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The Heisei Economy: Puzzles, Problems, Prospects

Edward J. Lincoln

The Journal of Japanese Studies, Volume 37, Number 2, Summer 2011, pp. 351-375 (Article) Published by Society for Japanese Studies DOI: 10.1353/jjs.2011.0036

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PERSPECTIVES

edward j. lincoln The Heisei Economy: Puzzles, Problems, Prospects

Abstract: The Heisei era started with high expectations as the economy was growing rapidly and the stock and real estate markets were booming. However, performance since then has been disappointing. The economy has grown but at a very low rate. Poor economic performance called into question the vaunted Japanese economic model, and considerable change has occurred to the institutional and regulatory framework in which business operates. Nonetheless, the economy continues to exhibit a number of distortions and the growth rate remains low. This essay explores what went wrong with the economy and raises questions concerning its impact on other aspects of Japanese society.

When the Heisei era began on January 8, 1989, the economic future looked bright for Japan. Following a lackluster first half of the decade, economic growth accelerated after 1985 to an annual average of almost five per cent, while real estate and stock market prices were soaring. Fears that the sharp rise in the exchange rate beginning in 1985 would push the economy into recession had come to naught. Growth at an annual rate higher than that of the United States seemed likely to continue indefinitely and led to considerable hubris about the superiority of the Japanese economic system. Around this time, a government official told me that Japan represented the future and that the United States would be relegated to the trash heap of industrial history. Flush with money generated from rising domestic real estate and stock market prices, Japanese investors moved abroad, buying skyscrapers, hotels, and golf courses in the United States and elsewhere, and causing some nationalistic anxiety in the host countries. Any mature, affluent industrial economy that finds a way to grow faster than the United States or European countries must be doing something right. Americans produced a plethora of books and articles attempting to find the secret of Japanese success, with many arguing that we should follow the example of Japans superior approach to running an economy. American students flocked to courses on Japan, either out of curiosity or from a belief
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that knowing about Japan would be a career enhancer. U.S. firms and some politicians fretted that this success hurt the United States because of Japans relatively closed markets for imports and inward direct investment. So what happened? For the next two decades (19902009), the average annual real (inflation-adjusted) growth rate of gross domestic product (GDP) was only 1.1 per cent compared to 2.5 per cent growth in U.S. real GDP over the same period. The stock market and real estate markets plunged, banks were overwhelmed with bad loans, and deflation (a decline in the overall price level) set in. The concept of Japan as a new model for market economies faded rapidly. Indeed, the existing system became discredited at home, leading to reform and deregulation. To be sure, what happened to Japan was not a disaster. Any visitor to Tokyo or other major Japanese cities sees clean, safe urban areas that have been transformed in the years since 1989 with a deluge of huge, new, modern glass and steel buildings. The excellent public transportation system just keeps getting better, and some Japanese firms remain strong global competitors in their fields. So what is the problem? The simple answer is that Japan has underperformed; the economy should have grown faster and Japanese households should have become more affluent. In addition, it is not clear whether the reforms of the past two decades have resolved the confluence of issues that caused the prolonged underperformance, or whether a relatively weak economic performance might continue. The Macro Economy The starting point for understanding Japans economic performance is the natural slowdown in potential growth. Economies grow by using more workers, creating more capital stock (factories, office buildings, computer equipment, and the like), and becoming more productive (getting more output from each worker or unit of capital stock, something economists designate by the awkward name total factor productivity). In the 1950s and 1960s Japan experienced rapid growth in all three of these sources. The expanding labor input was largely the consequence of natural population growth. The distinctive piece of the story of the high-growth decades, therefore, was a high level of investment in new capital stock and strong rise in productivity. What happened in the high-growth years came from the unusual profitability associated with importing advanced technology and combining it with low-cost domestic labor. Investment in new capital stock put in place new technologies, and these enabled the rapid climb in productivity. This pattern has now been replicated by other developing countries, most notably China. In Japans case, the result was an annual average real GDP growth rate from the early 1950s to 1973 of nine per cent.

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High growth eventually must come to an end. By the mid-1970s Japan had largely caught up technologically with the advanced industrial nations and had a large stock of capital for each well-paid worker to use. Economies that reach this level of economic development cannot grow rapidly because they are constrained by the advance of the global technological frontier. Such countries also typically have lower increases in their working-age populations, limiting economic growth due to the slower expansion of the number of workers. In Japans case, the oil price shock of 1973 provided a dramatic demarcation point between the era of high growth and one of prolonged deceleration. Because of a falling birth rate, Japan also experienced a gradual deceleration in the growth of the labor force (with the working-age population, officially designated as those people aged 15 to 64 years old, shrinking since 1996). Calculating the potential growth rate of an economy is more of an art than a science. For the decade of the 1990s, the potential growth rate was probably on the order of 2.0 to 2.5 per cent, diminishing to no more than 2.0 per cent in the first decade of the new century. Therefore, the real question concerning the Heisei period is why the economy grew at an average annual rate of only one per cent rather than two per cent for two decades? The difference between one and two per cent might not seem like very much, but over a 20-year period even a small gap can make a large difference. In 1990 GDP per person was 3.6 million, and in 2009 it was 4.1 million, 14 per cent higher than it was in 1990 (with all amounts measured in 2000 prices). Had the economic growth rate been 2.0 per cent over this time period instead of the actual 1.1 per cent, GDP per person in 2009 would have been 5.3 million, 46 per cent higher in inflation-adjusted terms than in 1990 and 28 per cent higher than it was in actuality.1 How, then, can this underperformance be explained? At the macroeconomic level, the root of Japans problems lies in the extraordinary speculative bubble that occurred in the real estate and stock markets from 1985 to the end of the decade. Figure 1 indicates what happened to prices in these two markets. The widely used Nikkei Average of stock prices tripled in value from 1985 to a peak on the final trading day of 1989. The official index of urban real estate prices for the six largest urban areas also tripled in value, peaking in 1991. All of the gains have been lost since then. Indeed, in 2010 both the Nikkei Average and the urban real estate price
1. Calculations based on GDP statistics from Cabinet Office, Economic and Social Research Institute, Tables of GDP and Its Components, http://www.esri.cao.go.jp/en/sna/ qe1022/gdemenu_ea.html (September 12, 2010), and population statistics from Ministry of Internal Affairs and Communication, Statistics Bureau, Japan Statistical Yearbook, Table 2 1B: Growth of Population 19202008, http://www.stat.go.jp/english/data/nenkan/143102. htm (September 12, 2010), plus Japan Monthly Statistics, Table B-1: Population, http:// www.stat.go.jp/english/data/getujidb/index.htm#b (September 12, 2010).

