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TODAY’S STORY
25 Jan
,
2023

The Keiretsu Jutsu — Part 2: Trust Capital and Transaction Costs

“Certain societies can save substantially on transaction costs because economic agents trust one another in their interactions and therefore can be more efficient than low trust societies, which require detailed contracts and enforcement mechanisms.”

— Francis Fukuyama

A political scientist, Francis Fukuyama is known for his works exploring the intersection of society, governments, and markets. In his book Trust, he posited that a society's ability to form large networks is largely a reflection of that society’s level of trust. 

Fukuyama classified societies into two categories:

 “Familial” or low-trust societies, like those of southern Europe and Latin America, and, 

“High-trust” societies, like those of Germany, the United States, and Japan.

In familial societies, people don't trust strangers but deeply trust members in their own family and local community. Trust is hyperlocal and does not extend beyond the level of small communities.

In contrast, people in high-trust societies don't have a strong preference for their family when it comes to trusting others and are more likely to engage with everyone with the same graciousness. 

This has a few economic and development implications.

In familial societies, family networks are the dominant form of social organization where economic activity is embedded. Here, businesses are more likely to be 1. ventures among relatives, and hence, smaller in size and scale, or, 2. a few large conglomerates run by families.

High-trust societies, on the other hand, have professionally run businesses based on outcomes rather than kinship. In such societies, organizations can take up all kinds of sizes, including large ones. They extend beyond the family and are thus able to capitalize on a larger number of opportunities across geographies.

It is here that the Japanese Keiretsu system throws an interesting wrench into the mix. Japan, according to Fukuyama, is a high-trust society. But its keiretsus, from an external point-of-view, seem reminiscent of familial society behaviour.

So, what's going on?

The difference lies in understanding all the pros of the Keiretsu System, and why the Japanese, being a high-trust society, still prefer having large conglomerates run by a central organization.

But before we move on, it is crucial to understand the relationship between trust and economic transaction costs.

The issue of transaction costs

In late 1979, a 24-year old Steve Jobs visited Xerox's Palo Alto Research Center (Xerox PARC). It was there that Jobs learned about graphical user interfaces (GUIs) and object-oriented programming. And ultimately it was Apple, not Xerox, who succeeded in commercializing these technologies.

But the reason Jobs was able to visit Xerox PARC on a whim was because the people who brought him there trusted him.  

This trust ensured that an exchange of knowledge between Xerox and Apple could happen, without a lot of friction. In short, trust reduced the cost of transactions between two Silicon Valley companies.

In fact, Silicon Valley's porous boundaries facilitated by high-trust behaviour are what allowed it to give rise to the enormously innovative technological scene it has today.

"[Silicon Valley’s] dense social networks and open labor markets encourage entrepreneurship and experimentation. Companies compete intensely while at the same time learning from one another about changing markets and technologies through informal communication and collaborative practices. Loosely linked team structures encourage horizontal communication among firm’s divisions and with outside suppliers and customers. The functional boundaries within firms are porous in the network-based system, as are the boundaries among firms and between firms and local institutions, such as trade associations and universities."

— AnnaLee Saxenian, Economic Development Expert

Does this remind you of something similar we discussed yesterday?

If you're thinking of keiretsus, we are on the same page.

Trust is essential to make interactions feasible with low transaction costs. In the absence of trust, these simple interactions would quickly become expensive, as they would require costly and time-consuming contracts, insurance, and enforcement procedures.

Now that you've understood this, let's discuss how the Japanese Keiretsu System facilitates high-trust and low transaction costs, by design.

1. Keiretsus lead to easy dissemination of information.

Trading companies and banks at the centre of horizontal keiretsus have traditionally performed the role of information agencies and matchmakers. And companies specializing in foreign trade have historically acted as the keiretsu's information agency on the rest of the world. 

Consequently, they act as major information generators, gatherers, processors and distributors within the keiretsu, with every member company benefitting from this information.

The members get better access to relevant key information and also benefit from improved analysis and evaluation methods employed by the central bank, which feeds in market data, especially foreign market data into its algorithms and generates useful strategic insight for all members within the keiretsu.

Even companies in the keiretsu can leverage each other’s expertise; information shared among customers, suppliers, and employees within the keiretsu can lead to increased efficiency. Due to this easy flow of information within the keiretsu, member companies can make investment decisions faster, with better data.

2. Keiretsus create organization and process efficiency.

Keiretsus organize the operational activities of all group members. This is, by far, their most important function. 

This includes everything: infrastructure-related services, procurement, marketing, logistics, transport, warehousing, insurance, distribution and outlet management to ancillary administrative services and other general organizational functions.

