Japan's New Growth Strategy and the World Economy

Date September 24, 2012
Speaker Dale W. JORGENSON (Samuel W. Morris University Professor, Harvard University)
Moderator KOBAYASHI Keiichiro (Senior Fellow, RIETI / Professor, Institute of Economic Research, Hitotsubashi University / Research Director, Canon Institute for Global Studies / Senior Fellow, The Tokyo Foundation)



Dale W. JORGENSON's Photo


The authors of the new growth strategy deserve congratulations for their excellent work. Its introduction appears to mark a turning point in the debate over economic growth in Japan, which has been underway for the last two decades. It is gratifying to see that the new growth strategy was endorsed by the Cabinet of Japan on July 31 this year. More details will be covered during the course of this presentation. In addition to discussing specifics on this strategy, alternative approaches worth considering will also be introduced. Finally, I will discuss the growth strategy proposed by the International Monetary Fund (IMF) in the Article 4 consultations which concluded on August 1.

There are several strategic issues facing the Japanese economy at present. The Great East Japan Earthquake and the related nuclear power plant accident is an important example. There is universal admiration of the efforts by Japanese citizens, businesses, and the governments in reaction to this very difficult situation. As this topic has been discussed at great length by RIETI, today's presentation will focus more specifically on Japan's economic growth going forward. Another strategic issue facing the Japanese economy is overcoming deflation and bringing about the depreciation of the yen. We are all aware that the economic and fiscal crisis that took place in the United States beginning in 2007 and continuing through 2009 had a major, indirect impact on Japan. Japan became a safe haven for many financial investors, which led to great demand for securities denominated in yen. This in turn resulted in a very strong appreciation of the yen relative to the U.S. dollar and the euro, which caused a downturn in exports and industrial production more severe than that of many other industrialized countries. Finally, Japan is facing the issue of a rapidly aging population along with constraints on energy. Those two issues will play the largest role in discussing Japan's new growth strategy.

When considering economic and fiscal management, overcoming deflation is a very difficult problem for the Japanese economy to address. According to IMF research, there is currently a gap between aggregate supply and demand in Japan of about 2.6% of the GDP. In other words, aggregate supply exceeds aggregate demand by 2.6%. The IMF projects that this will exert deflationary pressure through 2016, and that it will only be by 2017 when Japan will attain a 1% inflation rate. The IMF also projects a real growth rate between now and 2017 of only 1.3%. However, the nominal growth target in Japan is 3% per year for the period 2010 to 2020, and the real growth target over the same period is set at 2% per year. Questions must be asked about whether or not such targets are reasonable in the face of the well-informed IMF projections.

The IMF has a series of recommendations regarding reforms necessary to produce 2% growth per year. Such recommendations include raising the labor force participation rates of women and the elderly. The IMF points to disincentives to female labor supply in the Japanese tax system and recommends their removal. However, institutional changes that would be required to increase the female labor force participation rate would be challenging and would need to be phased in over a considerable period of time. This is something which deserves immediate consideration. In terms of promoting increased labor force participation by the elderly, reform of the pension system may be required, although this is also a difficult process. Another recommendation is raising the level of immigration, and incremental steps in the right direction are being made. Finally, the IMF also recommends opening the protected sectors and easing regulations.

The new growth strategy consists of four main packages of policy proposals. The first relates to energy and the environment, and its objective is to conserve energy and increase reliance on renewable energy sources. Japan has been at the forefront of energy conservation and environmental technologies ever since the energy crisis of the 1970s, and Japanese technology and expertise has found markets throughout the world as other countries begin to move toward similar standards. Emerging countries such as China and India will surely need to rely on Japanese technology and expertise for some time to come. Therefore, this appears to be a platform for a sustained comparative advantage for Japan as well as an appropriate point to focus on in policy. One example of this is that Japan has been an international leader in hybrid and electric vehicles for several decades.

An entirely different initiative in terms of energy and the environment is also worth considering, which is to provide a single electric power market throughout Japan. Japanese electric utilities have always rejected the idea of a single market. However, when Japan had to undertake severe conservation efforts in the aftermath of the nuclear accident last year, a system which is a model of inefficiency was revealed. This needs to be replaced and would require a major effort in economic organization and technology. An added advantage of a single market for electricity in addition to improved efficiency would be enabling the use of whatever forms of energy supply that evolve out of the energy debate.

The second proposal of the new growth strategy involves health and life sciences. Japan's health system is a model for the world. The results in health policy terms are impressive, and the quality of technology is high. This is another source of a sustained comparative advantage for Japan. It is important in particular to recognize that in order to realize the benefits of such an advantage, trade negotiators must incorporate the export of medical devices and drugs into the agenda for trade policy.

