Nishimura, Nakajima, and Kiyota (2005) analyze the entry/exit behavior patterns of Japanese firms during the 1990s and find that relatively efficient (high total factor productivity (TFP)) firms exited while relatively inefficient (low TFP) firms survived during the banking-crisis period of 1996-97. They conclude from this finding that the natural selection mechanism (NSM) apparently malfunctions during severe recessions, but we offer a much more plausible interpretation: the NSM continued to function effectively even during this period, but aberrant banking practices (in particular, "forbearance lending" ("evergreening") and the "forcible withdrawal of loans" and/or the "reluctance to lend") caused a shift in the type of natural selection from "directional selection" to "disruptive selection," with the most efficient (highest TFP) firms as well as the least efficient (lowest TFP) firms being favored and firms of intermediate efficiency and TFP being selected against.

Charles Yuji Horioka

Tae Okada

English

Research Papers in Economics

Discussion Paper No. 682 
 
 
 
 
 
 
 
 
A COMMENT ON NISHIMURA,   
NAKAJIMA, AND KIYOTA’S 
“DOES THE NATURAL SELECTION MECHANISM 
STILL WORK IN SEVERE RECESSIONS? 
EXAMINATION OF THE JAPANESE ECONOMY 
IN THE 1990s” 
 
Tae Okada 
and 
Charles Yuji Horioka 
 
 
 
 
 
 
 
 
 
