10. Postwar Recovery 1945-49

(See Handout no.8)

Physical war damage

Douglas MacArthur (1880-1964) and his big pipe. He led the US counterattacks against Japan and later became the head of GHQ.

After the war defeat, Japan was occupied by the allied forces (actually, the US was the only country in the allied forces to do this). The occupying force was called the Supreme Commander of the Allied Powers (SCAP) or the General Headquarters (GHQ--this term was more popular among Japanese). Douglas MacArthur (US army general) headed the GHQ. In contrast to Germany, Japanese occupation was indirect (the Japanese government continued to exist and function, and sometimes even resisted US orders), and by only one country (US).

After the war, the US conducted a review on the effectiveness of military attacks against Japan during the war. There were two factors that contributed to Japan's defeat.

Sea lane blockade--by sinking virtually all Japanese military and commercial ships, the country lost the means to transport energy and materials between the mainland and the colonies or occupied areas. Without inputs, production came to a halt. This was the primary reason for the collapse of Japan's war economy.

Strategic bombing (mostly in 1945)--Virtually all Japanese major cities were subject to US aerial bombing. The largest air raid was conducted in the eastern sections of Tokyo on March 10, 1945 when about 100,000 people were trapped in fire and killed within a few hours. Atomic bombs were dropped on Hiroshima (90-120,000 immediately killed) and Nagasaki (60-70,000 immediately killed). However, bombing did not reduce Japan's production capacity as much as expected, although it had a strong psychological impact.

Thus, the US report concluded that the sea lane blockade was more effective than the strategic bombing. It also argued that US bombing should have targeted railroads rather than housing.

The Japanese government also produced a report on war damage. Between 1935 and 1945, Japan lost the following percentages of physical assets (most loss was incurred toward the end of the war):

Type of capital Loss
Total capital stock 25%
     Military planes and ships 100%
     Commercial ships 81%
     Industrial machines 34%
     Urban housing 33%
     Buildings and structure 25%
     Telegraph, telephone, water supply 16%
     Electricity and gas supply 11%
     Railroad and other land transportation     10%

The majority of machinery stock survived despite heavy air raids. The surviving factories and railroads were inoperative, however, due to the lack of energy and inputs. Immediately after the war (1945-46), output collapsed to only 20% of the wartime peak, or 30% of the prewar peak (1934-36). The lack of inputs was the reason, not the lack of capacity.

Shortage and inflation

Economic planning was continued even after the war (until 1949--see below). In a crisis situation, economic control must replace paralyzed private sector activity. As during the war, necessities continued to be rationed and the government directed production and input procurement. Prices were controlled, subsidies were provided and the economy was still tightly regulated. However, compared with the wartime, controls became less effective because of the emergence of black markets.

Shortage was most severe and living standards were lowest in 1946,  a year after the end of the war. As food became extremely scarce, it was feared that many people would be starved to death (this did not happen). Black markets popped up and urban residents had to travel to rural villages in super crowded trains to exchange their remaining property (kimono, clothes, etc) for food. Farmers who produced food were better off, at least economically. Many people worked in the informal sector to survive. [My grandmother, after her house was destroyed by an air raid in Kobe, opened a barbershop on the street.]

Rationed food was too small in quantity. Everyone had to violate the law and go to the black market to survive. It is reported that Judge Yoshitada Yamaguchi of Tokyo District Court was so honest that he did not want to break the Food Control Law. He ate only rationed food and refused to take advantage of illegal food. In October 1947, he died of starvation.

As soldiers and civilians returned home from war fronts and former colonies, unemployment became a serious problem. It was feared that joblessness would reach 10 million. This did not actually happen because most returnees were absorbed in the (informal) service and agricultural sectors.

The people's economic life was hardest from late 1945 to 1946, Many urban people lost their houses and properties, even if they survived the US bombing. From left to right, (1) life in a makeshift hut; (2) eating simple food at a black market; (3) a train packed with city dwellers traveling to country side to barter clothing for food (but if caught by police, they would confiscate your purchase).

To cope with output collapse and unemployment, the Japanese government printed money to finance subsidies while trying to control prices. Clearly, this strategy could not be sustained for long. Monetization of fiscal deficits created triple-digit inflation from 1946 to 1949. Black market inflation was even higher, especially in the early period. This was the highest inflation that Japan ever experienced, before or after.

Foreign trade was strictly controlled and had to be approved by SCAP. Private foreign trade was prohibited. For each commodity, SCAP decided the dollar price and the yen price separately, so an implicit exchange rate existed for each item (multiple exchange rates). Exchange rates for exports (150-600 yen per dollar) were generally more depreciated than exchange rates for imports (125-250 yen per dollar).

