ECONOMIC SURVEY OF JAPAN(1994-1995) (Provisional Translation)



JULY 25, 1995




Chapter 1
The Japanese Economy: Searching for a Sustainable Recovery
Section 1
State of the Japanese Economy from 1994 to Mid-1995
Section 2
Personal Consumption: A Slow Recovery
Section 3
Fixed Business Investment: The Decline Stops
Section 4
Industrial Production: Mirrorig Economic Activities
Section 5
Improving Corporate Profits
Section 6
Continued "Price Destruction"
Section 7
Peaking Housing Investment
Section 8
Public Investment: Showing Slower Increase
Section 9
Decreasing Current Account Surplus
Section 10
Employment: The Severe Situation Continues
Section 11
Topics: Related to Asset Prices
Section 12
Topics: Related to Financial Issues
Section 13
Current Position and Prospect of the Japanese Economy
Chapter 2
Industrial Adjustment and Supply Side of the Japanese Economy in the Face of he Appreciation of the Yen
Section 1
Price Competitiveness of Japanese Industry
Section 2
Trade Structure Viewed from Equilibrium Exchange Rates by Industry
Section 3
Price Differentials between Japan and the Rest of the World; Productivity in the Nonmanufacturing Sector
Section 4
Catch-up Process of Developing Economies and Industrial Adjustment in Japan
Section 5
"Hollowing out" of Japanese Financial Markets
Section 6
Supply Side of Japanese Industry
Section 7
Technological Gap and Progess in the International Context
Chapter 3
Public Sector Issues
Section 1
Viewpoints on Fiscal Policy under Globalization
Section 2
Population Aging and Fiscal Burdens
Section 3
Employment of Older People and Treatment of Public Sector
Section 4
Role of the Public Sector
Concluding Remarks


The term "market economy connotes an inherent mechanism that serves to accelerate the economy dynamically, repeating the adjustment process in every economic sector. For the past fifty years, Japan's post-war economic development did reflect the dynamism of the economy.

The term also implies that the dynamism of the economy may require the economy to make adjustments in economic frameworks like institutions and customs. The Japanese economy --since 1994 until the middle of 1995, the main focus of this report-- also underwent a variety of adjustments. To best capture these changes in the economy from the viewpoint of this economic dynamism, this report is composed of three chapters, each with viewpoints concerning economic development, adjustment in industries, and role of the public sector.

Chapter 1, "The Japanese Economy: Searching for a Sustainable Recovery" takes up economic issues beginning in 1994 up until mid-1995.

The Japanese economy recovered moderately in 1994 after overcoming the down-side risk seen until 1993 caused by a long period of stock adjustment, worsened balance-sheets, and continued appreciation of the yen.

This moderate recovery has recently paused in 1995. Previously, it had been moving toward a sustainable recovery phase as the Hanshin-Awaji earthquake and the appreciated yen occured under an already-moderate and fragile recovery.

Consequently, this chapter will focus on appraising the current conditions including

  • 1) the influence of unexpected external shocks, such as the appreciated yen, on the economy;
  • 2) the different features compared with the past recoveryphase;
  • 3) appreciation for the "price destruction";
  • 4) adjustment mechanism of the exchange rate on the current account surplus;
  • 5) topics related to financial issues.

Chapter 2, "Industrial Adjustment and Supply Side of the Japanese Economy in the Face of the Appreciation of the Yen," deals with structual changes from a longer-term viewpoint. The Japanese economy has consistently overcome economic difficuties, including two oil crises and the continual appreciation of the yen,until it became one of the world's economic superpowers. In this process Japansucceeded in filling the gap with other advanced countries, and resulted in an increase in purchasing power of the Japanese yen. Generally speaking, the strong yen reflects good economic performance and sophistication in industrial structure. Now the strong yen is functioning to expose the Japanese economy to severeadjustment, while the worldwide "mega-competition" has heightened with the emergence of the dynamic Asian economies. The coming adjustment seems so daunting that it casts a gloomy forecast on the Japanese economy. Chapter 2 analyzes the price competitiveness of the Japanese economy; the trade structure viewed from equilibrium exchange rates by industry; price differentials between Japan and therest of the world; productivity in the nonmanufacturing sector; and the catch-up process of developing economies and industrial adjustment in Japan. It also surveys the supply side of the Japanese economy, including technological development.

Chapter 3, "Public Sector Issues," takes up the problems of gradual changesin the public sector. Although there have been market-based vitalities of the private sector behind the postwar success of the Japanese economy, it should also be remembered that the public sector has played an important role in producinga stable economic environment and thereby giving rise to such vitalities of theprivate sector. Nonetheless, the role of the public sector is again subject tochange. The forces behind this are changes in the domestic and overseas environments, especially the globalization of the Japanese economy and the unprecedentedly rapid aging of the population. Population aging is one of the fruits from the postwar fifty years of the Japanese economy. At the same time, there existssome unknown concerns about the next fifty years: this scale of rapid aging hasnever been experienced. That is, we are concerned about such diminished expectations that the arrival of the aged society might curtail growth henceforth and lead to increased burdens on the next generations as well as to a worsening of their living standards. Keep these points in mind, in Chapter 3 we analyze firstthe problems concerning fiscal policy under globalization. We then look at theaging and fiscal burdens, employment for the elderly, public pensions, and finally the relationships between the public sector and economic growth. We also provide a review of changes in the public sector during the past fifty years. Based on these analyses, future issues of the public sector are discussed.