On a related note, another important issue is the growth of an industry which would provide institutional care for the elderly. This could also potentially act as a business opportunity for the female entrepreneurs called for under the new growth strategy. Child care is a related sector which is underdeveloped in Japan and, if expanded, will most likely result in a larger female labor force participation rate.

The third proposal of the new growth strategy involves agriculture, forestry, and fisheries. Challenges related to this sector have so far led to a lack of progress and frustration. The result is that Japan has the highest food costs of any advanced country in the world. On top of this, the most rapidly aging labor force in the country is that of agriculture. Connections between reforms in the agricultural sector with economic growth have been noted in the new growth strategy. The removal of trade barriers would help to open up international markets for Japanese products including agricultural products.

Finally, the new growth strategy includes proposals in relation to small- and medium-sized enterprises (SMEs). In Japan, there is a challenge related to the long-term public support of SMEs through subsidized credit, which has given rise to a large number of financially unviable enterprises that are dragging down productivity and economic growth in the trade and services areas in which they operate. SMEs appear to be the source of significant employment, thus a personal proposal would be based on a prefecture of origin principle. The prefecture of origin principle suggests that if you have an SME in one part of the country and wish to open a branch of that enterprise in a different part of the country, you would be licensed to do so. This principle would potentially act to remove barriers to entry and allow capable business entrepreneurs the opportunity to expand their businesses and create new employment opportunities.

Going back to IMF recommendations mentioned earlier, there are sectors which are protected from competition by regulations mainly at the prefectural level in Japan. IMF research suggests that there is growth potential from such protected sectors. Studies on the Japan-U.S. productivity gap have helped to identify the industry sources of the productivity gap which contributes to slow economic growth in Japan. Comparisons on the level of productivity in various sectors in Japan and the United States have been conducted in order to stimulate growth potential.

In 1960, Japan's productivity relative to that of the United States was approximately 60% less. As the Japanese economy progressed, the productivity gap decreased; by 1970, it was only half of that of 1960, and by 1990, it dropped to a low of 14%. Since then, Japanese productivity has dropped, and the gap has increased to approximately 20%. In terms of the manufacturing industry, Japan closed the productivity gap with the United States by 1990. However, the non-manufacturing gap has continued to remain large between the two countries. Therefore, we now know which sectors Japan should focus on improving.

Industry contributions to the Japan-U.S. productivity gap reveal that the wholesale and retail trade productivity gap was as little as 2% in 1990 but rose to 6% by 2004. This remains the most important industry in terms of contribution to the productivity gap. Such a sector is protected by layers of regulations created by the prefectural and municipal governments. Such regulations must be addressed and can be through the use of the prefecture of origin principle. Other protected industries in Japan appear to include food, construction, agriculture, electricity, other transportation, and other services.

Although the Japanese economy is faced with several issues, they are not unique to Japan. Mario Monti, the Prime Minister of Italy and a distinguished economist, prepared a report on a new strategy for the single market in 2010 for the EU. He expressed that the EU was built around the idea of a single market for goods but not for services. He added that although the services sectors account for 70% of EU GDP, the market is strongly fragmented with only 20% of the services provided in the EU having a cross-border dimension. Prime Minister Monti concluded that the productivity gap between the United States and EU area is as wide as 30%. Therefore, in the EU area as well as Japan, the trade and services sectors have been protected by efforts that were originally for the purpose of creating jobs to absorb the repatriation of millions of Japanese after World War II. Those regulations have never been changed and can now be considered a hindrance to economic productivity.

In conclusion, Japan has not overcome the problem of deflation, and therefore economic and fiscal management are still first-order problems. An initiative on the part of the Bank of Japan has come in to effect to restart quantitative easing, which is a step in the right direction. However, the time has come to deal with problems other than economic and fiscal management mentioned in the new growth strategy. Japan would benefit from a single market for energy and combining the exploitation of new health and life science technologies with expansion of institutional facilities for the elderly. Japan would also benefit from removing barriers in order to allow successful SMEs to expand and create employment opportunities in the process and exchanging agricultural protectionism for the opening of this market to international trade negotiations.

With regard to the demographic decline, there needs to be a pension system reform and a focus on efforts to increase the labor supply of the elderly. The most promising aspect of the IMF agenda seems to be the potential benefits that would come about from opening up the protected sectors. RIETI has responded to the Great East Japan Earthquake with a program of research which has offered a range of policy alternatives which should be debated by policy makers. RIETI now has a great opportunity to create an agenda to raise Japan's potential growth rate.


KOBAYASHI Keiichiro's Photo


There are three issues which will be covered in today's presentation. The first is how to enhance productivity growth. The second topic will be on how to restore the sustainability of Japan's government debt. Finally, the last issue will be on income inequality in Japan.

