School for Scandal: Why Japan May Lose Its Competitive Edge : Business: Preferential business practices revealed by financial corruption undercut what makes the Japanese economy go round--trust.

Few in Japan expect that the country’s current financial scandals, set off by reports that its major brokerage houses absorbed the investment losses of their blue-chip corporate clients, will lead to serious reforms. True, some participants have been lightly punished, the finance minister has resigned and Parliament has called for greater independent regulation. But to many Japanese, Japan’s financial improprieties pale in comparison with those committed in the United States, like the savings-and-loan debacle.

The true significance of the Japanese scandals, however, cannot be simply measured by the size of the payoffs. Much more important are the preferential business practices that the financial deceit reveals. Despite billions of dollars invested in Japan, not one foreigner was rescued from a bad investment. Also left out in the cold were thousands of smaller Japanese investors. In effect, Japan’s blue-chip corporations were the beneficiaries of an investment insurance program paid for, unwittingly, by every other investor. Left uncorrected, such preferential business behavior may ultimately erode the source of the economy’s competitive advantage--trust.

Trust, new research suggests, profoundly affects economic performance. When individuals and businesses trust each other, exchanges of technology, of manufacturing skills, of marketing know-how and personnel are easier. Businesses can collaborate to achieve market goals. In a “high-trust” economy, such as California’s Silicon Valley, rapid product development, flexible manufacturing capabilities and aggressive, adaptive marketing flourish.

But when economic participants fear each other’s motives, and cannot alleviate these concerns, they are driven to protect themselves by insisting on minutely specified, highly inflexible work rules or contracts. In a “low-trust” economy, such as the U.S. or British automobile industries, exchanges and collaboration that foster competitiveness are frustrated.

Japan currently enjoys a high-trust economy. But in the 1950s and early 1960s, it seemed destined to be another Detroit. Japan’s larger companies, with tacit bureaucratic approval, ruthlessly squeezed wage and price concessions from the country’s numerous subcontractors. In response, the subcontractors won broad remedial legislation, massive financial support from specialized banks and substantial technological assistance. Aided in this fashion, they effectively resisted the most onerous attempts at wage and price exploitation.

Larger contractors, in turn, adjusted their procurement strategies and began to rely on and foster the subcontractors’ increasingly sophisticated design, manufacturing and assembly skills. As collaboration between the two sectors grew, mistrust abated. Continuous new-product development, rapid commercialization of technology and dramatic quality advances--the hallmarks of a high-trust, highly competitive economy--became commonplace.

The preferential business practices that created the latest scandals threaten to undo these accomplishments. For starters, they may signal the resurgence of large-firm self-dealing, one of the reasons for Japan’s early postwar industrial conflicts. If the economy again tilts unfairly in favor of the larger firms, the domestic balance of power that created Japan’s high-trust economy may come undone. Small firms, which now possess design, manufacturing and marketing skills as good as any in the world, might refuse to collaborate freely with the major contractors.

Japanese subcontractors might also shift their business to foreign contractors, which may offer them better terms and treat them more equitably. If so, foreign companies will acquire the same extraordinary skills that have been fundamental to the success of Japan’s brand-name corporations. In fact, U.S. and European companies have already begun to exploit the growing rift between Japan’s larger and smaller firms, luring disgruntled, sophisticated producers away from their traditional business partners in Japan.

The anti-foreign bias revealed by the scandals may also further inhibit the global expansion of Japan’s high-trust economy. To compete in the future, producers will have to search for and procure industrial, financial and marketing skills around the world. But Japanese multinationals appear to be much less able to integrate with foreigners than their U.S., European or (in the Pacific region) non-communist Chinese counterparts.

Despite the fact that Japanese investors may be the overwhelming economic force in their countries, foreign producers often resist collaborating with them, instead courting business partners from other countries. In some instances, especially in Southeast Asia, local firms and government officials actively promote investment from other nations to reduce their reliance on Japan. In other cases, top indigenous talent has simply refused to work with Japanese multinationals because of perceived--or actual--unfair treatment. Should these trends continue, Japan will be increasingly isolated as the world’s economies become increasingly integrated, thereby diminishing its competitive edge.

Undercutting foreigners may also inadvertently transform Japanese firms from high-trust to low-trust institutions. At home, Japanese corporate behavior has been shaped by the prevailing high-trust environment. There are few defensive, low-trust barriers affecting the flow of personnel, technology or market information both inside and between firms.

But outside their home base, Japanese companies often develop low-trust bad habits. Even in comparatively advanced countries, such as in the United States and Europe, non-Japanese employees are typically denied routine information and have little corporate responsibility.

Conditions can be much worse in Asia or Latin America, where Japanese companies frequently desire only to exploit the low-wage, low-skill indigenous workers. Japanese companies thus take on low-trust attributes as they move abroad. As a result, their overseas subsidiaries usually underperform comparable producers in Japan. In service sectors like banking, where interpersonal trust is indispensable, Japanese subsidiaries are even proving much less competitive than indigenous companies.

Such low-trust relations developed abroad may also come back to haunt Japanese multinationals at home. Thousands of Japanese are exposed to low-trust business practices as they rotate through their firms’ overseas affiliates. It is likely that, after returning to Japan, their business instincts will be shaped by these experiences. Furthermore, as new corporate policies are formulated to guide transactions with foreigners, two sets of rules will arise inside Japanese companies. Existing high-trust principles applicable to “normal” Japanese employees will begin to commingle with the new low-trust rules for everyone else. It is far from clear that the Japanese firms’ high-trust system can survive this influence.

The financial scandals thus deserve much more serious attention in Japan. Properly understood, they provide early warning signals of the effects of preferential business practices that, if unmodified, can reverse the country’s spectacular success. High-trust economies are fragile; they can all too easily be transformed into far less competitive, low-trust alternatives. If the Japanese continue to ignore the real message of the current scandals, their economic future may be considerably less bright than their past.