Here, I would like to consider a macro framework for achieving sustainable economic growth. Recently, many people have been saying that raising wages above the level of price hikes is necessary for sustainable economic growth. However, this view confuses the cause-effect order. In a practical sense, continued economic growth (an increase in the total production in the economy) makes it possible to raise wages beyond price hikes.
If wages are raised above price hikes before we see an increase in the gross domestic product (GDP), which shows the size of the national economy, companies' earnings and investments will decrease and the economy will lose further growth potential. Accordingly, economic growth must occur first.
When considering this in the framework of growth accounting, an increase in the GDP means a continued increase in any of the labor input, capital input, or total factor productivity (TFP)
First, labor input will naturally decrease in Japan as the population is declining. How to incorporate foreign workers, including immigrants, is a serious problem, but if they do not increase in number, the labor force will not increase.
With regard to TFP, under a steady-state growth path with no distortions in capital investment, if labor input decreases, an increase in TFP is the only growth engine left. Japan's TFP is about 20% lower than that of the United States, but its growth rate is not particularly low compared with Western countries.
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What is problematic is low capital input. An analysis of Japan's potential growth rate (the growth in the total supply capacity) and relevant indices shows that capital input has been very low since the 2000s, which is explained in an easy-to-understand manner in the 2024 Bank of Japan paper by Mr. Ichiro Fukunaga et al. (see the graph below).
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The graph shows that sluggish capital investment in Japan has stagnated capital stock accumulation eventually reducing capital input in production activities. In other words, companies are engaging in excess savings rather than excess investment.
As investment and saving balance (I-S balance) theory indicates, excesses and deficits of savings in each of the household, corporate, government, and foreign sectors net to zero. In other words, large excess of savings in the corporate sector is balanced out by proportional shortfalls in other sectors. The savings shortage in recent years in the government sector (a large budget deficit) can be interpreted as reflecting a surplus in savings in the corporate sector.
If we consider that the low potential growth rate has been caused by a shortage in corporate investment (investment not being commensurate with productivity gains), it is important to increase corporate investment in order to achieve growth. The I-S balance theory implies that the transformation of the corporate sector from excess savings entities to excess investment entities through increased investment means that the government must also become an excess savings entity through transforming its deficit structure.
In the end, aiming to achieve sustainable growth means creating a future where corporate investment increases and the government's deficit decreases.
If so, what policies can increase corporate investment in the medium to long-term? Within the government there is an awareness of the problem that fiscal resources are currently excessively allocated to social security and inadequately allocated to investment in growth. One way to utilize public finances to induce corporate investment in the medium to long-term is to support investment through subsidies. This is justified if there are positive externalities in corporate activities. However, there is a deep-rooted problem in organizational management related to whether this can cause moral hazard or corruption.
A fair and effective method to encourage corporate investment in the medium to long-term would be to support public education and university and graduate school research. Public investment in education and research should enhance human capital and induce innovation (technological innovation), thereby increasing corporate capital investment in the medium to long-term.
One of the factors stifling investment and inhibiting economic growth is the environment surrounding companies, i.e., policy and institutional uncertainty. According to the study conducted in 2016 by Masayuki Morikawa, specially appointed professor of Hitotsubashi University, the top policy and institutional areas where corporate executives feel medium-term uncertainty are "social security" (39%), "government spending" (26%), "trade policies" (23%), and "taxation system" (21%).
Interest rate trends are even more closely related to uncertainty. Let us suppose that the inflation rate remains at 2% and the economic growth rate hovers around 1.2% (as in the case of the transition to a growth-oriented economy based on the calculation up to FY2060 conducted by the Cabinet Office). Assuming the interest rate remains comparable to the growth rate, nominal long-term interest rates should be 3% or higher, as a sum of the former two rates.
However, most market participants believe that the long-term interest rate will remain around 1% to 2% at the highest. There is a large gap between the market’s perception and the level assumed in the normal growth path simulated by the government.
If higher inflation rates continue, tax revenues will increase. This may exert various influences on public debt, but in any case, the government should create a consistent vision concerning the future changes in government debt, inflation rates, and interest rates. In order to reduce fiscal policy uncertainty and motivate companies to invest, this vision should be shared among the government, the Bank of Japan, and market players.
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The major uncertainties that inhibit investment are not limited to fiscal policy and social security, but are also political. With start of the second Trump administration, the global outlook is chaotic. People say that democracy is in crisis, but what lies under the current situation is a backlash against the free market economic system, and this should be accurately recognized as a “crisis of liberalism.”
The current expansion of populism in western countries can be said to have been caused by a backlash against the capitalist system as an inherently unjust system that produces widening inequality.
As argued by Friedrich Hayek, this idea is related to human nature in that we cannot accept it as fair that our fates are determined by “the market” which is an impersonal "entity.” Humans naturally want to be able to blame someone for their difficulties. Therefore, in the age of widening disparity and increasing uncertainty, populism spreads as it favors authoritarian politics led by strong leaders.
However, the lessons of history show us that under authoritarianism and dictatorial systems, people are eventually oppressed through fear and victims of corruption with the spread of cronyism, making society more unfair with greater disparity.
In a small community, a single strong and fair leader may be able to achieve good governance to everyone’s satisfaction. However, in a large society of several million to several hundred million strangers, no single leader can provide adequate fairness.
The allocation of resources that occurs when people freely operate in the impersonal market system paradoxically provides the fairest outcomes in reality. This is the significance of the free-market economy advocated by Friedrich Hayek.
Needless to say, social security systems are absolutely essential in correcting market-based resource allocation and mitigating disparities. However, the fundamental value that must be protected is allowing resource allocation through the free market activity of people. The question for today is whether the world will be able to reach this understanding.
>> Original text in Japanese
* Translated by RIETI.
February 11, 2025 Nihon Keizai Shimbun
