IT Innovation and the Japanese Economy: Remaining Growth Potential

Fellow, RIETI

The Japanese economy has recently been through a series of ups and downs. Pessimism, exemplified by concerns over the "lost decade," Japan's decline in the IMD international competitiveness ranking, the hollowing out of industry, the so-called threat of the Chinese economy, and so forth, was pervasive two or three years ago but has since receded somewhat. In the mean time, the medium- to long-term prospects for the Japanese economy are far from being bright. Indeed, Japan's growth rate has been stagnant for a long time and we can hardly expect that robust growth exceeding 4%, as was common prior to the bursting of the economic bubble, will ever return. Yet I believe the growth potential of the Japanese economy remains relatively high. This is because the decline in Japan's growth rate, viewed over a 10-year time span, is primarily attributable to a decrease in labor input while productivity, supported by information technology (IT) innovation, has been on the rise since the later half of the 1990s.

Japan retains sufficient potential for IT-driven productivity growth

Focusing on the supply side, the economic growth rate can be broken down into the contribution made by increased input of production factors - capital, labor and so forth - and an increase in total factor productivity (TFP). Future changes in each component determine the medium- to long-term potential for economic growth. Of these factors, the level of labor input is, to some extent, exogenously determined by demographics. In the case of Japan, whose population is fast aging, labor input is expected to fall as the labor force shrinks. Seen in this light, it is surely true that the robust economic growth seen until the 1980s is beyond our reach. Meanwhile, capital, another key production factor, is internally determined by the degree of economic activity and therefore cannot become a driving force of economic growth by itself.

Nevertheless, there are a number of factors suggesting the possibility of further growth of TFP. The accelerated increase in TFP in the 1990s is largely attributable to the increased presence of the IT industry in the overall economy as a result of the IT revolution. IT investment, which accounted for a modest 5% of Japan's gross domestic product (GDP) as of 2000, can be counted on to serve as an engine driving future gains in macroeconomic productivity. On the other hand, the rise in the TFP of IT-using industries remains modest. The author's analysis using firm-level data indicates that, in general, Japanese companies have yet to fully exploit the benefits of IT systems as compared to their American counterparts. Conversely, however, this means Japan still retains substantial potential for IT-driven productivity growth.

Will this potential be realized? One bright sign is the emergence in Japan of high-performance companies that have successfully revamped their business processes by taking advantage of IT. According to McKinsey & Co., the increased productivity of the U.S. retail sector is the result of innovative IT applications initiated by Wal-Mart Stores, Inc. that have since spread to other retailers in the U.S. Japanese businesses lag far behind in their use of IT in business processes. Therefore, one may expect overall economic productivity to be boosted in Japan by expanding innovative IT applications.

Japan's economic reform through IT innovation has just begun

Some argue that further progress in IT innovation will accelerate the outsourcing of business processes, thereby undermining the stable employer-employee relationships and supplier networks that have been a key strength of the Japanese economy. In fact, the author's analysis shows that the rigidity of the labor market has been a drag on the organizational reform of Japanese companies, and one reason why Japanese companies have been unable to take full advantage of IT. At the same time, however, it has been also found that the introduction of IT networks has prompted many companies to strengthen their relationships with business partners. The same tendency is observed in analyses conducted in the U.S. Greater use of IT does not necessarily result in more market base transactions (i.e., externalization of business transactions). The Toyota Production System (TPS), which is built upon a close-knit network of suppliers, has been refined over the years to achieve greater efficiency by making full use of information and communications technologies. Japanese companies should be very good at establishing a close company-to-company network utilizing the unique features of IT.

Although the author's analysis of IT innovation and its economic implications remains inconclusive in many respects, the aforementioned findings have recently been compiled into a book entitled IT Innovation no Jissho Bunseki (Empirical Analysis of IT Innovation) (RIETI Economic Policy Analysis Series, Toyo Keizai Inc.). Moore's Law on the exponential growth in the number of transistors per integrated circuit (i.e., the doubling of the number of transistors every couple of years) is predicted to hold true for at least another 10 years. The reform of the Japanese economy through IT innovation, including various IT applications, has just begun. It is my hope that further research achievements in this field will stimulate discussions on the revitalization of the Japanese economy through IT innovation.

Related article: Author's words, "Empirical Analysis of IT Innovation"

March 22, 2005

March 22, 2005