 
January 2007 
 
 
The Institute of Social and Economic Research 
Osaka University 
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan 
 A Comment on Nishimura, Nakajima, and Kiyota’s “Does the
natural selection mechanism still work in severe recessions?
Examination of the Japanese economy in the 1990s”∗
Tae Okada
Graduate School of Economics, Osaka University, Osaka, Japan
and
Charles Yuji Horioka†
Institute of Social and Economic Research, Osaka University, Osaka, Japan, and
National Bureau of Economic Research, Cambridge, Massachusetts, USA
January 16, 2007
Abstract
Nishimura, Nakajima, and Kiyota (2005) analyze the entry/exit behavior patterns of
Japanese ﬁrms during the 1990s and ﬁnd that relatively eﬃcient (high total factor produc-
tivity (TFP)) ﬁrms exited while relatively ineﬃcient (low TFP) ﬁrms survived during the
banking-crisis period of 1996-97. They conclude from this ﬁnding that the natural selection
mechanism (NSM) apparently malfunctions during severe recessions, but we oﬀer a much
more plausible interpretation: the NSM continued to function eﬀectively even during this
period, but aberrant banking practices (in particular, “forbearance lending” (“evergreen-
ing”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”) caused a shift
in the type of natural selection from “directional selection” to “disruptive selection,” with
the most eﬃcient (highest TFP) ﬁrms as well as the least eﬃcient (lowest TFP) ﬁrms being
favored and ﬁrms of intermediate eﬃciency and TFP being selected against.
JEL Classiﬁcation: D21, D24, O47, L11
Keywords: Total factor productivity, Entry and exit, Natural selection, Directional selection,
Disruptive selection, Evolution, Banking crisis, Forbearance lending, Forcible withdrawal of loans,
Reluctance to lend, Credit crunch, Recession, Japanese economy, and Japan
∗The authors are grateful to Kazuo Ogawa for his valuable advice.
†Address all correspondence to: Charles Yuji Horioka, Institute of Social and Economic Research, Osaka
University, 6-1, Mihogaoka, Ibaraki, Osaka 567-0047, JAPAN. Tel.: 81-6-6879-8586/8574. Fax: 81-6-6878-2766.
Email: horioka@iser.osaka-u.ac.jp
11 Introduction
Previous authors have found that the natural selection mechanism (hereafter NSM) of economic
Darwinism works well in normal times, but, in an important paper, Nishimura, Nakajima, and
Kiyota (2005) (hereafter NNK) analyze the entry/exit behavior patterns of Japanese ﬁrms during
the 1990s and show that this mechanism apparently did not function eﬀectively during the
severe recession of the 1990s in Japan and that relatively eﬃcient (high total factor productivity
(hereafter TFP)) ﬁrms exited while relatively ineﬃcient (low TFP) ﬁrms survived during the
banking-crisis period of 1996-97.
NNK’s analysis is carefully executed and we do not have any major quibbles with the analysis
itself, but we want to oﬀer an alternative interpretation of their results. NNK conclude from their
ﬁnding that the NSM apparently malfunctions during severe recessions, but we oﬀer a much more
plausible interpretation that assumes that the NSM continued to function eﬀectively even during
the banking-crisis period of 1996-97 but that there was a shift from one type of natural selection
to another as a result of a number of aberrant practices followed by banks.
2 Did the NSM Continue to Function Eﬀectively during
Japan’s Severe Recession?
NNK conclude that the NSM malfunctioned during the banking-crisis period of 1996-97, but
they use an unduly narrow concept of natural selection. In this section, we describe three types
of natural selection and argue that the NSM continued to function eﬀectively even during the
1996-97 period but that there was a shift from one type of natural selection to another.
In the theory of evolution, there are at least three types of natural selection: (1) “stabilizing
selection” which acts against phenotypes at both extremes of the distribution and favors the
multiplication of intermediate phenotypes, (2) “directional selection,” which acts against only
one extreme of phenotypes, causing a shift in the distribution toward the other extreme, and
(3) “disruptive selection” (sometimes also called “diversifying selection”), which acts against
intermediate phenotypes, creating a bimodal distribution (see Darlington and Mather (1949)
and Mather (1953, 1955) for more details).
If we apply this taxonomy to the case of the Japanese economy of the 1990s, our interpretation
is that, until 1995, the NSM functioned eﬀectively in Japan and that the Japanese economy
exhibited “directional selection,” with natural selection favoring relatively eﬃcient (high TFP)
ﬁrms. Thus, relatively ineﬃcient (low TFP) ﬁrms exited and relatively eﬃcient (high TFP) ﬁrms
survived, as shown by NNK.
However, during the banking-crisis period of 1996-97, banks engaged in both “forbearance
2lending” (“evergreening”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”
(these two practices are collectively referred to as “credit crunch”), and this caused natural
selection to favor ﬁrms at both extremes. This caused a shift in the type of natural selection from
“directional selection” to “disruptive selection,” but the NSM continued to function eﬀectively
even during this period. In what follows, we describe in more detail the aforementioned banking
practices and how they led to a shift in the type of natural selection (see Kobayashi, Saita, and
Sekine (2002), Ogawa (2003), and Peek and Rosengren (2005) for more details).
“Forbearance lending” (“evergreening”) refers to the practice of banks continuing to lend to
less eﬃcient (low TFP) ﬁrms to keep them aﬂoat and to thereby avoid the need to declare existing
loans to theses ﬁrms as non-performing. Banks engaged in this practice during the banking-crisis
period of 1996-97 because the severe recession and the concomitant collapse of asset prices led
to a proliferation of non-performing loans and myopic bank managers wanted to delay writing
oﬀ those loans until they had retired and received the full amount of their lump-sum retirement
allowances, and because the Bank for International Settlements (hereafter BIS) regulations on
the capital adequacy of banks introduced in 1993 required banks to meet certain risk-based
capital ratios, which created a further incentive for banks to keep non-performing loans oﬀ their
books. And this practice of “forbearance lending” (“evergreening”) caused relatively ineﬃcient
(low TFP) ﬁrms to be favored.
However, banks also engaged in the “forcible withdrawal of loans” and/or the “reluctance
to lend,” which refers to the practice of banks’ calling in loans to more eﬃcient (high TFP)
ﬁrms and/or reducing their lending to such ﬁrms. Banks engaged in these practices during the
banking-crisis period of 1996-97 because the recession and the concomitant collapse of asset prices
had reduced bank capital, because banks had to reduce lending to satisfy the newly introduced