The volume of international trade was very limited. Apart from controlled trade, the US provided large amounts of humanitarian and economic aid to Japan (cumulative $1.95 billion during 1946-50) which helped to offset the shortage in food and consumer goods.

It was said that the Japanese economy was barely surviving with two artificial supports: subsidies and US aid. These supports had to be removed as quickly as possible.

"Basic Problems" of 1946

Immediately after the war defeat (actually, preparation began even before that), a few young officials started to discuss the way to rebuild the Japanese economy from war damage. Their names were Saburo Okita and Yonosuke Goto [the former is the father of Prof. Yoichi Okita of GRIPS]. They were electrical engineers stationed in Beijing, but they knew Japan would soon lose the war. They returned to Tokyo and began to organize a study group.

The first meeting of the study group was held on August 16, 1945, one day after Japan's defeat. The topic was the possible impact of the Bretton Woods Agreement concluded a year earlier and the creation of the IMF and the World Bank. After that, study meetings on various topics were hosted every week with the attendance of prominent officials and academics. Okita and Goto provided secretarial service, summarizing the key points of each discussion and drafting a report. The study was started as a private endeavor but later officially recognized as the Special Survey Committee of the Ministry of Foreign Affairs. The interim report was issued in late 1945 and the final draft was produced in March 1946. With minor revisions, the Final Report was published in September 1946.

This report with the title of "The Basic Problems of Japan's Economic Reconstruction," was an excellent example of Japanese development thinking. Many of the ideas proposed here are common to Japan's policy advice even today. For example, when Prof. Tatsuo Kaneda drafted a policy recommendation for Kyrgyzstan in 1992, or when Prof. Shigeru Ishikawa wrote a JICA report on Vietnam in 1994, their perspectives were very similar to the "Basic Problems" report. While the targeted industries differ from one country to another, the procedure to identify and study them is common. [Even my ongoing project on Vietnam's industrialization under integration is influenced by the methodology of this report.]

The report has 193 pages in two parts. The first part analyzes the new global situation and the historical and geographical position of the defeated Japan. War damage is carefully examined and some positive aspects are also noted. The second part contains proposals for promoting industries and targeting exports, sector by sector and with concrete policy actions needed. Real sector issues dominate, while monetary and fiscal problems are discussed only lightly. The key ideas in the report are as follows (also see handout 8):

--Japan's economic vision should be based on the deep analysis of shifting global trends.

--A comprehensive and concrete recovery strategy must be designed and implemented. It must be based on industrialization, technology improvement and dynamic trade pattern.

--For now, investment is more important than consumption. People should endure low living standards until the economy is firmly on a growth path.

--A free economy does not function properly in a crisis situation. Recovery requires concentrated efforts, but free markets fritters away scarce resources.

--Each important industry must be analyzed carefully, and realistic and concrete promotion programs must be proposed. More specifically, Japan must aim at skilled labor-intensive industries. Comparative advantages in textile and agriculture were now lost because of expected emergence of the rest of Asia.

Many people were inspired by this report, but its recommendations were not formally adopted by the government. Indirectly, however, the idea that "limited resources must be selectively used for restarting an expansionary reproduction cycle" was put into practice by the priority production system directed by Prof. Hiromi Arisawa, one of the members of the study group (see below).

The "Basic Problems" report is now available in English translation (see the reference section).

The red line (left scale) shows the stock of Bank of Japan notes in circulation; the blue line (right scale) shows the Tokyo retail price index (the average of 1934-36 =1.0).  "The Basic Problems of Japan's Economic Reconstruction." Printing paper was extremely scarce at that time.

How to stop inflation

After inflation peaked in 1946, it persisted at triple digit level until 1949. Its cause was clear: monetization of the fiscal deficit. The fiscal deficit in turn was generated by the following two policies.

Subsidies--mainly directed at intermediate inputs (coal, steel, copper, fertilizer and the like) but some were targeted at consumer goods (food). More precisely, price controls were imposed, and the government provided production subsidies (literally called "compensation for price gaps") in order to cover the losses incurred by private manufacturers.

Recovery Financial Fund (fukkin) loans--this was mainly for the coal industry. Policy loans were provided by the Ministry of Finance to designated priority industries. Government bonds (fukkin bonds) were issued to finance these loans. Most of these bonds were directly purchased by the Bank of Japan, which increased money supply.