As Professor Jorgenson mentioned, the most important sector in terms of potential growth in Japan is the services sector. This sector accounts for approximately 75% of the GDP and hours worked, and there are great differences between each sector. The distribution services sector has rapid total factor productivity (TFP) growth, whereas the financial services sector has low TFP growth. In considering the issue of which area of innovation is most promising in terms of enhancing productivity growth, research conducted using induced innovation methods suggests that the direction of technological change is determined by the market environment. This research also indicated that an increase in the supply of skilled labor in the 1960s and 1970s enhanced innovation and skill augmenting technology. The biggest change in the market environment in recent times is that of an aging population. There is an increasing demand for nursing care services, and therefore it could be argued that innovation in nursing care services is necessary in the form of gerontology.

With regard to the government debt problems, many economists argue that Japan needs a 25%-30% consumption tax increase to sustain the debt-GDP ratio. Raising the co-payment of medical services for the elderly from 10% to 20%, along with a substantial decrease in pension benefits and a general spending cut are other suggestions which have been made. Such measures would take an incredibly long time and require the persistence of the Japanese people, and the outlook for implementation of such plans doesn't look positive.

There are several implications of income inequality. Using a neoclassical growth model including worker and capitalist agents, it is found that if the share of worker's capital stock decreases, the labor supply by workers increase, the income of workers decreases, the income of capitalists increases, and total output increases. However, an increase in total output may not be good for social welfare. It would be worth bearing this in mind when considering Japan's economic growth problems.


Q1. Could you provide us with an example of a country which successfully moved from a fragmented electricity market to a unified electricity market?

Unfortunately, there are not many good examples of this. However, the UK has been successful in creating a national grid for electricity. New Zealand and Norway are other successful examples.

Q2. Could you confirm that when you mentioned female participation, you were alluding to the possibility for female workers to increase their productivity?

As far as female participation is concerned, one fact is of great importance. Women who are coming out of the Japanese educational system and entering the labor market today are better educated than men. This is a fantastic opportunity for these women and the Japanese economy. This doesn't simply apply only to jobs in the services sector, but also to leadership roles that women could fill in all sectors of the economy. In order to do that, it is necessary to change the career path system. It is fundamental to address the issue of educated women.

Q3. As I'm not sure all of us share your understanding on this matter, could you please explain about the existence of protected sectors at a municipal level?

The issue of regulation is often discussed in Japan. The regulations I mentioned in today's presentation were decentralized to prefectural and municipal governments shortly after the period of the American occupation of Japan and have been allowed to remain in place. This has resulted in the encrustation of sectors which have been protected from competition and would have generated technical change along with investment and employment. Such policies were reasonable at the time of creation when millions of Japanese were returning to Japan and in need of jobs. However, this is contrary to the current needs of the Japanese labor market. It is time to make a change that will set the legal and constitutional basis for creating a single market in services throughout the country. In Europe, there has been success to a certain extent in the creation of a single market in goods and some services such as financial services. However, similar problems to those of Japan exist in terms of a lack of single markets for services.

Q4. What is your opinion on what the government should do about declining industries and failing companies?

On the issue of declining firms and industries, the problem probably should be dealt with both from short-term and long-term perspectives. My impression is that of most observers, which is that Chrysler and General Motors, which were bailed out by the U.S. government, were in fact viable under the usual rules of bankruptcy. Such rules state that equity holders and bond holders are to be eliminated if they are going to lose money. If there are no equity holders and bond holders left, the company must also be eliminated. However, in the case of General Motors, this rule didn't apply. Investors were wiped out, and a very substantial part of the remainder of the business was turned over to the pension funds. This would never usually happen in bankruptcy proceedings. This is a capital error and is not the best way to go about industrial policy in relation to a viable firm. If the firm isn't viable, it must be eliminated, and examples include companies such as SAAB and Volvo. Industrial policy should be rationalized carefully, and firms which are bankrupt shouldn't be maintained on the basis of subsidy regardless of size. This is a rule to which policy makers should try to adhere, even in the face of political pressures. The U.S. government has failed to do this.

Q5. Which services sectors do you see as attracting foreign direct investment in Japan? Which of these sectors do you think is protected? Finally, what actions by both the public and private firms do you recommend should be taken with regard to this topic?

In response to the question regarding opportunities for foreign investment, the prefecture of origin principle which was suggested during the presentation would apply to foreign firms. By using the prefecture of origin principle, any business which is licensed to have operations in Japan should be allowed to expand to any other area in the country regardless of whether that firm is foreign or domestic. Therefore, opportunities for foreign investors would be created. Foreign investors already established in Japan that have encountered barriers regarding expansion of their businesses due to prefectural or municipal regulations would no longer need to face such hindering issues. The IMF has also expressed that it would like to open up the Japanese market to companies that are not yet established in Japan. This is an admirable objective, although one that seems to deserve lower priority than the idea that businesses already established in Japan should be allowed to operate anywhere in the country.

*This summary was compiled by RIETI Editorial staff.