Growth or Decline: Improving the economic metabolism to raise productivity
FUKAO Kyoji Faculty Fellow
Since the 1990s, for the most part of the "two lost decades," Japan has suffered from a lack of demand. The backdrop of this situation includes not only stagnant investment and consumption due to deflation, the dysfunction of financial institutions, the corporate balance sheet problem, and other factors, but also a low birth rate and an aging population as well as long-term stagnation in the growth rate of total factor productivity (TFP or productivity based on technological innovation in a broad sense). These factors have aggravated the problem of excess savings which has lasted since as far back as the mid-1970s.
Against this background, what is above all necessary for Japan to overcome the excess savings problem is a recovery in consumption and capital investment in the private sector.
For a recovery in consumption, it is important to find a way to lower the private savings rate, which remains persistently high. To this end, it is necessary to overcome the negative asset effects and reduce the motive for precautionary saving by creating employment and raising the long-term expected growth rate.
In the economic recovery led by external demand in the 2000s, companies tried to streamline operations and improve profitability by reducing employment. This resulted in a so-called jobless recovery and likely contributed to the stagnation in consumption. Expanding employment in order to lower the uncertainty that households face is indispensable for a recovery in consumption.
In terms of investment, capital accumulation in Japan has for many years brought almost no rise in TFP, resulting in excess capital and a decline in the return on capital.
The graph below provides a comparison between Japan and the United States of the trend in the "capital coefficient," which is the value of corporate facilities and equipment (nominal capital stock) divided by gross domestic product (GDP) (the higher the value, the more excessive is the capital stock) and of the "return on capital" (gross operating surplus divided by GDP), which shows how much income companies have earned from their facilities and equipment. In the United States, where economic growth has been led by a rise in productivity rather than by capital accumulation, the capital coefficient has declined, and return on capital is on an increasing trend, in contrast to Japan. It is thus highly likely that the sluggishness in investment in Japan is caused by the fact that capital has been excessive for a prolonged period of time.
Instead of pointlessly stimulating investment by reducing the real interest rate, the expected return on investment should be raised by increasing productivity and restoring the competitive advantage of Japan as a business location. In addition, it is also important to create an environment in which firms actively invest in promising new business areas and capital investment grows in a sustainable manner.
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The slowdown in TFP growth since the 1990s has been particularly pronounced in the manufacturing sector, which until then had been driving productivity growth. On the other hand, TFP growth in the non-manufacturing sector has been sluggish since the 1970s.
Let us consider what is necessary to raise Japan's TFP growth. To start with, Japan's "economic metabolism," i.e., the normal pattern whereby the output of highly productive firms and establishments increases, while that of less productive firms or establishments decreases, has been low since even before the 1990s. In order to resolve this issue, it is necessary to recognize it as a structural and long-term problem rather than a temporary one caused by, among other things, balance sheet problems and the fact that firms that were essentially bankrupt following the collapse of the bubble economy did not exit the market.
Furthermore, it is necessary to solve problems such as the very low investment in information and communication technology (ICT) relative to other countries and a financial system that makes it difficult to create startup companies. In both of these areas, Japan has been lagging behind other countries since the 1990s. Japan must also solve such problems as stagnant investment in intangible assets, including organizational restructuring and in-house vocational training, and the stagnation in human capital accumulation due to increased part-time employment.
Many of these factors are also closely related to rigidity in the labor market. It seems imperative to promote labor market reform to enhance employment mobility and eliminate the unfair gap between full-time and part-time workers while expanding the social safety net.
A breakdown of firms in terms of size indicates that the TFP growth rate of large firms such as listed corporations since 1995 in fact has been higher than before 1990. Thus, for large companies, there was only "half a lost decade" at most.
The reason for Japan's productivity problem is that the TFP growth of small and medium-sized firms continues to stagnate. The gap between large firms on the one hand and small and medium-sized ones on the other in terms of R&D intensity and internationalization has been growing since around 1995, and this very likely has increased the disparity among firms.
Another possible reason is that since the 1990s, the traditionally close inter-firm relationships in the manufacturing sector have started to unravel, which may have lead to a decrease in technology transfers from large to small and medium-sized firms. In fact, research shows that, all else being equal, the TFP growth rate of subsidiaries of large or foreign companies tends to be higher than that of smaller independent firms. The likely reason is that companies belonging to a corporate group benefit from technology transfers from their parent company.
The above considerations imply that large, highly productive firms should have expanded further, while less productive small and medium-sized firms should have contracted, and this acceleration in the metabolism should have contributed to a rise in productivity in industries overall. However, this did not happen.
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Although the cash income of large companies quickly recovered in the 2000s against the background of the economic recovery and cost reductions, they did not increase capital investment. Rather, it was young independent companies and subsidiaries of foreign firms that were most active in terms of capital investment. Moreover, although subsidiaries of large companies absorbed employment, they were rather reluctant to carry out new investments.
A number of reasons can be identified as to why capital investment and job creation by large companies were sluggish. First, the majority of large companies in the manufacturing sector have already internationalized, and they have been transferring production overseas to gain access to overseas markets and inexpensive labor.
Second, large companies, in order to lower labor costs in Japan as well, shifted employment to subsidiaries and restructured their own operations. The shift to overseas production in the manufacturing sector is likely to accelerate further in the future due to the unstable power supply following the nuclear power plant accident and delays in the conclusion of free trade agreements (FTA).
On the other hand, not all small and medium-sized companies have experienced stagnating productivity. Relatively young companies and firms actively engaged in export and R&D have performed well both in terms of their TFP level and TFP growth.
In a recent study "Nihonkeizaisaisei no Gendoryoku wo Motomete" [In Search of the Driving Forces for a Revival of the Japanese Economy] with Hyeog Ug Kwon, Associate Professor at Nihon University, I examined what types of companies have created or reduced employment, using data for individual business establishments from the Establishment and Enterprise Census, which covers the entire Japanese economy. The study showed that the driver of job creation were young independent companies and subsidiaries of foreign corporations in growing industries, primarily in the service sector.
Similarly, a recent study on the United States using firm panel data published by the Census Bureau showed that firm age was an important determinant of job creation. Especially in such industries as communication, finance, insurance, and services, the employment share of young companies is surprisingly high.
The observations suggest that, provided certain conditions are in place such as the development of an environment that facilitates the entry and growth of new firms and the appropriate conduct of macroeconomic policy, it is highly possible to create jobs and achieve acceleration in economic metabolism.
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As large companies are rather hesitant to invest and increase employment in Japan, raising productivity growth may require policies that focus on companies that are relatively young, have considerable room for growth, and are promoting innovation and job creation.
However, it would be undesirable to support small and medium-sized companies across the board, prolonging the life of firms whose productivity is low and has stagnated for a long time. An environment should be developed in which young companies are ultimately fostered and selected through the market mechanism.
Conceivable measures include providing support only for firms' R&D and internationalization efforts or establishing quotas for small and medium-sized firms for government procurements of goods and services where economies of scale are not important, with suppliers chosen on a competitive basis.
As noted above, raising labor market mobility may also help to foster young promising firms as it facilitates new entry by enabling new entrants to secure competent personnel and reducing the expected exit costs upon failure.
Mergers and acquisitions (M&A) can be an effective means of supporting small and medium-sized companies left behind in R&D and internationalization. Finally, it is also important to make it easier for small and medium-sized companies to access new technologies, for example by expanding the Japanese version of the Bayh-Dole Act (the Industrial Technology Enhancement Act), which facilitates technology transfer from universities to local communities.
* Translated by RIETI.
July 27, 2011 Nihon Keizai Shimbun
August 23, 2011
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