Perspectives from Around the World

Japan's Growth Strategy and the World Economy

Samuel W. Morris University Professor, Harvard University

1. Introduction

The financial and economic crisis that originated in the United States in 2007 had a major impact on Japan. The Japanese yen appreciated sharply, relative to the U.S. dollar, the euro, and other major currencies. The yen-dollar exchange rate has now reversed course, and the yen has depreciated substantially. This has led to a rise in the Japanese stock market and a discussion of measures to stabilize the exchange rate at current levels. This is a major issue to be confronted by the Japanese government, led by Prime Minister Shinzo Abe, and the new management of the Bank of Japan, led by Governor Haruhiko Kuroda.

Prime Minister Abe moved quickly and decisively to establish a new economic strategy for Japan, outlined in the Cabinet Decision of January 11, "Emergency Economic Measures for the Revitalization of the Japanese Economy." In the words of this key document, the strategy consists of a bold monetary policy, flexible fiscal policy, and a growth strategy that promotes private investment. These Three Arrows of Japan's economic strategy were echoed in the Cabinet Decision of February 28, "Fiscal 2013 Economic Outlook and Basic Stance for Economic and Fiscal Management."

Monetary policy is, of course, the prerogative of the Bank of Japan, but dramatic changes have already taken place and more are in prospect. Deflation has been a problem for the Japanese economy for more than two decades. According to the International Monetary Fund's (IMF) latest forecast, Japan will achieve its 2% inflation target in 2014. However, the growth rate of real gross domestic product (GDP) in Japan will average only 1.3% per year for the next five years, well below the target of 2% real growth announced by the Abe government.

Improved economic and fiscal management is an important prerequisite for the successful revival of Japanese economic growth. The Cabinet Decision of February 28 announced a 15-month budget, combining the fiscal 2013 budget and the emergency measures adopted in January. This flexible fiscal policy will be followed by a period of consolidation, leading to halving of the primary budget deficit of national and local governments by fiscal 2015. The details of a new growth strategy have not been announced, but this is promised for the middle of this year.

Foremost among the issues confronting the Japanese economy is recovery from the Great East Japan Earthquake and the Fukushima Daiichi Nuclear Power Plant Accident. This unprecedented and tragic series of events resulted in an internationally admired response by the Japanese citizens, businesses, and governments. Energy supply has now joined the aging of the Japanese population as a first-order problem for the future of the Japanese economy. Prime Minister Abe has announced that reconstruction will be accelerated and that idled nuclear power plants in Japan will be re-opened under new safety standards. These will be promulgated by the Nuclear Regulation Authority as early as July.

2. Growth Strategies

In this column, I will discuss possible directions for a new strategy to revive Japanese economic growth. I will begin by considering the Article 4 consultations with the IMF, which were completed on August 1, 2012. This is an annual exercise conducted by the IMF and policy-makers in all advanced economies and was the subject of the Japan-IMF Seminar on February 7, 2013 in Tokyo, "Japan's Growth Challenge." The IMF's policy recommendations, taken together, are intended to raise Japan's potential growth rate to the 2% target.

The IMF staff follows the Japanese economy closely and consults regularly with Japanese officials. The views of the IMF are up-to-date, comprehensive, and objective. They provide a valuable perspective on the outlook for the Japanese economy that can be compared with the views of experts in Japan. The IMF staff report devoted considerable attention to measures that could increase the potential growth rate of the Japanese economy, and many of these will figure in the ongoing debate over the growth strategy in Japan.

The most important headwind facing the Japanese economy is the decline in the size of the population and the labor force. Other Asian countries are facing similar demographic problems, and more will do so in the future. Japan's problems have been widely anticipated, and policy measures have been adopted to try to deal with these problems. So far they have not been effective. The first three IMF recommendations are intended to increase the supply of labor. All of these have been discussed at great length in Japan.

Female labor force participation in Japan is below the levels in many other advanced countries. Institutional changes required to increase and sustain higher female labor force participation will require considerable time, so that this should be an immediate focus for policymakers. The IMF points to disincentives to work that are part of the Japanese tax system and recommends that these be removed. Pension reform has been discussed at length in Japan and could increase the labor supply with older members of the population. Immigration is a hotly controversial topic in Japan and has been modified incrementally over time.

The main focus for increasing the female labor supply must be the creation of career paths in business and the professions for Japan's rapidly growing cadre of highly educated women. A substantial expansion of institutionalized child care would have to accompany any increase in female labor force participation. This would create employment opportunities, especially for women interested in flexible arrangements compatible with raising a family. However, expansion of female employment would require the removal of tax disincentives to female labor force participation, like those identified by the IMF.

