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No.9 ,Economy  Jan 30, 2012


Photo : Kato Hisakazu

Kato Hisakazu

The effect of Japan’s “lost decade” lingers today, nearly ten years later, and there are still few signs of convincing recovery. Faced with new challenges of recovery and reconstruction from the Great East Japan Earthquake, Japan’s economy will likely continue to confront medium- to long-term constraints that lie ahead, including further population decline, a lower birthrate combined with population aging, and accumulating fiscal deficits. Viewing the current situation it is hard to say that deflation is under control. Advancing strength of the yen and low stock prices tied with the increasing sovereign risk in Europe and the United States are making it increasingly difficult to identify a new growth path.

This article narrows down the impacts of medium- to long-term constraints on the Japanese economy, particularly with regard to population aging, the declining birthrate and fiscal deficits, and ties this together referring to policies necessary for sustainable economic growth.

Current state of the Japanese economy

The pace of economic activity in Japan has remained slow. The nominal value of the gross domestic product (GDP) on a System of National Accounts (SNA) basis was 475.8 trillion yen (preliminary figure) in fiscal 2010, very close to the 472.3 trillion yen in fiscal 1991 when Japan was in the midst of the bubble economy. Looking at real GDP, although the absolute level rose from 464.2 trillion yen in fiscal 1991 to 538.5 trillion yen in fiscal 2010, the compound annual growth rate (geometric mean) during this period was a scant 0.78%. (Source: National accounts published by the Cabinet Office, Government of Japan). Viewing only the GDP levels and growth, it is clear that the “lost” ten years, now in fact twenty years, is not over.

Moreover, compared to other advanced nations, the sluggishness of Japan’s economy is striking. According to the Organisation for Economic Co-operation and Development (OECD) Economic Outlook No. 89, Japan’s annual average economic growth (calendar year historical data, simple mean value) for the period of 1997-2010 was the lowest among the G7 countries, at 0.69% (with Italy the second lowest, at 0.79%), which is significantly short of that of the United States and United Kingdom, at 2.47% and 2.04%, respectively. It is also markedly lower than for South Korea (4.37%).

Japan’s economy has been suffering not only from low GDP levels but also from falling price levels. Using the OECD’s above data that capture price levels in terms of GDP deflators, among the G7 economies only Japan posted a negative figure (-0.9%) in average price inflation throughout 1997-2009, while the other six countries seldom posted negative figures during that period. This speaks of the strong deflationary forces Japan has been under and that this is a situation peculiar to the Japanese economy.

Though it is not easy to list deflationary factors, they are generally divided into, among others, demand, supply, and financial factors. One of the current ideas is that supply factors such as a declining population cause deflation may actually not be a major factor for Japan, since countries such as Germany, Italy and Spain that are similarly experiencing population aging combined with declining birthrates are not actually suffering strong deflationary pressure. Thus, weak demand factors can be considered a major cause behind Japan’s deflation. While, as mentioned above, population factors are not currently a major factor, if and when population declines take hold across Japan together with structural weakening of consumption and investment demand, it may not be easy to lift the Japanese economy out of persistent deflationary trends.

Is Japan’s economic underperformance now a result of temporary shocks, or is it due to structural factors? Given that the Japanese economy has been under unfavorable periods for such a long period, strong growth prospects for the future are unlikely. Looking at the 14th circular boom period between the first quarter of 2002 and third quarter of 2007 (these dates are tentative as of the time of writing this article), for example, real GDP growth on an annualized basis was only around 2.1% (based on the author’s estimates). By comparison, according to the “Economic and Fiscal Projections for Medium to Long Term Analysis” published by the Cabinet Office in August 2011, real GDP growth is assumed to be around 1% from and after fiscal 2012 in its “Prudent Scenario” (which takes past trends into account), which appears reasonable. Therefore, it is difficult to expect economic growth of 3%-4% as was seen in the 1980s.

The above factors imply that the Japanese economy has gone through a great structural change. A look into factors behind this change finds impacts from supply aspects that may be larger than those from demand aspects. We can analyze the past trends in the Japanese economy from the viewpoint of growth accounting. This approach gives us important perspectives because, in considering the future Japanese economy, population aging combined with the declining birthrate have impacts in terms of supply. Growth accounting is a method for dividing the economic growth rate into the three factors of capital stock, labor force and technological progress based on the contribution of factor inputs to growth.

