Locating the Source of Growth: New Goods and Services Lead the Way

Faculty Fellow, RIETI

The sustained growth of the economy was never a given in the long history of mankind. This concept only came into vogue at the start of the modern economic growth period following the Industrial Revolution in the 18th century. Despite giving rise to a host of problems including those involving the natural environment, sustained economic growth has been a source of remarkable achievements.

For example, today, all countries with average life expectancies of around 80 years are countries with per capita Gross Domestic Product (GDP) of more than USD 30,000. On the other hand, the average life expectancy in countries in equatorial Africa with low per capita income is 50 to 59.

The Report, Made in America, published some time ago in the US, begins with the sentence, "To live well, the nation must produce well." To this day, economic growth continues to be a major issue even for the industrialized nations including Japan.

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What is the source of economic growth? In Japan, demographics are becoming the center of attention. Japan's population will shrink to 50.5 million by the year 2115 (Medium variant projections by the National Institute of Population and Social Security Research). And while the size of the labor force, which is the number of people who actually work, will depend on various factors including to what extent the elderly and women participate in the labor market, the fact remains that it will decline both rapidly and dramatically.

According to estimates by the Japan Institute for Labour Policy and Training, the number of employed workers, which currently stands at 65.30 million, will decline to 60.24 million in 2040, even with greater economic growth and labor participation, and may even shrink to 52.45 million, if no progress is made in those contributing factors. Many people believe that growth is impossible because of the decline in population, and at best, we will maintain zero growth.

It is an undeniable fact that a decline in population will have a negative impact on the country's economy. However, the population is not the only deciding factor for economic growth. This is because the growth in "per capita" GDP plays a far greater role.

For example, the Chinese economy, until recently, maintained a growth rate of 10% but its population growth was around 1%. This means that the per capita GDP had been growing by 9% each year. The growth rate of the Chinese economy has slowed down to around 6% but this does not necessarily point to a change in the demographics. It simply means that the growth rate of per capita GDP has declined from 9% to 5%.

The fact that the growth rate of per capita GDP plays a major role from a quantitative perspective is also true in the current Japanese economy, which has entered an era of population decline. For the past twenty years, the real economic growth rate of the Japanese economy has been an average 0.8% (From 1996 to 2015, with 2011 as the base year). As the labor force has already entered an age of decline, the contribution of labor to economic growth has been an average -0.3% per year. However, 0.8% economic growth has been achieved due to the 1.1% growth of "GDP per labor input."

How does per capita GDP, the pillar of economic growth, increase? Capital input including machinery contributes to a certain extent, but the most important factor, i.e. the source of growth, is innovation. When conducting empirical analysis and using the standard method of "growth accounting," contributions other than labor and capital are commonly understood under the concept of total factor productivity (TFP).

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The source of growth is understood to be innovation/TFP but what exactly is it? That is the problem. A series of new technologies appearing on the production site is easy to understand. In the past, ticket gates at train stations required manpower but now they have been replaced by automation and the same phenomenon is occurring all around us, at construction sites and even supermarket checkouts. Artificial Intelligence (AI) and similar technology hold the key to solving the problem of labor shortages. The past 250 years of capitalist economic history may be summarized as the history of labor-saving efforts triggered by rising wages as a result of labor shortages.

However, innovation is not limited to the progress in hard technology which generates greater production efficiency. For example, let us say that an owner of a Japanese soba-noodle shop with a declining clientele, after considering regional attributes, decided to change his shop into an Italian restaurant, and that business started to boom as soon as it re-invented itself as an Italian restaurant. If this change is analyzed under growth accounting, it would find that the TFP had risen. In other words, the decision of the noodle shop owner was a prime example of innovation.

There are many types of innovation including hard and soft innovation. An especially important factor is the creation of new goods and services. Demand for existing goods and services will always reach a saturation point. This is an ironclad rule of economics. Even with the smartphone, its spread seems to have come full circle and its growth seems to have plateaued. Unless new goods and services that can generate significant demand appear, there will be zero growth in per capita income—in other words, economic growth will decelerate to the levels equivalent to the rate of population growth.

In many cases, newly-introduced goods and services have higher added value than goods and services that are being phased out. Some people believe that total consumption will necessarily decline in line with the decline in the population but this type of thinking assumes that new products will have the same added value as old products despite technological advances. However, given that the unit price of products will rise in conjunction with growth, total consumption will increase even if the population declines. The history of economics has been the history of such phenomena. In order to achieve this, however, new goods and services with high added value must be created.

It is a well-known fact that the industrial structure changes with economic growth. In 1950, prior to the start of high economic growth, primary industries including agriculture accounted for a 26% share of the GDP, while in 2000 they had fallen to a mere 1.8%.

Such changes in the industrial structure are understood as macroeconomic phenomena but in the RIETI Project led by Koichi Ando, Professor of Chuo University and lead author, research was conducted on the relationship between the almost-microeconomic level changes in the composition of Japan's consumer price index of goods and services and the economic growth rate, using the data of the smallest unit of "basic classification" in the Ministry of Internal Affairs and Communications' "Industry Input-Output Tables."

The Figure shows the relationship between the indices (horizontal scale) indicating the extent of change in the composition of Japan's consumer price index of goods and services from decade to decade starting from the 1960-1970 period to the 2000-2011period and the average growth rate (vertical scale) during the same period. The Japanese economy, which started at the upper right of the diagram, has transitioned to nearly the point of origin in the bottom left. During periods of high growth rates such as the period of high economic growth, a succession of new goods and services appeared and as a result, the composition underwent significant changes. However, as the growth rate declined, the changes in the composition also decreased.

Figure: Changes in the Composition of Japan's Consumer Price Index of Goods and Services and the Economic Growth Rate (1960-2011)
Figure: Changes in the Composition of Japan's Consumer Price Index of Goods and Services and the Economic Growth Rate (1960-2011)
Source: YOSHIKAWA Hiroshi and ANDO Koichi, Population Decline, Structural Change and Economic Growth, 2019 (RIETI Discussion Paper)

It is this very creation of new goods and services that drives growth. The composition of the index undergoes significant changes, with the succession of new goods and services appearing, which, in turn, generates the relationships illustrated in the Figure.

In the past 30 years of the Heisei era, the Japanese economy could not escape a sense of stagnation. While many believe deflation and population decline were the fundamental factors of this problem, the author does not subscribe to this view. The reason for this economic stagnation was the failure on the part of Japanese enterprises to create new, high-impact goods and services and to bring about successful product innovation.

In the past 30 years, the Japanese economy has failed to ride the tide of information and communication technology (ICT) innovation. The giant IT enterprises including Google (GAFA), the victors in this great competition, may symbolize the tide of this new era but the battle is not over yet. Digital technology is a mere tool and the crucial question is what we can create with these tools.

New goods and services can create new value by changing the way we live. The leaders of innovation are always thinking about new sources of value for the future, beyond anything imagined in the past. Japanese enterprises, by thinking about dealing with an unprecedentedly hyper-aged society and the new sources of value required by such a society and rushing headlong into product innovation encompassing every step, from materials to the final consumer goods and services, will hold the key to revitalizing the Japanese economy.

>> Original text in Japanese

* Translated by RIETI.

April 1, 2019 Nihon Keizai Shimbun

June 11, 2019

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