Introduction
Japan is grappling with an unexpected economic downturn as it enters a recession, marked by two consecutive quarters of contraction. The final quarter of 2023 saw Japan’s gross domestic product (GDP) shrink by a more severe-than-anticipated 0.4%, following a 3.3% contraction in the previous quarter. This decline has resulted in Japan relinquishing its status as the world’s third-largest economy to Germany. Despite economists’ expectations of over 1% GDP growth for the fourth quarter, the actual figures indicate a different reality, presenting a challenging economic scenario. The International Monetary Fund (IMF) had foreseen Germany surpassing Japan in economic rankings, a change awaiting final economic growth figures from both nations. The weakening Japanese yen against the US dollar has played a role in this shift, impacting stock prices positively but contributing to economic challenges. The Nikkei 225 index recently reached its highest point since 1990. The data also suggests that the Bank of Japan may postpone plans to raise borrowing costs amid ongoing economic struggles. In the backdrop of this economic uncertainty, understanding the historical context becomes crucial. Japan’s post-World War II recovery was a remarkable tale of resilience and growth, fueled by strategic reforms, Western influences, and technological advancements. The nation transformed into an economic powerhouse, but the current downturn raises questions about the sustainability of Japan’s economic prowess. Examining the historical trajectory provides insights into the factors contributing to Japan’s economic challenges and prompts a closer look at the intricate web of issues affecting its present economic landscape.
Phases of the Postwar Japanese Development
Phase I: Postwar Reconstruction and Catch-up
The postwar development of Japan unfolded in three distinct phases, each marked by its own set of challenges and achievements. Phase I, spanning from 1945 through the 1960s, was characterized by the collective endeavor of businesses, households, and the government to catch up with the industrial economies of North America and Europe. Coordinated efforts, often orchestrated by the government, aimed at overcoming obstacles such as the shortage of savings. The establishment of the ‘Japanese style market system’ fostered stable relationships among economic agents, underpinned by long-term employment practices, corporate governance structures built on cross-shareholdings, and the main-bank system. These initiatives, coupled with active public policies, played a pivotal role in Japan’s successful catch-up with industrialized nations.
Phase II: Era of Transition and the ‘Bubble Economy’
Phase II, from the early 1970s to the late 1980s, witnessed Japan’s emergence as a major player in the global economy. Having achieved its catch-up goal, the Japanese economy entered an era of transition characterized by increased autonomy for businesses and households in coping with risks amid a more competitive environment. However, the era also saw the emergence of speculative bubbles fueled by expansive macroeconomic policies to counter the yen’s rapid appreciation. The bursting of these bubbles in the late 1980s and early 1990s, precipitated by restrictive monetary measures, marked the onset of significant economic challenges.
Phase III: Lost Decade and Beyond
In Phase III, spanning the 1990s and beyond, Japan grappled with the aftermath of the burst bubbles, facing issues such as excess capacity, mounting non-performing loans, and persistent deflation. Delayed stock adjustments to address these imbalances, driven by concerns over job security, contributed to prolonged stagnation and financial crises. To address these challenges, Japan embarked on an effort focused on halting deflation, reforming the public sector, stabilizing the financial system, and stimulating business confidence through regulatory and tax reforms, alongside fostering an environment conducive to technology development. This phase reflects Japan’s ongoing struggle to navigate the complexities of post-bubble economic realities and enact reforms necessary for sustainable growth and stability.
Reasons Behind Japan’s Prolonged Economic Stagnation:
Lost Decades:
The term “Lost Decade” often describes Japan’s economic woes during the 1990s, marked by prolonged stagnation, which extended into subsequent decades, including up to 2011. During this period, Japan experienced minimal GDP growth, averaging only 0.5% annually until the onset of the global financial crisis. The slow growth persisted, earning the timeframe the monikers “Lost Score” or “Lost 20 Years” from 1991 to 2010. Subsequent years saw slightly improved growth, with GDP averaging just under 1.0% from 2011 to 2019. However, the onset of the COVID-19 pandemic in 2020 triggered a new global recession, exacerbating Japan’s economic challenges. Recent research indicates that Japan’s GDP growth rates suggest it will take 80 years to double, a striking contrast to the previous 14-years doubling rate.