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Figure 1. Real Estate and Stock Price Indices Sources: Index of Urban Land Prices (19612004), from Japan Statistical Yearbook, http://www.stat.go.jp/data/nenkan/zuhyou/y1711000.xls (September 8, 2010). Nikkei Average, Bank of Japan Long Term Data Series, http://www.boj.or.jp/en/stat/dlong_f.htm (September 8, 2010). Note: Stock price is for the end of the year, not average for the year.

index were back to the levels of about 1984, more than a quarter-century earlier. This asset bubble and collapse was more severe than the recent one in the United States. The Dow Jones Industrial Average, or other stock price indices, did not surge in the 2000s prior to the severe drop in 2008, and much of the stock market price drop has already been reversed. For real estate, the Case-Shiller index shows U.S. real estate prices for the 16 largest urban areas doubling (rather than tripling) in the six years leading up to the peak in 2007.2 Subsequently, real estate prices dropped 30 per cent and have now stabilized. In contrast, both real estate and stock market prices in Japan dropped by over 70 per cent from their peaks and have remained at that low level. Falling asset prices have several negative effects on an economy. First, consumer spending is affected by wealth. People who have a stock portfolio or own a home either feel more confident about spending or are able to borrow against that wealth. This effect was more important in the United States than Japan since few Japanese households own stock and because the market for home equity loans was not well developed in Japan. Second, the collapse of housing prices can have a deadening effect on
2. Standard and Poors, S&P/Case-Shiller Home Price Indices, http://www.standard andpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff-p-us---- (September 20, 2010).

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household mobility. In all economies, there is a continuous geographical shift of population as people respond to the possibility of better jobs elsewhere in the country or as they are enticed by life in urban areas. With falling real estate prices, however, homeowners can become stuck because sale of their existing home will not yield enough money to pay back the mortgage. In the case of Japan, several bits of statistical evidence suggest that this factor may be in play. First, the number of people moving from one dwelling to another has declined since the beginning of the 1990s. In 1990, 5.3 per cent of the population moved to a different address, but that ratio declined continuously to 4.2 per cent by 2008.3 Of course, only about 55 per cent of households in Japan own their dwelling, so these data include renters who are moving as well (who might be more inclined to move because lower real estate prices enable them to rent a better apartment at a lower price). By way of comparison, this ratio was 1415 per cent from 2000 to 2006 in the United States and then dipped to 12 per cent in the recession of 2008, still much higher than in Japan.4 A second bit of suggestive evidence is that the number of real estate sale transactions has declined in Japan. In 1990, 2.2 million transactions occurred, with that number falling to 1.7 million by 2000 and 1.2 million by 2009.5 These statistics are affected by a variety of factors, including the aging population (with older households probably less mobile than younger ones), but underwater mortgages are certainly one possible factor. Whatever the cause, the decline in people moving geographically and the decline in sales of real estate indicate an increasing rigidity in the deployment of human and real estate resources that is not conducive to economic growth. A third effect of asset deflation comes through the financial sector. When individuals or corporations that borrowed from banks to finance the purchase of real estate or stock can no longer meet the full amount of monthly interest and principal payments, the loan is considered to be nonperforming. A developer putting up a new apartment building may find, for example, that rents are lower than initially expected and do not generate enough revenue to meet the terms of the bank loan. The bank could foreclose on the property, but with dropping real estate prices, the resale of the property will yield less than the value of the loan. The result is a two-fold blow to the economy: firms unable to repay loans go bankrupt and their employees lose their jobs, while the banks have their own financial positions eroded. Either the banks cannot
3. Japan Statistical Yearbook 2010, Table 229: Migrants by Prefecture, http://www .stat.go.jp/english/data/nenkan/143102.htm (October 19, 2010). 4. U.S. Census Bureau, Statistical Abstract of the United States, Migration: Table 30. Mobility Status of the Population by Selected Characteristics, http://www.census.gov/ compendia/statab/cats/population.html (October 19, 2010). 5. Ministry of Land, Infrastructure, and Transportation, Heisei 12-nendotochi ni kansuru ido , http://tochi.mlit.go.jp/hakusyo/h22tochi.pdf (October 19, 2010), p. 11.

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Figure 2. Real GDP Growth (calendar year, per cent) Source: Economic and Social Research Institute, Cabinet Office, Quarterly Estimates of GDP, http://www.esri.cao.go.jp/en/sna/qe102/gdemenu_ea.html (September 1, 2010).

make new loans (because they need to hoard cash to handle the losses on nonperforming loans) or they go bankrupt themselves. Asset bubbles, their collapse, and the attendant negative economic effects have been relatively common around the world over the last several decades. In that sense, there was nothing unique about what happened to Japan, although the size of the bubble was unusual and the government dithered for a long time before taking action to rescue the banking system. The slowness of the policy response (dealing with failed banks and shoring up those that remain viable) contributed to the prolonged period of weak economic performance. Figure 2 shows what has happened to economic growth in Japan since 1985. During the lost decade from 1992 to 2002, average annual real (inflation-adjusted) growth of GDP was only 0.8 per cent, the slowest economic growth of any advanced economy during that period and far below the U.S. average annual growth of 3.4 per cent over the same years. The government took an initial small step in dealing with the nonperforming loan problem in 1995 when the seven ju sen (real estate lenders that raised funds by borrowing from banks) collapsed and were liquidated. But the first serious effort to deal with the problem did not come until 1998, and the total amount of nonperforming loans in the banking sector did not fall until after 2001. Only by about 2006 had the value of nonperforming loans subsided to a level that was no longer a threat to the stability of the banking system. Mistakes in the governments macroeconomic policy also delayed recovery, stretching out the lost decade. The Bank of Japan had deliberately pricked the asset price bubble by raising interest rates and applying admin-