Economists still debate the merits and demerits of these policies. From the viewpoint of stopping inflation, they were clearly undesirable and had to be terminated as soon as possible. But from the viewpoint of real sector recovery, a delicate balance must be struck between fighting inflation and sustaining output. Cutting these subsidies and loans immediately might have killed all remaining industrial activities.

The first (failed) attempt to stop the inflation was the deposit blockade of 1946. The government suddenly announced that (i) everyone now had an upper limit (500 yen/month) in the withdrawal of bank deposits; (ii) existing paper notes would be annulled unless they were deposited at the bank. Thus, people were forced to keep their money at the bank while inflation continued. This reduced money supply to one-third and slowed inflation temporarily. But people naturally felt deceived by the government and the credibility of monetary policy was lost. Soon, inflation accelerated again.

There were different approaches to disinflation, and they were hotly debated.

(1)Accepting inflation: in July 1946, finance minister Tanzan Ishibashi stated that a budget deficit and high inflation were acceptable as long as they prevented further output collapse and unemployment. He said the present inflation in Japan was caused by supply shortage and not by demand excess. Thus, price stability called for supporting producers and workers. A sound budget in such a situation meant accepting a fiscal deficit.

(2) Shock approach: in January 1948, Mr Kihachiro Kimura, a socialist member of parliament, argued the opposite. He said that price stability was the precondition for output recovery. As long as inflation continued, people would hoard goods in anticipation of higher prices. This would reduce supply and raise prices even more. A bold anti-inflation policy was necessary to stop this vicious circle. The US government (in Washington) also shared this view.

(3) Gradualism: the Economic Stabilization Board as well as General MacArthur of SCAP feared that big-bang stabilization would devastate Japanese industries and lead to social crisis. They hoped to lower inflation step by step using subsidies, fukkin loans and US aid while reducing these support measures over time.

(4) Conditional shock approach: Prof. Hiromi Arisawa of Tokyo University recognized that anti-inflation policy would reduce output temporarily. But he also knew that inflation had to be eliminated to end speculation and hoarding. He argued that output must be raised by the planning method to 60% of the prewar level, then an strong anti-inflation package should be adopted. Output would probably fall back to about 30% of the prewar level following this shock, but people could somehow endure this level, which actually prevailed in 1946. If anti-inflation policy was implemented too soon without such initial output recovery, the shock would be too severe.

The actual policy turned out to be close to what Prof. Arisawa proposed.

Priority production system, 1947-48

The priority production system (PPS) refers to a policy of concentrating scarce resources on a few strategically important industries to jump-start a recovery (though it is called "system," it is actually a policy). It is a type of economic planning. Recovery of a few key industries is expected to have positive spillover effects on the entire economy.

Prof. Arisawa was a member of the personal advisory group of prime minister Shigeru Yoshida. In July 1946, General MacArthur of SCAP told Yoshida that he would allow Japan to import a few goods. Yoshida ordered bureaucrats to prepare a wish list for imports, but the list they produced was too long. So Yoshida asked his advisors to shorten the list. The following five items finally remained: steel, coal (anthracite), heavy oil, rubber, and buses.

Mr. Mizutani, minister of commerce and industry, visited Joban coal mine underground to encourage workers in 1947.

MacArthur did not want to let Japan import heavy oil since it was globally in short supply. But Prof. Arisawa urged prime minister Yoshida to renegotiate with the Americans, saying that if Japan was permitted to import heavy oil, the Japanese government would promise to produce 30 million tons of coal. Heavy oil was input to steel production, and steel was needed to rehabilitate coal mines. For Japan, coal was the only energy source which was domestically available. If enough coal was produced, the surplus could be distributed as an energy input to other industries.

MacArthur agreed to let Japan import heavy oil under this promise. Prof. Arisawa, who proposed the idea, became the chairman of the subcommittee responsible for producing 30 million tons of coal. His method was meticulous. He summoned general directors and chief engineers of all coal mines in Japan for information. Based on actual coal deposits, veins, extraction speed, working hours and so on, he calculated the supply capacity. On the demand side, he estimated the possible coal use by SCAP, power companies, railroads, and industries.

"Dig 30 million tons of coal" became a sort of national campaign. The minister of commerce and industry visited the Joban Mine to encourage workers. In the streets of large cities, the daily output of coal was posted. The evening radio program sent words of thanks to hard-working coal miners all over Japan. The government secured inputs (using subsidies and fukkin loans) and provided housing for coal miners. Although the actual delivery of imported heavy oil was delayed, the production goal was more or less realized. Domestic coal production in 1947 was 29.32 million tons.