Declining Population and Aging Workforce:
Japan faces significant demographic challenges due to declining birth rates and an aging population. This is leading to a shrinking workforce, declining productivity, and dwindling social welfare systems. Over the next 40 years, Japan’s population of 127 million is expected to decrease by over a quarter, equivalent to the entire population of Malaysia or Peru. This rapid aging and population decline position Japan at the forefront of global demographic shifts, presenting economic hurdles. Despite a resilient 2020 economic growth projected at 0.7 percent by the IMF, the increasing proportion of older workers and fewer younger ones will likely dampen growth and productivity. Estimates suggest Japan’s economic growth may decline by 0.8 percentage points annually over the next four decades due to demographics alone. The decline in population has also resulted in an oversupply of homes, particularly in rural areas, leading to weakened house prices and posing risks to the financial health of households and banks. Also, Japan’s financial sector faces growing vulnerabilities due to its ongoing demographic transition.
Banking Crisis:
The burst of the asset bubble triggered a banking crisis, as financial institutions faced significant losses. This led to a credit crunch, hindering investments and economic growth.
Labor Shortages:
Auguste Comte is often quoted as having said, “Demography is destiny.†Japan may face a shortage of more than 11 million workers by 2040. Due to Japan’s aging population, almost half of enterprises lack full-time workers. The labor shortage is especially apparent in the hotel industry. The number of visitors to Japan has recovered to over 60% of pre-pandemic levels.
As Japan prepares for a workforce shortage, generative artificial intelligence, and economic threats, the labor market may be at a critical point. There is rising concern about the sustainability of wage growth, which has accelerated at the fastest rate in 30 years. Prime Minister Fumio Kishida wants wage increases in excess of inflation. Japan’s long-term salary stagnation is due to its seniority-based employment structure, low labor productivity, and worker reluctance to move occupations.
Seniority – Nenko Joretsu, the Japanese system where individuals are promoted by length of service, is a hallmark of the Japanese system of lifetime employment. When wages are generally not connected to performance evaluations, productivity generally suffers.
Labor Productivity
Japan’s labor productivity is the lowest among the G7 countries and is about two-thirds of the United States’ productivity. In 2022, Japan’s labor productivity was $53.2 per hour worked, compared to the world average of $71.1 per hour worked. Remarkably, the nation that brought us kaizen, kanban, and Ishikawa “fishbone” diagrams, methodologies that have immensely improved labor productivity, is itself highly non-productive now as measured by the value of labor output.
Labor Mobility
Japan’s job mobility is less than half of the OECD average. What this means is that rather than switching to jobs where they would be more productive, employees stay at a firm after they have passed peak productivity. In addition to being less productive, they block newer employees from having upward mobility to help attract and retain talented workers.
Structural Rigidities
Japan’s labor markets have faced criticism for their inflexibility, often characterized by lifetime employment practices prevalent in many industries. While providing job security, these practices have hindered companies’ ability to adapt to changing economic conditions and restricted labor mobility. The prevailing labor market norms, rooted in Japan’s rapid growth era, emphasize long-term job security, seniority-based wages, and company-based labor unions, seen as vital for skill formation and industrial harmony. However, rigid practices have led to a dual labor force, creating inequality between regular and non-regular workers, with non-regular workers serving as shock absorbers during recessions. College graduates encounter challenges in finding jobs, as large companies reduce job openings, leading to a competitive job search process. Additionally, married women face a trade-off between full-time employment and raising children due to long working hours and job rotations. Despite criticism, there is a reluctance to embrace labor law deregulation.
Moreover, Japan has been criticized for its reluctance to adopt technological innovations, particularly in software development, compared to other advanced economies. This hesitancy has affected competitiveness, especially in industries like information technology, as the world shifts focus from hardware to software. Historically, Japan’s economic success relied heavily on hardware manufacturing, shaping a mindset that undervalues software development. Software engineers are often considered less prestigious compared to hardware engineers. Japanese firms prioritized operational effectiveness over innovation, evident in their limited investments in software development compared to the United States. The disparity in software investments reflects Japan’s broader cultural and economic emphasis on hardware manufacturing rather than embracing software innovations to drive technological advancement.
Persistent Deflation
Japan has grappled with deflationary pressures, experiencing a prolonged period of mild deflation since the latter half of 2010. This situation, where prices decline over time, has led consumers to delay purchases, dampening economic activity. Traditional monetary policies struggle to stimulate growth in such an environment. Annual average Consumer Price Index (CPI) inflation rates, which reached 11.6 percent in the first half of 1990, declined to around zero or slightly negative from the middle of 2010. The weakness in prices becomes more apparent when accounting for the hike in oil prices and the yen’s depreciation against the US dollar.