Figure 1 shows estimates in growth accounting for fiscal 1980 and subsequent years that were divided into the three periods of fiscal 1980-1982, 1992-2000 and 2000-2009. The first conspicuous result of the estimates is a drop in the contribution of the labor force. The labor force working population peaked in 1998 and has trended downward. The unemployment rate also rose sharply in the latter half of the 1990s while there was no increase in the number of workers; therefore this result is inevitable. Considering population aging and the declining birthrate and population, this trend will likely remain largely unchanged in the future.

japanese economy.JPG

In the meantime, most notable is the result of estimates on technological progress (total factor productivity). The contribution of technological progress decreased greatly to 0.4% during fiscal 1992-2000, a large drop compared to the 1980s. This supports the view that sluggish technological progress in the latter half of the 1990s was part of the reason for slower economic growth (Hayashi and Prescott, 2002). On the other hand, results of the estimates also show that the rate of technological progress recovered in the early 2000s and accounts for almost all economic growth rates. The contribution of capital stock started to show negative figures in the early 2000s. As described later, if the domestic saving rate declines further as population aging and the declining birthrate progress, it may also have an effect on the accumulation of capital stock. This trend is likely to continue in the future.

Fiscal deficits and economic growth

It goes without saying that fiscal deficits and the policy response to them will also greatly affect the current state and future trends of the Japanese economy. In fiscal 2009, the general government sector’s primary balance as a percentage of GDP was -9.4%. The primary balance has continually remained in the negative range since fiscal 1993. Behind this have been large tax cuts and fiscal stimulus in response to shortages of demand after the lost decade. Issuance of public bonds to cope with the situation has added up to huge amounts. The balance of ordinary government bonds expanded to 363.3 trillion yen as of the end of fiscal 2010 from 178.4 trillion yen at the end of fiscal 1992. Frequently quoted national government debt as a percentage of GDP show that Japan’s public debt to GDP was 199.7% in fiscal 2010, by far the highest among the G7 economies. This is much higher than the ratios of problematic countries that are suffering from sovereign debt crunches, such as Greece (147.3%) and Spain (66.1%) (Source: OECD [2010] “Economic Outlook No. 89”.)

Though there is a view that a high public debt level as a percentage of GDP does not necessarily lead to default risk of a government in a direct and forward manner (Reinhart and Rogoff, 2011), loss of confidence in the government adversely affects economic conditions. Recently, the credit default swap (CDS) rate, which is an indicator of the probability of default, rose to over 1% (as of August 2011) for Japanese government bonds. This means that national public finances aggravated by accumulated public debt face the added risk of downgrading of government bonds. An actual lowering of the rating of Japanese government bonds will cause the bonds’ price to fall. This would bring medium- to long-term impacts such as higher interest rates and declining stock prices, and hinder the Japanese economy.

Factors behind fiscal deficits that impair the Japanese economy include not only the above concerns about risks of rising interest rates, but also the direct harmful effects on the economy from the way the government operates public sector finances. These, specifically, are mainly heavier burdens caused by higher taxes, lower degrees of freedom in the use of government policy expenditures that is caused chiefly by increases in debt servicing costs, and associated restrictions on the government’s fiscal administration. The Japanese government therefore employs a policy of managing public finances from a medium- to long-term perspective with the aim to recover and improve the primary balance. In June 2010, the “Fiscal Management Strategy” was approved by the Cabinet, in which targets were established for: (1) halving the primary balance of the central and local governments by fiscal 2025 from their fiscal 2010 levels and achieving a surplus in fiscal 2020, and (2) stably lowering the balance of national and local government debts against GDP from fiscal 2021. One reason behind this is that securing revenues through tax hikes and other means is imperative in order to finance foreseeable expansion in social security expenses associated with population aging. The other reason is that it is vital to achieve economic growth through new growth strategies.