Chapter 1

The Japanese Economy: Searching for a Sustainable Recovery

Section 1

State of the Japanese Economy from 1994 to Mid-1995

Modest economic recovery is under way after bottoming out in the fourth quarter of 1993. This moderate recovery could be made possible, considering that final demand has stopped decreasing due to the increase in public-sector investment and housing investment.

Owing to the modest recovery in final demand, it can be expected that the economy may move toward a sustainable recovery phase, led by fixed investment in business, which showed three consecutive quarter to quarter increases beginning in the third quarter of 1994.

Its pace, however, is expected to be very moderate because the extent of contribution to the recovery in public-sector investment and housing investment has shrunk; it should take some time for business fixed investment to accelerate its pace.

Under these circumstances, the recovering force toward a sustainable phase has recently paused (since the second quarter of 1995), caused by the appreciated yen.

In order to make the shift to sustainable recovery possible, support for final demand, which has been suffering downside pressure from the Hanshin-Awaji earthquake and the appreciated yen, is needed.

The Influence of the Hanshin-Awaji Earthquake on the Economy

The impact of the earthquake on the economy can be divided into two phases.The first is, from a short-term perspective, the negative impact caused by the decrease in production and personal consumption. Although a number of economic indicators declined temporarily in January, economic activities in the rest of the country have shown moderate growth since February. The second is, from a medium- to long-term perspective, the positive effect on the economy accompanied by the recovery of fallen stock, which was equal to 2% of nominal GDP.

Section 2

Personal Consumption: A Slow Recovery

Comparison with the Past Recovery Phase

The pace of increase in personal consumption has become more moderate than any other past recovery phase, while it showed a similar recovery just after the trough.

Consequently, judging from the ratio of real personal consumption to real GDP contrary expectations, personal consumption could not lead the overall economy.

This moderate recovery can be explained by the slower increase in real income while the propensity to consume remained unchanged.

The Background of the Unchanged Propensity to Consume

Until now, we do not have an economic recovery with an evident increase in the propensity to consume. This is in contrast with other developed countries such as the U.K., Canada and Australia, which have registered economic recovery a long with an increase in propensity to consume.

The reason is that personal consumption in Japan can be easily affected by short-term income and price movements rather than medium-term income expectation. In this sense, the consumer seemes to be cautious toward consumption due to a slower increase in real income and a sluggish movement of asset prices.

The Possibility of Money Illusion

Money illusion, in which real consumption is more affected by nominal income despite the same real income, is a discursive issue during the present phase. Our analysis contends that the extent of money illusion has been smaller. Thisresult can be reconfirmed by the fact that consumers, facing a decline in prices, are willing to feel a future decline in price than a decline in nominal income.

The Linkage between Buoyant Sales in Durable Goods and Overall Consumption

If income constraints existed, there is the posibility that consumers will buy durable goods instead of engaging in other types of consumption. In order to make the growing trend in durable goods contribute to overall consumption, an increase in real income is needed.

Section 3

Fixed Business Investment: The Decline Stops


The fixed business investment, still below the previous year's level, has shown three consecutive quarter-to-quarter increases.

With respect to manufacturing sectors, this phenomenon could be led by the improvement of capacity utilization. Meanwhile, however, the balance-sheet adjustment has not been improved. The improvement in capacity utilization after 1994 can be attributed to the end of the decline in final demand, in addition to the slower increase in capital stock.

Regarding non-manufacturing sectors, although the worsened balance-sheets have had a restrictive impact, a slower decrease in construction and a moderate increase in personal consumption could mainly contribute to the end of the decline.

The Path to the Sustainable Recovery

The expected sustainable recovery phase can be made possible by accelerating the tempo of increase in business investment at a level of capacity utilization of around 90.

In this sense, final demand is expected to play an important role for raising the capacity utilization to 90.

The Impact of Appreciated Yen on Business Investment

The mechanism through which the appreciated yen has a negative impact on investment has two components: a decrease in sales for export and a rise in import penetration.

According to a simple analysis, both ways may reduce the 11% of overall investment for manufacturing sectors.

Estimation of Moderate Business Investment

Current modest movements of fixed business investment should not reflect the structural factor (decline in potential growth rate), but should reflect cyclical factors such as the lower level of utilization and the appreciated yen.

Section 4

Industrial Production: Mirrorig Economic Activities

Comparison with the Past Recovery Phase

Compared with the past recovery phase, the differential of the tempo of increase in industrial production became large after the fourth quarter of the recovery phase; acceleration in the tempo was not observed during the current phase.


The reasons are as follows:

  • 1) the production for consumer goods has remained unchanged due to the modest recovery in personal consumption and the increasein cheaper imports;
  • 2) production for manufactured goods has still not shown acceleration under the influence of moderate business investment.

The pace of increase in real GDP, in contrast, has been more moderate sincethe begining of the recovery. It is due to the fact that non-manufacturing sectors have registered a more sluggish recovery than any other past phase.