Simultaneously, Japan’s heavy reliance on exports has faced challenges due to changes in global trade dynamics. Trade imbalances have impacted the economy, with Japan’s terms of trade worsening with time. Import prices rose significantly (60.7 percent) compared to export prices (27.7 percent) during this period. This was influenced by rising commodity prices and the supply shock from Russia’s invasion of Ukraine. Additionally, the Japanese yen depreciated due to divergent monetary policies, with the US and Europe tightening policies while Japan maintained a loose one.
The deteriorating terms of trade have affected Japan’s national income, equivalent to a 4.6 percent loss of real gross national income. Despite some offset by increased net income from abroad, the trading loss has weighed on Japan’s economic recovery, particularly impacting private consumption. The rise in inflation, peaking at 4.3 percent in January 2023, significantly discouraged private consumption.
Addressing these challenges necessitates a comprehensive approach, encompassing structural reforms, innovation promotion, labor market flexibility, and strategies to mitigate the impact of demographic shifts.
Impacts of Economic Stagnation
Declining Real Wages
Despite being an advanced economy, Japan has experienced prolonged periods of stagnant wage growth. Real wages, adjusted for inflation, have not seen substantial increases for decades. The lack of significant wage growth has led to a decline in real purchasing power for many Japanese workers. This, in turn, affects living standards as households face challenges in keeping up with the rising costs of goods and services.
According to Japan’s Ministry of Health, Labor and Welfare, real wages in Japan saw little growth from the early 1990s to the mid-2010s. For instance, between 1990 and 2015, real wages increased by only around 3%, contributing to a prolonged period of income stagnation.
Lack of Capital Spending
Economic stagnation has led to low levels of business investment in new technologies, research and development, and infrastructure projects. Companies may be hesitant to invest in the face of economic uncertainty and low demand.
Data from the World Bank shows that Japan’s gross fixed capital formation as a percentage of GDP has been relatively low compared to some other developed countries. In the 2010s, Japan’s gross fixed capital formation ranged between 20-25% of GDP, indicating a cautious approach to capital spending.
Growing Inequality
Economic stagnation has contributed to growing income inequality in Japan. Those with assets and investments may fare better than those dependent on traditional employment, exacerbating social and economic disparities. According to the Organization for Economic Cooperation and Development (OECD), Japan has seen an increase in income inequality over the past few decades. The Gini coefficient, a measure of income inequality, rose from 0.26 in the 1980s to around 0.33 in the 2010s, indicating a significant shift. The trajectory of this income inequality is still in the upward direction.
Demographic Pressures
The global economy is undergoing a significant shift due to demographic change, contrary to past predictions. Instead of the feared scenario of overpopulation leading to resource depletion and economic collapse, the world’s population is expected to nearly stop growing by the end of the century, mainly due to declining fertility rates. Japan serves as a prominent example of this trend, with its unique history of population, fertility, and immigration patterns. The effects of an aging and shrinking population are evident across various aspects, including economic performance, financial stability, urban landscapes, and public policy priorities such as ensuring the long-term sustainability of pension, healthcare, and long-term care systems. As demographics increasingly impact societies, Japan’s experience serves as a model for understanding and addressing the challenges of “shrinkonomics,” influencing other countries to draw valuable lessons from its experiences.
The IMF’s work on the Japanese economy has focused heavily on demographics in recent years—mirroring the intense debate within Japan on how best to respond to the pressures from a rapidly aging and shrinking population. While each country’s experience will be different, and prompt different solutions, some of the key macroeconomic and financial effects can be identified from Japan’s recent experience.
 Low Fertility Rate:
Japan has one of the lowest fertility rates globally, with the number of births consistently below the replacement level needed to maintain the population size. Societal factors such as high living costs, career demands, and changing gender roles contribute to this trend. According to the World Bank, Japan’s total fertility rate (the average number of children born to a woman over her lifetime) was around 1.4 in recent years, significantly below the replacement level of 2.1
Declining Working-Age Population
Japan’s working-age population (15-64 years old) is decreasing, leading to concerns about the sustainability of the social safety net. This demographic shift is a consequence of both a declining birth rate and an aging population.
