The missing piece in the puzzle of Japan’s lost decades

Author: Ippei Fujiwara, ANU

Japan’s average GDP growth rate was around 9.5 per cent between 1955 and 1970, and 3.8 per cent between 1971 and 1990.

But in the past two decades it has dropped to just 0.8 per cent a year. This big drop in the growth rate is synonymous with ‘Japan’s two lost decades’.Inflation also disappeared through the lost decades, from 2.5 per cent in the 1980s and 1.2 per cent in the 1990s, to an average of -0.2 per cent in the 2000s. This prompted claims that aggregate demand has not been large enough to match aggregate supply, or, in other words, output has been below its full employment capacity. The Bank of Japan has been blamed for not having pursued an expansive enough monetary policy to boost aggregate demand and incomes.

In 1999, the Bank of Japan reduced its policy interest rate to 0.15 per cent, thus starting its so-called zero interest rate strategy. Given that nominal interest rates cannot go below zero, any deflation (or negative inflation) results in higher real interest rates. Throughout the 2000s the Japanese inflation rate was, on average, negative. Hence deflation could have had a negative impact on aggregate demand through higher real interest rates.

Just how high was Japan’s real interest rate?

Because expectations about inflation are not observable, expected real interest rates cannot be set with precision. Roughly measured, long-term real interest rates — or the difference between nominal bond yields and realised inflation rates — in both Japan and in the United States actually tend to show very similar trends, in both their levels and the way in which they have changed. The free international movement of capital means that the real interest rates will tend to be similar in all countries, although, to be precise, this depends on a host of factors and conditions, including the similarity in consumption patterns and the exchange rate risk premium, among many others. A rough measure of real interest rates in Japan and the United States shows that they actually became very similar after the 1985 Plaza Accord and grew even more similar in the 2000s, until recently. Deflation, together with a zero lower bound on the nominal interest rate may not, after all, have caused Japanese real interest rates to deviate significantly from the theoretically consistent level that was operating in the global economy.

Though real interest rates are not heavily influenced by domestic factors, deflation can still have long-run detrimental effects and, through nominal appreciation of the exchange rate, adversely affect exports and aggregate spending.

Persistent deflation might arguably have been avoided if the Bank of Japan had adopted a more aggressive and expansionary monetary policy in the 1990s. But the Bank of Japan was operating under uncertainty about responses in the economy — an inevitable problem with policy making in real time. Optimal policy can look very different with the benefit of hindsight.

Japan’s per capita GDP level reached almost the level of the United States toward the end of the 1980s. When that happened Japan’s era of high growth, which was based on the technological catching-up, inevitably came to an end. Thus, the puzzle of the lost decades is not what caused the fall in growth chronologically, but the difference in growth rates across countries, and particularly between Japan and other advanced economies. Between 2000 and 2010 (in the second of the two lost decades), other advanced economies grew at an average rate of 1.4 per cent while Japan grew at around 0.9 per cent.

What are the reasons for this difference and can the growth rate be lifted now?

The rapid ageing of Japanese society is a widely known phenomenon. Total population has recently started to fall, and the working age population had already started to fall around 1995. A most important factor in producing economic output is the input of labour. With the working age population shrinking, unless technology allows a smaller workforce to produce more output per head, GDP is bound to grow more slowly. Yet, if the output growth rate per person of working age is compared with that of other industrial nations, Japan records the highest growth rate among advanced economies in the 2000s.

Now that Japan is becoming a greyer society, gross national product (GNP) is the variable that should be monitored to assess the health of the Japanese economy and the welfare of its people. Offshore assets are now providing income for the elderly in Japan, so GNP is a better measure because, unlike GDP, GNP includes financial income from the rest of the world stemming from investment of assets abroad.

These supply side factors have had a significant impact on Japan’s GDP growth rate, at least since 2000. Society’s ageing results in not only a decrease in production inputs, but also in a future increase in the scope for fiscal and social security expenditure. This is likely to further constrain aggregate demand by reducing permanent income.

Ageing will continue to have wide-ranging effects on the Japanese economy and Japanese society; the priority is to manage the policy changes needed to continue to lift the productivity of a declining workforce and maintain and improve living standards.

Ippei Fujiwara is Associate Professor of Economics at the Crawford School of Public Policy, the Australian National University.

This article appeared in the most recent edition of the East Asia Forum Quarterly‘Japan: leading from behind’.


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  • Lincoln Fung

    It is argued that ” if the output growth rate per person of working age is compared with that of other industrial nations, Japan records the highest growth rate among advanced economies in the 2000s.”
    What about the growth of total factor productivity?
    It is understandable that labour productivity would generally increase when capital labour ratio increases. Japan’s declining working aged people and population in general is likely to mean that capital labour ratio may increase by that factor alone.
    Further, the argument of technological catching-up only assumes that the new comers can only reach the “frontier” and there is no momentum to push that frontier out a bit fast. That assumption perhaps needs to be questioned.
    So deeper causes have to be found for the Japan’s lost decades in general and the decade of the 1990s in particular.
    The bubble burst around 1990, its effect on consumer and firm behaviour, the policy responses and so on need to be carefully studied. This is particularly so in the wake or the midst of the prolonged GFC.

  • Andrew Harrington

    The Japan Question has bugged me for a long time.
    So I started gathering the stats. I took the latest IMF World Economic Outlook and the global demographic data from the US census bureau.

    Debt is a claim on the future. Debt is repaid from wealth. People (in the private sector) create wealth. How many people does Japan have to create wealth? As of 2012 Japan has 80m people between the ages of 15-64. By 2017 it will have only 75m workers.

