The decline of the Japanese economy is continuing. In 2023, in terms of gross domestic product (GDP), Japan was overtaken by Germany, a country with a population two thirds of its size, for the first time in 55 years. In 2025, Japan is expected to be overtaken by India as well, falling to the fifth position in terms of GDP.
In terms of per-capita GDP, a metric closely linked to living standards, Japan’s fall in the global ranking table is more dramatic. In 2000, Japan was ranked second, after Luxemburg, but it fell to 18th in 2010 and to 28th in 2021 and on a purchasing power parity basis, Japan was ranked 38th in the world. Among Asian countries, Japan was far behind Singapore (second), Taiwan (12th) and South Korea (30th).
What determines the level of per-capita GDP is not a demographic factor, such as population size or the rate of population change. The determining factors are the capital-labor ratio, which represents the level of capital stock employed per worker, and total factor productivity (TFP). Differences in the capital-labor ratio across construction sites, for example, may indicate whether heavy machinery like cranes and bulldozers or manual tools such as shovels and pickaxes are used. Meanwhile, a rise in TFP is brought about by technological advances in the broad meaning of the term, including improvement in terms of both tangible and intangible resources, so when TFP rises, that may be referred to as innovation.
An increase in capital stock is also accompanied by the creation of new products, a quality improvement, or a productivity improvement in production processes and therefore represents innovation, as with a rise in TFP. After all, it is innovation that raises the level of per-capita GDP. A lack of innovation is the root cause of the stagnation of the Japanese economy, known as the “lost 30 years.”
Some people have pointed out that the paucity of innovation in Japan has been inevitable, blaming the country’s shrinking population, but this incorrect reasoning misunderstands the fundamental nature of innovation. Joseph Schumpeter, who contributed to the widespread acceptance of the concept of innovation in the field of economics, emphasized that innovation is a phenomenon that occurs at the micro level. In other words, innovation does not depend on population size.
For example, the combined market capitalization of the four U.S. high-tech companies that are at the leading edge of this new era (GAFA) increased 385% between 2012 and 2022, while the population of the United States expanded only 6.2% over the same period. Demographics and innovation are decoupled as factors.
Regarding member countries of the Organization for Economic Cooperation and Development (OECD), there is no correlation between those countries’ levels of the Global Innovation Index (GII), an indicator published by the World Intellectual Property Organization (WIPO), and their rate of population growth (see the figure below). In the case of developing countries that do not belong to the OECD, there is in fact a clear negative correlation—that is, innovation tends to be more vibrant in countries where the rate of population growth is lower or where the population is shrinking.
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Innovation is an entirely micro-level phenomenon and is not directly related to demographics, which is a macro-level factor. When we consider the future of the Japanese economy, we must not presume that the shrinking population is an insurmountable problem. It is important that private-sector companies bring about innovations at the micro level. It is often said that there is nothing new for consumers to purchase. While the shrinking population means that demand for conventional products has reached a saturation point, it also portends the dawn of innovation that will take us beyond the saturation point, and in fact, many companies are developing innovative products. The results of such efforts increase per-capita GDP.
A traditional Japanese confectionery shop that was founded in 1707 and that sells the “Akafukumochi” soft rice cake, famous as a souvenir for visitors to the Ise Shrine, has been developing Western confectionary in the past several years in order to adapt to changes in consumer preferences. That is exactly what innovation is. Apart from the shrinking population, the changing times are another underlying factor of innovation.
A fishing net maker, facing declining demand for fishing nets, has turned attention to soccer goal nets and focused on improving their quality. As a result, the company has succeeded in developing an innovative net with a hexagonal mesh in place of the conventional square meshes by taking advantage of its fishing net expertise. This net creates the dramatic illusion of the ball stopping in midair for a moment after connecting with the net.
An alcohol producer has developed a new type of canned beer with a draft beer-like experience of the can containing foam, created by fine bubbles that seep out the moment the lid is opened. This change represents the combined effects of a change in the processing of the inner surface of the can and other innovations.
There is no doubt that the shrinking population in Japan in itself encourages labor-saving innovations, and there have already been many such examples. As the shrinkage of the population accelerates in the future, the need for labor-saving innovations is expected to grow further.
Moreover, the expansion of the elderly population requires the use of high technology for nursing care in addition to creating the need for goods and services that are intended specifically for elderly people. Indeed, the use of advanced technology for nursing care is spreading, and there will be an ever-increasing need to apply advanced technology to nursing care in the future. A handful of innovations are not sufficient to meet all those needs. The challenges posed to Japan by the shrinking population and the aging of society are laying the foundation for creating innovations.
Financial institutions also have an important part to play in encouraging economic dynamism and promoting innovation. If companies are to overcome the so-called death valley stage of startup development and commercialize their innovations, financial assistance is essential. Until this point, financial institutions have not distinguished between risk-taking and risk aversion sufficiently to promote dynamism. Now that an economy with positive interest rates has returned, financial institutions’ risk-taking capacity has a greater role to play than before.
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The fact that private-sector companies are the main drivers of innovation does not imply that the government has no part to play. One example of the government’s failure to adapt to the changing times leading to the erosion of Japan’s national power is the “Super Core Port” policy, which was launched in fiscal 2004. In the global ranking table of ports in terms of container handling volume, in 1980, there were three Japanese ports among the top 20, including Kobe, ranked fourth. However, in 2021, no Japanese ports held a place among the top 40. Japan has lost its ability to perform as an international ocean transportation hub.
On the other hand, there are some examples of successful adaptation to changes. Inbound tourism (represented by foreign tourists visiting Japan), which has grown rapidly since the 2000s, is a prime example. That success is the result of a series of necessary measures taken by the government, including granting visa exemption, easing visa requirements, establishing the Japan Tourism Agency, developing statistical datasets, and keeping track of inbound consumption using information and communications (ICT) technology. The government expenditures necessary for those measures were minimal. This is a case of wise actions delivering successful results.
Naturally, this success in tourism represents the fruits of not only governmental measures but also various innovative ideas, including building luxury hotels targeting foreign tourists, providing new products and services adapted to foreign tourists’ needs, and developing a smartphone-based language translation application that facilitates conversations with foreigners. Collaboration between the public and private sectors has brough about innovations in the field of tourism.
As the population continues to shrink, pessimistic views on the future development of innovation are prevalent in Japan. However, there is in fact a wave of innovations, including product innovations at the micro level, already on the horizon.
>> Original text in Japanese
* Translated by RIETI.
June 13, 2024 Nihon Keizai Shimbun
