Go Beyond Stop-Gap Solutions to Overcome Secular Stagnation

Program Director and Faculty Fellow, RIETI

With inflation and wage hikes coming into full swing, the monetary policy goal of stabilizing the inflation rate at 2% may be coming within reach at long last. However, unless the cause of the low growth of gross domestic product (GDP) is identified, Japan may not necessarily be able to boost its economic growth rate even if inflation takes hold. This article examines what has caused the secular economic stagnation of the past 30 years and what measures may be taken to overcome it.

First, there is an argument that the aging population is the cause of the stagnation. In a working paper in 2022, Richard Anton Braun of the Federal Reserve Bank of Atlanta and Daisuke Ikeda of the Bank of Japan verified this argument through theoretical model simulations. It was a study of the secular stagnation in Japan that is based on a theory similar to the demand theory of the price level (DTPL), proposed by Professor Marcus Hagedorn of the University of Oslo.

Under the DTPL, the price level is determined by the volume of aggregate demand, which is determined by the combined effects of monetary and fiscal policies. Depending on the mix of monetary and fiscal policies, instability of pricing channels, which is considered to occur under conventional theories, may not arise. The paper by Braun and Ikeda analyzed the impact of the population aging under an overlapping generation model incorporating that feature. If the population aging proceeds further, the value of currency and other liquid assets rises due to elderly generations’ preference for holding liquid assets that can be readily used for payment, resulting in price drops. Consequently, deflation continues.

Moreover, as the aging of society causes the average productivity to decline, per-capita production volume falls. As the working-age population also shrinks, the entire economy, or GDP, declines as well. As a result, the price level, economic growth rate, and interest rates all remain stagnant. By verifying this proposition, the paper by Braun and Ikeda indicated the possibility that Japan’s secular stagnation has been caused by the aging demography.


This line of argument is becoming increasingly popular although it has not yet been accepted as an established theory. In fact, the argument that the aging demography is the cause of Japan’s deflation was presented in 2010 by Kosuke Motani of the Japan Research Institute in his book The True Identity of the Deflation. At that time, although his argument attracted little attention in academia, it was a prescient idea. However, no economic policy can resolve the aging demography overnight.

Among the possible causes of the economic stagnation of the past three decades are the bad loan problem in the 1990s; the aftereffects of the disposal of bad loans and risk aversion due to the low interest rate environment in the 2000s; and the degradation of human capital in the 2010s.

In the 1990s, due to delays in the disposal of bad loans, uncertainty pervaded Japan, triggering various problems. Although the bad loan problem was redressed by 2005, its aftereffects lingered following the lengthy, 15-year process of disposal. Corporate activity contracted, leading to an extended period of low growth.

After the banking crisis in the late 1990s, Japanese companies’ tradition of placing emphasis on employment security crumbled, resulting in an increase in non-regular workers. According to a study conducted in 2022 by Professor Kyoji Fukao of Hitotsubashi University, wages fell due to an increase in non-regular workers in the 2000s, causing labor’s share of income to remain low. He pointed out that the low growth in the 2010s is a manifestation of the delayed effects of the sluggish investment in human capital in those years.

The Zero Nominal Interest Rate Policy had short-term positive effects such as supporting an economy weakened by the disposal of bad loans in the 2000s. However, as the zero-interest-rate circumstance lasted longer than had been expected, the economy-stimulating effects faded out and negative side-effects emerged. The low-interest-rate environment overly fostered risk aversion among the top management, with the result that low growth became entrenched.

From the standpoint of hired managers, there is no fear of being fired and a safe life in retirement is guaranteed even if they focus on low-risk, low-return businesses, because funds can be raised at low interest rates. As a result, managers refrain from venturing into businesses that involve higher returns with additional risks.

Let us consider a simple example (the figure below). In this example, which represents a hypothetical model, “low-risk, low-return” businesses are favored over “high-risk, high return” businesses in the low-interest-rate environment. It is possible, at least in theory, that as a result of the low interest rate policy, everyone chooses low-risk, low-return businesses, leading to an extended period of low economic growth. The same model also suggests the possibility that if a high-interest-rate policy lasts in the long term, everyone may choose high-risk, high-return businesses.

Hypothetical model of low interest rates leading to low growth
Hypothetical model of low interest rates leading to low growth

Low interest rates work to keep growth low as a side effect when the low-interest-rate environment is prolonged. To revitalize economic activity and business management, it is essential to consider ways of gradually normalizing the zero-interest rate environment, which has continued for a quarter century.

As for the degradation of human capital, Professor Tom Krebs of Mannheim University, Germany, proposed a theoretical model in a paper published in 2003. Krebs pointed out that if the volatility risk of wage income increases for some reason or other, stocks of human capital decrease.

For workers, wage represents the return from human capital investment (education and training), and therefore, an increase in wage volatility risk means an increase in human capital investment risk. As people avoid high-risk investment (investment in increasing their own value as human capital), human capital decreases on an economy-wide basis. In other words, if wage volatility risk increases, the economic growth rate falls due to a decline in human capital investment.

Krebs’ argument indicates that the cause of the low economic growth in Japan is attributable to the degradation of human capital due to the rise in employment security risk following the increase in non-regular workers in the 2000s. Of course, both the reduction of human capital investment made by workers of their own accord and the reduction of the investment in education and training of non-regular workers by companies are presumed to be factors contributing to the degradation of human capital.


I have now cited four factors behind Japan’s secular stagnation—the aging demography, the aftereffects of the disposal of bad loans, the side effects of low interest rates (excessive risk aversion among companies), and the degradation of human capital. In addition, growing concerns over long-term fiscal sustainability due to an increase in government debt may be a contributing factor to the secular stagnation (based on a paper I wrote in 2022 with Professor Kozo Ueda of Waseda University).

The factors above, excluding the aging demography, are problems that can be addressed through economic policy. Among effective solutions for the degradation of human capital are providing equal treatment to regular and non-regular workers doing the same job in order to level out wage income risk and creating a safety net that covers all types of employment arrangements (e.g., a tax credit program that provides benefits to non-taxable workers). To promote high-risk, high-return businesses by preventing companies from becoming overly risk-averse, it is essential to gradually normalize nominal interest rates. However, in order to avoid a short-term recession due to the interest-rate hike, it is necessary to engineer a soft landing. Moreover, since interest rate hikes lead directly to increases in the burden of government debt, monetary policy normalization should be implemented in combination with efforts to secure long-term fiscal sustainability.

One effective way of achieving such a mix of fiscal and monetary policies may be to establish an independent fiscal institution. According to the standards set by the Organization for Economic Cooperation and Development (OECD), independent fiscal institutions should present to the general public a neutral and highly credible fiscal forecasts for the 70 years ahead. If the general public is informed of such long-term fiscal forecasts, it will become easier to obtain a consensus on reforms that will maintain fiscal sustainability. I call for an integrated fiscal and monetary reform initiative that seeks to gradually normalize interest rates while securing public confidence in fiscal consolidation.

>> Original text in Japanese

October 12, 2022 Nihon Keizai Shimbun

December 21, 2022

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