Japan’s amazing growth from 1950 to 1973 and its emergence as one of the world’s leading nations was almost unprecedented. With an annual average growth rate of nearly 10% during that period, the size of the Japanese economy expanded fivefold. It was during this period that Japan’s economy surpassed those of France, Germany and the United Kingdom for the first time. This economic rebirth was marked by two confidence boosting events in 1964: hosting the Olympic Games in Tokyo and joining the OECD. Japan’s expansion paved the way for rapid economic development in other Asian economies, including Korea and Chinese Taipei. Japan has contributed importantly to the region’s development through trade and foreign direct investment.
The “Japanese miracle” is a term often used to describe the country’s rapid growth, which many attribute to the country’s cultural characteristics, such as innovation and hard work. However, standard economic factors offer a better explanation for Japan’s success, notably the closing of the large technology gap that existed between Japan and the more advanced countries in the middle of the 20th century. Japan was able to narrow the gap by importing and adapting foreign technology, which resulted in rapid productivity gains that made private investment highly profitable. Although the 1973 oil shock marked the end of Japan’s high growth era, it continued to outpace other OECD economies. Indeed, by 1991, Japan’s per capita income reached 84% of the US level, up from around 60% (see graph below). For a time, the country appeared to be on track to overtake the United States as the world’s leading economy and fulfil the prophetic title of a popular 1979 book, Japan as Number One.
But it was not to be. Japan’s rise came to an abrupt halt with the collapse of the asset price bubble in 1991. Over the past 22 years growth has slowed to an annual rate of around 1% in the context of falling asset prices, 15 years of deflation and rapid ageing of the population. By the end of 2012, the stock price index had declined 73% from its 1989 peak, while land prices have fallen for 23 straight years, contributing to a banking crisis. Numerous fiscal packages, accompanied by quantitative easing by the Bank of Japan, have failed to restore sustainable growth. Meanwhile, increased competition from other Asian economies, notably China and Korea, have squeezed Japanese world market shares. Also, in recent years, Japan has been hit by two major shocks: the 2008 global financial crisis and the tragic 2011 Great East Japan Earthquake.
Sluggish output growth and rising government spending in Japan, in part due to the ageing of the population, have led to 21 consecutive years of budget deficits. In 2012, Japan’s primary budget deficit was one of the largest in the OECD area, at around 9% of GDP. Gross public debt is projected to rise further into uncharted territory, to some 230% of GDP in 2014, the highest ever seen in an OECD country. While the impact of the large public debt has so far been mitigated by exceptionally low interest rates, there is no doubt that Japan’s fiscal sustainability is at risk. The government aims to eliminate its primary budget deficit by the 2020 fiscal year and stabilise the public debt ratio, but debt dynamics make this a challenging target. Large-scale fiscal consolidation will hold back nominal GDP growth, making such stabilisation difficult.
Japan’s success in overcoming sluggish growth, ending deflation and achieving fiscal sustainability is of crucial importance to the world economy. Japan remains the world's third largest economy and a major exporter of capital. Financial instability in Japan would have a serious impact on the global economy. Moreover, Japan is a vital link in global production chains, a point that was underlined when the 2011 Great East Japan Earthquake not only struck output in the Tohoku region, but disrupted car production around the world.
But overcoming today’s challenges will not be easy, particularly in light of demographic trends. Japan already has the largest number of elderly people relative to the working-age population among OECD countries (see graph opposite). Its total population started falling in 2010 and the working-age population is projected to decline by nearly 40% by 2050, keeping the elderly dependency ratio the highest in the OECD area. Indeed, the ratio of working-age people per elderly person is projected to fall by half, from 2.8 at present to 1.3 by mid-century. Japan offers an unsettling glimpse of the future for many advanced countries, and could lead the way in showing other countries how to cope with these challenges.
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Prime Minister Shinzo Abe, who took office in December 2012, has started to address these challenges by launching his “three arrows” strategy–a bold monetary policy, flexible fiscal policy and a growth strategy that encourages private sector investment–to reverse deflation and revitalise Japan. The first two arrows were launched in early 2013, with a fiscal stimulus package and the introduction of “quantitative and qualitative monetary easing” to achieve the new 2% inflation target. The impact was immediate. Business confidence surged and the Nikkei stock price index soared by 57% in 2013. Output growth in the first half of the year reached 4%, the highest among the G7 countries. These encouraging trends spurred the government to go ahead with the hike in the consumption tax rate from 5% to 8% in April 2014, a key first step toward fiscal consolidation.
The recent decision to award the 2020 Olympic Games to Tokyo has further fuelled public optimism, and is widely seen as an international vote of confidence in Japan, echoing the 1964 Olympics, which showcased the country’s post-war rebirth. No wonder Prime Minister Abe has adopted the slogan: “Japan is back”.
But Japan’s return to strength depends on its success in implementing structural reform, the third arrow of the prime minister’s economic strategy. Much of the positive impact of Abenomics so far is due to fiscal and monetary stimulus, which will fade quickly unless accompanied by reforms that tackle Japan’s structural impediments, notably in the labour and product markets and the agricultural sector. Prime Minister Abe’s resounding victory in the July 2013 election should embolden him to push through these urgently needed reforms.
The three arrows should be accompanied by a fourth arrow of fiscal consolidation to stabilise, and eventually reduce, the high public debt. The key is a detailed and credible medium-term fiscal plan, including further tax hikes and measures to reduce spending growth.
Japan is a creative and dynamic society. Over its long history, the country has repeatedly demonstrated its ability to overcome difficult problems. Success in implementing the three arrows and securing fiscal sustainability will ensure a strong Japanese economy 50 years from now. Then Prime Minister Abe will not be the only one to say, “Japan is back”.
©OECD Observer No 298, Q1 2014