Section 5

Improving Corporate Profits

The rate of increase in sales, has remained below any other past phase, reflecting

  • 1) disinflation,
  • 2) decrease in export sales affected by appreciated yen,
  • 3) progress of efficiency among distribution system led by "price destruction."

As for the ratio of profits to sales, the ratio in manufacturing sectors has recently improved more than that in non-manufacturing sectors because restructuring for reducing the fixed cost can overcome the slower increase in sales variable costs can also be reduced by importing cheaper goods.

Regarding the prospects for profit increase, there is the possibility that firms would increase profits accompanied by a slower increase in sales.

This pattern, which was rare during the past recovery phase, seemed to be sustainable in the sense that the tempo of restructuring has outpaced the slower increase in sales. In addition, the real purchase capability of firms is expected to improve against a background of disinflation.

Section 6

Continued "Price Destruction"


Background of Disinflation

It should be noted that disinflation, in which price increases fall off, has occured against the background of two different factors: demand-side and supply-side.

Demand-side factors which are caused by weak demand and were usually observed during past recessions, are likely to introduce a decrease in income or unemployment. On the other hand, supply-side factors, the so-called "price destruction," caused by a rise in productivity or a reduction in cost, are expected to increase real income.

Thus, the government should examine carefully which factors are the main cause of the current disinflation, and try to promote "price destruction," thus avoiding the demand-side oriented disinflation.

Permeation of Price Destruction

Permeation of price destruction can be confirmed by the fact that a declinein the Consumer Price Index (CPI) became evident in 1994 while the "unit purchase price" (which is taken from purchase into expenditures) stopped declining.

It seems to imply that existing distributors are essentially able to reduce the price of goods while maintaining quality.

Sustainability of Price Destruction

Whether price destruction is sustainable or is simply a boom can be tested by the movements of margin (which is taken from sales into sales profits).

The conclusion is that price destruction will probably continue for a long time due to the following reasons.

First, newcomers --so-called discountors-- who have accelerated price destruction can keep their margin by continuing the reduction in costs.

Second, existing distributors such as department stores, facing price destruction, have tried to reduce their margin by improving the efficiencies of the distribution system.

Section 7

Peaking Housing Investment


Prospect of Housing Starts in Apartments

Housing investments have recently begun to show signs of peaking at a high level after having contributed to economic recovery.

As for the housing starts in apartments (so-called "mansions") which have contributed to the buoyant overall housing starts in the latter of half of 1994, the starts in 1995 are expected to peak out under the influence of the stock adjustment.

Piling up of stock in apartments due to buoyant housing investment can be confirmed by the fact that starts in 1994 are beyond the long-term trend estimated by population and number of households.

Role of Housing Investment on Economic Recovery

Housing investments have played in important role in supporting economic recovery through the following mechanisms;

  • 1) buoyant sales of household electrical appliances and furniture brought about by housing investments;
  • 2) promoting personal consumption through the support of income from housing-investment related industries.

In addition, housing investments have contributed to halting the decline in residential land prices between the latter half of 1993 and 1994.

Section 8

Public Investment: Showing Slower Increase

The timing of public investment, in terms of economic cycle, is the same asthe past recovery phase in the sense that it has shown a slower increase since the trough, after having resistered a double-digit increase in 1992 and 1993.

However, in terms of the shift from public demand to private demand --most important element toward sustainability of the economy-- the current period seemes to be simillar to the period after the first oil crisis.

The characteristic feature observed during both periods is that fixed business investment has not accelerated its pace of increase even after public investment has shown a slower increase.

Nevertheless, in contrast with the first oil crisis, the contribution to economic recovery is still expected, implying that public investment may support overall final demand until business investment accelerates its pace of increase.

Section 9

Decreasing Current Account Surplus


Backgroud of the Appreciated Yen

According to the factor analysis, though the cumulative current account surplus is one of the main factors which affects the exchange rate, the appreciation since 1993 could not be explained fully by the above factors.

It would, thus, suggest that the speculation based on treasury deficits in the United States among other factors, has had much influence on the appreciation of the yen.

Characteristic Features of Decreasing Phase

The mechanism of decreasing the current account surplus during the current period is as follows.

  • 1) Nominal exports are not likely to decrease despite the huge appreciationof the yen due to the J-curve effect, to the lesser effect of price on export volume, and to the world economic expansion.
  • 2) Nominal imports have increased, outpacing exports, reflecting the increase in durable-consumer goods that have become more sensitive to price and domstic demand as well as the increase in manufactured goods.

Development of Increase in Export Price

By now, firms are able to apply some effects of the yen appreciation to their export price more easily than the last yen appreciation period because of the worldwide tightened demand.

From the viewpoint of the lesser sensitivity of export price on export volume, the method of decreasing the current surplus by raising export prices is not supported.

Influence of Foreign Direct Investment on Trade Volume

With respect to export volume, durable-consumer goods have decreased considerably since 1993, as the goods produced by foreign direct investment (FDI) havesubstituted for exports from Japan. Meanwhile, an increase in manufactured goods has been induced.

Regarding import volume, consumer goods have continued to increase since 1993, against the background of the integrated economic cooperation with SoutheastAsia.