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istrative guidance to commercial banks to curb their real estate lending. Once real estate and stock prices began falling, the central bank was slow to lower interest ratesmuch slower, for example, than the response of the Federal Reserve in the U.S. case in 2008. Government can also use fiscal policy to stimulate the economy (by cutting taxes or spending more). The government did this, but the stimulus had an on-again, off-again character that undermined its effectiveness in jump-starting an economic recovery. The biggest mistake was the tax increase in April 1997when temporary income tax cuts were allowed to expire and a two-percentage-point increase occurred in the national consumption tax (shohizei). As Figure 2 indicates, the lost decade eventually came to an end. From 2003 through 2007, average annual real GDP growth accelerated to two per cent. With no population growth, the result was that GDP per person was also rising at two per cent, a respectable performance for an advanced economy. Nonetheless, the recovery was disappointing in two respects. First, following a period of recession or very low growth, economies typically rebound with a spurt of relatively rapid expansion. That is, Japan could and should have been growing faster than two per cent during this recovery. Second, the recovery occurred because of an acceleration of export growth. Cleaning up nonperforming loans and carrying out regulatory reform may have helped at the margin, but these factors were not the primary reason for the recovery. Enabling the export boom were two factors: a weak exchange rate and rapid growth in China. The exchange rate between the U.S. dollar and the Japanese yen is the most visible indicator of the strength or weakness of the exchange rate. However, this exchange rate does not tell us very much about the competitiveness of Japanese exports in global markets (or that of imports into Japan). Japan has trade with most countries in the world, so an indicator of the exchange rate should reflect the exchange rate between the yen and these other currencies. Furthermore, the price competitiveness of Japanese exports on global markets depends on what is happening to inflation in Japan and each of the other countries. Economists have devised an index number that reflects all the currency pairs and the differential inflation rate between the home country and each trade partner, called the real effective exchange rate (REER). The International Monetary Fund publishes monthly data on the REER for most major countries, including Japan. From 2000 to 2007, Japans REER fell by 37 per cent, a considerable drop for this measure.6 That fall made Japans exports more price competitive in global markets, fueling the rapid increase in exports. In addition, the rapid growth of the Chinese economy (and the increasing investment by Japanese
6. Data from International Monetary Fund, International Financial Statistics, interactive on-line database.

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firms in factories there that import components from Japan) also helped produce the rapid export growth. Regardless of the cause for the economic recovery, the overall mood among businesses and officials improved, with rising confidence that the lost decade was finally over. Unfortunately, this confidence was dealt a blow by the recent global recession. Japanese investors had not placed much money in exotic U.S. collateralized debt instrumentsthat veritable alphabet soup of bonds that sliced, diced, and repackaged mortgage loans. As late as the summer of 2008, the expectation was that the problems in the United States would have a relatively minor impact on Japan. A mild recession (which had started in Japan in the spring of 2008) was the worst that might happen. Unexpectedly, though, the recession in the United States and Europe had a temporary but devastating impact on global trade. Japan was particularly hard hit by this trade effect, with monthly exports dropping by a huge 53 per cent from the summer of 2008 to the low point in March 2009. Since economic recovery through 2007 had been highly dependent on exports, the sudden drop had a strong negative impact. In the first quarter of 2009, the economy was shrinking at a 13 per cent annualized rate (that is, if the actual decline in real GDP from the fourth quarter of 2008 to the first quarter of 2009 were to continue for an entire year, the economy would be 13 per cent smaller). For 2009 as a whole, the economy shrank 5.2 per cent, worse than the contraction of the U.S. economy which shrank 2.9 per cent in 2009. Since the second quarter of 2009, the economy has been recovering once again, paralleling the trend in the United States and Europe. However, one of the drivers of growth in the 20027 period is now missing: a weak exchange rate. In the short to medium term (that is, up to several years), one of the most important factors in determining exchange rates is interest rates. The yen was weak for several years through 2007 because interest rates were considerably lower in Japan than the United States and other countries (causing investors to convert yen into dollars to invest abroad, with the increased supply of yen and demand for dollars in the exchange market pushing the yens price down). When U.S. interest rates fell to a very low level during the global recession, the flow of investment money out of Japan slowed and the yen rose in value. The consequence was that Japanese exports lost some of their price competitiveness. From the low point in 2007, the REER for the Japanese yen rose by 30 per cent, ending the period of an unusually weak yen (and returning this index number back to the average level of the entire period 1980 to 2010). This development suggests that the recovery in 201011 could be relatively weak as Japanese exports have lost their unusual price advantage. The final piece of the macroeconomic story is deflation, a peculiar and unexpected development that requires a bit of explanation. Any visitor to Japan from the United States in the mid-1990s would have been appalled at

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the high prices. At then-current exchange rates, almost all prices were high, and some were outrageously so. If that was the case, then what is so bad about deflation? Prices in Japan needed to fall, and they did. What is wrong with this view is that Americans see prices in Japan through the lens of exchange rates. Bringing prices into greater equality across different countries might involve some domestic price decline for individual products, but it mainly requires shifts in exchange rates. Observing as a foreigner that prices no longer seem so high in Japan when making the mental conversion from yen to dollars does not tell us very much about what lower prices have meant inside Japan. Many Japanese also applauded falling prices, at least initially. If prices fall, then ones income can buy more. Unfortunately, deflation (just like inflation) impacts all prices, including that of labor. People might feel good that prices are falling, but eventually their incomes begin falling too. As measured in the national income accounts (in a data series published only on an annual basis, with 2008 the most recent year available), household income rose until 1997 but from 1997 through 2008 fell by 10 per cent.7 The consumer price index fell just under 3 per cent over that same 19972008 period, so that real (inflation-adjusted) household income fell about 7 per cent. How can we square this result with the fact that real GDP and GDP per person was risingalbeit slowly? The answer is that national income is split between household income and corporate income. Over this period, GDP increased, but a larger share of it went to corporations and a smaller share to households. The net result has been that households (on average) have watched their income level fall more than prices, making them worse off. For the entire 19902008 period, nominal household income rose slightly by 1.3 per cent, but in inflation-adjusted terms it fell over 6 per cent. John Maynard Keynes speculated in the 1930s that individuals are subject to something called money illusion.8 That is, they like to see their nominal income rise and are often unaware of, or disregard, or miscalculate the impact of rising prices on lowering the real value of that increase. If money illusion exists, then one of the explanations for the sour mood of households in Japan for the past two decades is the stagnation in their nominal income and not just the decline in their real income. Economists dislike deflation for several other reasons. First, if deflation is high enough, consumers might postpone purchases as they wait for lower prices; such postponement has a negative impact on consumer spending and
7. Cabinet Office, Economic and Social Research Institute, Annual Report on National Accounts of 2010, http://www.esri.cao.go.jp/en/sna/h20-kaku/22annual-report-e.html (October 19, 2010). 8. John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Classic Books America, 2009), p. 15.

