Can anyone say for sure that the long spell of deflation in Japan is now behind us? Many Japanese would say they don't feel convinced that it is. Government statistics indicate that the Japanese economy has recently marked the longest stretch of expansion since the end of World War II. Nonetheless, many Japanese people remain uneasy about the future of the economy. Against this background, I will focus in this article on the macroeconomic state of the country, especially from a supply-and-demand perspective.
To assess the actual state of the economy, it is the basic norm in economics to look at the prevailing economic trends from both the supply and demand sides. Macroeconomic scrutiny is no exception to this rule. To give the conclusion first, the Japanese economy is doing well to some extent in terms of stimulating demand, but there are many challenges on the supply side that have to be tackled.
The demand side of the macroeconomic scene is composed of four elements -- personal consumption, business investment, government spending and net exports (exports minus imports). For an economy to grow, it is important that each element of aggregate demand increases. Deflation is caused by sluggish domestic demand.
To pull the Japanese economy out of deflation, it is necessary to get the Japanese population out of a deflation mindset and expand demand. In that regard, the Abenomics remedies employed by the administration of Prime Minister Shinzo Abe in and after 2013 have been highly efficacious in spurring demand in the country.
Macroeconomic statistics prove it. In 1997, Japan's nominal gross domestic product -- the total value of goods and services produced in the economy during a given year -- increased to 534 trillion yen, an all-time high at the time. In November of the same year, a financial crisis broke out in Japan, with Yamaichi Securities Co. and Hokkaido Takushoku Bank Ltd. going under. In the following 15 years, Japan's nominal GDP remained below the 1997 record. In 2012, the GDP actually shrank below 500 trillion yen. Late in December 2012, Abe came back to power. The main culprit for the prolonged GDP contraction was the twin decline in prices and wages caused by deflation.
Fortunately, Japan's nominal GDP reverted to an expansionary path in and after 2013. According to the latest GDP data, the comparable figure for 2018 stood at about 550 trillion yen, surpassing the 1997 record for the first time in 20 years. The resumption of GDP expansion reflects the success of the government's demand-stimulating policy, whose positive effects are also apparent in other economic indicators.
For example, Japan's job-offers-to-applicants ratio is now two times greater than the 2012 level of about 0.8, which meant there were 80 job openings for every 100 applicants. Likewise, Japanese stock prices, as measured by the Nikkei 225 Stock Average and other stock market indices, have almost doubled over the same period. These improvements are illustrative of a significant upturn in earnings by Japanese businesses.
Supply-side dysfunction
Despite such remarkable improvements in economic indicators, neither the public nor the business community really feels yet that the Japanese economy is in good shape. Supply-side dysfunction is behind the chasm between the robust statistics and the bleak sentiments of the public and business community. Most symbolic of this is the fact that Japan's potential growth rate -- a measure of how much the economy can, in theory, grow without triggering rapid inflation -- has continued to be too low, at about 1 percent since around the turn of the century.
It has to be pointed out that a demand-driven economic growth model has limitations in keeping the economy growing. Sustainable economic expansion can become possible only when growth dynamics are also positively backed by supply-side factors, such as labor input and capital accumulation.
The reason that Japan's potential growth rate remains low at around 1 percent is the decline in the growth rate of its so-called total factor productivity (TFP), which is a measure of economic efficiency in terms of labor and capital productivity.
The potential growth rate can be measured by adding up growth rates of four factors -- labor (employee) hours, the number of employees, capital stock and TFP.
To the disappointment to Japan, the country's TFP growth rate has been on the decline for about six years now. As a result, while increases in capital accumulation and labor input account for much of the current rate of potential growth, TFP growth is limited to a mere contribution of about 0.2 percentage points.
Supply-side factors of the GDP, such as labor input and capital accumulation, are essential to measure the Japanese economy's aggregate supply capacity. In the face of a decrease in the population, Japan will be unable to look forward to any big increase in capital accumulation and labor input in the economy. This means that Japan will have no choice but to get capital and labor distributed much more efficiently and, as a consequence, realize an increase in the TFP growth rate.
If Japan wants to become a high-productivity economy, it should adopt a new business model that can help businesses bolster productivity. When the country chooses to adapt itself to a high-productivity environment, those companies and industries that have been less productive may be eliminated to the extent that its overall productivity will be greatly enhanced. Technological innovation can be an important driving force for the aforementioned change in the country's business landscape. Regrettably, Japan is not yet prepared to initiate such innovation quickly. In other words, I have to say there are a lot of problems with the Japanese economy in terms of labor and capital distribution and innovation capabilities.
Ways to raise productivity
Why does Japan's TFP fail to rise? There must be a number of reasons, but a major one is that many of the country's companies continue to find it comfortable to rely on and maintain outdated business models. It has to be noted, indeed, that they are very cowardly when it comes to trying to boost productivity and increase added value -- the factors that are indispensable for GDP.
Generally speaking, Japanese businesses tend to be slow in coping with labor market conditions and making effective investment decisions.
First, they have repeatedly complained of labor shortages for some time now, but what they must do first and foremost is vigorously introduce innovative measures to raise labor productivity. Once wages increase sufficiently, businesses are naturally compelled to raise productivity. However, they have been doing the opposite -- they have been reluctant to raise wages sufficiently while delaying bold structural change. On the labor market, it is necessary to restore the supply-demand balance by substantially raising wages. This is a prerequisite for the labor side to contribute to increasing productivity. Lamentably, the labor market has not fulfilled such a macroeconomic role yet.
Second, Japanese businesses have adopted less enthusiastic investment behavior. It is widely known that they have amassed a huge amount of surplus savings. The excess of savings over investment in the corporate sector, as included in GDP statistics, has accounted for more than 5 percent of the nominal GDP for more than 10 years. This proportion is notably high, compared with the comparable figures for other advanced countries.
In short, Japanese businesses have kept as surplus savings the money they should have spent on investment and raising wages. To increase capital and labor productivity, businesses must continue active investment aimed at increasing added value and productivity.
In today's business environment, corporate investment does not have to be limited to the traditional method of spending capital simply for production expansion to increase revenues. Instead, there can be various forms of investment, such as in technology, mergers and acquisitions, human resource development and startups. As Japanese companies have been and still are less enthusiastic about investing in new businesses and technology development, their surplus savings have only remained and kept increasing.
The Japanese economy has so far been steered quite well in terms of demand stimulation, yet it has gathered a very limited amount of steam from the supply side. It is clear that here is a situation, as mentioned above, that is within "the government's reach" -- its influence or control. As far as demand-side activities are concerned, they can be stimulated when fiscal and monetary policies are effectively mobilized, as in the case of Abenomics.
However, as we learned above, the government can exert little influence in stimulating supply-side activities. Of course, there are some measures the government can initiate and carry out -- including regulatory reforms and growth strategies. Nevertheless, at the end of the day, productivity and added value cannot be raised when businesses remain inactive, sitting passively on a hefty amount of surplus savings. That said, I am still looking forward to seeing them fired up to actively and innovatively help the Japanese economy really get in good shape.
Special to The Yomiuri Shimbun
Itoh is a professor at the Faculty of International Social Sciences of Gakushuin University. Until March 2016, he was a professor of economics at the University of Tokyo.
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