Japan now has a shrinking population and this is a major challenge in all aspects of economic, social and political life. It also affects Japan’s conception of its self in the world and its approach to international affairs.

The recent epoch-making political shift to the DPJ government provides evidence of national understanding that there needs to be drastic change to deal with Japan’s new circumstances. But established systems of government and social organisation appear remarkably resilient to the comprehensive change and reform that will be necessary to deal with the problems that Japan now faces. And leadership of the style needed to take up the task that has to be managed appears nowhere in sight.

What could be carried in the way of economic and administrative inefficiencies, in a country whose population was young and still growing and in which the opportunities for catching up to the industrial world were palpable now are huge dead weight burdens in a mature industrial economy with a declining workforce and population.

At 190 per cent of GDP, public debt could become a crisis tipping-point. While the debt is overwhelmingly domestically held and sovereign risk appears low, unless there is a clear, well-timed strategy to finance it over time, at some point the market will lose confidence in the country’s ability to manage its fiscal affairs and put a crippling premium on funding it.

While the DPJ government has tried, as it needs, to take charge of the policy process and decision-making to deal with Japan’s challenges, it has not articulated a comprehensive strategy for doing so and appears more focused on particular symptoms of the problem than its fundamental causes. Reform of labour market institutions to allow more flexibility in the re-allocation of labour and increased participation of women when the labour market is not growing is a case in point. Failure to break the deadlock on agricultural reform is another. Government continues to work in silos when the interdependence of policymaking is paramount to progress. Attempts to institute national policy coordination, through the establishment of the National Policy Unit in the Cabinet Office and Cabinet approval of a New Growth Strategy (see pdfs here and here), are brave but inadequate attempts to cut deeply into the problems that have to be dealt with. Drill down through the plan that constitutes the New Growth Strategy and there appears to be more tinkering at the edges with measures that are small fixes here or there than a comprehensive plan across the whole-of-government for dealing with systemic issues.

These domestic circumstances also infect the psychology of economic diplomacy and foreign policy. While the new DPJ government brought initiatives in foreign policy to the relationship with America and dealings with Asia, these are in retreat. The scope for cutting through on foreign economic diplomacy through dealing with agricultural reform and people movement issues has diminished. The initiative in East Asia, to build a new relationship with China and the region, is dominated by reversion to the US alliance framework for hedging against China. The strategic inconsistencies in the politics and economics of relations with China are little remarked upon, if understood. There appears more and more acceptance of Japan’s middle-power and dependent status internationally. This is not necessarily a bad thing, but it appears a consequence of drift rather than strategic choice. Foreign and security policy has gone back to the future. Whether this will be sustainable in the long term given Japan’s deeper and deeper economic dependence on China’s growth remains a question.

Japan also needs to open more to foreign investment and talent, seeking greater international experience. The share of foreign participation in the Japanese economy is very low compared with other industrial countries. In a disturbing trend, the number of Japanese students enrolled at American universities dropped 38 per cent to 29,264 over the past decade.

And yet, under the burdens that have condemned Japan to two decades of stagnant growth, the manufacturing sector, exposed to intense international competition as it continues to be (unlike services and agriculture) has achieved a remarkable turnaround. While manufacturing firms cannot change the institutions that impede adjustment, for example in the labour market, it has gone around them, creating others to serve the purpose. Such actions help explain why a third of the Japanese workforce are now employed as non-regular workers (non-lifetime employed). An adverse side effect, however, has been increased social vulnerability.

Manufacturing corporations have also lifted competiveness by taking production of low-valued activities offshore into Asia and China in a big way. Over a third of the output of Japanese manufacturers is now produced abroad, significantly in Asia (see my report for Austrade on Australia and Japan: A new economic partnership in Asia [pdf]). This has not produced the same strains at home as are evident in North America because of globalisation because the labour force is shrinking.

So how can Japan find a way through its demographic crunch?

Shinji Fukukawa, former Vice Minister of MITI and now President of the Dentsu Research Institute, asks in this week’s Japanese press ‘whether Japan’s national politics are capable of changing people’s despair into hope for the future’. People need some kind of political messiah to lead them across the abyss, he suggests. Iwao Nakatani, an old and close friend, former Chair of Sony, economist turned social guru, in another recent book laments lost Japanese values, the narrow economic calculus of the West and urges return to Japanese philosophic roots. Hiroshi Mikitani, dynamic, young Chair and CEO of Rakuten, doyen of electronic retailing today ties the survival of his firm to making English its language of business and global recruitment.

Each of these friends has some part on the answer to Japan’s woes. Fukukawa is right: someone needs to articulate comprehensive new national goals. Nakatani has a point: the gadget society has lost its core being and intellectual foundations for guiding social purpose. And Mikitani has a timely strategy that does not take Japan backwards into itself but takes on the world, where it can still clearly set benchmarks of quality and service that few will likely beat.

Peter Drysdale is Emeritus Professor in the Crawford School of Economics and Government and Editor of EAF and Head of EABER.