The growth of institutional forms of care for the elderly, a substitute for the family-centered care that is traditional in Japan, is crucial for expanding the female labor supply. Institutional care for the elderly will undoubtedly increase as the lower birth rate in Japan makes family-centered care more and more burdensome. This industry could also be an important source of opportunities for women who are looking for flexible forms of employment. Expansion of female employment in this industry would encounter obstacles that are similar to those inhibiting the development of institutionalized child care.

The IMF's fourth objective of deregulating markets and opening protected sectors is much debated in Japan. The IMF specifically mentions agriculture and services. I would add electric power and wholesale and retail trade. Easing product-market regulation is a worthy objective, but it encounters the very important obstacle that regulation of services, as well as wholesale and retail trade, and involves consultation with prefectural and municipal governments that reflect the interests of market incumbents. Labor market deregulation to remove job protection and create incentives for job creation is largely the responsibility of the central government and could be implemented through changes in employment law.

3. Protected Sectors

Why are there opportunities for Japan to enhance its potential growth rate by focusing on the protected sectors? This is because of the large and growing productivity gap in these sectors between Japan and the United States. This is a challenging area of economic research that is well-developed in Japan, for example, in the Japan Industrial Productivity Database, created by Kyoji Fukao of Hitotsubashi University and his collaborators. I will draw on Japan-U.S. productivity comparisons that I have developed with Koji Nomura of Keio University. We are now updating our research.

Nomura and I have quantified the sources of the Japan-U.S. gap in total factor productivity or output per unit of input in order to spotlight opportunities for enhancing Japan's growth potential. Differences in total factor productivity, as measured in our study, reflect differences in technology. In many of the protected sectors of the Japanese economy, the United States has been able to deploy superior technologies, many of them based on information technology. In view of the high quality of the Japanese labor force, it would be possible to transfer these technologies to Japan, as has been done with manufacturing on a vast scale.

Figure 1 shows the productivity gap by industry as it has evolved over time. Information Technology Manufacturing is an industry where Japan led the United States until the mid 1990s. Japan established a lead in Motor Vehicles as early as 1970 and has maintained this lead, even with a substantial Japanese transplant industry in the United States counted as part of the U.S. industry. Japanese manufacturing achieved overall parity with the United States around 1990, but has fallen behind more recently. However, what stands out in this chart is the huge productivity gap in non-manufacturing.

Figure 1. FTP Gap in manufacturing and non-manufacturing during 1960-2004Figure 1. FTP Gap in manufacturing and non-manufacturing during 1960-2004

Figure 2 identifies the seven industries that are responsible for most of the Japan-U.S. productivity gap. The same seven industries lag in 2004, which is the top bar, and in 1990, the bottom bar. These bars represent the contribution of each industry to the Japan-U.S. productivity gap. This was 13.9% in 1990, but had grown to 21.5% in 2004. The contributions reflect the industry gaps in total factor productivity weighted by the relative size of the industry. The most important industries in terms of contributions to the gap are Wholesale and Retail Trade and Other Services, principally Business and Personal Services. The contribution of Trade has grown substantially, mainly because of rapid productivity growth in the United States and slow growth in Japan.

Other industries that contribute to the productivity gap are also protected sectors. Electricity was a low performer in both 1990 and 2004. Note that these dates long precede the earthquake and nuclear accident. Agriculture and the closely related Food Manufacturing sectors are also important contributors. Finally, Construction and Other Transportation are also contributors. Except for Agriculture and Food Processing, all of these industries are part of the trade and service sectors that make up most of any advanced economy. I have now identified the targets for enhancing potential growth in Japan: trade and services.

Figure 2. Industry Contributions to the Productivity Gap in 2004 (21.5) versus 1990 (13.9)Figure 2. Industry Contributions to the Productivity Gap in 2004 (21.5) versus 1990 (13.9)

Reform of electricity markets has received a major boost from the Cabinet decision of April 2 to split power generation and distribution into separate businesses in order to promote competition among alternative sources of power. Prime Minister Abe has directed Toshimitsu Motegi, head of the Ministry of Economy, Trade and Industry, to submit legislation on electricity reform to the Diet as soon as feasible. Careful attention to the design of operating and investment protocols for a reformed electric power industry will be required if the legislation is to be successful.

The earthquake and nuclear accident revealed that Japan was unable to take full advantage of its available supplies when nuclear plants were shut down. My top priority would be to establish a single market for electric power throughout Japan. The creation of a national grid is a major engineering challenge that would require common technical standards. While the costs of creating a single market are considerable, the benefits are sufficient to move this to the top of the national energy agenda. An added advantage is that the costs and benefits of choices among continued use of existing nuclear facilities, renewable sources of energy, and conventional fossil-fuel technologies could be more readily assessed.

Agriculture offers policy challenges that have so far stumped Japanese policymakers and their counterparts in many other countries. Japanese food, especially rice, is expensive by international standards, and this is an important obstacle to raising the standard of living. While agricultural policy will continue to be a highly charged issue in the political debate in Japan, the aging of the labor force is very rapid in the agricultural sector. This could create opportunities for thoroughgoing reform in connection with the removal of trade barriers.