The National Institute of Population and Social Security Research in Japan projects a significant decline in the working-age population from around 76 million in 2020 to about 45 million by 2065.
Labor Shortages
Labor shortages are becoming more prevalent, particularly in industries that require physical labor, such as construction, healthcare, and agriculture. According to the Ministry of Health, Labor and Welfare in Japan, there has been a noticeable increase in job openings exceeding the number of job seekers in recent years, indicating labor shortages in various sectors.
Potential Consequences of Demographic Pressures
A shrinking workforce poses concerns for productivity and economic growth as fewer individuals contribute to various sectors. The International Monetary Fund (IMF) identifies demographic challenges as a key factor contributing to Japan’s low potential growth, predicting a decline in potential output in the coming decades. Additionally, the aging population increases the demand for social security services, including pensions and healthcare, leading to higher social security costs. The rising dependency ratio, reflecting more dependents, mainly the elderly, compared to the working-age population, puts strain on government budgets, as noted by Japan’s Ministry of Health, Labor, and Welfare. Beyond economic implications, changing demographics disrupt Japan’s traditional social fabric, impacting family structures, societal norms, and community dynamics. These shifts may necessitate adjustments in policies and social systems to address the evolving landscape.
Persistent Deflationary Tendencies
Japan’s long-standing deflationary trend stems from economic stagnation since the 1990s, where falling prices dampened demand and growth. Policymakers have sought to combat this trend since 2016 by maintaining ultralow interest rates to stimulate economic activity, aiming for a sustained inflation target of 2%. However, the recent rise in U.S. interest rates has led to a yen sell-off, causing imported consumer goods prices to surge and pushing food inflation to 9%. The inconsistency between official inflation measures and perceived inflation, as indicated by the Bank of Japan, has sparked concern among voters and policymakers. Despite inflationary pressures driven by factors like the cheaper yen and higher energy costs due to the Ukraine war, the BOJ remains committed to its loose monetary policy until inflation is supported by rising incomes and sustained economic growth. Japan’s deflationary spiral, witnessed during the “Lost Decades,” has led to consumer price index (CPI) inflation frequently below zero. The country’s high debt-to-GDP ratio, exceeding 200%, limits the effectiveness of fiscal policy in stimulating economic activity. Persistent deflation also contributes to weak consumer confidence and job insecurity, impacting consumer spending habits and worsening deflationary pressures.
Negative Impacts of Persistent Deflation:
Businesses hesitate to invest in new ventures when they anticipate declining future profits. This in turn hinders long-term economic growth. In Japan, investment as a percentage of GDP has experienced periods of stagnation, reflecting businesses’ reluctance to expand. Fluctuations in gross fixed capital formation, highlighted by World Bank data, illustrate this cautious approach. Deflation discourages consumer spending as people delay purchases in anticipation of lower prices, which in turn leads to economic stagnation. Household consumption expenditure data, published by Japan’s Ministry of Internal Affairs and Communications, reflects periods of stagnation or decline during deflationary periods. Persistent deflation can instill expectations of further price declines among consumers and businesses, contributing to an entrenched deflationary mindset. This mindset reduces inflation expectations, making individuals less inclined to borrow, spend, or invest, thereby perpetuating the deflationary cycle.
Conclusion
In short, Japan is facing big economic problems that need careful planning for long-lasting growth. These issues include a stagnant economy, changes in its population, constant low prices, and the need for big changes in how things are done. Japan’s economy has been slow for more than 20 years, with periods where it hasn’t grown and prices have stayed low. Experts from the International Monetary Fund (IMF) say Japan’s low birth rate and people getting older are affecting how much the country can grow. Data from Japan’s National Institute of Population and Social Security Research shows there are fewer people of working age. Japan has also had a problem with prices staying low, which affects how people and businesses spend money and how well the government’s plans work. Information from the World Bank shows that Japan has been dealing with low prices for many years. Fixing these problems means making lots of changes. Japan needs to make it easier for businesses to hire and adapt, while also making sure jobs are secure. Rules need to be simpler to encourage new ideas and businesses to start up. Investing more in new ideas and technology is important too. This can help Japan come up with new ways of doing things and create more jobs. Japan also needs to sell more goods overseas to make up for fewer people buying things at home. By working together and sticking to these plans, Japan can turn things around and have a strong economy again. It will take time and effort, but with the right changes, Japan can have a bright future ahead.
