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Tuesday, January 18, 2011

Does Japan need a Strategy to Achieve Growth ?

Japan faces daunting challenges due to the decline and aging of the population. If Japan were to become much more open to immigration, the picture could change, but a major increase in the number of foreigners living in Japan appears unlikely. Further deregulation, better utilization of women in the labor force, and a reversal of the low birth rate will all help, but the shrinking population will be the dominant factor affecting economic performance over the next several decades.

The short answer to the question posed by this title is “yes,” Japan does need a strategy. Even with a strategy, however, the starting point for any discussion of Japan must be that the economy’s growth over the next several decades will be very low due to its shrinking population. What Japan needs is a coherent strategy to ensure that the economy performs as well as possible given this severe demographic constraint. The obvious strategy of simply removing that constraint through expanded immigration is considered later in this paper.


In the short to medium term, Japan also faces a number of pressing issues regarding its financial markets and the conduct of both fiscal and monetary policy. Others on the Japan panel will tackle those issues. This paper, therefore, focuses mainly on some of the longer term issues raised by demographic change.


General Background

Japan is what might be called an early-late-developer. Civil war in 1867-68 led to a new government that quickly adopted a commitment to modern economic growth and development. By the 1970s their dream had come true, with the level of GDP per capita reaching European levels (though still slightly below that of the United States). During that long period of catching up, the government played a relatively activist role in guiding the allocation of productive resources, particularly after the Second World War. Aided by stiff import barriers and strong controls on the inflow of foreign direct investment, the government was able to shape an economic system quite different from that in the United States or Europe. This system was characterized by a number of features, including a heavy reliance on bank financing (rather than on capital markets), indicative lending by government-owned banks that provided signals to commercial banks, weak shareholder rights, “lifetime employment,” and a government-private sector coordinated effort to acquire technology from abroad and to develop new technologies at home.


From the early 1950s through 1973, the economy grew at an average real rate of almost 10 percent. This performance seemingly endorses the value of the distinctive “Japanese economic mode,” but economists remain divided on the question of whether the economic system enhanced the growth rate. From 1992 through 2002, in contrast, Japan experienced an average annual real GDP growth rate of only 0.8 percent. The immediate cause of this “lost decade” was a bubble in real estate and stock market prices in the second half of the 1980s, followed by a collapse in the early 1990s. Recognition that structural problems contributed to the asset bubble, its collapse, and the subsequent prolonged stagnation, led to extensive reform and deregulation in a number of areas.


On the regulatory front, the response of the private sector to some of the changes remains mixed. A long list of legal changes have affected corporate governance, ranging from tighter accounting rules, easier merger and acquisition procedures, better bankruptcy work-out procedures, encouragement for the venture capital industry, and new stock markets aimed at listing small, new, innovative firms. Nonetheless, many aspects of corporate behavior have changed little. Start-ups of new firms remain low in international comparison. The venture capital industry is very small relative to those in the United States and Europe. Bank loans remain the dominant form of corporate outside fund-raising. And despite supposedly improved corporate governance, return on assets and return on equity are still much lower in Japan than in the United States.

From 2003 through 2007 growth accelerated to an average annual 2 percent. However, this acceleration came predominantly from a fortuitous jump in (net) exports enabled by currency weakness and rapid growth in China, not from the beneficial effects of resolving some of the problems in the economy. When exports dropped as the global recession hit (with Japan’s exports falling 50 percent from the summer of 2008 to a low in February of 2009), the economy experienced a severe year-long recession in which GDP shrank by 5 percent. Like other advanced economies, Japan is now experiencing a relatively weak recovery.


Problems

Going forward, the economy faces a number of problems or distortions that could jeopardize economic performance. Among these are reliance on exports to drive economic growth, and demographics.


As the economy recovers from the recent recession, the pattern of reliance on growth of net exports has resumed. If this continues, the implication is a re-emergence of global current-account imbalances of questionable sustainability. As the current-account surplus rose to over 4 percent of GDP in the 2003-2007 period, Japan faced no serious criticism from the United States (mainly because Japanese import markets appeared to be more open than in the past, and because China became the new target of American criticism). Nonetheless, Japan clearly cannot rely upon exports to drive growth indefinitely. One of the major problems the economy faces, therefore, is a need to create a sustained domestic basis for growth.

Reliance on exports may also face a more short-run problem. The yen has strengthened over the past two years, eliminating one of the causes of rapid export growth in the 2003-2007 period. By historical standards the real value of the yen (the real effective exchange rate) remains well below its peak in 1995, but the relatively rapid increase over the past two years is certainly driving some marginal producers out of export markets.


The second problem is demographics. The population is now falling and aging, driven by a low birth rate (that has been below the steady-state reproduction level since the early 1970s). The government produces a future population estimate every five years, laying high, middle, and low scenarios. The current (made in 2006) middle forecast by the government shows a decline in total population of 21 percent by 2050 (from 127 million to 100 million). The working age population (those aged 15 to 64 years old) in this estimate would fall by 35 percent. Meanwhile, the proportion of the population age 65 and over was already 22 percent of total population by 2008, and is estimated to rise to 28 percent by 2020 and 36 percent by 2050. Population estimates are notoriously inaccurate, but over the past twenty years actual population trends in Japan have been closer to the middle or pessimistic estimate rather than the high one.


