(This column originally appeared in the November 2021 issue of my newsletter “Kaleidoscope of Civilization.” The basic situation has not changed much since then, so I am reposting it here.)
. .Akio KAWATO
Ever since the 2010 publication of the book The Real Cause of Deflation: Economies Move with Population Waves, a powerful idea has taken root in Japan: that the Japanese economy must inevitably shrink because the working-age population is declining.
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However, when you look around now, the picture is not so simple.
Over the past twenty years, the quality of newly built housing in Japan has improved dramatically. Anyone who travels to the United States or Europe quickly notices that in many ways the quality of life in Japan is ahead: the convenience and cleanliness of public transportation, the diversity of food, and the level of customer service.
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Japan’s official development assistance (ODA) to developing countries has recently fallen to fourth place in the world, but the country still provides roughly $16 billion a year. Particularly valued are Japan’s long-term, low-interest yen loans for infrastructure projects. These loans still amount to around one $6.5 billion annually, financed largely by repayments from earlier loans that are then lent out again.
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Even so, Japan’s GDP has barely grown, whether measured in yen or dollars. At this rate, Japan could eventually be overtaken by Germany and fall to fourth place in the world economy. So I began thinking about why this is happening.
Leaving China aside for the moment, let us first look at the United States and Europe.
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In Britain, the 1986 “Big Bang” reforms dramatically loosened financial regulations, allowing the financial industry to grow into a sector accounting for roughly 10 percent of GDP. The United States also pursued major deregulation in the late 1990s. The barriers between banks and securities firms were removed, and banks were allowed to engage in highly leveraged investment and speculative activity. Money supply expanded rapidly during this period.
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This raises a question: have the United States and Europe partly inflated their GDP through financial expansion? Looking at the statistics, the answer seems to be partly yes.
Definitions and calculation methods differ by country, so the numbers are only rough comparisons. But in 2020, finance and insurance accounted for 6.8 percent of U.S. GDP. In Japan, the figure was 4.1 percent in 2019. At first glance, the gap does not appear very large.
But America’s economy is roughly four times the size of Japan’s, so in absolute terms the difference becomes enormous — close to $ 0.8 trillion.
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Japan remains far more dependent on manufacturing. In 2019, manufacturing still accounted for roughly 20 percent of GDP. In the United States, the figure was about 11 percent in 2020, though even then America’s manufacturing output exceeded Japan’s by roughly $ 0.87 trillion in absolute size.
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Manufacturing, agriculture, forestry, fisheries, and mining create the fundamental base of wealth. Finance, transportation, and other service industries expand and multiply wealth on top of that base.
This makes one want to conclude that Japan’s economy is fundamentally solid because its manufacturing base remains strong. What is more, Japan earns steady returns from overseas investments, and with a declining population, perhaps GDP does not need to grow very much anyway.
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But there is a problem: government spending needs continue to rise. Defense budgets and social security costs (healthcare and nursing care) are among them. The tax base — whether manufacturing, finance, or other industries — must become much larger.
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In 2018, U.S. GDP grew by 2.9 percent. The single largest contribution came from the “professional and business services” sector, which added 0.71 percentage points to growth. This category includes consulting firms, accounting services, and similar industries.
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At the same time, American manufacturing contributed 0.46 percentage points to GDP growth in 2018, making it the second-largest contributor to economic expansion.
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In short, it is true that the United States benefited enormously from financial deregulation and monetary expansion. But finance alone did not produce America’s GDP growth. The modernization and expansion of manufacturing also played a major role.
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The Undervalued Yen and the “Over-Shrinking” of Japan
At the same time, the undervaluation of the yen in recent years has steadily reduced Japan’s apparent economic weight when measured in dollars.
In Japan, even a decent hotel in Kyoto can often cost under 10,000 yen ($ 64) a night. In Europe or America, a comparable hotel can easily exceed $300.
According to the “Big Mac Index” published by The Economist, the yen’s actual purchasing power is closer to 69 yen per dollar. If Japan’s GDP were converted into dollars at that rate, the economy would appear roughly 67 percent larger than it does today.
On top of that one should consider Japan’s approximately $ 1. 8 trillion in overseas direct investments — factories and businesses abroad that generate value every year. About $ 0. 13 trillion flows back into Japan annually in the form of licensing fees and other income, while the rest is reinvested overseas.
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Add all this together, and Japan’s true economic strength may be closer to $ 8.7 trillion. On that basis, Japan’s per capita income would rise from around 24th place in the world to roughly 4th place.
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So why does Japan still feel as though it were shrinking?
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Because we have trapped ourselves psychologically. Companies hesitate to raise prices because they fear consumers will stop buying. As a result, profits remain weak, investment does not increase, and wages stagnate. In effect, we are collectively making the economy smaller.
At some point, this vicious cycle has to be broken.
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If people constantly believe that Japan is shrinking, they become more cautious and defensive — which only facilitate a real decline.
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Japan should stop binding itself with this self-defeating mentality. Even today, Japan still possesses many of the historical and social conditions necessary for economic growth.