Though expenditures are expected to increase temporarily in the aftermath of the Great East Japan Earthquake in March 2011, the government intends to maintain the targets laid out in the Fiscal Management Strategy. Achieving these goals is not an easy task. The above-mentioned “Economic and Fiscal Projections for Medium to Long Term Analysis” shows how those targets will be achieved on the assumption that recovery and reconstruction measures in response to the disaster will cost approximately 19 trillion yen and that the consumption tax rate will be raised to 10% by the mid-2010s. Under its “Prudent Scenario” that assumes a target of over a 1% growth rate of real GDP on average in fiscal 2011-2020, a recovery of the primary balance in fiscal 2020 is difficult, while under the “Growth Strategy Scenario” in which a 2%-3% growth rate of real GDP from fiscal 2011-2020 is assumed, a primary balance deficit in real terms of approximately 1.4% is expected. To achieve the targets in the above Fiscal Management Strategy, additional revenues, etc. will be needed.

The fundamental determinant of fiscal deficits is increased social security expenses related to population aging. According to “Cost of Social Security in Japan,” published by the National Institute of Population and Social Security Research, the cost of social security was only 10.1% of the GDP in fiscal 1980, at 24.8 trillion yen. Yet this increased to 78.1 trillion yen (15.5% of GDP) in fiscal 2000, and the updated final report figure for fiscal 2008 was as high as 94.1 trillion yen (19.1%).

In response to this, social security expenses accounted for 31.1% of the entire initial budget in the general account for fiscal 2011, at 28.7 trillion yen. Considering that public works spending, etc. has been declining and the ratio of government debt expenses in the general account has not posted meaningful rises against a backdrop of low levels of long-term interest rates, it is clear that the fundamental determinant of fiscal deficits in recent years is this increase in social security expenses. These are expected to further increase, as evidenced in the materials presented in June 2011 during the review process for integrated tax and social security reform. The data indicate that the cost of social security is expected to grow to 135.5 trillion yen in fiscal 2020 and 151.0 trillion yen in fiscal 2025. Assuming that social security will expand, a recovery of the primary balance in fiscal 2020 will likely be challenging unless measures to secure considerable amounts of revenue are devised.

The first reason for the expansion of social security is the advancement of population aging, and it is difficult to significantly curb this expansion. So then what kind of relationship is suggested between the expansion of social security and economic growth? The author (in a 2006 book) examined the relationship between the two using panel data on OECD countries. An empirical result shows that the economic growth rate declines as the cost of social security increases. Based on this and by parity of reasoning, does a favorable turnaround in fiscal balance promote economic growth?

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Figure 2 shows the result of estimating the relationships between fiscal balancing and economic growth of G7 countries based on fixed-effect models that use panel data for the period of 1997-2009. The results of the estimates show that a surplus achieved in fiscal balance promotes economic growth. Implied reasons for this relationships include: (1) freedom in economic activities being made possible for the economy as a whole when there is less burden from expanding fiscal deficits, (2) the smaller the risk of higher interest rates, the more positive the impact on capital spending, etc. and (3) flexible management of public finances by the government is enabled.

Finally, it would be good to look at a consumption tax hike and its impacts on national economic activity. In the above-mentioned “integrated tax and social security reform” (Cabinet Council report), the assumption is that the consumption tax rate is raised to 10% by the mid-2010s. However, considering the expanding cost of social security and other factors, it would be better to expect that the rise in the consumption tax will not stop at 10% but instead reach 15-20% in the future (by comparison, the lowest value added tax rate in the EU is 15%.)

With the current condition of fiscal deficits, securing revenues will become necessary in the long run, and a consumption tax hike in stages will be inevitable. It should also be noted that delays in raising tax rates to avoid their negative impact on the national economic activity would push the country more deeply into debt and result in higher sovereign risk. Use of the consumption tax to finance the expanding cost of social security in the future is unavoidable. We should not fear temporary shocks caused by a hike in the consumption tax, but rather we should expedite establishing this as a fundamental fiscal resource for population aging and the declining birthrate.

Population aging combined with declining birthrate and economic growth

Over the long term, continuing impacts on the Japanese economy from population aging and the declining birthrate and associated decrease in population may be larger than those from fiscal constraints. Solving the related fiscal deficits and challenges is not an easy task, but if it is grasped as a medium- to long-term mission, there may be measures that can be adopted. Restraining the population decrease, on the other hand, could take as much as fifty years (if Japan’s immigration policy, etc. remains unchanged). For this reason, to grasp the behavior of the Japanese economy, assumptions should include the population and birthrate issues.

