The Growth Potential of the Japanese Economy - the age of endogenous innovation

As today's title is "The Growth Potential of the Japanese Economy," I will talk about the main points to consider when discussing economic growth, focusing on productivity. Since around 2000, economists have been rapidly paying more and more attention to the debate on productivity. One can find the origins of this trend in the long-term stagnation of Japan's economy that started in 1990. Thus, I will examine the developments of Japan's economy in the 1990s, and then explain the reasons behind the sudden focus on this debate on productivity.

I will divide the 15 years between 1990 and 2005 into three time periods, and analyze each of them. The first is from 1990-1997 when Japan's economy was in a serious stage of recession following the collapse of the bubble economy. Out of this period, from 1993-1997, with the government's fiscal and monetary policies, the economy experienced a moderate recovery. However, conventional economic policies failed to eliminate the nonperforming loans, and this led to the next round of even deeper economic stagnation. During the second period from 1997-2001, several major financial institutions filed for bankruptcy. This was when the private sector lost its faith in the government, and in an attempt to reorganize their businesses on their own carried out massive restructuring of their debt and their workforces. In addition, consumption further decreased as consumer taxes and medical insurance rates rose, and the long-term stagnation reached its most serious point. Prospects finally began to brighten up in the period between 2002 and the present day, in which the economy began to recover. One of the factors behind this recovery is the massive restructuring that began in 1997; a second is the fact that Japan was still able to make technological innovations. The third, and perhaps most important, impetus for recovery however was the emergence of China, a country that had steadily maintained a growth rate of around 10%, as a major source of demand.

In contrast to these direct influences on the economy, what factors have been discussed within the academic circle? From the late 1990s to the beginning of the first decade of the 21st century, there were two main theories that explained the long-term stagnation of the economy. One was the belief that no economic recovery could be hoped for unless deflation was eliminated. The strongest point of this argument was that as deflation is rather a monetary factor, a sound monetary policy was necessary. Another view, which placed importance on real factors, argued that the Japanese economy had entered into long-term stagnation from the 1990s because of a slump in the rate of productivity growth. It argued that in the face of such a slump in the rate of productivity growth, not only could no recovery be hoped for through traditional monetary and fiscal policy but that it was in fact essential to work on policies which would expand technological capabilities, and to grapple with structural problems.

In the current economic recovery, the formation of public capital had experienced negative growth and thus fiscal policy had not made much of a contribution. On the other hand, regarding the policy of zero interest rates and quantitative easing policies that have been in place since the beginning of the first decade of the 21st century, it is too early for a conclusive evaluation, but it would surely be difficult to say that deflation has been eliminated and that the economy has made a recovery. What this means is that we should focus our attention on real factors underlying this period of recovery, and that the issue of productivity is of enormous importance when thinking of the medium-term growth of the Japanese economy.

In the area of productivity, there are two concepts. The first is "labor productivity," which may be viewed on a macroeconomic level as the value added by each individual worker, and on an industrial level as the production volume of each worker. In Japan Railways (JR) stations in the past, there were large numbers of station workers at the gates and workers selling tickets, but they have now been replaced by automatic ticket gates and automatic ticket machines. However, as the actual numbers of trains and passengers have not decreased, this capital and technological capability has caused the numbers of passengers and level of transport per station worker to skyrocket. On a firm level, the labor productivity may be considered to have increased.

However, it is not necessarily the case that increasing capital will cause productivity to rise. This is the second concern of Total Factor Productivity (TFP), which refers to the added value and productivity volume of the full range of production factors; even if production factors such as labor and capital are increased, TFP growth is ultimately considered to be limited. As it is important to see how the added value and production value can be increased in relation to the total set of productivity factors, we too have recently been turning our attention to this concept of TFP.

The issue of how to measure TFP is a difficult one. However, according to Solow's growth accounting model, the rate of increase in productivity volume is the sum of the growth rates of capital, labor and intermediate input, each multiplied by their respective distribution rate, and the TFP increase. Therefore, by subtracting the contribution of the various production factors from the rate of increase in productivity volume - the grand total - one should be left with the rate of increase in TPF. As TFP is not measured directly, results vary depending on the method of estimation, but allowing for a certain degree of variation it seems fair to say that from the 1980s to the 1990s the rate of increase in TFP in Japan went down. In estimations based on the Japan Industrial Productivity (JIP) 2006 database*, the rate of increase in the macro TFP was 1.29% per year in the 1980s, falling by 0.71% to 0.58% per year in the 1990s.

*Japan Industrial Productivity Database 2006: A database created by a RIETI project on industry and corporate productivity and designed for use in research on Japan's industrial productivity structure and TFP.

