Japan Almost Made It!

by John West, Asian Century Institute

Japan flirted with very high income status in the late 1980s. But following a financial crisis 20 years ago, it has slipped back. Today, convergence with world leaders is “mission impossible”.

Japan flirted with achieving very high income status in the height of its bubble economy in the late 1980s. Its GDP per capita reached 90% of that of the US. But when its bubble economy burst in the early 1990s, financial crisis struck, and two lost decades ensued. Today, Japan’s GDP per capita is only 70% of the US’s. And despite the ambitions of Abenomics, the prospect of convergence with the world’s leading economies is now “mission impossible”.

Japan was Asia’s original miracle economy. It rose dramatically from the ashes of military defeat in 1945. In the 1950s and 60s, Japan’s annual economic growth rate was around 10%, the same as China in the first three decades of its reform period. In the 1970s and 80s, Japan’s annual growth rate slipped down to the still-respectable 4%.

But a real estate and stock market bubble took hold, fuelled by easy money policies in response to a rising yen. The bubble was also driven by hubris and irrational exuberance. Many believed that Japan was becoming the leading global power, and that the US was set for decline.

In the early 1990s, the bubble burst. Real estate and stock prices came crashing down. Many banks, companies and citizens were thus saddled with large debts. A sluggish response by the government led to two “lost decades” of economic stagnation, with weak economic growth of around 1% reflecting a sharp slowdown in productivity growth.

But more than that the early 1990s proved to be a major turning point in Japan’s history. The tectonic plates underlying Japan were shifting. Strategic, systemic adaptation was required.

But Japan chose to sleep-walk through the past two decades.

What were these tectonic plates?

Japan’s model of economic catchup became outdated. Its high growth, catchup period was engineered by partnership between business, bureaucrats and politicians (the “iron triangle”). Infant industries were protected from imports and inward investment.

This gave the export-oriented manufacturing sector the breathing space for industrial upgrading. Japan’s world-beating automobile and electronics companies were the visible sign of the success of these policies.

By 1990, however, Japan’s manufacturing sector no longer needed protection. It was already internationally competitive. It should have then been fully exposed to international competition to remain innovative and dynamically competitive.

And favoritism for industry incumbents should have been removed to give new entrants a chance to break through. The evidence shows that new firms are the most dynamic — like Apple and Google in the US, and SoftBank and Uniqlo in Japan. But in Japan’s case, the many regulatory barriers to doing business mean that there are too few successful start-ups.

While the export-oriented manufacturing sector had matured, the domestically-oriented services and agricultural sectors became horrendously inefficient behind the walls of protection. Fresh competition from trade and investment liberalization and deregulation was necessary to lift productivity in these inefficient sectors.

Despite some efforts at market opening over the years, inward foreign investment and imports face high restrictions and are still very low by international standards. The closed nature of Japan’s market is evident from its global ranking of 194th out of 198 countries for the stock of inward foreign investment, and 167th out of 172 countries for imports (both as a share of GDP).

Thus productivity in the services and agricultural sectors remains chronically low. The very success of Japan’s developmental state model, and the constellation of interests that coalesced around it, made subsequent reform so difficult.

Infrastructure is another area where the government’s policies came unstuck. Japan’s construction industry rebuilt the nation’s infrastructure, which facilitated rapid economic development. By 1964, Japan had a high-speed train, something which neither the US nor Australia have even today. Japan would have the world’s sixth best infrastructure, according to the World Economic Forum.

But Japan’s construction industry infiltrated Japanese collusive politics through bid-rigging, corrupt financial kickbacks to bureaucrats and politicians, lobbying for wasteful infrastructure projects, and acting as vote-gatherers. This helped Japan’s Liberal Democratic Party retain a stranglehold on the nation’s politics for most of the post-war period.

By the 1990s, Japan’s need for new infrastructure had been substantially fulfilled. But with a sluggish domestic economy over the past two decades, the government undertook much wasteful infrastructure spending to prop up the economy and support the tight political connections between Japan ‘s construction industry, politicians and bureaucrats.

Japan’s education system also needed reinvention. It was very effective at promoting the literacy and numeracy of its population. According to the OECD, Japan’s adult population is best educated in the advanced world. And Japan’s leading corporations had excellent training programs for their many “lifetime employees”.