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the overall economy. Luckily, the deflation in Japan has been low enough that this effect does not appear to have been a problem. Second, unexpected deflation is bad for debtors. Think of a fixed-rate housing mortgage, with a constant monthly payment over the duration of the loan. Under deflation, with falling household income, that monthly payment becomes an increasing burden to the borrower. The consequence is nonperforming loans, the prospect of which discourages banks from lending and potential borrowers from seeking loans. All economies depend critically on debt to fuel economic growth and development. Debt is what enables the creation of new housing, office buildings, and factories with new equipmentthe investments that produce a growing economy. Discouraging borrowing, therefore, is a negative consequence of deflation. Third, deflation complicates monetary policy. Central banks rely mainly on raising and lowering interest rates to affect economic growth and inflation. However, interest rates cannot be lowered below zero per cent. With deflation, a zero interest rate is still a positive real (inflation-adjusted or, in this case, deflation-adjusted) interest rate. Central bankers worry, therefore, that they will be unable to drive real interest rates low enough to stimulate growth and eliminate deflation. Nominal (not-inflation-adjusted) interest rates have been extremely low in Japan since the late 1990s, pinned down by the inability to escape from deflation. Figure 3 shows what has happened to the GDP deflator, the broadest price index for the economy. Except for 1997 (when the increase in the consumption tax pushed up prices paid by consumers) and 2008 (when a temporary spike in oil prices and some other internationally traded commodities affected Japan), Japan has experienced deflation since 1995. For the entire period from 1995 to June 2009, the GDP deflator fell at a 0.9 per cent annual rate. This represents a rather mild deflation (unlike what happened to Japan at the beginning of the 1930s). Nonetheless, the persistence of this deflation has been troubling to economists, for the reasons just outlined. In summary, much of the rather weak performance of the economy since the beginning of the 1990s was due to standard macroeconomic factors. The maximum possible economic growth rate was declining due to the lower population growth and the attainment of advanced industrial status. Nonetheless, the economy has grown at roughly half the rate it should have been capable of producing. Excessively loose monetary policy in the second half of the 1980s unleashed the stock market and real estate bubbles. Overreaction to the bubble left interest rates too high for too long as the bubble collapsed. By the time the Bank of Japan reacted, deflation had set in, undermining the ability to use monetary policy to stimulate the economy. The on-again, off-again nature of fiscal stimulus undermined its effectiveness in helping the economy. Recovery finally occurred, only to be dealt a blow once again in 20089 by the global recession. Going forward, potential

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4 3 2 1 0 -1 -2 -3 1990 1995 2000 2005 2010


Figure 3. GDP Deflator (quarterly, year-on-year comparison, in per cent) Source: Economic and Social Research Institute, Quarterly Estimates of GDP, http://www.esri.cao.go.jp/en/sna/qe104/gdemenu_ea.html (March 5, 2011).

growth will be even lower as the population, and especially the working-age population, shrinks. Structural Issues So far the story of what happened to Japan in the Heisei era has relied entirely on macroeconomic explanations. Are these sufficient? Macroeconomists studying many countries tend to believe they are, because asset bubbles and macroeconomic policy mistakes have occurred elsewhere so that what happened to Japan is unremarkable and can be explained fairly well by the same standard macroeconomic factors as in other countries. However, it is possible to make a structural argument as well. Problems and inefficiencies in the economic system contributed to both the severity of the bubble and the delayed policy response. It is truly ironic that at the very time many U.S. and Japanese academics were touting the superiority of the Japanese economic system in the 1980s, its flaws were setting the stage for the lost decade. Indeed, the flaws were so evident by the late 1990s that a flood of regulatory and legal changes has now altered the system. The starting point for considering the structural argument is to recognize that, from the late 1930s until recently, Japan has had a set of laws,

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regulations, institutions, and economic behavioral patterns quite different from those in the United States. One Japanese economist dubbed this the 1940 system.9 Claiming that Japan was very different from the United States should not be controversial, since such structures vary considerably across the range of market-based economies. At the core of Japans system was a relatively intrusive role for the government, driven by a suspicion concerning the consequences of unfettered competition and a desire for predictability and stability for all participants throughout the system (workers, financial institutions, and nonfinancial businesses). All economies are complex, and for the purposes of this short essay, it is possible only to provide the barest of outlines of the elements that made up this distinctive economic system.10 Financial flows were predominantly through banks (rather than the bond market or stock market), and behavior in the banking industry was constrained by the government, with limited entry of new banks, and by control over interest rates (both deposit rates and lending rates) until the 1970s. Corporations operated largely independent of pressure from shareholders, though perhaps with some oversight from each firms main bank (the bank from which the firm had its largest loan). Workers enjoyed considerable job security, especially if they managed to obtain work in a large corporation as regular full-time employees. The result was lower labor turnover in Japan than in the United States. Price competition among firms was muted, and entry of new firms in leading sectors of the economy was limited. Rather than relying on new firms to shake up industries and drive the economy forward, the system relied more on expansion of existing large firms into new products or technologies. In manufacturing, firms were linked in vertical production networks (parts through finished products) with long-term stable relationships. Many large firms, including financial institutions, were members of informal horizontal groupings (horizontal keiretsu), although the real impact of these on the economy has never been very clear.11 Government played a soft role in influencing the direction of financial
9. Yukio Noguchi, 1940-nen taisei (Tokyo: To yo keizai Shinpo sha, 1995). 10. Sources detailing the nature of the postwar economic system include ibid.; Edward J. Lincoln, Arthritic Japan: The Slow Pace of Economic Reform (Washington: Brookings Institution, 2001), pp. 1655; Steven K. Vogel, Japan Remodeled: How Government and Industry Are Reforming Japanese Capitalism (Ithaca: Cornell University Press, 2006), pp. 121; and Ulrike Schaede, Choose and Focus: Japanese Business Strategies for the 21st Century (Ithaca: Cornell University Press, 2008), pp. 4984. 11. Two detailed attempts to unravel why horizontal keiretsu existed are Michael L. Gerlach, Alliance Capitalism: The Social Organization of Japanese Business (Berkeley: University of California Press, 1992), and James R. Lincoln and Michael L. Gerlach, Japans Network Economy: Structure, Persistence, and Change (Cambridge: Cambridge University Press, 2007), but not even the more recent book considers the weakening or disappearance of these ties in the 2000s.

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resources to favored industries through an industrial policy that included subsidized loans from government banks (with the granting of these loans serving as a signaling device for commercial-bank lending decisions), protection from imports, relaxation of antitrust laws, and government financing for cooperative research and development. Government also ensured that sectors of the economy in relative decline (agriculture and mining) were provided subsidies of various kinds to ensure that people living in the parts of the country where these industries predominated were not left behind as prosperity grew. The fact that the economy grew very rapidly from the early 1950s until levels of GDP per person had caught up to European levels by the 1970s suggests that the economic system might have helped accelerate growth. At the least, the system did not hold economic growth back since it is difficult to imagine that Japan could have grown at an even faster rate during the 1950s and 1960s. Nonetheless, evaluating the impact of the economic system on the overall growth of the economy is difficult since it is not possible to observe what might have happened under a different set of laws, regulations, institutions, and behavioral patterns. The consequence has been a long-running academic argument that generally pits economists (industrial policy did not help growth) against political scientists (it did help).12 Which side is correct matters less than what went wrong with the system over time. When a country is poor, the path to affluence is relatively clear, since government officials can look at the existing advanced economies as representing the ideal or the goal for development purposes. If, for example, the advanced economies had semiconductor industries, then Japan needed one too. For countries like Japan in the 1950s, it is at least possible to make a theoretical argument in favor of a strong government role in allocating investment resources toward those industries that are the most important to achieving rapid economic development. This theoretical argument stretches back to a book published by Alexander Gerschenkron in 1962.13 However, the situation facing an economy that has educated its workforce, built up its capital stock, and is using the most advanced technology is quite different. No one knows what will be the successful industries or firms of tomorrow. In such circumstances, it is critical to have a system that enables a very fluid response to the daily flow of information about new technologies and cor12. One of the original sources arguing against a positive role for industrial policy is Philip H. Trezise, Politics, Government, and Economic Growth in Japan, in Hugh Patrick and Henry Rosovosky, eds., Asias New Giant (Washington: Brookings Institution, 1976), and one of the initial arguments in favor of a positive role for it is Chalmers Johnson, MITI and the Japanese Miracle: The Growth of Industrial Policy, 19251975 (Stanford: Stanford University Press, 1982). 13. Alexander Gerschenkron, Economic Backwardness in Historical Perspective, a Book of Essays (Cambridge, Mass.: Harvard University Press, 1962).

