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Why Japan’s economy is ailing?

Rajaram Panda was Senior Fellow at the Institute for Defence Studies and Analyses, New Delhi. Click here for profile
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  • November 22, 2010

    Japan’s astounding economic growth in the 1960s and 1970s was the talking point in world capitals. This success story was possible because of coordination between the government and the private sector, in which the government encouraged competition between industries and thereby weeded out the weaker ones. From the beginning of the 1980s, this strategy has no longer worked. When the focus shifted towards knowledge-intensive industries, labour-intensive industries were transferred to nearby countries, thereby heralding the flying-geese pattern of economic development and the emergence of the Four Tigers. As wage levels increased and markets contracted, Japan started stagnating, while countries such as South Korea and Taiwan continued to reap dividends from the Japanese model of economic development. South Korea, for example, succeeded in putting in place a well balanced relationship between stable governments and the private sector.

    From the 1980s, Japan has lost the way and is still struggling to come out of it. Eisuke Sakakibara, a leading Japanese economist and one of the architects of the Japanese “miracle” of the 1980s, now pleads that Japanese planners should emulate the South Koreans, whom Japan indirectly taught how to develop their economy.

    Free market economists Fumio Hayashi and Sakakibara, and most other Japanese economists, call the years 1990 to 2000 as Japan’s “lost decade”. What are the fundamental reasons for this malaise and prolonged stagnation? The reasons are many. Unlike the post-World War II generation which worked hard to rebuild Japan, the younger generation does not work that hard. While the duration of work has shrunk, the strong yen encourages the current generation of Japanese to enjoy longer vacations. The shrinking of the population because of the declining birth rate since 2005 has further undermined Japanese growth. Japan also maintains a restricted immigration regime, which prevents migrant population to join the domestic economic workforce. To ameliorate this situation, Japan urgently needs to liberalise its immigration policy, and encourage people to work harder and to have more babies. Though the DPJ government started some measures to reverse the decline in the population, these seem to be inadequate and no impact can be expected in the near term.

    Some comparisons with South Korea may be relevant to place Japan’s current situation in perspective. Korea has had a turbulent history. For 35 long years, the peninsula was under Japanese control, after Japan annexed it in 1910. Then the peninsula plunged into a three-year-long civil war and was fractured in two – South and North. The latter came under the control of the Communists. The southern wing of the peninsula lives under the constant threat of a communist prodigal brother even today. For almost four decades, the South was ruled by military dictators. Yet, today South Korea is not only a democracy but the world’s 13th largest economy and one of Asia’s vibrant democracies. While the South Korean economy is registering an annual average growth rate of 5 per cent for the past decade, Japan’s economy has grown by a mere 0.42 per cent annually during the same period.

    One may argue that South Korea was trying to catch up with Japan. Probably this was true until the 1970s. Now South Korea’s industrial growth is driven by private entrepreneurship, innovation and quality products. Samsung, Hyundai and LG are brand names the world over and symbols of South Korea’s economic prowess. Even in nuclear power plant sector, a South Korean consortium won a contract to build four nuclear reactors in the UAE in 2009, by beating the French. While South Korea has already started negotiations with India on civil nuclear cooperation, Japan is bogged down by its strict nuclear principles, ignoring the economic fundamentals for such cooperation.

    Japanese companies dread another “lost decade” and some are thinking of relocating operations overseas. The depressing scenario in Japan today can be seen from the fact that its gross government debt stood at 63 per cent of GDP two decades ago but today stands at nearly 200 per cent. Compounding this, consumer prices have fallen in the last 20 years, thereby depressing production. The unemployment rate has jumped to nearly 6 per cent and if part-timer workers are taken into account, it could as well be over 10 per cent. The social welfare burden on the salary class will increase as the falling birth rate would mean just two workers to support each retiree. Immigration reforms to inject new dynamism to the work force do not seem to be a priority of the government.

    The country’s political system is such that drastic reforms to address the malaise do not appear in the horizon. While the DPJ’s policy towards the US, especially relating to the relocation of the Futenma base, strained Japan’s ties with its ally for some time, an unfriendly and assertive China has caused much concerns in Japan. Even Japan’s ties with Russia have been strained over the Kurile Islands issue. Japanese corporates also do not feel comfortable with the DPJ’s policy, as is perceived by Japan’s lead industrial organization, Keidanren.

    Yet, in a New York Times article, Ian Bremmer, author of The End of the Free Market: Who Wins the War Between States and Corporations? dispels Japan’s overblown anxiety and pessimism. He offers three reasons to suggest why this pessimism is overdone. First: the DPJ has introduced, or attempted to introduce, drastic reforms in the bloated and powerful bureaucracy unfriendly to change and transparency, thereby making interface between political leaders and business elites possible. It will take a while for the people to accept the demise of one-party domination and to the change in the political culture introduced by the DPJ. Second: China’s assertive posture will propel Japan to strengthen its ties with the US. Progress on building the Trans-Pacific Partnership, a multilateral free trade pact with the long term vision of integrating the Pacific Rim’s largest economies, may help Japan’s economic future. Third: Japan’s elected political leaders do not have to worry about a backlash at home for pursuing radical reform measures as Japan is a tolerant society. Unlike in South Korea where students pelt stones, or transport workers’ strike in protest against certain government decisions in France, Japanese people have faced two decades of economic stagnation with grace and poise. While Japan enjoys relative domestic tranquillity despite low growth, China struggles to maintain a growth rate of 7 to 8 per cent necessary to create jobs to safeguard “social stability”.

    Such optimism, however, underplays the deeper malaise that afflicts Japan’s economy. Sakakibara, formerly Japan’s top currency official, predicted a year ago that the yen will climb to 80 a dollar. This has now happened (with the yen hovering around 84 a dollar), hampering economy recovery. A strong yen has caused stock losses and enhanced deflation. As a result, Japan’s economy has slipped into a double-dip recession. During his tenure at the Ministry of Finance in 1997-1999, Sakikibara, known as “Mr. Yen”, made efforts to influence the yen rate through verbal and actual intervention effectively to weaken the yen in the currency market. Unlike in 1995, the central bank’s intervention now to stem the currency’s gains is unlikely to succeed because the US is unwilling to cooperate in joint currency operations.

    The external economic environment, especially in the US and China, is no longer favourable to Japan, as was the case in 2002. Japan was able to export its way out of the recession for a short while as consumption continued to increase in the US and the Chinese economy continued to grow. Now, while the US market has contracted, China is embroiled in the enormous task of distributing the economic dividend accrued from high growth from key centres of production to a larger segment of its population. Japan, therefore, needs to change focus from the export-oriented model to one that is domestically oriented.

    How can that be done? One way to stimulate and structurally transform domestic demand is by expanding the service sector. There has been a paradigm shift in consumption. The shift is from consumer durables and towards medical services, education, environment, and health, and therefore Japanese firms need to change their focus and business models accordingly. At the same time, the government needs to deregulate and encourage private corporations to enter the agriculture sector and thus address the rural depopulation problem. If jobs are created in rural areas and incentives are made available through government instruments, more and more unemployed youth may be attracted. The agriculture sector is already heavily protected and any reforms in this sector’s transformation would require additional subsidy at least in the short-run to create the right environment to stimulate the economy. Is the DPJ government prepared to undertake such a huge task? If delayed, Japan’s economy risks further decline.