Output of key industries other than coal fell slightly short of targets in 1947. But PPS was continued in 1948 and most targets were achieved in that year. The economy began to rebound in 1947. But inflation was still high.

US policy on occupied Japan

Japan was under US occupation from 1945 to 1951. During this period, US policy on occupied Japan shifted significantly.

At first, the objective of occupation was demilitalization of Japan. The US wanted to cripple the Japanese economy so that it would never be able to produce military goods again. No heavy industry was to be allowed. Remaining machines were to be stripped and shipped to the rest of Asia as reparation in kind. (These policies were not actually implemented.) SCAP also introduced democracy, since the lack of democracy--monopolistic businesses, lack of workers' rights, exploited peasants--was considered to be the cause of Japan's military invasion. The following three democratic reforms were adopted:

Zaibatsu breakup--big businesses were accused of helping militarism during the war. Group companies were broken up into separate entities. But this policy was later reversed and a new type of industrial groups, called keiretsu, emerged.

New labor laws--the new laws guaranteed workers' rights on organizing labor unions, collective bargaining and basic working conditions.

Land reform--all farmlands of absentee landlords and holdings above certain limits were confiscated and sold to actual tillers (the price was low and high inflation quickly depreciated its real value). This increased the land ownership of farmers significantly, which was good, but land was now divided into too many small plots to conduct efficient farming, which was not good. This situation continues even today.

In addition, a new constitution was drafted and implemented under the pressure of SCAP on May 3, 1947 (the government now celebrates this day as a national holiday). Compared with the Meiji Constitution of 1889, the following features are noteworthy:

--Sovereignty rests with people.
--Emperor is a symbol of Japan with no political functions.
--Renunciation of war and non-possession of military forces (Article 9).
--Guarantee of basic human rights.
--Separation of power among legislative, administrative and judicial branches.

Article 9 is unique to Japan and has caused many heated arguments ever since. Although the possession of armed forces is renounced by the constitution, Japan now actually has the Self-Defense Force (its headquarter is in Ichigaya near the GRIPS campus--you can see its tall communications structure). Hardliners want to change Article 9 so Japan can own full military force. Others want to keep Article 9 and abolish the Self-Defense Force. The full text of Article 9 runs as follows:

Aspiring sincerely to an international peace based on justice and order, the Japanese people forever renounce war as a sovereign right of the nation and the threat or use of force as means of settling international disputes.
In order to accomplish the aim of the preceding paragraph, land, sea, and air forces, as well as other war potential, will never be maintained. The right of belligerency of the state will not be recognized.

But around 1947, US occupation policy shifted dramatically because of the start of the Cold War. Now the US wanted to strengthen Japan as a capitalist ally and an anti-communist base. Besides that, economic aid to Japan was becoming too burdensome for US taxpayers. Remilitarization and economic recovery of Japan (including heavy industries) were promoted. Socialist and labor movements were discouraged.

In addition, a policy gap existed within the US government as noted above. Washington demanded free markets and big-bang macroeconomic stabilization as soon as possible, but MacArthur and his SCAP staff in Tokyo (they were called "New Dealers": they supported official intervention at the time of the Great Depression in the 1930s) preferred gradualism with appropriate state roles.

Dodge Line stabilization of 1949

But this debate within the US government was ended when Washington sent Mr. Joseph Dodge to Tokyo in early 1949. Mr. Dodge was the president of Detroit Bank and a strong believer of the free economy. He ordered the following austerity measures to terminate inflation. His policy package was called "Dodge Line."

--Stop fukkin loans.
--Abolish all subsidies and raise utility prices.
--Strengthen taxation and cut expenditure.
--Have a "super-balanced budget" (the primary balance should be zero, which means the entire budget should be in surplus).
--Unify multiple exchange rates at $1=360 yen.

In addition, Prof. C.S. Shoup (fiscal expert) was also sent to Japan to introduce a new tax system. His advice was adopted in 1950 and became the basis of Japanese taxation in the postwar period. It was a system with a heavy reliance on direct taxes (income and corporate taxes) which became a key feature of the Japanese tax system for a long time to follow. Japan had no broad-based indirect tax (such as VAT or general consumption tax) until 1989.

The Dodge Line stabilization was very successful in stopping inflation. But as feared, the shock on economic activity was severe and people expected a serious recession. Indeed, output soon began to decline. The Bank of Japan tried to supply liquidity against the order of Mr. Dodge. Prof. Arisawa felt that stabilization measures were adopted too soon; he thought that Mr. Dodge should have waited another year.

