Japan as number four

Harvard Professor Ezra Vogel’s 1979 book, Japan as Number One: Lessons for America, became an instant bestseller in Japan. The flattering title certainly helped sales, but it was the book’s central argument — that the Japanese approach to governance and business were superior to others — that really made a splash.

At the time, Japan was riding high. Its GDP had grown by about 10 per cent annually for most of the 1950s and 1960s, and 4-5 per cent during the second half of the 1970s — a trend that would continue throughout the 1980s. In the years that followed, Japan appeared to be progressing toward this goal. In the second half of the 1980s, Japanese stock prices tripled, and real asset prices rose fourfold.  In 1995, following a sharp appreciation of the yen, Japan’s economy was about three-quarters the size of the US economy.

That turned out to be “peak” Japan. Soon, the economy was gripped by decades-long stagnation and deflation. From 1995 to 2010, Japan experienced negative GDP growth (in yen terms). The news that China had surpassed Japan as the world’s second-largest economy did not prompt much of an outcry from the Japanese public, which appeared practically resigned to their economy’s decline. To be sure, Japanese voters had handed the opposition Democratic Party of Japan (DPJ) a victory over the long-dominant Liberal Democratic Party (LDP) the previous year. But the honeymoon with the DPJ did not last long. The party fell far short on governance, diplomacy, and economic policy, and from 2009 to 2012, a parade of DPJ prime ministers each lasted barely a year in the position.

In the December 2012 election, Japanese voters tried a different approach, electing the LDP’s Abe Shinzo as prime minister for the second time. Abe quickly introduced a bold economic-policy package — dubbed Abenomics — that aimed finally to lift the Japanese economy out of two decades of deflation and recession with three “arrows”: Massive monetary easing, expansionary fiscal policy, and a long-term growth strategy.

Abe’s plan worked — to a point. Thanks to the Bank of Japan’s monetary expansion, Japan finally achieved a positive inflation rate. But real growth remained elusive, owing to rapid population aging. Though labour productivity increased significantly, the gains were insufficient to offset the decline in the number of workers and working hours. Add to that yen depreciation in 2012-14, and Japan’s GDP declined (in US dollar terms), before flattening out.

Now, Japan has fallen even further: Last year, Germany surpassed Japan as the world’s third-largest economy. And, once again, the public reaction to the news of Japan’s declining global position has amounted to a shrug. The kind of constructive anger that can spur dynamic reform is nowhere to be seen. The list of measures needed to revitalise the Japanese economy is as well-known as it is long. For example, Japan must steer personal bank deposits and institutional savings to equities and alternatives. And productivity increases are sorely needed in every sector — an imperative that should be pursued through aggressive digitalisation, given declining population size.

In the meantime, today’s labour shortages should drive up nominal wages, and strong demand for goods and services, as well as the rising costs of inputs, should be reflected in higher prices. 

The good news is that “deflationary mindsets” are changing, not least because the BOJ has managed to keep inflation above its 2 per cent target for nearly two years. But ultra-accommodative monetary policy carries high costs. The growing interest-rate differential with the US, where rates rose rapidly in 2022-23, contributed to the yen’s rapid depreciation against the dollar, from ¥115 in January 2022 to ¥150 ten months later and throughout 2023.

But while the yen’s depreciation vis-à-vis the US dollar might have contributed to Japan’s declining GDP in US dollars, it is not the whole story. After all, a weak currency can often boost growth by making exports more competitive. But there is no sign of this in Japan, which reflects a deeper problem: Both innovation and production have largely left the country. Payments to US IT-service companies are rising fast, pushing imports higher. Japan must take urgent and decisive steps to reverse this trend, such as by promoting science and technology education to generate IT-service production domestically.

If the economy’s fall to number four is not enough to wake Japan up, it will soon fall to number five. The International Monetary Fund projects that India’s GDP will overtake Japan’s (in dollar terms) in 2026. To stave off further decline, Japan’s government must devise a clear strategy for raising productivity, expanding the workforce, and allocating scarce labour to the most productive sectors.

The writer is a former Japanese deputy vice minister of finance. ©Project Syndicate, 2024