Japan: Canary in the Coal Mine or Economic Experiment Gone Wrong?

In recent months, Japan has been getting increased attention; not for its economic success, but its supposed failure. Jeff Kingston’s “Contemporary Japan: History Politics, and Social Change since the 1980s” tells a story of Japan in stagnation since the bursting in the early 1990s of its economic bubble (like us, based on excessive real estate values). “The Economist” describes Japan as being in a state of “gentle decline.” The “New York Times” has been running a series on “Japan’s slow disheartening decline.

This is a critically important topic, not only for its implications for the United States and other developed economies, but also for the future of the global trading system and for nations like China that are taking a page out of the Japanese development play book.

First, the stories on Japan. It’s long been popular among the Washington economic punditry to sneer at the Japanese economy. Japan, Inc. (the idea that business and government should work collaborative to grow the economy) has long been a threat to the so-called “Washington consensus” that holds that markets, not governments, should be the sole determinate of an economy’s fate. And so these stories are nothing new. But this time are they right, given that Japan’s woes seem quite severe?

As is often the case, the reality is more nuanced. First, while Japan is not thriving, it’s hardly the economic disaster many of the stories would have us believe. The New York Times writes that the Japanese economy has declined since the mid-1990s and the average worker is worse off. The only way an economy can get smaller is if fewer people are working or if productivity (e.g. output per hour worked) goes down. In fact, between 1996 and 2007 Japanese per-capita income went up 7 percent, nowhere near the 23 percent for the United States, but still up. Japanese citizens on the whole are a bit better off than a decade ago.

Moreover, certain Japanese industries continue to perform well in global markets. Remember, it was GM and Chrysler that went bankrupt and had to be rescued by government, not Toyota and Honda. In fact, as The Economist notes, Japanese firms hold more than 70 percent of world market share in 30 industries worth more than $1 billion, including digital cameras and car navigation devices. Likewise, as ITIF found in The Atlantic Century, out of 40 nations, the one that made the least amount of progress over the last decade on a collection of innovation indicators (such as growth in corporate R&D, scientists and engineers, IT investment and others) was not Japan, but the United States. Japan actually ranked a quite respectable 10^th in progress.

But still Japan’s overall GDP growth is slow, and it has just been overtaken by China as the world’s second largest economy. One reason for this, however, is that Japan is one of the few countries seeing its working age population decline. Since 2000, they have lost about 2.3 percent of their workforce as cohorts moving into retirement age are not replaced by children becoming adults. In contrast, the U.S. workforce increased about 7.7 percent during this time. This means that even if the Japanese economy was as productive and innovative as the U.S., it would still underperform it by about 1 percentage point on annual GDP growth.

This gets to Japan’s real problem, and perhaps our own. As long as the ratio of retirees to workers continues to grow in Japan, the only way that they can see average worker incomes grow at all, much less grow at the rates they enjoyed from the 1950s to the 1980s, is to boost productivity. In other words, they have to produce more with less.

Unfortunately, whenever the Japanese think they have to produce more with less they turn to their standard approach: when in doubt crank up the export machine (in part by keeping the yen artificially low). But it’s actually the reliance on this strategy that has been their problem. The McKinsey Global Institute recently studied six leading developed nations, including the U.S. and Japan, and calculated the rate of growth expected based on the country’s initial industrial mix (in other words the mix between high growth, high value-added sectors and low growth, lower value added sectors). The expected growth actually falls into a small band from 1.8 to 2.3 percent. But the actual growth is widely divergent. Japan had the lowest growth (0.4 percent per year) while the United States had the highest (3.3 percent).

Why the difference? It’s pretty simple. The comparatively greater productivity performance of all U.S. industries (think retail and wholesale trade, insurance, telecommunications, etc.) contributed to the U.S. annual growth rate between 1995 and 2005 being 0.9 percent larger than would otherwise have been expected, while Japan’s comparatively lesser productivity growth over that time period was 1.7 percent less than would have been expected.

Thus, while Japan boasts world-leading exporters of manufactured products—think Sony, Toyota, and Toshiba — its non-traded sectors are decidedly sub-par. Japan’s service sectors have achieved but a fraction of U.S. productivity levels. Japan’s retail sector has achieved barely half of U.S. productivity levels, while its construction and food processing industries have reached only 40 and 33 percent of U.S. productivity levels. This helps explain why the whole of Japan’s economy, even with some of the world’s most productive manufacturing industries, is only 70 percent as productive as America’s. When only about one-quarter of your economy is growth-oriented, you can’t grow very fast.