We do not know how serious this recession would have been, because another big event intervened. As the Japanese economy started to shrink, the Korean War (1950-53) broke out. Whatever the political implication of this war might be, its impact on the Japanese economy was positive. The US forces used Japan as a supply base and procured great amounts of military and civilian goods. For Japanese industries, this was tantamount to a sharp increase in external demand (just like during WW1 previously). The recession ended quickly and the Japanese economy began to grow. Minor inflation also returned, but price stability was restored after the Korean War.

Dodge Line stabilization also had important systemic implications. The Japanese economy had been under planning since 1937 and economic control continued during the postwar recovery period. The achievement of price stability and the end of price controls and subsidies finally allowed Japan to return to a freer economy. Now the national economy could be deregulated and the role of government could be reduced. However, this did not mean a completely free economy; a lot of official interventions remained even after the end of planning.

Mr. Joseph Dodge is sometimes appreciated for ending inflation and restoring economic freedom, and sometimes criticized for implementing a shock therapy (although its undesirable effect was cancelled by the Korean War). I think there are more Japanese who thank him than blame him.

Hiromi Arisawa and Saburo Okita discuss the postwar recovery policy

Professor Hiromi Arisawa (1896-1988) Mr. Saburo Okita (1914-1993)

Below is the excerpt (pp.33-34) from a dialogue which took place between these two gentlemen in 1986 (quoted from Arisawa's 1989 book listed in the reference section). Both of them were deeply involved in the postwar recovery policies.

OKITA: What was your opinion on the nationalization of coal mines [around 1946-47]?

ARISAWA: As for me, I never thought about it.

OKITA: Was it at the time of minister of commerce and industry Chosaburo Mizutani? A law on nationalization of coal mines was proposed.

ARISAWA: I never thought of nationalization. As a matter of fact, the Japanese coal mines were already operating under government's directives. In other words, coal mines were virtually under state control. Germany nationalized coal production, and I discussed the matter extensively in many articles. But I had no intention of nationalizing our coal mines. Of course, if some unexpected situation arose, nationalization would have been an option. But what was the point in nationalizing only coal?

OKITA: Around that time, there was a debate over the so-called Chukan Antei Ron [intermediate stabilization, which means not big bang but gradual disinflation] between you and Mr. Kimura, the socialist member of the parliament. Your idea was to stop inflation after the government permitted the output to recover to a certain level relative to the prewar size. But Mr. Kimura regarded disinflation as the prerequisite for output recovery. That was the key point in the debate. You wrote in an article that the two views differed in the prioritization of policies. It certainly was a big difference, from the viewpoint of your "economics of transition."

ARISAWA: Regarding the disinflation policy, my view at that time was to adopt the priority production system first to let the production recover to 60% of the prewar level, then stop the inflation by bold measures. If the big bang disinflation were introduced before output recovery, it would have plunged the Japanese economy into a tremendous confusion, so it should not have been done. In either case, inflation stabilization would cause the output to decline. The crucial point was how severe this decline would be. Bold stabilization measures were unavoidable, but the timing must be chosen wisely, at a time when the priority production system proceeded further and the output reached 60% of the prewar level.

My view was that bold stabilization would surely cause the output to decline. Under the worst scenario, the output might even decline to a half. I insisted on the recovery to 60% of the prewar level, because if you had that level, the subsequent output decline would take it to the 30% of the prewar level. Since output actually fell to that level immediately after the war and people could somehow survive, to me that was the minimum acceptable level.



Arisawa, Hiromi, Sengo Keizai o Kataru: Showashi eno Shogen (A Commentary on the Postwar Economy: A Testimony to the History of Showa), Tokyo University Press, 1989. 

Iwanami Shoten, Keikakuka to Minshuka, Nihon Keizaishi 7  (Planning and Democratization,  Japanese Economic History vol. 7), T. Nakamura ed, 1989.

Kosai, Yutaka, En no Sengoshi (The Postwar History of the Yen), NHK Ningendaigaku Textbook, 1995.

Kosai, Yutaka, and Juro Teranishi, eds, Sengo Nihon no Keizai Kaikaku: Shijo to Seifu (Economic Reforms of Postwar Japan: Market and Government), Tokyo University Press, 1993.

Okita, Saburo, ed, Postwar Reconstruction of the Japanese Economy, University of Tokyo Press, 1992 [this is the English translation of the report mentioned in the text as the Basic Problems of Japan's Economic Reconstruction, which is a literal translation of the title].