If you want to see the future of the advanced economies, Japan might be a good place to start. Despite full employment, Japan is showing muted wage pressures, minimal GDP growth, low interest rates and continued high government deficits. How do these seemingly contradictory elements fit together? Are they unique to Japan, or symptoms of a more general malaise?
In Japan, demographics are largely responsible. The country is facing an unprecedented meltdown in population. After peaking in 2010 at 128 million, the country’s population has eased back to 126 million and will continue to decline. Its population is set to shrink by 0.4 percent annually, with the decrease expected to accelerate to 1.0 percent annually by the 2040s. By 2050, Japan will have 23 percent fewer citizens. Not since the great plagues of the Middle Ages have we seen population collapse of this magnitude. Nor does it stop in mid-century. Demographers see current trends persisting to the end of the century, when Japan’s population falls to fifty million, only 40 percent of its all time high.
In the medium term, not all age cohorts are similarly affected. Japan’s sixty-five-plus age group continues to increase, but interestingly, is already almost at steady state. (The seventy-five-plus age group continues to grow until the late 2020s.) Most affected are the fourteen-and-under and the 15–65 age groups, the latter here being treated as the potential labor force. From 2017 to 2050, the fourteen-and-under age cohort is forecast to fall by nearly 40 percent. The workforce (15–65) falls by 34 percent in the same period. Thus, not only is Japan’s population declining, its workforce is declining much faster than the population as a whole.
The loss of workers constrains GDP growth. In essence, the loss of workers offsets productivity gains, such that Japan’s GDP in 2050 will be not materially higher than it is today. Importantly, worker productivity gains are expected to continue at a reasonable pace, about 1.4 percent per year. The average Japanese worker continues to improve his productivity. That’s not the problem. Nevertheless, the number of workers declines by 1.2 percent on average during the forecast period, with greater declines closer to 2050. Working smarter is negated by fewer people working. That’s the problem.
Thus, we should expect GDP in Japan in the coming decades to be stagnant, with periods of gains alternating with periods of retrenchment, and no visible trend in either direction—much as we have seen for the last fifteen years or so. Importantly, a decline in Japan’s GDP cannot be unambiguously interpreted as a cyclical downturn. It is as likely to be a function of demographics. The key number to watch will be GDP / worker, which will tell us more about the health of the Japanese economy than will GDP in aggregate.
Japan does have certain hidden reserves. For example, an increase in senior employment, already high in Japan, would represent a modest hidden reserve of GDP growth. The employment-to-population ratio could also move up a bit, although this too is fairly high by OECD standards. Both these factors might make GDP growth a bit better than forecast, but probably not by much.
Demographics are also a key driver of the national budget. Japan has run hefty national budget deficits for the last quarter century. The country’s working age population peaked in the late 1990s, and has been falling since. With a decline in its workforce, Japan’s GDP growth also declined, and this appears in turn to have led to lower domestic interest rates. At the same time, Japan’s elderly population has been soaring. Given fewer workers, more retirees and lower interest rates, the Japanese government decided to load up on debt as the path of least resistance. This is no surprise given the politics of the advanced democracies.
Japan started to run sizeable deficits in 1995, and does to this day. These cumulated into a national debt exceeding 200 percent of GDP, which will continue to grow until peaking at 225 percent of GDP around 2025 in most the scenarios we examined. To put this in context, the IMF historically considered a debt / GDP ratio of 60 percent to represent the maximum prudent level. Japan blew through this limit twenty years ago and continues to be able to operate. But for how long?
Without the prospect of meaningful GDP growth, Japan cannot count on continued expansion of the economy to fund a reduction in either absolute or relative debt levels.
Our analysis suggests that Japan may nevertheless be able to thread the needle. If real spending per dependent can be held flat in real terms, workers accept ongoing tax rate increases, and no internal or external shocks hit the economy, Japan can muddle through. This would stabilize debt / GDP above 200 percent, but not much less than that.