The Abe government has announced its intention to join negotiations for a Trans-Pacific Partnership, a trade agreement that would involve Japan, the United States, and other major trading countries on both sides of the Pacific. A key feature of the negotiations is the inclusion of all markets, including agriculture. Japan could use international trade negotiations to reduce the level of protection for Japanese agriculture in return for opening markets to Japanese products, including agricultural and marine products.

Finally, small- and medium-sized enterprises (SMEs) are specifically mentioned in the January 11 Cabinet Decision. The IMF points out that substantial public credit for these enterprises has created a new category of non-performing loans and a population of enterprises that are not viable without public subsidies. This is a growing burden on the Japanese economy and the service and trade sectors where SMEs are most prevalent. These sectors are highly regulated with the obvious goal of limiting competition.

SMEs are a very important potential source of employment opportunities, especially for younger workers. However, SMEs are very heterogeneous and differ substantially in entrepreneurial ability. My recommendation would be to remove existing barriers to entry and exit by SMEs. This would have the advantage of encouraging successful SMEs to invest and create new employment opportunities all over Japan. Unsuccessful SMEs would be allowed to exit, many by selling their franchises to potential competitors along with their leases for real estate and other productive assets. A few of the rapidly expanding SMEs would become the major new business units that Japan sorely needs.

Japanese trade and service industries have been protected from competition within Japan by stifling regulations on entry into new lines of business and new locations. Much of this regulation dates back to the beginning of the post-war period. The regulations were originally justified by job creation to absorb the repatriation of millions of Japanese at the end of the war. However, these regulations have persisted in the face of a looming labor shortage. This drama has played out during the Lost Decades of the 1990s and 2000s when Japan has had an over-valued exchange rate and a production gap that has resulted in persistent deflation and unemployment.

Markets for trade and services have been organized to limit domestic competition. This is not the result of a single government policy, but rather the consequence of regulatory practices that protect local incumbents from potential competitors all over Japan by deferring to municipal and prefectural governments in licensing new businesses and new locations. Freedom of entry will create competition that will drive innovation and efficiency improvements in the critical trade and service industries, especially for SMEs. Improved efficiency will create important opportunities for investment and expand employment opportunities.

4. Conclusion

I conclude that the government of Prime Minister Abe has correctly identified the problems of economic and fiscal management that have led to the Lost Two Decades. The Cabinet Office has been re-organized to focus on this issue and the cabinet-level Headquarters for Economic Revitalization will assure that this remains the most important priority of the government. The Council on Economic and Fiscal Policy will play an important coordinating role in formulating the growth strategy, but the details will be negotiated by the economic ministries.

What are the key initiatives?

Create a single market for the production and distribution of electricity. Why continue to prop up the inefficiency of this industry that became so apparent during the earthquake and nuclear accident?

Remove the barriers to expansion of service industries for the care of children and the aged. Start by freeing entry into these fields and recognizing that new entrants will be regulated by the same standards as existing enterprises.

Exchange Japan's agricultural protectionism for market-opening measures by other countries through international trade negotiations. The first step is to join the Trans-Pacific Partnership negotiations, which will require that all trade issues must be included.

Remove barriers to entry by SMEs and allow non-viable firms to exit and be replaced by stronger entrants. This would be strongly reinforced for deregulation of entry into new lines of business and new locations.

The sequence of reforms will be crucial to success. The Abe government has chosen to focus initially on monetary policy and has adopted improved economic and fiscal management as a priority. The adoption of new safety standards for nuclear plants and reopening these plants must be handled carefully, but also requires immediate attention. Reform of the electricity system should follow. Trade negotiations deserve the high priority that they have been assigned. Removing barriers to entry in the trade and service industries will be a painful process, but will reinforce improved economic policies by creating new employment and investment opportunities.

Dealing with Japan's demographic decline is in some ways a very straightforward issue, since this is highly predictable and people have already begun to experience the consequences. Pension reform is ripe for discussion but is politically challenging. Increasing female labor force participation should proceed incrementally, beginning with tax reform to remove disincentives to work identified by the IMF and by economists in Japan. This should be done very gradually and with plenty of advance notice, but it should not be delayed. Immigration should begin by systematically expanding existing programs.

Japan has entered an era of political and economic reform that could end the stagnation of the past two decades. The new growth strategy announced by the Abe government later this year must establish the foundation for a long-term effort. Implementation of the new strategy will require new policies like those I have outlined in this column and new institutions, some of which have already been established. The sequence of reforms must be carefully designed to uproot sources of inefficiency, build political support, and guide the nation toward its new destiny.

May 2013

May 1, 2013

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