Income inequality is relatively high in Japan and is likely to worsen as the number of ‘aged poor’ increases. Japanese firms are lagging in so-called digital transformation and start-ups are distinctively fewer and less successful in Japan than in other developed countries.

Japan’s policymakers have attempted to respond to lacklustre growth and other economic problems. ‘Growth strategies’ have been formulated one after another by past administrations. But if these strategies had been successful, Japan’s present economic situation would look very different.

Monetary and fiscal policies have also been used extensively. The result has been an enormous expansion of the Bank of Japan’s balance sheet with limited impact on inflation and the world’s highest public debt-to-GDP ratio — 257 per cent in 2021. It is now clear that these demand-based stimulus policies are incapable of creating sustainable economic growth.

The lessons we should learn from this experience are twofold. Macro-monetary and fiscal policies are stop-gap measures at best and should not be relied upon for an extended period of time. Japan also needs consensus on the efforts required to strengthen its supply-side, as this will be the ultimate source of sustainable growth.

These two lessons seem obvious, but unfortunately still elude policymakers. In the 2022 Upper House election, all opposition parties called for fiscal sedatives — such as consumption tax cuts and government intervention into gasoline prices — to curb inflation. The ruling coalition did not join this chorus, but also did not make a clear statement that voters should stop relying on temporary fiscal relief and prepare for supply-side reforms that may be painful for some.

What is needed is for political leaders — including those from the opposition — to squarely face economic reality and pursue policies that are consistent with these two lessons. From now on, the main focus should be on how to strengthen the supply-side of the economy, while demand-side policies should play only a supplementary role.

Before discussing specific supply-side issues, it is useful to distinguish aggregate growth from per capita growth. As Japan’s population shrinks, its aggregate GDP is likely to stagnate or even decline. This is not necessarily a problem because Japan’s GDP per capita could grow at the same time. In this case, Japan would become a smaller but individually richer country. Achieving per capita growth would be easier than increasing aggregate GDP.

Should Japan set this goal, which is more modest and realistic? Unfortunately, the answer is no, because past indulgence in demand-side policies makes it unviable. Aggregate GDP, which is the denominator of the debt-to-GDP ratio, is a key indicator of debt sustainability. It represents the country’s tax base from which resources for future debt repayment are obtained. Since population ageing increases fiscal demand for aged-care services and pensions, the numerator of the debt-to-GDP ratio will be difficult to reduce. This means that Japan cannot afford to become a smaller but individually richer country and should strive to increase aggregate GDP growth. Doing so will affect both the nature and scale of the required reforms.

What kinds of reforms are required? The list of necessary supply-side improvements is well known. And while most are actions to be undertaken by the private sector, the government can encourage the private sector to take action. It is already doing so through deregulation to create business opportunities and by providing fiscal support for education, child-bearing and childcare, research and development, digital transformation and start-ups. However, the efficacy of these measures in changing the behaviour of firms and households is often unclear and may take a long time to bring tangible benefits to the economy.

Does this mean that Japan must endure continued stagnation for decades to come? There are certain segments of manufacturing and services in which Japan’s international competitiveness is still high, such as digital cameras, online games, and animation. However, they are individually not large enough to be the main drivers of economic growth. For now, it seems there are only two rays of hope. One is inbound tourism and the other is increased acceptance of foreign workers.

Inbound tourism creates demand for Japan’s services sector, a demand not constrained by the shrinking domestic population. Policies are being explored by the government to support private sector efforts to better accommodate foreign tourists. This is a form of supply-side reform because, like many other Japanese firms and citizens, Japan’s tourism industry was not ready to interact with foreigners until recently. The industry has had no choice but to adapt to offset the expected decline in domestic demand and it has become a pioneer of Japan’s globalisation from within.

It is unfortunate that the sharp rise in inbound tourism that began in the early 2010s faced serious setbacks due to COVID-19. As soon as the situation permits, the government needs to normalise the entry of foreign tourists into Japan by relaxing remaining restrictions.

As for foreign workers, demand for them is already high and it will continue to rise, including in aged-care services. In light of this, the government took a major step in 2019 towards accepting unskilled workers from abroad. This was a politically sensitive issue, so the government made it clear that the measure would not affect its immigration policy.

However, what Japan needs is not temporary workers who send their earnings back home: to increase aggregate GDP, workers need to spend in Japan. To encourage this, Japan should offer permanent residency and accept migrant workers as members of the community.

Changing immigration policy is another attempt to globalise Japan from within, but one that will require the cooperation of Japanese society. The hurdle is naturally higher, because many will see it as socially disruptive and detrimental to the income of locals competing for work. Despite this, it is a critical strategic choice that Japan must make for its survival.

Masahiko Takeda is a Senior Fellow in the Australia-Japan Research Centre at Crawford School of Public Policy, the Australian National University.