It has been thought that the reason for this lies in the decline in the rate of technological progress, but recently greater attention has been paid to other factors. From an industry-level perspective the factor behind the fall in productivity could be expressed in one phrase: lack of industrial dynamism. The revival of the U.S. economy that took place in the 1990s is seen as being due to the rise of the new IT industry in place of old industry; that is to say, the resultant industrial and corporate metabolism raised the productivity of the economy as a whole. In Japan, however, the opposite development took place. The analysis shows that because labor and capital did not move to the high-productivity industries, the industries and companies with low productivity remained on the market, thus leading to long-term stagnation. Another factor was that in the 1990s in Japan, while IT development and regulatory reform did proceed to a fair extent, this was not able to transform much the intra-industrial structure of production factors, capital and intermediate inputs within industries, and the structure of the labor force in particular; accordingly, this did not lead to increases in productivity.

Looking at industrial transformation, I used the JIP 2006 database to investigate the cumulative contribution rate in the growth rate of 108 industries; that is to say, what factors were contributing to the economic growth of each industry over five-year periods. In the 1970s, all industries had seen growth to an extent. However, from the 1990s the number of industries in the minus figures increased, and by the late 1990s the picture had become sharply divided into winners and losers, with more than 60 industries experiencing negative growth and the overall growth being supported only by the remaining 40 or so industries. The industries with a high rate of growth were in the early 1970s construction and civil engineering, in the 1980s processing and assembly line industries such as automobile manufacture, and in the late 1990s information and communication service industries. Moreover, the transformation took place not only on the supply side but also on the demand side, with digital cameras and DVD players rapidly becoming widespread from the late 1990s. However, although the growth rate of these industries was high, the effect on the economy as a whole was small because the shift of resources did not go ahead, among other reasons.

If we break down the factors behind labor productivity, the rate of change of TFP has shown a certain degree of recovery from the late 1990s; the problem, however, is the efficacy of labor reallocation. As workers stay in low-productivity sectors rather than moving to high-productivity sectors, the result is that the rate of increase of labor productivity is brought down. Thinking this way, although it is said that there has been a fall in the rate of technological progress in Japan, the problem is not only that; it seems also that the problem of the Japanese economy between the late 1990s and the early part of the first decade of the 21st century is that the gap between high-productivity sectors and low-productivity sectors has grown in size, and movement of labor and capital from low-productivity sectors to high-productivity sectors has decreased.

If we think about future medium- to long-term growth in this way, we see that productivity is indispensable. Last year, the population of Japan fell; however, I do not believe that population decrease is a significant restraining factor. Despite the fact that the productive age population ratio has already been falling since the mid-1990s, the economy continued to grow by up to 2%. The question from now is how to increase the capital accumulation and TFP which are supporting our economic growth.

1) The issue of capital accumulation
The issue of capital accumulation is an important factor in increasing productivity. Listening to the arguments relating to the development of IT in the U.S., there is emphasis on the fact that not merely the quantity but also the quality of capital has increased; yet in the period of economic stagnation, Japan's capital was aging. Looking into the ages of facilities on an industry-by-industry basis, in most of the traditional industries, by 2002 facilities had aged by 7-8 years from their original condition in 1970. In contrast to the U.S. where companies prominent in the IT industry have taken a leadership role, in Japan technology has been improved through industrial partnership, and accordingly it is important to maintain high-quality capital across a wide range of industries. This means that we need to activate replacement investment in facilities.

2) Development of IT
Compared to the late 1990s, the development of IT in Japan is extensive in terms of quantity. Tax regulations to encourage investment in IT were introduced in 2003, and simulated models show IT investment to be increasing. The problem is: why has productivity not increased even though there has been a fair increase in IT investment? In the U.S., a moderate positive correlation can be seen between the two, with an increase in TFP accompanying the progress of IT investment in industries such as wholesaling, finance and insurance, retailing and services; in the case of Japan however, IT investment has increased in services, wholesaling/retailing and construction, yet TFP has not risen. Reasons given, predictably, are that the human resource development and institutional reform to accompany the IT capital accumulation have been insufficient. Going forward, I believe more substantive IT development is necessary in the service sector.

3) Human resource development
Appropriate distribution of labor is an issue of the highest importance for the productivity of the economy as a whole. In the short term, it is essential to correct the labor distribution both between sectors and between generations before 2007, when the baby boomer generation will start enter the non-labor force en masse. In particular, I believe it is essential that these gaps are filled up by measures such as the proactive mid-career employment of the younger generation who have not been in employment between late 1990s and early part of the first decade of the 21st century.