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porate strategies. Government does a relatively poor job of both identifying critical future technologies and providing a flexible response as conditions change. Private-sector financial markets, for all their flaws, do a much better job. To be sure, markets can overreact (as happened in the information technology stock-price bubble in the late 1990s), but they are generally quickly self-correcting. Thus, one can construct a hypothesis that even though the Japanese economic system may have worked well in the early decades after World War II, it was no longer appropriate by the 1980s.14 Driving debate on this issue was the exposure of a number of flaws or problems during the 1990s in the wake of the collapse of real estate and stock market prices. Commercial banks, having relied in part on informal signals from government on how to lend their money, had weak processes to evaluate loan applications and had made many loans to very dubious projects, especially in real estate. Once loans began turning sour, banks managed to hide their nonperforming loan problems for several years because accounting rules were weak. The system of amakudari also created an incestuous relationship between the Ministry of Finance and commercial banks, making it difficult for government officials to deal firmly with the banks as problem loans mounted. The political bargain to assist rural areas had its own momentum, leading to overinvestment in rural public infrastructure, as revealed in a seemingly endless series of scandals concerning wasteful public works projects. Furthermore, the lack of shareholder pressure on the management of corporations resulted in excessive private-sector investment in capital stock which in turn led to low profits, something economists regard as a sign of misallocation of productive resources in the economy. The vertical keiretsu relationships in manufacturing were proving to be excessively rigid, saddling the large assembly firms with excessive costs for their parts in the context of an increasingly competitive global market. The lack of a vigorous market for high-tech start-up firms was finally recognized as a problem as leading Japanese manufacturing firms began to lose global market share to foreign competitors. The list could go on, but this gives the flavor of the problems surfacing in the 1990s. As evidence of these problems began to mount, a process of reform got underway. The most critical issue concerned the financial sector. The badly damaged commercial banking industry needed to be rescued, and oversight of banking needed to be reformed. This process finally began in 1998, when bank oversight was removed from the Ministry of Finance and placed in a new Financial Services Agency. Rescuing the banks involved new laws to provide an infusion of government capital and to establish a regular procedure for dealing with failed banks. These new policies worked, although as
14. Richard Katz, The System that Soured: The Rise and Fall of the Japanese Economic Miracle (Armonk, N.Y.: M. E. Sharpe, 1998), provides a detailed analysis of how the system had gone awry by the 1980s.

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noted earlier, reducing the mountain of nonperforming loans on the books of the banks took several more years. A second issue for the financial sector was a broader reform of the flow of money through the system, away from commercial banking and toward bonds and equity. A major step in this direction was the Big Bang financial sector reform, announced by Prime Minister Hashimoto Ryu taro in 1996. The result of this policy was a series of legal and regulatory changes over the next several years that were supposed to both strengthen the function of the bond and stock markets and make Tokyo more of an international financial center.15 One of the components of these reforms was permission for the creation of financial holding companies, providing a means of getting around the strict separation of commercial banking, investment banking and securities dealing, and insurance. The consequence of this change was a consolidation of the major Japanese banks and other financial institutions. From the late 1990s to around 2005, 16 large commercial banks merged into four holding companies that also brought in a number of securities firms, trust banks, and insurance companies. Part of the motivation appears to have been the same too big to fail notion that has affected other countries. These four companies (Mizuho Financial Group, Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group, and Resona Holdings) now dominate the commercial banking industry. One consequence of this wave of mergers was the demise of the former horizontal keiretsu, since the banks that had been a central part of them were now part of these new broader financial groups. Whether new horizontal keiretsu will assemble around the four large financial holding companies remains unclear but is a question worthy of future research. A wave of regulatory and legislative changes has affected the nonfinancial corporate sector as well. Accounting rules have been improved and financial reports are now required quarterly rather than semiannually (a critical change to enable investors to monitor corporate performance on a more continuous basis in a constantly changing economy, despite the past Japanese belief that quarterly reports would force corporations to focus too much on short-term profits). Bankruptcy procedures have been improved, and firms can more easily divest themselves of pieces of their operations. Legal responsibility of boards of directors for the accuracy of corporate financial reports has been clarified. In short, a number of the distinctive features of the corporate sector are now gone.16

15. Sayuri Shirai, Promoting Tokyo as an International Financial Centre, in Soongil Young, Dosung Choi, Jess Seande, and Sayuri Shirai, eds., Competition among Financial Centres in Asia Pacific (Singapore: Institute of Southeast Asian Studies, 2009), pp. 13078. 16. Schaede, Choose and Focus, especially pp. 87173, and Vogel, Japan Remodeled, pp. 115204, provide extensive description and analysis of corporate reform and restructuring.

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What should we make of all these changes? The legal and regulatory changes are certainly extensive. But the core question is whether regulatory reform and structural change of industry has led to changes in behavior. Has the flow of funds shifted away from the bank-centric model? Have corporations unleashed their competitive abilities? The short answer to these questions is: not much. On the positive side, some changes in behavior have occurred. Mergers and acquisitions have increased, a useful development since changing economic circumstances naturally demand a reshuffling of corporate pieces over time. Lawsuits brought by shareholders against corporate boards have increased, suggesting that shareholders are demanding better performance from the corporations in which they have invested. Corporations responded to slow growth and recession by trying to inject more flexibility in their work forces by bulking up on temporary and part-time employees (who are not covered by the legal job guarantees that apply to regular, full-time workers).17 The big question, though, is whether broader indicators of corporate performance and financial sector flows have changed substantially. Consider first the structure of financial flows. One useful indicator of what is happening to the financial sector is the nature of household financial assets. Throughout the postwar period, households have held the bulk of their financial assets in the form of bank accounts (demand deposits and savings accounts). With changes in the financial system, extremely low interest rates on savings deposits, and an aging population that might have rising concern about the slowly growing size of the assets needed to finance their retirement, it would be reasonable to think that households would turn increasingly to the stock market (at least in the form of mutual funds) and international investments. Mrs. Watanabe, goes the conventional wisdom, is tired of investing her money at 0.1 per cent interest in the bank and is becoming more aggressive in her investment strategy. The numbers, however, do not support this conclusion, as shown in Table 1. From 1990 to 2009, households actually increased the share of their total assets held as bank deposits, from 45 per cent to 55 per cent, while the portion held in the form of stocks and bonds fell from 28 per cent to 13 per cent. U.S. households, in contrast, hold only 15 per cent of their assets in the form of bank deposits. These data, therefore, provide no evidence that household behavior is changing; the majority of household savings still goes into banks. What about the corporations? Data on corporate financial liabilities (loans, bonds and other debt securities, and trade credit) indicate that corporations have not moved away from bank loans in favor of bonds. In 1990,
17. Labor market changes are detailed in Schaede, Choose and Focus, pp. 17499.

