Japan’s Economy at a Turning Point

Japan is struggling to recover from economic stagnation that has lasted for more than 20 years. This period of persistent deflation has been a new experience for Japan in its postwar history. As suggested by the phrase “deflationary trap,” it is not easy to defeat deflation once it overtakes the economy due to the difficulty of achieving recoveries in consumption and investment once individual citizens and companies are in the grip of deflationary sentiment.

The administration of Prime Minister Abe Shinzō, formed toward the end of 2012, has pursued bold measures to end deflation, which have become known as Abenomics. The unprecedented monetary easing of the Bank of Japan has brought significant changes to such economic indicators as the foreign exchange rate and stock prices. Even so, it is no simple matter to lift the economy as a whole. Influenced by the global decline of crude oil prices, the BOJ has been compelled to delay somewhat the timing for achieving an inflation target of 2%.

Firm Corporate Recovery Under a Lasting Administration

Under its growth strategies, the Abe cabinet is pursuing real and nominal growth targets of 2% and 3%, respectively. These targets, however, are quite ambitious. Many economic experts question whether such high growth rates can really be achieved.

Positive changes, however, are being seen in the economy under the Abe cabinet. In addition to stock prices and the foreign exchange rate mentioned above, a heartening development is the substantial improvement of corporate earnings, which can be expected to translate into higher investment and wages. As the economy recovers, the employment situation has improved markedly, and the unemployment rate has fallen to 3.3%, a level that can virtually be considered full employment.

The Abe administration, which was reinstated after the 2014 lower house election, is expected to hold power for an extended period. Prior to the 2012 election, Japan cycled through six prime ministers in just six years, but the longer-term outlook of the new administration means decisive reforms can be anticipated. There is no denying that reforms will be difficult to implement in many sectors where regulations are strongly defended by vested interests. At the same time, though, there are also sectors where changes are occurring at an unprecedented pace.

A leading example is energy reforms centering on the nation’s power grids; much activity can be observed in the electricity market, such as the restructuring of incumbent companies and the appearance of new entrants. Major changes are also being made to corporate governance and companies are being compelled to act even more than before in the interest of investors. With the growth of corporate earnings, the return on equity is continuing to rise and corporate governance reform is closely related to a trend for the more active allocation of the massive financial assets held by Japanese citizens. These are trends that the government is encouraging. Another closely related development is the reform of the Government Pension Investment Fund.

Major changes are also unfolding in such sectors as agriculture that many have viewed as resistant to reform. While agricultural reform has a strong political element, structural changes are already accelerating. Farming households ranking in the top 10% are said to supply more than half of Japan’s agricultural products. Farmers dependent on government protection are continuing to retire, and competitive farmers are pursuing new business opportunities including export markets.

Can 2% Growth Be Achieved?

As described above, Japan’s economy is associated with both positive and negative aspects, and a key factor in considering its future direction will be the economy’s growth rate. Abenomics is aiming for high growth, which would significantly affect the progress of restoring government finances to health.

But the potential growth rate of the economy calculated from past growth is not all that high. The rapid contraction of the labor force will also be a significant adverse factor for the sustained growth of Japan’s economy. Unless labor productivity and total factor productivity increase by a considerable margin, it will be difficult to achieve 2% growth in Japan.

However, if we start with the assumption that rapid growth is difficult, economic recovery will not be readily achieved. This is the strongly held view of many in the Abe administration. Its emphasis of growth strategies reflects the administration’s desire to achieve high economic growth by whatever means possible.

Secular Stagnation of Japan’s Economy

The secular stagnation hypothesis of Harvard University’s Professor Lawrence Summers is a useful point of view in considering the growth prospects for Japan’s economy. According to this hypothesis, the growth rate of the economy is greatly influenced by the preceding macroeconomic environment. While there is a tendency to assume that the long-term growth rate is determined by the supply side, Summers argues that prior demand trends influence the medium-term growth rate through hysteresis effects.

This hypothesis appears to apply to Japan’s economy. Japan has experienced macroeconomic stagnation for two decades. During this period, the collapse of an asset bubble gave way to balance sheet adjustments in the broader economy, including excessive adjustments in employment, debt, and fixed assets. The country also endured a financial crisis and persistent deflation during this period. According to the secular stagnation hypothesis, it is this kind of stagnation that explains the low growth rate of Japan’s economy. Hence, should the economy continue to recover, there may be reason to hope that the growth rate will rise by some degree.

I often explain this situation to students by having them imagine a department store. Should fewer customers visit the department store, the productivity of the store will naturally decline. However, if customers return to the store, productivity will gradually rise. If customers increase further, the store will allocate employees and floor space from low productivity to high productivity areas, and if customers increase beyond that, the store will consider expanding its retail space.

Higher Productivity Holds the Key

Japan’s economy is in a similar situation. The growth of total factor productivity has slowed sharply in the period since the collapse of the asset bubble. Clearly this is related to the waning of demand. While the growth of total factor productivity has remained weak, will this be the case going forward?

In Summers’ secular stagnation theory, the low potential growth rate of the economy, ensuing from the weak growth of productivity, is greatly influenced by preceding macroeconomic conditions. The expectation that Abenomics will enable the recovery of Japan’s economy is based on the view that, if macroeconomic conditions can be improved significantly, this has the potential of augmenting the growth rate of productivity that has remained low in the post-bubble period.

As the expansion of demand drives the growth of the economy, how far can productivity be expected to increase? This prospect will depend on the various reforms included in the Abe administration’s growth strategies. It will be problematic if the ongoing expansion of demand gives rise to labor shortages that become a bottleneck stifling the economy. For this reason, higher productivity to offset labor shortages will be essential.

The tendencies described above are already materializing in Japan’s economy. The unemployment rate was 4.1% before the formation of the Abe cabinet, but has now fallen to 3.3%, and many industries are expressing concerns about labor shortages.

These shortages will without question entail higher wages. The government is also hoping for the increase of wages. What bears watching is the nature of the impact labor market trends and wage trends will have on productivity.

Should wages rise by 10%, companies that are unable to increase productivity or added value by 10% will lose competitiveness. Serious labor shortages and rising wages will mean that many companies will endeavor to increase labor productivity. They will do so by revising business models, by investing in labor-saving facilities, and by providing higher value-added goods and services.

There is no guarantee that all companies will succeed in these endeavors. Companies that cannot keep up will gradually fall by the wayside. Many companies, however, will produce results. Through such an adjustment, it will be possible to respond to labor shortages and to increase the labor productivity of the economy as a whole. Hence, such severe intra- and inter-industry restructuring will serve to increase the productivity and growth rate of Japan’s economy.

(Originally written in Japanese and published on June 29, 2015. Banner photo: People on the way to work in Tokyo’s Marunouchi district. © Jiji.)