A shrinking and aging population presents a number of problems for the economy. First, with a diminishing pool of people of working age, labor supply will certainly shrink (even if somewhat more people over age 65, and more women, work). Therefore, GDP growth will be low (at best), even if rising productivity enables GDP per capita to grow close to the 2 percent rate that has characterized industrialized countries for a long time. Second, aging presents the usual problems for financing the social security system and the national health insurance program (concerning which at least partial solutions involving higher payments and lower benefits have already been put in place). Third, the paucity of young new entrants to the labor force could rob Japanese firms of some of their vitality (if one believes that young engineers and managers are often the source of innovative new ideas). Fourth, aging may accelerate the structural shift in the economy away from efficient sectors (manufacturing) to inefficient ones (labor-intensive personal services for the elderly).


Ensuring Future Growth


Realistically, the world must recognize that Japan will not be a global engine of growth under the best of circumstances because of the daunting demographic developments. The important question is whether Japan will perform up to its constrained potential or not. During the 1990-2009 period, clearly the economy under performed. To ensure a performance closer to potential, the following issues are critical:


Deregulation. Further deregulation and legal changes are needed, particularly regarding industries in the service sector. Unfortunately, the current government appears to be more interested in traditional government involvement (such as using government financing and other resources to promote high-tech manufactured exports) rather than further efforts to unleash the power of the market. The political uncertainty over privatization of the large post office savings bank and life insurance company is a further example of the unclear stance of the government.


Sexual Equality. With a shrinking pool of potential employees, Japan desperately needs to make better use of its well-educated women in the workforce. Japan continues to rank near the bottom in international comparisons of women managers, for example. Laws against sexual discrimination in employment were enacted in Japan over 20 years ago, but relatively little change has occurred in the proportion of women among managers, or in the gap in pay between men and women. The evidence indicates, therefore, that women remain poorly utilized in the corporate sector. Making better use of their education and talent would help to accelerate productivity growth. How to accomplish this goal is a difficult question, though simple enforcement of existing laws, and encouragement for women to file more court suits, would be a start.


Pro-Family Policies. Marriage and bearing children has become an increasingly problematic choice for Japanese women. The percentage of unmarried women in the age cohort 35-39 years old, for example, rose from 12 percent in 1990 to 26 percent by 2005. Japan needs to create an environment in which men and women are more confident that they can be married and raise a family while also working and living a fulfilling life. Doing so will have little impact on the economy in the next two decades, but would eventually address the problem of a falling working-age population. The issues can be complex and difficult to diagnose, but to its credit the government has given some attention to this topic (with an announced desire to improve the availability of day care centers, and provision of subsidies to families with children).


Greater International Economic Openness. Japan is more open today than during earlier decades, and yet the economy could benefit from further progress in this area. Although inward foreign direct investment has increased, the stock of that investment relative to GDP remains far lower than in other industrialized countries. And, although manufactured imports have increased, in a number of markets the share of imported products is remarkably low. Productivity growth would benefit, for example, if more foreign private equity firms saw more opportunities to buy and transform Japanese companies. And, more competition at home from the products of non-Japanese firms would have a stronger impact on the productivity and competitiveness of Japanese manufacturing firms.


Greater International Human Openness. One obvious solution to a falling population is to allow or encourage immigration (and not simply “foreign workers” who are often thought of as living in Japan temporarily and without families). The percentage of the population born outside Japan was 1.2 percent (1.5 million people) in 2008, the lowest among advanced industrial countries. If immigration were to fully offset the government’s middle prediction for the decline in population, then the number of foreigners living in Japan would need to rise to 27 million by 2050, and they would amount to 21 percent of the population. In addition to the simple increase in workers, a large increase in immigration would bring a higher birth rate, and (to the extent that foreigners are young corporate managers) new vitality into Japanese management.


Can such a large increase in immigration occur? The experience of the major European countries and the United States over the past several decades suggests a positive answer. However, Japan is one of a relatively small number of countries that is both a nation state and a relatively homogeneous ethnic group. Society has been quite resistant to large inflows of foreigners. Immigrants in most societies face discrimination, so Japan is not unusual in that sense. The barrier is more likely one of both a reality and a perception among potential immigrants of limited opportunities for personal success. Making Japan a location where foreigners perceive a real opportunity to succeed is likely to be very difficult.


A second aspect of human interaction involves Japanese universities. The number of international students enrolled at Japanese universities has increased over the past two decades, but lags behind the number of students (or the ratio of international to domestic students) in other industrialized countries. The same is true of the faculties of Japanese universities, which have very few foreign faculty members. The consequence is that the university system has been a less vibrant generator of new commercially useful technologies than has been the case in some other advanced economies.


To summarize, Japan faces daunting challenges due to the decline and aging of the population. If Japan were to become much more open to immigration, the picture could change, but a major increase in the number of foreigners living in Japan appears unlikely. Further deregulation, better utilization of women in the labor force, and a reversal of the low birth rate will all help, but the shrinking population will be the dominant factor affecting economic performance over the next several decades.


Source: Does Japan need a Strategy to Achieve Growth? | indiapolicyforum.org

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