The issue of long-term human resource development from 2007 onwards needs to be considered on an industry-by-industry basis. In the area of manufacturer, the handing down of skills is essential and on-the-job training cannot be dispensed with. I believe that the costs of training such human resources need to be given preferential treatment in terms of tax regulations. On the other hand, in the case of non-manufacturing industry, whether the traditional methods of human resource development have been good or not, it is essential to master standard concepts, particularly regarding financial engineering and international law and accounting methods etc., through higher educational institutions. As a result, the mobilization of the labor force will become inevitable, but this needs to be accepted by companies as well. I believe that accepting the immigration of foreign workers, adapted to the Japanese system, in the function of carers, nurses, housekeepers and so on, would be useful in assisting the entry of women into society and in alleviating the declining fertility.

4) Rebuilding organizational capital
The recovery in the Japanese economy has come about through companies desperately carrying out restructuring, and recovering profit margins, not through emergence of a new business model resembling the Japanese-style management practices in the 1980s, or through the contribution of IT capital accumulation to the increase in productivity. In order for a large number of companies to make good use of technological innovation for increasing productivity, I believe that accumulating organizational capital (intangible assets) is essential. Promoting mergers and acquisitions which allow all different kinds of organizational capital to be exchanged effectively in the market is one of the best ways of doing this. Another way is to bring in new business capacity and organizational capital. I believe this would lead to the activation of direct investment in Japan and the jump-starting of regional economies.

5) The role of government
Regarding the role of government going forward, I myself feel that the debate about big government versus small government is not very constructive. I believe the important role of the government is to draw out the energy of the private sector. What I mean by this is that a new industrial policy is essential. If the policy consists only of transferring of initiatives from the public to the private sector, there may be a coordination failure and the private sector may not be able to select the appropriate industries or markets. It is very important to avoid such risks, through public and private sectors sharing information. To be specific, we must focus on looking afresh at tax measures to encourage facility renovation, the promotion of investment in research and development to match the pace of technological innovation, and replacement investment in public investment. Preferential tax treatment for research expenses would be effective. On a macro scale, reformation of the tax system is of course important. In terms of monetary policy, unless the function of interest rate recovers, I do not think it will be possible to introduce stable funds from overseas to combat the fall in the savings rate, which is another problem.

If we carry out policies to increase productivity based on the above, following sustainable increases in IT investment, the improvement of the labor market and, apart from this, knowledge capital, I believe that real economic growth of 2% in the medium term is possible. This is a calculation based on a capital contribution rate of 1.5%, labor contribution rate of minus 0.5% and technological progress rate of 1%, making 2% growth possible; however, if the right conditions do not occur together, the rate will settle at 1%-1.5%, and if nothing is done, it will converge at 0%-0.5% in the long term.

The question is whether or not there are sufficient savings to maintain such growth further. I believe that low interest rates play a large part in the current low savings rate seen in Japan, but this trend will progress further in the future as society continues to age. However, a low savings rate in itself is no reason for gloom. In fact, the U.S. economy is also lacking in savings. Despite this, the U.S. achieved 4% economic growth in the 1990s, which means the U.S. had a stable financial market and the Federal Reserve Board (FRB) ensured its stability. Therefore, it is not impossible for Japan to achieve such growth. Indeed, I believe that we are entering a new stage of monetary policy, in which dialogue with the markets is more essential than ever.

Q: I believe that difficulties in the reallocation of the labor market were there in the 1970s and 1980s. Could you explain why this issue was brought to the fore as a factor for the decline of productivity in the 1990s in particular?

A: In the 1970s and 1980s, many industries were growing, so there was little need for labor to move around much. However, in the 1990s, there were only a few industries with high productivity and growth capabilities, and the majority were capable of only minus growth. There were big changes in the structure of industry. Thus, it became extremely important for labor to move to the growing industries.

Q: I understand your arguments on the supply side; but will overall demand not shrink due to declining fertility and the aging population?

A: Certainly, if you think only in terms of Japan demand will fall due to population decrease; but if you look at demand on a global scale, it is going to expand. Currently in Japan, some companies such as Toyota are reaping the benefits of globalization, and ultimately in the service industry too we must establish organizational capital and management as Wal-Mart and P&G have done, to exploit demand outside of Japan. Surely Japanese companies focus too much attention on domestic demand.

>> Original text in Japanese

* The original Japanese text, published in the May 2006 edition of METI Journal, was compiled by RIETI editorial staff from a presentation delivered by Professor Tsutomu Miyagawa at a seminar on March 6, 2006.