    By 2012 the exhilarating politicians and bureaucrats in Japan have managed to amass a debt of JPY 1,124,401,000,000,000 (yes, 1.1 quadrillion Yen) or USD14.105 trillion (YES, trillion!) in the name of their people. That means that each worker has an individual debt of USD176,800. Even more wretchedly, both numbers are worsening over the next 5 years.

    There is little chance that the Japanese workforce can repay that sum, that’s a mortgage before you’ve left year 10 in high school.
    Here is a conundrum for you: What happens to the economy and interest rates when the proverbial Mrs Watanabe’s husband retires and she wants to cash-in her 0%pa government bond while the government wants to keep issuing more bonds to fewer and fewer workers whose income that isn’t taxed is being sought to finance the deficit? Also interesting will be what happens when Mrs Watanabe dies and Ms Watanabe (likely single and childless) inherits a bond that is impossible to cash-in unless she buys two to replace it. Extrapolating; when Ms Watanabe dies what happens to those two bonds? This is the only happy resolution for the government, cancel all the bonds that fall intestate. This happy resolution depends on the equivalent of Japan’s GenXs dying quietly and mostly without kids. So far so good…except that the nation called Japan will eventually cease to exist.*

    But the other resolutions are not happy ones. The usual suspects are the same – money printing and/or hyperinflation and/or default and/or regime change (MHDR). People worry about grey power and the ability of the aging boomers to skew government benefits to themselves. I think that it is overblown – if there are protests no one is worried about geriatric rioters. Ultimately in a fight for vanishing services, it will be the 15-64s that win in the street. The famous obedience and unity of the Japanese people will be sorely tested.

    The other countries
    The relative absurdity of the Japanese situation should not diminish the seriousness of the problems for the other countries in Fig.1. And they don’t have the famous unity and obedience of the Japanese people. The USA sits at USD95k per worker. Every major European economy sits at over USD40k per worker. None of these countries seems prepared to make the hard choice of running a budget surplus. France hasn’t had one for a generation. A surplus will cause a recession. Big deal. Continued deficits will cause MHDR across several countries.
    Note that Chile, Denmark, Finland, Norway, Sweden, Switzerland, Saudi Arabia, and UAE are in better positions than Fig.1 indicates. They have massive SWFs or other assets and their NET debt positions are small or negative. (But if most of those assets are the bonds of other governments…)

    To fix the problem some commentators say ‘growth’ is the answer and do it anyway you can, including money printing if no one else will buy your bonds (hello Krugman). As many have said more politely, it is insane to try and fix the problems caused by debt by issuing more debt. This is what the Japanese have already tried. I call it the General Haig theory: “What? We lost 60,000 men in a day and we didn’t win. Send more men against the machine guns next time”. You eventually run out of men**. Some do worry that Debt/GDP will reach an upper limit but that is the wrong measure.

    First of all forget Debt/GDP – it becomes meaningless when the “G” is composed of ever greater government spending. Debt is repaid from wealth and governments don’t create wealth, they redistribute it. The IMF forecasts both GDP and Total government expenditure. I have subtracted one from the other to get PDP (Private Domestic Production). Growth in PDP is what will create the wealth that can repay debt. The first thing to note is that over the next 5 years, the IMF is not forecasting any recession, anywhere. Either the financial markets are jumping at shadows or the IMF is woefully wrong. The IMF does have declining government spending across most countries but still has GDP growth. I suspect that maybe the IMF forgot about the multiplier effect or that GDP and Government deficits are not strongly linked in their forecasting. Eg, it is highly unlikely that the UK PDP will grow by 8%pa over the next 5 years. Regardless, they are the best numbers available.

    Certain observations can be made by comparing the debt claim of various countries on their work force, the growth of the work force, and the growth of the private economy.

    Ø The biggest surprise is Germany, the so-called fiscal hawk of Europe. It has a debt claim on par with the other major Europeans but its workforce is shrinking faster and its economy is forecast to grow more slowly than every other major economy in the world except Italy.

    Ø The second-biggest surprise is Canada. In all three measures it sits with the well-known European laggards.

    Ø Spain – from the news headlines it sounds like a death spiral but on this graph it looks much better than Italy or Germany.

    Ø Japan is no surprise, but it is still scary. It is (almost) off the charts in every measure – in a bad way.

    Ø Russia has a big demographic problem but debt and PDP look excellent.

    Ø India beats China because of demography.

    Ø India, Turkey, Chile, Brazil, Mexico – look good on all measures. But would you invest in Mexico during a drug war? Would you invest in Turkey during a civil war in Syria? Perhaps.

    Ø AIDS is punishing South Africa.

    Ø The US debt is the second biggest but it is positioned well, it might just be able to grow out of it.


    *When the second-last Japanese person dies resting on a mountain of government bonds, the last sole remaining bureaucrat can cancel the debt pile by lighting his own funeral pyre. He must do this because he will have no one left to whom to issue a bond in order to pay his own salary, which, in the end, is his only reason for being. Unless he finds an American, because only Americans seem foolish enough to buy 0% government bonds…

    **Haig eventually ran out of English men, and Welsh men, and Scottish men, and Canadian men, and Australian men, and New Zealand men, and South African men, and Indian men, and French men. The point here is that these type of “I-didn’t-fail-you-need-to-try-harder” personalities are driving our fiscal train today.

    • Victor

      Andrew – i follow your comments, however why do you think that the Japan govt bonds dont trade at a higher discount rate? Their suppy seems to have few limits and demand can only be based on a greater fool theory, as there seems little to no real ability for the issuing entity to repay them. I hope you get this message and reply.