This dual economy (a few world class exporters and a lot of sub-par domestic serving firms) world is no accident. Japan is not set up to be a high productivity economy for the simple fact that the raison d’être of Japanese economic strategy since WWII has been export-led growth. In other words, Japanese economic planners bought into the notion that the way to grow your economy is to shift your industrial base to high value-added, export-based sectors. And they did.

What they failed to do was remove (or resist passing) a host of restrictive laws and regulations that reinforce the backwardness of their non-traded sector. For example, in Japan, laws limiting the entry of large supermarkets and providing incentives for small retailers to stay in business explain the country’s high share of family retailers, and their low productivity. Japan’s government subsidizes mom and pop stores with generous loans, while the country’s high capital-gains tax rate provides little incentive for owners to sell some of the most valuable real estate in the world. Consequently, Japan’s retail sector is 50 percent comprised of mom and pop stores, compared to 25 percent in France, and 12 percent in the United States. The combination of onerous environmental and safety regulations, along with rules stating that no new retail stores greater than 10,000 square feet in size could be opened in Japan, have blocked the evolution of higher-productivity retail formats and kept out foreign competitors, such as Carrefour, which aborted its efforts to enter Japan’s retail market after just two years.

Japan’s myopic focus on export-led growth strategies misses the greatest opportunity to improve their economic growth: by increasing the productivity of domestic sectors, particularly through the application of IT. Indeed, the evidence suggests that Japanese firms have invested much less than U.S. firms in productivity-enhancing IT. Jorgenson and Nomura find that investments in IT can explain the productivity differences between the United States and Japan since 1990. The authors found that Japanese productivity levels increased from 52.4 percent of the U.S. productivity levels in 1960 to 86.1% in 1990 (during the Japanese economic miracle). Yet, over the last 15 years the productivity gap between widened to 79.5%. According to the authors, two key factors in this growing gap were the rapid productivity growth of American IT industries in the late 1990s and the explosive productivity growth of American IT-using industries after 2000. Fukao and Miyagawa confirm their conclusions by finding that Japanese sluggish productivity growth after 1995 has been due to insufficient investment in IT capital. Japanese firms may know how to make computers, but they don’t know how to use them, or at least not as well as U.S. firms do.

As ITIF notes in its new report The Good, the Bad, and the Ugly of Innovation Policy, countries that rely predominantly on export-led strategies risk being a one-trick pony; they may reach the technological frontier and boost growth for a while, but they are liable to languish there, or perhaps even decline if global export markets become saturated, as countries with more robust service sectors pass them by. Clearly this explains Japan.

But it also explains China, Korea, India, and many other Asian nations who look to Japan as the model. Crank up the export machine, including through a wide array of unfair trade practices and sit back and reap the benefits. Only for Japan, the benefits are over. Japan can’t continue to grow through the tech-mercantilist model. Whether they can summon the understanding and political will to shift course—for doing so risks alienating powerful political constituencies who enjoy the safety of lack of competition domestically—remains to be seen.

It’s even worse for the Japanese wannabes. In essence, nations like China are on a path to becoming Japan—a country with competitive export sectors, but woefully lagging in domestic services. However, unlike Japan, China will never get there, because it will not be able to generate enough trade surplus (because the United States and Europe are no longer in a position to import sufficient amounts) to get them there. So the more we and our allies push these nations to end technology-mercantilism the better for them and us.

What lessons can Japan hold for the U.S? There are at least two. The first is that we need to take much more assertive steps to keep people in the workforce for longer before retiring, while also limiting excessive pensions, especially to state and local government workers. No one should be retiring with a pension before the age of 65, unless they are on disability. And the retirement age should continue to move over the next decade towards 70. Unless we want to be a society where every last spare dime in the public purse goes to health care, starving out investments in education, infrastructure, and research and technology, we had better start making sure that people work longer and contribute more back to society before they start taking it out.

The second lesson is that unless we want to end up like the Japanese we will need to keep the pedal to the metal and keep pushing IT-enabled growth and innovation. The U.S. has been the global leader on IT innovation, but we risk losing it, especially if we cut back on needed investments in health IT, smart grid, broadband, R&D tax credits, and a host of other areas, while at the same time passing innovation-dampening legislation on issues like internet privacy and net neutrality.

The stakes are too high, for ten years from now we don’t want to be reading in the New York Times about America’s “slow disheartening decline.”