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Table 1 Household Financial Assets (per cent of total in each class of asset) Japan 1990 Bank Total Currency and Demand Deposits Time and Savings Deposits Insurance and Pension Reserves Stocks and Bonds 45 7 39 21 28 2000 57 12 45 29 15 2009 55 12 32 27 13

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U.S. 2008 15 1 14 28 53*

* Note: For the United States, stocks and bonds includes money market funds. Sources: U.S. Department of Commerce, Statistical Abstract of the United States, 2010, Table 1132, http://www.census.gov/compendia/statab/ (August 10, 2010); and Bank of Japan, http://www.boj.or.jp/en/theme/research/stat/sj/index.htm (August 10, 2010).

bank loans were 58 per cent of corporate financial liabilities, falling very modestly to 53 per cent in 2009, while debt securities rose from 10 per cent to 12 per cent in 2009. This is certainly not a major change, so it is fair to say corporations still rely predominantly on bank loans as a source of outside funds. A large distinction between the borrowing pattern of Japanese and U.S. firms persists. Part of the story of changing the financial sector also involved the market for financing high-tech start-up firms. The government has pursued a variety of measures over the last 20 years to foster a more vigorous venture capital market, but no major change has occurred. At the microeconomic level, to be sure, there are examples of new firms in areas such as biotechnology.18 And in 20002005, there appeared to be some increase in activity by venture capital firms and on the specialized stock markets for young companies. But since 2006well before the onset of the recession in 2008the number of new firms listed and the amount of money raised in initial public offers plummeted, as did the daily volume of trading on these exchanges. Meanwhile, Japan still lags very far behind the United States and Europe on both the birth and death of corporations. Another indicator of misallocation of resources in the economy is the amount of investment in plant and equipment in the corporate sector. How
18. Kathryn Ibata-Arens, Innovation and Entrepreneurship in Japan: Politics, Organizations, and High Technology Firms (Cambridge: Cambridge University Press, 2005), provides case studies of high-tech start-up firms.

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20

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Figure 4. Nonresidential Fixed Investment as a Share of GDP (per cent) Sources: Japan: Economic and Social Research Institute, http://www.esri.cao.go.jp/en/sna/ qe102-2/gdemenu_ea.htm1 (September 11,2010); and Bureau of Economic Research, Department of Commerce, National Income and Product Accounts Table, http://www.bea .gov/national/nipaweb/TableView.asp?SelectedTable=5&ViewSeries=NO&Java=no&Reque st3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=19 50&LastYear=2009& 3P1ace=N&Update=Update&JavaBox=no# (September 11, 2010).

much additional capital stock an economy needs to produce additional output is not a precise science. Furthermore, some investment is used to simply replace buildings and equipment that have worn out (depreciation). An economy that is growing very rapidly needs to allocate an unusually large share of each years economic output to provide enough new capacity to sustain the desired increase in output the next year. But an economy growing slowly uses less of each years GDP for such investment. As advanced economies, both Japan and the United States grow slowly, although since 1990 the United States has grown faster than Japan. As indicated earlier, Japan grew at an average rate of 1.1 per cent from 1990 through 2009. The United States grew at an average annual rate of 2.5 per cent over the same period.19 A reasonable hypothesis would be that the ratio of private nonresidential fixed investment to GDP would be higher in the United States than Japan. Figure 4 indicates that the ratio of private fixed nonresidential investment has actually been higher in Japan than the United States, despite the economys lower average growth rate. The only reasonable conclusion to
19. U.S. GDP growth data are from Bureau of Economic Activity, United States Department of Commerce, National Economic Accounts: Gross Domestic Product, Percent Change from Previous Period, http://www.bea.gov/national/index.htm#gdp (October 13, 2010).

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draw from these data is that Japan invests too much. That is, the corporate sector simply did not need to create that much new plant and equipment to enable the economy to grow at an average rate of 1.1 per cent. If the structural reforms of the 1990s and 2000s had a real impact on both financial-sector and corporate behavior, then this excess investment should have abated. But as is clear from the figure, the gap has continued. Even during the recent recession, when Japans GDP shrank by 5.5 per cent in 2009 while that of the U.S. economy dipped only 2.9 per cent, and fixed investment dropped in both countries, the level remained higher in Japan. When economies invest more than they need to, the result is a lower rate of return or profit. The higher level of investment in Japan strongly suggests that both the financial sector and the nonfinancial corporate sector continue to behave inefficiently. The financial sector still provides funds to finance the investments of the corporate sector, suggesting that it is offering more money to corporate borrowers than it should. If financial institutions were careful about sorting out the many options for lending (including, for example, the choice between lending in Japan and overseas), they would lend less to corporations at home. Similarly, if corporate borrowers were really under stronger pressure from their shareholders to produce higher profits, then they would not borrow so much to finance additional capital stock. The failure of this ratio of investment to GDP to converge with that of the United States, or to decline below the U.S. level, therefore, is an indicator of the incomplete structural reform in the Japanese economy. This conclusion is reinforced by looking at the level of profits earned by the corporate sector. Economists use two statistics to obtain some sense of the profitability of corporations. One is the return on total assets, or ROA (that is, pretax profits divided by the total assets listed in the balance sheet of a corporation), and the other is the return on equity, or ROE (pretax profits divided by the net worth of the firm). These are ratios that stock market investors look at for individual firms, but they can be aggregated for the economy as a whole. For Japan, ROE fluctuated at a low level between 2 and 4 per cent in the 1990s and then experienced an increase to 7 per cent in 2007 before the recession hit. In contrast, the measure of ROE in the United States has averaged close to 13 per cent over a long period (fluctuating from about 10 per cent to 18 per cent over the business cycle). ROA in Japan was between 1 and 2 per cent in the 1990s and rose close to 3 per cent by 2007. In the United States, ROA has averaged 6 per cent. An optimist might argue that the increase in both measures from 2000 to 2007 in Japan indicates the positive impact on corporate behavior from structural reform. However, these measures are highly cyclical, and the rise in the decade since 2000 mainly reflects the increased economic growth rate of the 20037 period. More telling is the failure of either measure to come close to the levels that prevail in the United States.

