Japan's Economy on Thin Ice: Why Did Domestic Demand-Led Growth Fail to Happen?

YASHIRO Naomitsu
Consulting Fellow, RIETI

The Japanese economy on thin ice

The official economic outlook of the Japanese government, which I took part in formulating as a representative of the Ministry of Economy, Trade and Industry (METI), predicts a real growth rate of 1.3% for fiscal year 2007, the weakest growth in the past five years. Technically speaking, this essentially means zero growth, given the fact that the real GDP at the beginning of the fiscal year 2007 was 1.3% larger than in 2006 (the so-called "launch pad" growth rate). Although such a weak forecast mostly reflects the huge drop in housing construction caused by the revised Building Standard Law, the Japanese economy faces a fundamental turning point that is much more than a mere shock created by poor administration. While the growth rate for fiscal 2008 is projected to be 2%, it would actually fall short if a special factor was subtracted: the jump in housing investment due to the normalization of housing construction. Such a weak scenario is close to the consensus of economists in the private sector.

The very source of the current economic recovery has been strong exports owing to robust global economic growth. The resulting increase in corporate earnings has in turn encouraged expansion of capital investment and employment, the latter translating into improvement of household income and private consumption. However, private consumption failed to become the second engine of growth as per-capita wages remained sluggish despite record high corporate profit, leaving economic growth fairly export-dependent. As concern over Japan's exports deepens given the slow down of the U.S. economy, and rocketing oil prices squeeze corporate profits, the mechanism that has sustained Japan's longest postwar economic recovery is now standing on thin ice.

Why didn't domestic demand-led growth happen?

The major stumbling block to domestic demand-led growth has probably been sluggish wage growth. Although the Monthly Labor Survey, the typically cited wage indicator, needs to be observed with several points kept in mind, such as the effect of baby boomers' retirement depressing the average wage level, wage weakness stands out even after taking these factors into account. While a sharp increase in non-regular employment and intensified global competition have obviously contributed to this wage trend, further attention should be devoted to structural problems namely low labor productivity growth in the non-manufacturing sector and small- and medium-sized enterprises (SMEs). Japan's non-manufacturing sector, holding 80% of employment, suffers from low labor productivity growth in service-related industries, compared to the manufacturing sector. These industries are more labor-intensive than manufacturing, and they also face slow growth in household consumption demand while manufacturing benefits from buoying exports. But it is also true that small firms, often with relatively low productivity compared to large enterprises, comprise a large share of firms operating in these industries. And those industries are the ones with the weakest wage growth.

A look at 2007 wage trends by company size reveals that although wages continued to lag in large enterprises of 500 or more employees and mid-sized companies of fewer than 500 employees, declining 0.1% year-on-year in the former and 0.7% in the latter, the smallest firms, with 30 or less employees, which hold 40% of Japan's employment, saw the largest fall of 1.2% in wage payment. Given the fact that as many as 90% of small enterprises operate in the non-manufacturing sector, low productivity and sluggish wages in non-manufacturing sector are to some extent, problems of small enterprises. Although it would be wrong to think a priori that productivity is necessarily lower in small enterprises, Japan has not seen significant productivity improvement due to the exit and entry of firms, which has been observed, for example, in the U.S. Thus, a fundamental reason why economic growth led by domestic demand has not been realized in Japan may be the fact that the overall productivity of the Japanese economy has not improved to a point where all workers are rewarded with higher wages. This in turn may be because structural reforms that could have enhanced efficient resource allocation have not been pursued with sufficient vigor.

Did the government contribute to domestic demand-led economic growth?

Did the Japanese government try its best to bring about domestic demand-led growth, especially to encourage private consumption? Some recent policies influencing households include the abolishment of temporary income tax breaks and years of sustaining a low interest rate policy, both unlikely to be favorable to household income. A further raise of the consumption tax rate is under debate, while uncertainty about the sustainability of the nation's pension system has yet to be resolved. Although the Japanese government often stresses that fiscal consolidation and economic growth go hand in hand, while there has been an emphasis on the need for stable economic growth for successful fiscal consolidation, the possible role of fiscal policy in achieving domestic demand-led growth has seldom been discussed.

The Japanese government recognizes that improving labor productivity is essential, and sets the enhancement of labor productivity in service-related industries and small enterprises as a key element of its growth strategy. However, actual policy measures are mostly designed to support existing firms under the current industrial structure, and there is a lack of perspective on structural adjustment, such as encouraging the exit of less efficient companies, promoting market competition, and economies of scale and scope.

Just as the U.S. economy experienced an adjustment period in the 1980s before its long expansion once referred as the "new economy," Japan must also undergo a substantial and most likely painful structural reform, to improve its own economic performance. Although strong political leadership is essential for swift and effective structural reforms, it is most unfortunate for the Japanese economy that political disarray spoiled a great opportunity, that is, the strong export demand over the past five years, to force through structural reforms.

Now that the Japanese economy stands on thin ice, we must consider seriously policies that truly realize stronger household consumption, as well as policies that shift people and capital to more productive firms and sectors, so that the Japanese economy can sustain its energy and dynamism over the medium and long terms.

February 26, 2008

>> Original text in Japanese

February 26, 2008