Nishimura et al. (2005) analyze the entry/exit behavior of Japanese firms during the 1990s and find that relatively efficient firms exited while relatively inefficient firms survived during the banking-crisis period of 1996-97. They conclude that the natural selection mechanism (NSM) apparently malfunctions during severe recessions, but we offer a more plausible interpretation: NSM continued to function effectively even during this period, but aberrant banking practices caused a shift in the type of natural selection from directional to disruptive selection, with the most efficient as well as the least efficient firms being favored and firms of intermediate efficiency being selected against.

Charles Yuji Horioka

Tae Okada

English

Research Papers in Economics

NBER WORKING PAPER SERIES
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
Charles Yuji Horioka
Working Paper 13298
http://www.nber.org/papers/w13298
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
August 2007
The authors are grateful to Kazuo Ogawa for his valuable advice. The views expressed herein are those
of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
© 2007 by Tae Okada and Charles Yuji Horioka. All rights reserved. Short sections of text, not to
exceed two paragraphs, may be quoted without explicit permission provided that full credit, including
© notice, is given to the source.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
NBER Working Paper No. 13298
August 2007
JEL No. D21,D24,L11,O47
ABSTRACT
Nishimura et al. (2005) analyze the entry/exit behavior of Japanese firms during the 1990s and find
that relatively efficient firms exited while relatively inefficient firms survived during the banking-crisis
period of 1996-97.  They conclude that the natural selection mechanism (NSM) apparently malfunctions
during severe recessions, but we offer a more plausible interpretation: NSM continued to function
effectively even during this period, but aberrant banking practices caused a shift in the type of natural
selection from directional to disruptive selection, with the most efficient as well as the least efficient
firms being favored and firms of intermediate efficiency being selected against.
Tae Okada
Institute of Social and Economic Research
Osaka University
6-1, Mihogaoka, Ibaraki, Osaka 567-0047
JAPAN
tokada@iser.osaka-u.ac.jp
Charles Yuji Horioka
Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki-shi
Osaka-fu 567-0047  JAPAN
and NBER
horioka@iser.osaka-u.ac.jp1 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 et al. (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 pe-
riod of 1996-97.
NNK’s analysis is carefully executed, and while we do not have any major quib-
bles with the analysis itself, 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 sec-
tion, 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.
I nt h et h e o r yo fe v o l u t i o n ,t h e r ea r ea tl east 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) “direc-
tional selection," which acts against only one extreme of phenotypes, causing a
1shift 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 and 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 lending" (“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 ex-
tremes. 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 aforemen-
tioned banking practices and how they led to a shift in the type of natural selection
(see Kobayashi et al. 2002, Ogawa 2003, and Peek and Rosengren 2005 for more
details).
“Forbearance lending" (“evergreening") refers to the practice of banks contin-
uing to lend to less eﬃcient (low TFP) ﬁrms to keep them aﬂoat, thereby avoiding
the need to declare existing loans to these ﬁr m sa sn o n - p e r f o r m i n g . B a n k se n -
gaged 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 while 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 (here-
after 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. This practice of “forbear-
2ance 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 en-
gaged 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 regula-
tions 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. 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; 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 “for-
bearance lending" (“evergreening") 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 type of natural
selection from “directional selection" to “disruptive selection." This interpretation
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 se-
vere recessions. Moreover, our interpretation seems more plausible than NNK’s
o w ni n t e r p r e t a t i o no ft h e i rﬁndings because they do not provide a convincing ex-
3planation of why a severe recession would ipso facto cause a breakdown of the
NSM. Indeed, NNK (p. 74) themselves assert that the combination of “forbear-
ance lending" and the “forcible withdrawal of loans" is a possible explanation of
their ﬁnding.
3C o n c l u s i o n
To summarize, in an important paper, NNK analyze the entry/exit behavior pat-
terns of Japanese ﬁrms during the 1990s and show that relatively eﬃcient (high
TFP) ﬁrms exited while relatively ineﬃcient (low TFP) ﬁr m ss u r v i v e di nJ a p a n
during the banking-crisis period of 1996-97. NNK conclude from this ﬁnding that
the natural selection mechanism (NSM) apparently malfunctions during severe re-
cessions, but we have oﬀered a much more plausible interpretation. Our alternative
interpretation is that the NSM continued to function eﬀectively even during this
period but that aberrant banking practices during this period (in particular, “for-
bearance lending" (“evergreening") and the “forcible withdrawal of loans" and/or
the “reluctance to lend") caused a shift in the type of natural selection from “di-
rectional selection" to “disruptive selection," with the most eﬃcient (highest TFP)
ﬁr m sa sw e l la st h el e a s te ﬃcient (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
4the 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.
NNK deserve a great deal of credit for their meticulous analysis that sheds light
on how the entry/exit behavior patterns of ﬁrms changed during theb a n k i n g - c r i s i s
period of 1996-97, but we believe that our interpretation of their ﬁndings (that the
NSM continued to function eﬀe c t i v e l yb u tt h a ti tc h a n g e df r o mo n et y p eo fn a t u r a l
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, C.D., Mather, K., 1949. The Elements of Genetics. London: Allen
and Unwin.
[2] Kobayashi, K., Saita, Y., and Sekine, T., 2002. Iwayuru ‘oigashi’ ni tsuite (On
so-called evergreening). Working Paper 02-2, Research Department, Bank of
Japan (in Japanese).
[3] Mather, K., 1953. The genetical structure of populations. Symposia of the
Society for Experimental Biology 7, 66-95.
[4] Mather, K. 1955, Polymorphism as an outcome of disruptive selection," Evo-
lution 9, 52-61.
[5] Nishimura, K.G., Nakajima, T., and Kiyota, K., 2005. Does the natural selec-
tion mechanism still work in severe recessions? Examination of the Japanese
economy in the 1990s. Journal of Economic Behavior and Organization 58,
53-78.
5[6] Ogawa, K., 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, J., Rosengren, E. S., 2005. Unnatural selection: Perverse incentives and
the misallocation of credit in Japan, American Economic Review 95, 1144-1166.
6

Does the natural selection mechanism still work in severe recessions? Examination of the Japanese economy in the 1990s.

Iwayuru ‘oigashi’ ni tsuite (On so-called evergreening). Working Paper 02-2, Research Department, Bank of Japan

Polymorphism as an outcome of disruptive selection,&quot;

The Elements of Genetics. London: Allen and Unwin.

The genetical structure of populations.

Unnatural selection: Perverse incentives and the misallocation of credit in

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"

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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