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The evidence shows that the legal or regulatory system governing the economy has changed substantially since the mid-1990s. Perhaps these reforms will eventually yield an economy that behaves differently than in the past. As of 2010, however, the evidence of meaningful change in household, corporate, or financial sector performance is meager. The legal changes could have unleashed animal spirits in the economy but have not done so yet. Why this has not occurred is an important question for economists and political scientists to pursue, and the lack of substantial change in behavior will be a problem if it persists. The Future For the next several decades, and perhaps longer, the most interesting questions about the economy relate to demographics. The size of the population is now decreasing, and the working age population has been declining since 1996. As total population shrinks, the age structure shifts, with a rapid increase in the portion of the population age 65 and older and decline in the portion under 14. The contracting and aging of the population has profound economic, social, and political implications. Looking at the future, the shrinking population implies that there will be fewer people available to work. GDP growth might still be positive, if each worker has more equipment to work with or if productivity continues to increase. But a shrinking population does mean that overall GDP growth will be very low at best. Of course, economists prefer to focus on GDP per person rather than simply GDP. After all, it is easy for an economy to have a large GDP merely because the population is large. It is more interesting to look at how much the economy manages to produce for each person. The fact that China passed Japan in terms of GDP in 2010 (when the yuan and yen values of GDP are converted at market exchange rates) is a basically uninteresting observation, given the fact that Chinas population is ten times larger. Therefore, the big question is whether Japans GDP per person will grow at a rate similar to that in other industrialized economies. Consider first what the level of overall GDP growth might be for the next decade. From 2010 to 2020, the working-age population (people aged 15 to 64 years old) will decrease at about a one per cent annual rate. Assume for the sake of argument that this decline will be roughly equivalent to the trend in the actual labor force. Output per worker has increased in advanced industrial nations over the last half-century at an average rate close to two per cent per year. If that is true of Japan in the 201020 period, then GDP growth would average only about one per cent. However, over the period from 1990 through 2009, GDP per worker in Japan grew at an annual pace of just 0.8 per cent. Leaving out the recent recession (when output fell faster than employment causing output per worker to shrink), the average annual

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growth in GDP per worker through 2007 was 1.2 per cent. If that pace of productivity growth were to continue in the next decade, then GDP would grow at an annual pace of only 0.2 per cent. Furthermore, a society that has a falling percentage of its population in the age group that generally works has a problem in raising the overall level of affluence since that shrinking slice of the total population must produce for the whole society. In Japan, the relative share of the 1564 age group had risen during the high-growth years. In 1950 the ratio was 60 per cent, rising to 68 per cent in 1975. But since 1975, the ratio has fallen, reaching 64 per cent by 2009, and is expected to drop to 60 per cent by 2020.20 As the working-age populations share was rising, GDP per person could rise even without an acceleration in productivity growth, simply because a higher share of the total population was working. Now the opposite effect is settling in. For a given annual productivity growth, GDP per person will not rise as rapidly simply because the share of people in the total population who are working is falling. These developments imply that the key question is whether output per worker will grow faster or slower in the future. In any society, this is a difficult question to answer. But the situation for Japan is clouded further by the fact that economists have never studied a country with a shrinking population. Since the start of the industrial revolution more than two centuries ago, economic growth has been occurring in the context of rising populations. That means that economists really do not know what the dynamics of a country with a falling population might be. One simplistic answer is that output per worker will be completely unaffected by population growth or decline. Nonetheless, there are factors that might cause productivity growth to decelerate. First, corporations depend on a constant inflow of young, bright, welltrained engineers and other managerial talent to remain flexible and aggressive in pursuing new products, technologies, and corporate strategies. Japanese firms are facing a serious decline in new talent. Consider the age group of people 2024 years old, who roughly correspond to young adults completing school and entering the labor force. That age cohort had 9.9 million people in 1995 but had shrunk to only 7.1 million by 2008 (down 30 per cent) and will be only 6.0 million by 2028 (down a further 24 per cent from 2008) based on the number of people who were 04 years old in 2008. The
20. Calculations of output per worker based on Cabinet Office, Tables of GDP and Its Components, Japan Statistical Yearbook, Table 28, Population by Age Group and Indices of Age Structure (19352008), http://www.stat.go.jp/english/data/nenkan/143102 .htm, and National Institute of Population and Social Security Research, Population Projections for Japan 20012050, Table: Projected Future Population and Proportion by Age Group 20002050, Medium Variant, http://www.ipss.go.jp/pp-newest/e/ppfj02/t_1_e.html (October 18, 2010).

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total decline of 45 per cent from 1995 represents a rather drastic drop and could have a negative effect on the innovative vigor of Japanese firms. Second, accompanying the decline in population is a rapid increase in the portion of the population that is over age 65. That ratio had been rising rapidly, almost doubling from 12 per cent in 1990 to 23 per cent in 2009. Population forecasts are often inaccurate, but the current government midrange forecast shows this ratio reaching almost 28 per cent by 2020 (and even higher thereafter).21 This older age group is likely to consume more services and fewer manufactured goods than younger groups. They will consume more health care, physical therapy, library services, and tours, while buying fewer automobiles or advanced entertainment equipment. This implies a change in the structure of the economy, away from manufacturing toward services. The service sector in Japan is characterized by lower productivity levels than manufacturing, so this shift would have a depressing impact on productivity per worker. Third, this same growth of the 65-and-over age group will create fiscal strains for the government. Some changes have already occurred: increased minimum age for receiving national pension benefits, increased payments into the national pension plan, higher monthly charges for national health insurance, and higher copays for doctor visits. But a fiscal hole is still looming for both the national pension plan and the national health insurance system. Assuming the necessary changes occur, the increased size and burden of these programs are likely to suppress other government spending, since Japanese voters are as resistant to tax increases as their U.S. counterparts. If the government spends less on discretionary programs, the impact on the economy could be negative. The common image of Japan is of a country that overspends on public infrastructure, for example. But the ratio of that spending to GDP has been falling since the late 1990s and is now close to that of the United States. Will fiscal constraints push it even lower? Will the government cut back on government-financed basic scientific research? These questions were already being debated in the political system in 2010. On the plus side, perhaps some of the structural changes of the past decade will eventually produce more positive outcomes. If the financial sector shifts away from heavy reliance on banks toward the bond and stock markets, then perhaps the allocation of financial resources will be more nimble as investors respond quickly to publicly disclosed corporate information. If corporations are held accountable by increasingly observant shareholders, perhaps return on equity and return on assets will rise. If venture capital
21. Japan Statistical Yearbook, Table 28, Population by Age Group and Indices of Age Structure (19352008), and National Institute of Population and Social Security Research, Population Projections for Japan 20012050, Table: Projected Future Population and Proportion by Age Group 20002050, Medium Variant.