BIS regulations on the capital adequacy of banks, and because banks had to ﬁnd some way of
securing the funds needed to engage in “forbearance lending” (“evergreening”) to less eﬃcient
(low TFP) ﬁrms. And the “forcible withdrawal of funds” and/or the “reluctance to lend” acted
against ﬁrms of intermediate eﬃciency and TFP and forced some of them to exit.
Finally, the most eﬃcient (highest TFP) ﬁrms presumably did not have loans outstanding
to begin with, and even if they did, they could repay those loans without having to exit, and
moreover, they did not require additional loans to survive. Thus, their survival was not at all
threatened by the “forcible withdrawal of loans” and/or the “reluctance to lend.”
Thus, the NSM continued to function eﬀectively even during the banking-crisis period of
1996-97, but aberrant banking practices (viz., the combination of “forbearance lending” (“ever-
greening”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”) caused natural
selection to favor both the most eﬃcient (highest TFP) and least eﬃcient (lowest TFP) ﬁrms
and to act against ﬁrms of intermediate eﬃciency and TFP, which in turn caused a shift in the
3type of natural selection from “directional selection” to “disruptive selection.” This interpreta-
tion can explain NNK’s ﬁnding that relatively eﬃcient (high TFP) ﬁrms exited while relatively
ineﬃcient (low TFP) ﬁrms survived during the banking-crisis period of 1996-97 just as well as
their interpretation that the NSM malfunctions during severe recessions. Moreover, our interpre-
tation seems more plausible than NNK’s own interpretation of their ﬁndings because they do not
provide a convincing explanation of why a severe recession would ipso facto cause a breakdown of
the NSM. Indeed, NNK (p. 74) themselves assert that the combination of “forbearance lending”
and the “forcible withdrawal of loans” is a possible explanation of their ﬁnding.
3 Conclusion
To summarize, in an important paper, NNK analyze the entry/exit behavior patterns of Japanese
ﬁrms during the 1990s and show that relatively eﬃcient (high TFP) ﬁrms exited while relatively
ineﬃcient (low TFP) ﬁrms survived in Japan during the banking-crisis period of 1996-97. NNK
conclude from this ﬁnding that the natural selection mechanism (NSM) apparently malfunctions
during severe recessions, but we have oﬀered a much more plausible interpretation. Our alterna-
tive interpretation is that the NSM continued to function eﬀectively even during this period but
that aberrant banking practices during this period (in particular, “forbearance lending” (“ever-
greening”) and the “forcible withdrawal of loans” and/or the “reluctance to lend”) caused a shift
in the type of natural selection from “directional selection” to “disruptive selection,” with the
most eﬃcient (highest TFP) ﬁrms as well as the least eﬃcient (lowest TFP) ﬁrms being favored
and ﬁrms of intermediate eﬃciency and TFP being selected against. Thus, it was not that the
NSM malfunctioned but rather that aberrant banking practices caused a shift from one type of
natural selection to another.
Moreover, the shift from one type of natural selection to another during the banking-crisis
period of 1996-97 was induced not by the severe recession itself but by the aberrant banking
practices precipitated in part by the severe recession and the concomitant collapse of asset prices
and in part by other factors such as moral hazard on the part of myopic bank managers and
the introduction of BIS regulations on the capital adequacy of banks in 1993. It was this unique
conﬂuence of factors that produced the aberrant banking practices, and it was the aberrant
banking practices rather than the severe recession itself that caused the shift in the type of
natural selection. Therefore, it is not appropriate to draw sweeping generalizations from the
ﬁndings of NNK about the applicability of the NSM during severe recessions. It is quite possible
that not only does the NSM continue to function eﬀectively during severe recessions in other
countries and/or time periods but that there is no shift from directional selection to disruptive
selection.
4NNK deserve a great deal of credit for their meticulous analysis that sheds light on how the
entry/exit behavior patterns of ﬁrms changed during the banking-crisis period of 1996-97, but we
believe that our interpretation of their ﬁndings (that the NSM continued to function eﬀectively
but that it changed from one type of natural selection to another) is more plausible than their
own interpretation (that natural selection malfunctioned). It thus appears that natural selection
is still very much alive and well, even in Japan and even during severe recessions.
References
[1] Darlington, Cyril Dean, and Mather, Keith (1949), The Elements of Genetics. London: Allen
and Unwin.
[2] Kobayashi, Keiichiro; Saita, Yumi; and Sekine, Toshitaka (2002), “Iwayuru ‘Oigashi’ ni tsuite
(On So-called Evergreening),” Working Paper 02-2, Research Department, Bank of Japan (in
Japanese).
[3] Mather, Kenneth (1953), “The Genetical Structure of Populations,” Symposia of the Society
for Experimental Biology, vol. 7, pp. 66-95.
[4] Mather, Kenneth (1955), “Polymorphism as an Outcome of Disruptive Selection,” Evolution,
vol. 9, pp. 52-61.
[5] Nishimura, Kiyohiko G.; Nakajima, Takanobu; and Kiyota, Kozo (2005), “Does the Natural
Selection Mechanism Still Work in Severe Recessions? Examination of the Japanese Economy
in the 1990s,” Journal of Economic Behavior and Organization, vol. 58, pp. 53-78.
[6] Ogawa, Kazuo (2003), Daifukyou no Keizai Bunseki: Nihon Keizai Chouki Teimei no Kaimei
(An Economic Analysis of Severe Recessions: Shedding Light on the Long-term Stagnation
of the Japanese Economy). Tokyo: Nihon Keizai Shinbunsha (in Japanese).
[7] Peek, Joe, and Rosengren, Eric S. (2005), “Unnatural Selection: Perverse Incentives and the
Misallocation of Credit in Japan,” American Economic Review, vol. 95, pp. 1144-1166.
5

Daifukyou no Keizai Bunseki: Nihon Keizai Chouki Teimei no Kaimei (An Economic Analysis of Severe Recessions: Shedding Light on the Long-term Stagnation of the Japanese Economy). Tokyo: Nihon Keizai Shinbunsha

Iwayuru ‘Oigashi’ ni tsuite (On So-called Evergreening),” Working Paper 02-2, Research Department, Bank of Japan

Polymorphism as an

The Elements of Genetics. London: Allen and Unwin.

Unnatural Selection: Perverse Incentives and the

A Comment on Nishimura, Nakajima, and Kiyota's "Does the Natural Selection Mechanism Still Work in Severe Recessions? Examination of the Japanese Economy in the 1990s"

http://www.iser.osaka-u.ac.jp/library/dp/2007/DP0682.pdf

A Comment on Nishimura, Nakajima, and Kiyota's "Does the Natural Selection Mechanism Still Work in Severe Recessions? Examination of the Japanese Economy in the 1990s"

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