Section 10

Employment: The Severe Situation Continues


Because the slow economic recovery has been delayed, the employment situation continues to be stark. Overtime hours have increased, mainly in manufacturing in 1994, but improvement in the actual job offers-to-seekers ratio has remained slow since mid-1994. The growth of the number of employees become much more sluggish, as shown in the decline of manufacturing, wholesale and retail trade, and restaurants and bars. The unemployment rate is still high, recording a historical high of 3.2 % in April 1995. In the background of this severe situation, a feeling of overemployment by enterprises still exists. The ratio of enterprises adjusting employment, though in a decreasing trend afterthe fourth quarter, is still high. So far the enterprises have carried out theemployment adjustment while keeping the existing employees. On the other hand, difficulty in finding employment for the new graduates has increased.

Observing wage adjustment, the trend in increasing real wages in the current business cycle remains relatively slow compared to past cycles, and it shows that severe wage adjustment has been carried out in the current cycle.

The employment situation in the current business cycle has been very severe, but it is thought that so far the degree of worsening of the employment situation has not gone beyond that of past recessions. Enterprises and government have made efforts to maintain employment, particularly in the current economic downturn. Maintaining employment by enterprises supported consumption from the income side. Yet it cannot be denied that it has been under personnel expense pressure and a fetter to the recovery of profits. Economic recovery may not be linked to the increase in employees directly, because it is thought that labor-hoarding is enforced by enterprises, and that they can use hoarded labor in the early recover period. It is also thought that the slow improvement of the labor situation has delayed consumption recovery.

Section 11

Topics: Related to Asset Prices


Level of Land Price from a Long-term Perspective

Compared with real asset prices and real GDP, residential land prices outpaced the trend of economic growth between the 1960s and first half of the 1970s. It has not adjusted until now.

In contrast, other asset prices (stock and commercial land prices) were higher only during the "bubble" period and have adjusted to the level of economic growth in line with the burst of the bubble.

The higher land prices observed among residential areas for a long time wasthought to be built into the postwar high growth economy, as one of its infrastructures.

Therefore, the viewpoint that the adjustment of residential land prices should be progressed is one of the structural revolutions for the postwar economy.

Background of Asset Price Fluctuation since Bubble Period

The characteristic feature from the beginning of the bubble period to its burst is that the expectation of a rise in asset prices has diversified the economic growth rate. In other words, the hard-landing scenario was not avoidable during the adjustment phase.

In this sense, the current stagnant development of asset prices can be explained by the fact that the expectation has shrunk excessively below the economic growth rate.

Decline of Return on Equity (ROE)

ROE in Japan has remained below the level of the long-term bond yield since1991. This is exceptional, taking into account that stock holders tend to require more return than long-term bond yield.

These lower levels of ROE seems to reflect that stockholders, the market, and firms have had a tendency to appreciate the ammount of profits led by the increase in new equity instead of the productivity of existing equity.

Section 12

Topics: Related to Financial Issues

Background of Year-to-year Decline in Lending

Total lending by city banks, long-term credit banks, trust banks, regional banks and regional banks・ has remained weak, showing a year-to-year decline from June 1994 to April 1995.


This reflects attemps by firms, particularly large firms from the manufacturing sector, to continue repaying their debts against the background that cashflow improves with an increase in profits, while fixed business imvestment remains stagnant.

In the context of prospects for outstanding bank loans, it is likely to show a slower increase in the case of continuing repayment.

Expanding Derivatives

Expanding derivatives can be recognized as a typical financial device by whichthe risk related to financial transactions should be allocated efficiently.

That is, derivatives can satisfy the various needs for taking risk among investors that has been expanding in line with the increase in financial transactions.

Derivatives, however, do not oblige more excessive risk-taking on investorsthan any other financial device. In fact, the huge loss related to derivatives observed recently is attributable to the lack of risk management. With respect to the impact of derivatives on bank management, the share of profit relating to derivatives to total profits has risen considerably beyond the half in major U.S. banks.

Comparing the Japanese financial market and other major markets by the share of volume, the share of derivatives in Japan to total transactions is relatively samaller than that of on-balance transactions such as securities, impling theposibility for derivatives to expand in the near future.

Section 13

Current Position and Prospect of the Japanese Economy

Moderate economic recovery is under way after bottoming out in the fourth quarter of 1993, led by the increase in public-sector investment and housing investment.


However, this moderate economic recovery has paused since the second quarter of 1995 under the influence of the following factors.

First, the extent of contribution to the recovery in public-sector investment and housing investment, which had been the main driving forces, has become smaller.

Second, it seems to take some time for fixed business investment --which is expected to be the next driving force-- to accelerate its pace of increase.

According to the above two factors, it is easily recognized that the shift in bringing moderate economic recovery toward sustainable recovery has been not easy.

Third, under these circumstances, the appreciation of the yen and the slowdown in U.S. economy has given pause to the economic recovery. As for the prospect of fixed business investments --which is expected to bethe next driving force, followed by public-sector and housing investment-- the pace of increase is likely to be more moderate and to take more time than any other past recovery phase.

The reasons are as follows:

  • 1) The delay both in the balance-sheet adjustment and in stock adjustment for construction has untill now restricted business investment.
  • 2) Permeation of "price destruction" is likely to have a restrictive impacton business investment for non-manufacturing sectors through the slower increase in profits brought about by the reduction in margins.
  • 3) The huge appreciation of the yen since March 1995 seems to have restricted business investment by the decrease in sales or lesser improvement in corporate confidence.