But Japan’s education system still emphasizes rote learning, memorization and passing tests, rather than critical thinking and creativity — at a time when Japan needs to become more innovation-driven. And while globalization has been the dominant feature of the past few decades, the Japanese are very poor at the world’s global language, English. This has many consequences from making Japan a difficult country to visit for tourists to isolating Japanese scholars from global networks.

While Japan’s corporate-trained company men were very effective for Japan’s catchup period, companies are now seeking more flexible, specialized staff. Lifetime employment is becoming now more rare, as some 40% of Japan’s employees have irregular status, meaning part-time, casual or short-term contracts. And most irregular employees have only limited access to corporate training, which is now diminishing Japan’s human capital.

Japanese Nobel Prize winning scientist Susumu Tonegawa had some insightful comments on Japan’s education:

“Having spent a half century abroad since I went to the United States to study, I now regard Japan as a society rather dictated by rules. Within a fixed framework, the Japanese are able to produce things with extreme precision…

… A climate that respects individualistic thinking – thinking not bound by conventional wisdom – will produce revolutionary discoveries that shatter the framework.

Unlike the Japanese, Americans put their own ideas first, and what others think of them is secondary. It is essential to have education that respects individual abilities and preferences.”

Another shifting tectonic plate has been Japan’s unfolding demographic drama, including a decline in the work force starting from 1995.

Like most countries, Japan passed through a demographic transition, with a decline in the mortality rate, followed by a decline in the birth rate, and increasing life expectancy. But the birth rate has been well below the replacement rate of 2.1 children per woman for many years, and is currently around 1.4.

These demographic trends have led to a sharp aging of the population, a declining workforce, and in recent years a declining population. This is costly for the economy, as a declining share of the population is economically active, and is supporting the inactive youth and seniors. It is also costly also for the national budget which finances health and pensions for its senior population.

And while Japan’s demographic drama has been looming for decades, the government’s response in terms facilitating greater economic participation by women and admitting more migrants has been woefully inadequate. To this day, Japan remains sadly xenophobic.

A geopolitical tectonic plate has been the rise as economic and political powers of once-feeble neighbors like Korea and China. They have become more assertive, and sought apologies and compensation for Japan’s military activities in the first half of the 20th century. It is critical for Japan to not provoke these countries, as Prime Minister Abe has done, and to maintain peaceful relations with these countries. Japan’s economic future relies on these strongly growing Asian markets.

The predicament in which Japan finds itself will be ultimately unmanageable, and will likely lead to financial, economic, social and political crisis. Consider this: Public debt of 240% of GDP. Chronic deflation. A rapidly ageing population, with the prospect of seniors accounting for some 40% of the population by 2060, up from 25% today. A population which is set to decline from 127 million today to 87 million by 2060. An economy whose productivity is now only 70% of the US’s, a figure which is only likely to decline further.

“Abenomics” is a brave and much belated attempt to revive Japan’s economy. But to date, it has been a case of much talk of its “three arrows” and insufficient action.

The structural reform arrow, which should involve trade and investment liberalization and deregulation, is blocked by the same entrenched vested interests which have blocked reform for over 20 years. Fiscal stimulus has had very little benefit, and has merely added even more to the nation’s public debt.

The main impact of monetary stimulus has been to push the yen exchange rate down by one-third. This has improved profits of Japan’s export-oriented big companies. But small enterprises and citizens are being hit by higher prices for imported products, and no wage increases as compensation. Thus, Japan’s chronically weak consumer demand is even weaker than ever. One bright spot from the weak yen is the current boom in foreign tourists visiting Japan.

In short, Japan is caught in a “stagnation trap“.

Perhaps the greatest symbol of modern Japan is Masayoshi Son, Chairman and CEO of SoftBank, and Japan’s richest person. Since creating SoftBank in 1981, he has had to battle ferociously with old business incumbents and government bureaucrats in order to succeed. He has achieved great success despite his poor family background and Korean heritage. And while he has been called the “Bill Gates of Japan”, he is widely treated as a maverick and outsider.

If Japan is ever to regain its past glory, it must embrace diversity in all its forms, as a source of creativity and dynamism. This means people like Mr Son, female entrepreneurs, immigrants and so on.

For the West, and especially America, the fate of Japan was a very big surprise. It had previously overestimated the strength of the USSR, based on its space program, without seeing the rot inside the economy. And it then overestimated Japan based on the strength of its export industries, without seeing the weakness of its domestic economy and the poverty of its politics.

Could today the West be also overestimating the strength of China, in light of the fragility of its authoritarian system?