A supply-based approach is suitable for grasping the situation of the Japanese economy from a long-term perspective. This approach generally assumes an aggregate product function, and the level of potential production capacity in the economy is considered. Similar to the examination of growth accounting described above, the method employed here is to analyze movements of the three factors of labor force, capital stock and technological progress (refer to the author’s 2007 article regarding this concept).

First we look at the labor force trend by briefly summarizing prospective population movements in the future as assumptions. Results of the 2010 population census (preliminary report) show that Japan’s total population was 128.06 million. According to the National Institute of Population and Social Security Research, this will fall to below the 100-million level in 2055, to 97.78 million (given the case of a high birthrate and medium-level mortality). Looking at the age structure of the population in 2055, the ratio of people 65 and older will have reached as high as 37.3% (compared to 23.1% in 2010). Moreover, the core working age population aged 15-64 will have declined to 50.73 million (compared to 81.52 million in 2010).

The labor force peaked in 1998, at 67.98 million, and stood at 65.90 million in 2010. As a forecast, the Employment Policy Study Meeting under the Ministry of Health, Labour and Welfare published estimates in its report made public in 2007. According to its estimates, if more women and older people participate in the labor force, it will be 61.8 million in 2030. On the other hand, if these groups stay at their current levels, this will decrease to 55.84 million. In this latter case, approximately 10 million workers are assumed to disappear over the next twenty years. In terms of supply, this would significantly affect the Japanese economy. Looking further into the future, if the rate obtained by using the population of ages 15-64 as the denominator and the labor force as the numerator is constant, the labor force in 2055 when the population is assumed to be as low as 50.73 million may drop significantly, to around 41.00 million; lower than two-thirds of the current level.

It is of course possible to offset part of a decline in the aggregate labor force with improvements in individual productivity. However, a labor force decline by two-thirds of its current level would render a 50% raise in productivity extremely difficult. As one would expect, political measures are needed to compensate for the declining labor force.

Next, we can consider the relationship between trends in capital stock and population aging. Capital stock is the accumulation of new financing and investments made every year, minus depreciation. Accordingly, the lower the depreciation, the more capital stock increases, thus, there is higher production capacity. The major source of financing and investments is savings, and savings if foreign direct investments are excluded the major source of domestic financing and investments is domestic. Consequently, the future direction of domestic savings, in addition to the advance of population aging, is the key to future movements of capital stock.

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Based on a general life-cycle hypothesis, the older an individual is, the lower his/her savings rate is and the more savings s/he uses. The national savings rate declines as population aging advances. Figure 3 shows the movements of the gross savings rate and gross investments in and after fiscal 1980. This rate reflects discretionary income minus final consumption expenditure, plus depreciation of fixed capital, divided by GDP. The figure shows that the gross savings rate has trended downward since fiscal 1980. When the relationship between population aging and movements of the gross savings rate is examined using time series data, (statistically) significant results that indicate a negative relationship can generally be obtained. The formula below is one example of this relationship. (Subjects include fiscal 1980-2009. Figures in parentheses below the formula represent t-values. The adjusted coefficient of determination is 0.801).

Gross savings rate = 0.278 – 0.962 x (ratio of population 65 years and older)

(-1.20) (-9.05)

+ 0.134 x (national disposable income)


If this trend continues, the gross savings rate will likely decline as population aging advances further into the future. As a result, capital stock accumulation is expected to decelerate. On the other hand, new investments may increase despite contracting domestic savings if overseas investment increases. However, as evidenced in Figure 3, gross investments and gross savings in Japan have moved almost in tandem, and so far overseas investments have not greatly contributed to capital stock accumulation. The ratio of depreciation of fixed capital in gross investments has also been rising each year. In 2010, net investment (gross investments less depreciation of fixed capital) as a percentage of GDP recorded a negative figure, at -1.5%, which indicates that the burden from maintaining the existing stock has become heavier.

The most important consideration in an approach from a supply standpoint would be that on productivity. Production function based on a production function approach is called total factor productivity (TFP). This indicates technological progress and is obtained as a residual from deducting contributions from the labor force and capital stock. As we have examined above, the level of contributions from TFP has grown since the start of the 2000s. In discussions on potential productive capacity of the Japanese economy, the movement of TFP is one point that draws attention.

