoki and MITI officials are pressing for tax revisions to enable holding companies to write off losses from money-losing ventures.

The government recently took another step in the right direction by smoothing the way for companies to offer stock options as a means of attracting talented staff. Japan had discouraged options in the past by taxing individuals on the value of their stock options even if they were unrealized paper gains. Three years ago, when Softbank Corp. chief executive officer Masayoshi Son started offering top officers such incentives, other Japanese executives scolded him for "stupidly giving employees the kind of financial incentives that would harm the nation's work spirit," he recalls with a laugh. These days, Softbank, Sony Corp., and others are sharing more wealth.

PRICEY CALLS. Despite such progress, numerous obstacles remain. One big barrier is the lack of spending on information technology in Japan--as Intel Corp.'s Andrew S. Grove and Microsoft Corp.'s William H. Gates III are quick to point out on every trip to Tokyo. Thanks to the current downturn, shipments of PCs in the fiscal year ended last Mar. 31 were down 5% from the previous year. And the high cost of telecommunications--a function of Nippon Telegraph & Telephone Corp.'s monopoly in local phone service--is discouraging greater use of the Internet. Japan invests only 2% of its gross domestic product in information technology, compared with 3% for Britain and Australia and 4% for the U.S.

Another problem is the dearth of talented entrepreneurs. Ito, who learned the ropes as a computer engineer in the U.S., is surprised at his peers' lack of skill. "The kind of people who go into venture businesses seem to be the type who can't do anything else," he says. That's not to say that Japan lacks talent. For the most part, though, gifted engineers and executives prefer to hold on to their jobs at big corporations.

That's because although the so-called lifetime-employment system is starting to crumble, large companies still manage to retain their best and brightest with the lure of job security and high pay. In doing so, they discourage job mobility--and creativity, too, since good ideas rarely make it through large corporations' bureaucratic structures. "Many talented engineers are trapped in large companies such as Toshiba Corp. or Fujitsu Ltd.," points out Tokyo University's Noguchi. "So even if they have creativity or brilliant ideas, they won't be able to realize their talents."

While the government has taken some steps to encourage growth in the information-technology sector, it could be doing a lot more. Some critics are calling on Tokyo to abolish taxes on computers and software products for corporate use to spur purchases of client-server systems and new services. Despite such pleas, the Finance Ministry decided to reduce from $1,400 to $700 the ceiling on what businesses may deduct for each information-technology purchase, starting this year.

ROTE LEARNING. It's obvious Japan also needs to seed innovation. The first step is to reform primary education to reduce the emphasis on rote learning and encourage creativity--as well as the use of PCs. While nearly all kids have access to at least some computers, the average elementary school offers just 10 machines for hundreds of students. And few teachers know how to use PCs, much less guide their pupils.

Next, the government must continue to revamp university labs to boost basic research--a strategy it initiated in 1996. Currently, some 80% of Japanese research and development takes place in private labs, which focus on application, not innovation. So it's no surprise that Japan trails in the race to become a sci-tech leader in the future. What about the country's prowess in such areas as semiconductors, robotics, and digital technology? "These are commodity components and not a cash cow," points out Kiyoshi Kuriyama, research director at Gartner Group Japan. "We're not going to create a revolution."

Yet a revolution is precisely what Japan needs. The alternative is to cede high-growth industries of the future to U.S. and European rivals. Homegrown software makers such as Ascii Corp. and Justsystem Inc. have been all but wiped out by Microsoft's dominance in operating-system and applications software. And even now, Japanese companies are cautious about embracing the information technologies that could get them back in stride. If business and government fail to heed the warning signs, Japan's future looks grim indeed. "If this situation develops into a real crisis, creative individuals and successful companies will start fleeing the country," warns Tokyo University's Noguchi. By then, it could be too late to catch up.

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