From the viewpoint of the difficulty of changing driving forces, the current period seems to be simillar to that after the first oil crisis in that the fixed business investment has not accelerated its pace in increase even after public investment has shown a slower increase.

Although the economic recovery after the first oil crisis failed to move toward sustainable recovery, it should be noted that there are evidently different features in the current period compared with the first oil crisis.

First, the potential growth rate is not likely to decline. Second, advantages of the appreciated yen (such as the increase in real income) are expected. Third, housing investment, having shown to have peaked, is not likely to decrease considerably. Fourth, public-sector investment, having shown a slower increase, is expected to continue to contribute to the recovery due to the Emergency Ecomomic Measures implemented in April 1995. Finally, the effect of monetary easing on the economy is also expected.

Based on the above circumstances, taking into account that economic recovery has paused, fostering the currently observable favorable trends and making efforts of appropriate and flexible economic management including the steady implementation of the Emergency Ecomomic Measures (April and June) will allow us to bring the economy toward a sustainable recovery phase.

Chapter 2

Industrial Adjustment and Supply Side of the Japanese Economy in the Face of the Appreciation of the Yen

Section 1

Price Competitiveness of Japanese Industry Japan-US Comparison in Unit Total Costs

Assuming that changes in unit total costs reflect price competitiveness, unit total costs (costs per each unit of value added, the sum of unit intermediateinput costs, unit labor costs and unit capital costs, hereafter UTC) in the manufacturing industry were compared between Japan and the USA. Dollar-based UTC of Japanese manufacturers rose much more rapidly than those of the US when the Japanese yen appreciated in 1986~88 and in 1991~93. When cost performance on a home-currency basis is viewed from price factors (intermediate input prices plus wages) as well as from productivity factors (labor productivity minus intermediate input per unit output), Japanese manufacturers performed better than US manufacturers in both factors. In particular, a decline in unit intermediate input cost contributed to lowering UTC significantly.

Intermediate Input Cost Structure of the Manufacturing Sector

Between 1985 and 1990, a price decline in input from the manufacturing sector contributed to the drop in intermediate input costs more than that from the nonmanufacturing sector. The latter contributed to the decrease in intermediatedinput costs much less than the former in terms of price and productivity. The shares in input value from the nonmanufacturing sector in theintermediate input structure of the manufacturing industry in both Japan and the US has been growing, and the pace is quicker in Japan. The share of services in Japan has been expanding especially rapidly. The output deflator in the nonmanufacturing sector has been on an upward trend, while that in the manufacturingsector has been declining.

Section 2

Trade Structure Viewed from Equilibrium Exchange Rates by Industry


Equilibrium Exchange Rates by Industry

Equilibrium exchange rates (hereafter EER) are calculated at the point which the theory of purchasing power parity would be satisfied for goods in seven manufacturing industries between the United States and Japan.

First, an appreciating trend in actual exchange rates reflects an appreciating trend in average EER (EER for industries as a whole). Second, leading industries with high productivity growth (primary metals in the 70s and electrical machinery since the 80s) improved their export competitiveness and led average EERto further appreciation. Third, the yen was cheaper than average EER until the80s. In the 90s, the yen actually appreciated much more rapidly than EER, so the gap between those two rates has widened. Fourth, a yen-dollar rate of \80-90/US$ level is higher than EER in almost all industries, which now confront a severe situation.

Price and Productivity in the United States, Japan and Germany

Price basically moves in parallel with unit labor costs (hereafter ULC); there is a negative correlation between price increase and productivity improvement. It is noteworthy that only in Germany prices in the nonmanufacturing sector grow more slowly than those in the manufacturing sector and only in Japan pricesin the manufacturing sector decline. These phenomena are attributable to productivity performance: in Germany ULC in the nonmanufacturing sector grow more slowly than the manufacturing sector, mainly reflecting higher productivity growth in the former. Productivity growth in the Japanese manufacturing sector is the highest among these three countries; the productivity gap among industries in theJapanese manufacturing sector is wider than that in Germany and in the United States.

Export Prices and Domestic Prices

The discrepancy in export and manufacturing prices is wider in Japan than in Germany. This reflects different price-setting patterns in some industries.

Section 3

Price Differentials between Japan and the Rest of the World; Productivity in the Nonmanufacturing Sector

Factor Analysis of International Price Differentials

Price differentials between Japan and the United States (hearafter, PD) have been expanding rapidly in line with the rapid appreciation of the yen. In calculating PD using the GDP deflator, exchange rate overshoot contributes to approximately 40% of the total PD level in 1993, while the remaining 60% is attributable to a difference in the intersectorial (manufacturing and nonmanufacturing) price gap (hereafter IPG) between Japan and the United States. Moreover, approximately 80% of PD level is caused by IPG on the Japanese side, which is attributable to higher productivity growth in the manufacturing sector than in the nonmanufacturing sector. Exchange rate overshoot contributes almost exclusively to a drastic expansion in PD since 1985.