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markets finally begin to mature, perhaps there will be more innovative, high-tech start-up firms that will provide new technologies to accelerate productivity growth. If the labor force is more flexible due to the decline in the portion of workers covered by strong job guarantees, then perhaps it will be possible for firms to acquire and shed workers more easily. If further deregulation of the service sector occurs, perhaps productivity growth will accelerate in that sector of the economy. This list of ifs could have been expressed at least a decade ago. So the question going forward is whether the next decade will be substantially different from the last one in terms of implementing real change that helps economic growth and efficiency. Economists and political scientists will have much to analyze in the coming decade. Broader Implications The economic issues outlined here provide an important backdrop for many dimensions of Japanese politics, social behavior, and even literature and the arts. Since the economic impulses affecting society are negative, the social and political outcomes involve some stress. On the other hand, the problems created by the economy provide a rich opportunity for research in political science, sociology, anthropology, and the humanities. The political system has been wrestling with a variety of economic problems for virtually all of the Heisei period, and voters finally became sufficiently dissatisfied with the Liberal Democratic Party to turn it out of power in 2009. But the underlying reality is that the economic problems the politicians are attempting to resolve are very difficult and would be divisive politically in any democracy. Prime Minister Kan Naoto, for example, was correct to say that an increase in the national consumption tax will be necessary (at some point in the future) to fix the fiscal hole, but his timing in making that statement a week before an Upper House election in 2010 was exquisitely bad. The choice between cuts in government services and increases in taxes is proving difficult for many democratic societies, and this political struggle will continue to roil the political scene in Japan for years to come because the shrinking and aging population makes the fiscal problems larger. The political system and broader society must also wrestle with the fundamental question of what to do about the dwindling number of workingage people. Can or should something be done to reverse the trend? One long-term issue is trying to raise the birth rate, whether through subsidies to families with children (introduced in 2010 but facing an uncertain future due to a new mood of budget cutting in 2011) or through some other policies. Keeping more people over the age of 65 in the labor force is another possibility, although Japan already has a higher percentage of such people working than does the United States. Getting a higher percentage of adult

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women into the labor force is another possibility, as is making better use of the skills of educated women in management. Finally, society will face the question of immigration. The number of foreign-born people living in Japan has risen, but Japan continues to have the lowest ratio of foreigners to total population of any of the large advanced economies. All of these issues raising the birth rate, workers over age 65, the role of women in the labor force, and immigrationwill be very difficult. Meanwhile, a number of aspects of social behavior are being affected by economic changes. Increased anxiety and personal financial problems caused by the poor performance of the economy have surely been a factor in the rise in the number of suicides. From 1990 to 2000, the number of suicides increased 50 per cent and then leveled off at around 30,000 per year from 2000 to 2009. Homelessness, an issue small enough that many Japanese could assume it did not exist through the 1980s, became quite visible over the course of the 1990s. The number of grown children living with their parents has also increased. In 1990, 5.0 million households consisted of a married couple with children over the age of 18, a number that increased to 6.2 million by 2005.22 Some of these households represent college students remaining at home, but as that number should be falling due to demographic shifts, some of the increase must represent children out of school. All of these shifts in behavior have complex causes, but the stresses resulting from the underperformance of the economy are almost certainly a contributing factor. In the realm of foreign policy, Japan appeared ready to play a larger role in regional and global affairs by the late 1980s. The government, for example, provided funds to the World Bank at the beginning of the 1990s to study successful economic development in East Asia (with the intent that the study would show that other Asian countries were following the Japanese model, in contrast to the emphasis on markets being pushed by the U.S. government).23 But in recent years, the voice of the Japanese government has been very low key in the global setting. The administration of President George W. Bush made a great deal of the bilateral partnership, and Japan reciprocated by sending naval vessels to the Indian Ocean to support the Afghan operation and by sending a small number of noncombat soldiers to Iraq. But Japans policy voice on both conflicts was virtually zero. The same has been true on global climate change. Prime Minister Hatoyama Yukio made a bold pledge on cutting emissions at the 2009 summit meeting in Copenhagen, but Japanese officials appeared to be completely silent in the
22. Japan Statistical Yearbook, Table 218, Households by Family Type, 19852005, http://www.stat.go.jp/english/data/nenkan/143102.htm (October 20, 2010). 23. Edward J. Lincoln, Japans New Global Role (Washington: Brookings Institution, 1993), p. 143.

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divisive international debate that occurred over what policies might be feasible and acceptable to advanced as well as developing countries. Will slow growth and continuing economic problems at home leave the public and the government more inward looking over the next decade? No one knows the answer, but it is a question worth pondering. Finally, the economy provides a setting for the production and consumption of art and literature. I am not competent to evaluate what is happening, but there are plenty of interesting questions to ask. Has the poor economic performance had an unexpected benefit by leading more talented young people to pursue careers in the arts or literature because the large corporations are not hiring as many new graduates? Do households, constrained by deflation, consume more or less of various forms of entertainment? Expense accounts are down, affecting restaurants and hostess bars, but what about movies, plays, magazines, concerts, and electronic entertainment? And what do people want in their entertainment? Do they want something light or uplifting to relieve the stress of everyday life? Or do they want the arts to explore the social problems and conflicts resulting from a stagnant economy (exemplified by the 2008 film Tokyo Sonata)? Conclusion The Heisei era began on a high note just over two decades ago. Economic performance has been disappointing for most of the subsequent years, and many of the beliefs about business and the economy prevalent in the 1980s have been shattered. Japan today remains an affluent society. After all, while the increase is small, the economy is producing 14 per cent more stuff today per person in Japan than it was in 1990. Households are worse off on average, but they can still enjoy some of that increase in the form of improved public facilities such as subways and sidewalks. The average, of course, masks an uneven distribution of pain and gain. Some people in Japanese societyincluding those who became unemployed or homelessare much worse off than they were two decades ago. Overall, the disappointment is that Japan could have done much better. What the future holds is difficult to predict. The structural reforms since the 1990s could yet unleash a more vibrant economy that expands at or close to its potential growth rate or even raises the potential rate if productivity growth were to accelerate substantially. While that would still mean a very slow-growing GDP, perhaps GDP per person will rise at a rate close to two per cent once again. But there is no guarantee that this optimistic scenario will occur. The economic dynamics of a shrinking and rapidly aging population may prove to be difficult, and the politics could continue to be very divisive. New York University