But the key here, again, is support, trust, and goodwill among member companies. Trust acts like a lubricant that makes coordination and collaboration way easier with other group members than they would be without such a system.

The joint deployment of special capabilities prevents redundant procedures and multiple expenses across group companies. In a hyper-competitive environment, this provides a significant cost and competitive advantage.

In vertical keiretsus, it allows the apex company to deepen its relationships with its suppliers in order to gain substantial benefits in the long run.

Companies in the West, in contrast, usually have contractual and purely transactional relationships with their suppliers, which might add a lot of hidden costs and friction that trust and deeper relationships can eliminate.

In fact, workers laid off from one group company are often hired by another group company that needs them.

This brings us to our third point, which is

3. Keiretsus distribute risk and allow hedging of bets.

Due to high trust and implicit arrangements between members based on goodwill and honour, group companies within a keiretsu will always be preferred over an outsider for products and services in times of scarcity. This allows them to tide supply chain crises and other economic and financial crises with relative ease.

In short, the keiretsu acts like a support system for all of its member companies. Shared resources between firms reduce individual risk and liability, while leading to better margins.

4. Keiretsus sort out financing for smaller group companies.

For this, the bank forming the nucleus naturally plays an important role. 

First, differing credit and investment requirements can be coordinated internally, which reduces total risk and frees up more financial resources for the nucleus bank.
This then allows it to serve like a powerful risk management tool during periods of crisis.

Second, the bank provides access to international money and stock markets that may be unavailable to individual, smaller, and less-known member companies. It bundles individual capital requirements together and aims at satisfying them efficiently — either from its own funds or sourcing funds via the global capital market. 

This reduces interest charges to smaller companies. And the extraordinary strength of the keiretsu main banks guarantees that group companies have relatively cheaper financing options when they're looking to expand.

5. Keiretsus confer their strength and goodwill to all group companies.

Within a keiretsu, associations of companies with each other by way of a president's club, or non-commercial credit relationships, share lock-ups, joint corporate images (logo, branding, nomenclature, etc.)... all of these lead to creating an image of solidarity, cohesion, and trust in the public eye.

When group companies present a coordinated public image, it heightens brand awareness, which then positively enhances the commercial success of each of its members.

Having listed all the pros of a keiretsu, I think it's also important to also discuss some of the downsides and slippery slopes keiretsu systems can lead to.

Keiretsu's can create large decentralized conglomerates that can monopolize markets.

This has some interesting second-order effects worth discussing:

1. Limited competition can over time lead to complacency among group companies. This complacency can, over time, create inefficient practices. It can also lead to overall sluggishness in responding to changing market conditions.

2. Easy access to capital can encourage risky behaviour. Group companies can make risky financial bets, knowing that they will be rescued by other members in case of a mishap. 

3. In the absence of competition and presence of a support system, there can be little incentive to innovate.

4. Cross-shareholding structures, on the one hand, employ collective skin in the game. But on the other, these conglomerates can indulge in crony capitalism by cozying up to government officials and keeping other players out of the market. They can operate in a way that is fundamentally against the spirit of capitalism, free markets, and competition.

“Japanese business is still done in a closed and networky way that favors insiders and keeps outside stakeholders at bay.”

— Jim Lincoln, Mitsubishi Chair in International Business and Finance Emeritus, UC Berkeley

Conclusion

Today, a few manufacturers in the West have designed their supply chains based on borrowing certain elements from the keiretsu system. 

For example, Scania, the Swedish bus and truck maker, has tried to deepen its loyalties to its manufacturers in order to improve the company's supply chains. It does this by investing in the growth and learning of its suppliers. Specifically, the company organizes workshops on its Scania Production System that focuses on continuous improvement and lean manufacturing methodologies.

The company also has incorporated an additional element of keiretsu into its purchasing system: Suppliers identify with the hub company, and the hub company works with them to improve their processes and make them more competitive. The only difference is that it does not hold shares in the supplier companies.

Even IKEA's approach to supplier relationships is inspired by the structure of keiretsus. The company works to build committed partnerships with its suppliers based on mutual advantage, trusts its vendors with significant tasks, and collaborates with its vendors in order to maximize efficiency.

So, even though familial, informal and implicit arrangements based on trust may be seen as alienating from the point of view of outsiders, they do hold certain unique advantages when it comes to minimizing transaction costs and facilitating the spread of information and resources of all kinds within the network.

Trust, ultimately, is the only true currency of the world.

If you don't buy this, just look at what that note issued by the Reserve Bank of India reads.

“I Promise to pay the bearer the sum of Five Hundred Rupees.” 

It's a promissory note, and you're trusting the Governor of The Reserve Bank of India to uphold the value of that note.

Anyway, money and debt are a separate topic, best reserved for another day.

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