Productivity and Efficiency in the Nonmanufacturing Sector

Levels of labor productivity in various Japanese nonmanufacturing industries still remain lower than the those of the US, although the former have been approaching the latter. In particular, the level in transportation and communication industries is much lower. Growth in labor productivity iscaused by growth in the capital labor ratio and in total factor productivity (efficiency in activities in a wide sense). In Japan, the contribution of capitallabor ratio is relatively large, and most nonmanufacturing industries are less efficient than those in the US.

How to Rectify Price Diffentials between Japan and the Rest of the World

PD reflects lower productivity growth in the nonmanufacturing sector in an international comparison. When productivity growth in the nonmanufacturing sector could be enhanced, increases in both real income and reduction in PD would berealized. Therefore, competition should be encouraged in the nonmanufactuing sector through deregulation.

Section 4

Catch-up Process of Developing Economies and Industrial Adjustment in Japan


A "hollowing out" arises from a shrinkage of the manufacturing sector as aresult of a decline in exports due to a strong yen, a substitution of imports for domestic production, and a substition of foreign investment for domestic investment. In Japan, the share of the manufacturing industry hasn't declined much in terms of both nominal and real value added as well as employment.

Increase in Imports and Domestic Output and Employment

The impact of imports on domestic output has been growing, as imports rise more rapidly than domestic output in most products and import penetration ratio has been rising. Imports of lower value have increased remarkably. These factsmean a greater sophistication in the industrial structure as a result of international product differentiation, and this process seems to continue further. Those industries with less comparative advantage are forced to experience a slowdown in growth or a decline in employment, when import penetration in those industries is rising.

Foreign Direct Investment and Trade

Foreign Direct Investment (hereafter FDI) by Japanese manufacturers in Asiahas been growing since the latter half of the 1980s. In particular, FDI by parts suppliers, which target the Asian market, has been increasing. FDI induces both exports and imports; when the appreciation of the yen induces FDI, FDI induces exports, and it should to some extent offset a decline in exports (caused by the appreciation of the yen).

FDI and Domestic Investment

There seems to be a substitutional relationship between domestic and foreign investments in a cross-sectional regression, supposing that other things (e.g.savings ratio) are equal. In fact, a positive relationship is found based on Japanese time-series data, which means "other things are not equal." After all, no clear relationship can be found between domestic and foreign investment, and a possible degree of substitution depends on methods of financing.

Trade and Wages in the Manufacturing Industry

Wage growth has dropped in those industries whose export ratio to output has declined. Those industries whose competitiveness is declining face a rise in import penetration and lowered relative wages.

The mechanism of factor-price equalization is assumed to be incomplete in Japan. The deterioration in export competitive strength of Japanese manufacturers mainly results from the appreciation of the yen, and it is not true that Japanese real wages have declined because of worsened terms of trade caused by an improvement in productivity in developing countries.

Section 5

"Hollowing out" of Japanese Financial Markets

Depending on the definition of "hollowing out" of financial markets, the analysis may have a wide variety of scopes.

In this report, hollowing out, like the case of hollowing out in the manufacturing industry, is defined as the phenomenon in which the financial transactions made by Japanese investors are carried out abroad for whatever reasons.

Thus, based on this definition, estimating the hollowing out would depend on whether the share of transactions by Japanese investors to total Japanese market declines or not, excluding the "setback of financial globalization" in which foreign investors reduce transactions in Japanese markets or withdraw their branches from Japan.

According to the two analyses,

  • 1) comparing the domestic financial transactions and the volume of the economy, and
  • 2) analyzing the six illustrations recognized as the typical hollowing out, it is not likely that the hollowing out has prevailed in the sense that domestic investors are pulling cut and going abroad.

This result, however, should not imply that Japanese financial markets are already attractive and competitive, as "setback of financial globalization" has been brought about against the background of the structural factors such as high transaction costs or tightened regulations.

Therefore, efforts to make the market more attractive and competetive are needed.

Section 6

Supply Side of Japanese Industry

Comparative Advantage Structure of Japanese Industry

Comparative advantages in Japanese industry are shifting from materials industries to processing and assembly ones, and from final consumer goods to capital/intermediate goods. Human capital and technological development contribute to those comparative advantages.

Sources of Economic Growth

Capital stock growth has been a big contributor to economic growth, while growth in total factor productivity (TFP:product efficiency) has contributed morethan capital stock growth since the second oil crisis. The growth rates in TFPare positively related to those in knowledge capital stock as well as the social capital stock for the industrial infrastructure such as transportation and communication. Average scholastic ability in Japanese labor force is rather high, and makes acquirement and application of industrial technologyeasier. Capital equipment of Japanese industry is newer than that of other major industrial countries. Accordingly, Japanese production factors are still considered to be advantageous.

Section 7

Tehnological Gap and Progess in the International Context

Japan spends a fair amount on R & D, carries out excellent research and is expanding technology exports. Still there is a technological gap between Japan and the United States and the countries of Europe. At the same time, the developing Asian economies have been approaching Japan in technolgical development very rapidly.

Pressure from Remarkable Technological Development in Dynamic Asian Economies It seems unlikely that the Asian NIEs will surpass Japanese technology verysoon, considering an existing industry-wide technological gap, lack of reseachers or engineers, and dependence on Japan for capital goods. On the other hand, high-tech industries in the Asian NIEs have been progressing very rapidly: high-tech exports have increased and their share in the world market has expanded, so that they have already come to surpass Japan in some high-tech areas. Highly educated human capital in the Asian NIEs and technological transfer from multinational enterprises of advanced countries contribute to this development. Therefore, the technological gap between Japan and Asian NIEs is likely to be reduced very rapidly.