While technological progress has been considered as exogenously determined, with the progress of endogenous growth theory since the 1980s, a large part of technological progress is now thought as affected by demographic factors such as the labor force. Examining the general relationships between technological progress and the working age population, there are factors such as lower collective force due to decreasing working age population ((i) effect of losing economies of scale), lower creativity and less positive attitudes of young people attributable to population aging ((ii) effect of losing creativity) and improved responsiveness to compensate for a deficiency in working age population. Of the above, a decrease in working age population will give rise to the effects of (i) and (ii), which will in turn decrease the speed of technological progress. If the effect of (iii) is exerted, on the other hand, technological progress is promoted. Consequently, the overall effect will need to be empirically examined. In addition to the above, there is a view that the larger the population is, the more potential innovators there will be. Intellectual exchange among them is promoted, which encourages specialization and division of labor. According to this view, a larger population brings faster technological progress.

Quoting results of the author’s previous measurements (refer to the author’s 2009 article), a positive relationship was shown between technological progress and the size of population for OECD countries. With respect to time series data on Japan, cointegration is also found among the rate of increase in TFP, working age population and the economy’s degree of openness (total export and import as a percentage of GDP), while a positive relationship is measured between the size of working age population and the rate of increase in TFP. Judging from these points, a decrease in population imposes a negative impact on technological progress, which will inevitably lead to a pessimistic view from a supply standpoint on all three factors of labor force, capital stock and technological progress.

Conclusion-for sustained economic growth

It is not easy for the Japanese economy to maintain medium-term growth under an environment of accumulated fiscal deficits and the tax reform in response. Moreover, the potential growth ability of the Japanese economy faces a higher hurdle in population aging, declining birthrate and decreasing population. Above all, it is vital to secure a stable fiscal balance and remove such risks as rising interest rates stemming from expanding national government debt. Flexible but determined implementation of tax reform that does not cause a strong negative shock to national economic activity is required in order to achieve this. Needless to say, strong political leadership will be essential.

Securing the working age population is vital for maintaining long-term sustainable growth. The time is ripe for national dialog on women and older people in the workforce as well as on proactively introducing labor force members from overseas. Naturally, we must learn a lesson from cases in the European countries suffering from the issue of social inclusion of foreign workers. Overseas investments also need to be encouraged. Unless true globalization is sought, including discussions about Japan’s participation in talks for the Trans-Pacific Partnership (TPP), which have been somewhat suspended, Japan will not attain economic growth.

There is no easy solution for how technological progress should be promoted. In that sense, we face a highly demanding response, and ultimately what is important is to make steady efforts to accumulate human capital. Patient efforts are needed for raising productivity through development and improvement in the areas of education and proactive labor market policies and by encouraging investments in human resources.

Sustained economic growth will not be achieved unless we overcome the difficult challenges of fiscal deficits and population aging combined with the declining birthrate. To hand down a strong economy to the next generation, we must press ahead by being more conscious of the fact that we are in the midst of a critical stage.


Hayashi F. and E. C. Prescott (2002) “The 1990s in Japan: a lost decade,” Review of Economic Dynamics, vol. 5.5.

OECD (2010) “Economic Outlook,” no. 89.

Kato H. (2006) “A Scale of Social Expenditure and the Roles of the Government: An Approach from the Point of View of Cross-Country Evidence,” Quarterly of Social Security Research, vol. 42, no. 1, National Institute of Population and Social Security Research.

Kato H. (2007) “Population Economics” (Nikkei Bunko), Nikkei Publishing Inc.

Kato H. (2009) “An Empirical Analysis on Population and Technological Progress,” NIRA report, “Is the Aging of Society a Threat to Japan?–Increasing Productivity in the Next Decade is the Key,” National Institute for Research Advancement.

Reinhart C. M. and K. S. Rogoff (2011) This time is different! Nikkei Business Publications, Inc.

Translated from “Shoshi-koreika jidai no shisan-unyo kankyo — Shoshi-koreika, zaisei akajika deno nihon keizai (Asset management environment in era of aging and a declining population–the Japanese economy amid an aging and declining population with fiscal deficits),” Nenkin to Keizai (pension and economy), 2011/October Vol. 30 No.3, pp. 3-9 (Courtesy of Research Institute for Politics on Pension & Aging) [October 2011]