Technological Competition with Advanced Countries

In the semiconductor market, the United States and Japan occupy an overwhelming share; the US holds a huge market share in high value added products (e.g. MPU and MCU), while Japan excels in hardware-technology and supplies indispensable electronic parts all over the world. Japan imports more technology than it exports; it shows net imports from America and Europe and net exports to Asia. Imports of high-technology, especially in software, have been expanding rapidly. It is difficult for Japanese manufacturers to enter the information technology market, since the US companies have led in this area for a long time, so their standard has become the de facto international one.

Production Shift to Abroad and Research and Development

As overseas production has increased, overseas research and development activities have grown, albeit to a small extent. For the time being, most Japananese manufacturers are planning to keep basic and essential research at home, although those technological development activities which are closely related to theproduction process are likely to be carried out overseas in accordance with production shifts abroad. Technology competition will become keener and keener. Japan should fully utilize its existing R&D ability, human capital and excellent hardware-technology. Moreover, it is product innovation in high-technology industries --and basic research as its essential precondition-- that are gaining importance.

Chapter 3

Public Sector Issues

Section 1

Viewpoints on Fiscal Policy under Globalization

1 Progress in Globalization and Effectiveness of Fiscal Policy

Progress in globalization in financial and capital markets would allegedly lead to a closer parallel movement of domestic and overseas interest rates. In such a case, an expansion of fiscal deficits might work toward higher long-term rates by slackening bond markets and lead to an appreciation of exchange rates by inviting capital inflow, thereby resulting in a reduction of the effectiveness of fiscal expansion on domestic demand. To examine this hypothesis, we estimated long-term interest rate functions. Although the impact of the U.S. rate on the domestic rate has been vaguely observed for the period since 1985, it almost disappears for the subperiod since 1990.

Furthermore, we tested causalities among some variables, including domesticand overseas interest rates, fiscal balances, and exchange rates. The result shows that no causality is detected from fiscal balances to exchange rates for the period since 1985.

Hence, we can conclude that the recent globalization has not weakened the effectiveness of fiscal policy.

2 Relationship between Savings/Investment and Taxation

There appears to be a trend of "international tax competition," in which many countries have abolished withholding taxes on interest earnings by nonresidents. However, this will lead to a loss of revenues from investment income while keeping the world aggregate savings constant, which implies a heavier tax burdenon labor income, which is hazardous for labor supply given the ongoing world-wide aging.

Section 2

Population Aging and Fiscal Burdens

1 Pessimistic Versus Optimistic Views around Population Aging

Economic problems caused by population aging can be summarized as the following two concerns: an increase in "burden for support" and a slowdown of economic growth.

To examine the concerns regarding "burden for support," we calculated an "augmented productive population ratio" defined as a ratio between "productive polulation" weighted by earning ability and "total population" weighted by consumption needs. It suggests that a 0.4% higher annual growth rate of productivity over the growth of consumption needs is required to maintain the ratio at the current level in 2015. Whether this can be realized or not is key in distinguishing optimistic views from pessimistic ones.

2 Impacts on Macroeconomy

It is well known from international cross-section analyses that negative correlations are observed between growth rates of labor force and rates of technological progress. This implies that the "labor-economizing effects" outweigh the"loss-of-scale-economy effects," both of which are possible relations between the two rates. In this section, we examined the growth rate of total factor productivity (a proxy for technological progress) by the growth rate of labor force using data from eleven industrial countries. The result can be read as a 1% reduction in the latter corresponds to an approximately 0.1% increase in the former.

Trends of future economic growth necessarily have a variety of possible scenarios. However, in an analysis including the above-mentioned scenarios, impacts of population aging on economic growth, if they are solely extracted, are not necessarily pessimistic.

3 Impacts on Public Finance

Relationship between Aging and Fiscal Expenditures

International cross-section data from industrial countries show that countries with elderly populations tend to have higher ratios of social protection expenditures to GDP.

However, a 1% increase in the ratio of population aged 65 and over corresponds to a 2% increase in the ratio of "total social protection expenditures" to GDP. This phenomenon stems from the fact that a 1% increase in the ratio of agedpopulation also corresponds to a 1% increase in the ratio of "expenditures for the non-aged" to GDP.

In addition, such relationships have become weaker. That is, there appearsa more conspicuous divergence between countries having contained fiscal expenditures and those not.

Therefore, "expenditures for the non-aged" will be determined as a result of choice to a large extent, depending on how expenditures for the non-aged wouldbe tackled or how the national preference on the scale of government would change.

Intergenerational Redistribution of Income and "Invisible Government Debt"

Generational accounting is a method in which benefits from government and burdens for it are chronologically allocated to each generation and its discounted present value of the lifetime net benefits is estimated. Our calculation under the assumption of unchanged benefits/burdens structure, a 3% growth of GDP perhousehold and a 5% interest rate, shows that the current generations aged under50 would incur excess burdens while those aged 50 and over would enjoy excess benefits.

Based on this calculation, fiscal deficits would exceed 8% of GDP by 2040 and the present value of the sum of future deficits or "invisible government debt" would be 1,200 trillion yen. This, in conjunction with the current governmentnet financial debt, entails additional burdens of 13 million yen per household on future generations.

Section 3

Employment of Older People and Treatment of Public Sector

Employment Behavior of Older People

One of the features of employment of older people in Japan is a strong desire to work. As for the reason behind this desire, the ratio of workers who workfor economic reasons is the highest. But this has fallen a little; the ratio of workers who work for health reasons and for reasons of participating in society have had a tendency to rise.

Looking at the relation the surroundings of elderly people with the employment rate of them, first, health condition is important factor. Regarding economic factors, necessity of maintaining a living is important. From the point of view of systems of enterprises, the existence of systems of promoting continuous employment --for example, no mandatory retirement system or extension of mandatory retirement-- raises the employment rate. Income from pension is an especially important factor, moving the employment rate as well as age. This is because pension income takes away from the necessity to work for economic reasons and because the amount of pension has been reduced; older workers have gained wages over settled income from the pension system until November 1994.

Another feature of the employment of older workers is the varied various work style. Looking at the factors which effect the choice of work style, first, people choose part-time work and retirement more often than normal (full time) work for supplementing pension income. Next, regarding the choice of part-time work or retirement, health condition is important, as is age, and the existence of sufficient savings has a large effect. An increase in pension income enhances the tendency for elderly workers to desire part-time work and retirement, but many cannot avoid employment.

Actual Conditions and Background of Employment of the Elderly

Actually, the employment environment is severe, and elderly peoples' hope --strong desire to work and choice of various working styles-- cannot always be realized. Most enterprises tend to prefer young workers to old.

Future Outlook and Demanded Measures to the Employment of the Elderly

Basic recognition of the employment of the elderly is that it is important that to the people who have a desire to work. Obstacles in employment systems must be overcome and various employment environments must be secured, given that freedom cannot be deprived in retirement. In that case, the employment system should be improved one, which has not supposed a society composed largely of elderly people.

The Japanese population structure has been rapidly shifting from a pyramid shape to a non-pyramid shape by the falling birthrate and the extension of average life span. On the other hand, the Japanese employment system so far has beenbased on a population structure of the pyramid type and was formed with the liftime employment practice and the steepness in the wage profile curve. The system has made narrow the employment opportunities of elderly people by using a mandatory retirement system and an early retirement system. From the wage profile, steepness in wage changes to a decrease after age 50 in total work-year groups compared to that of working years after adjustment. It showsthat the elderly are excluded from long-term employment as a seniority wage system. In the future, by increasing in the number of older workers, it is expected that the wage profile will gradually flatten. If it dose, the damage by job turnover will become small, so a menu of choice of employment will extend. Also,regarding employment practice, it is necessary that today's systems --which arenot neutral about job turnover-- be reappraised, maintaining the systems' merits such as the practical use of middle-aged and older peoples in enterprises. Inaddition, it is hoped that the surroundings for older workers will be adjusted, including securing various employment opportunities and reducing work hours.

On the other hand, it is necessary for the elderly to make efforts to accumulate capital stock enterprises, considering the occupations needed by enterprises.

As for the various systems related to employment of older people, several laws were revised for promoting a strong desire to work. By the revision of these systems, labor force participation among older people is expected to rise. Asa result, it will contribute to proper economic growth and to the balance of finances of public pensions.

Section 4

Role of the Public Sector

1 Public Sector in Japan: Postwar Fifty Years

The scale of the public sector in Japan in comparison with its national economy significantly expanded during the 1970s. The administrative and fiscal reforms since then have been only enough to contain the expansion; not enough to make the public sector smaller.

However, there is another aspect of the government expenditures (the ratio to GDP) in Japan: they are smaller than those in other industrial countries. Also their compositions are characterized by higher investment and lower consumption.

Evaluating the public sector also requires focusing on the following points in addition to the scale of government expenditures.

The first point is whether the government is "potentially large," with a consideration of a further increase in population aging.

The second point is whether the government is "functionally large," with a consideration of the existence of quasi-public sectors and public regulations.

By defining regulated fields as those with any pertinent legislations, we obtained the result that 42% of GDP was regulated to a certain degree in 1990. On the other hand, most of those regulations have existed since1965; few have been legislated since then. Hence, to the extent of their coverage over industrial categories, public regulations still broadly remain. However, during this period, an increase in the share (measured by its added value) ofthe service sector which has many regulated subsectors has been outpaced by increases in the shares of the regulated parts of the manufacturing sector, and so on, thereby resulting in a slight fall in the shares of the regulated fields of GDP (from 48% in 1965 to 42% in 1990).

2 Long-term Relationship between Public Sector and Macroeconomy

Scale of Government and Economic Growth

Government expenditures can be characterized by a heavier weight in services compared with private expenditures, efficiency problems due to lack of market competition, and distortions on the supply side while raising revenues.

With international cross-section data for industrial countries, a negative correlation is observed between the ratio of government consumption to GDP and the rate of economic growth.

Furthermore, a negative correlation is also observed between the ratio of income tax revenues to GDP and economic growth.

Scale of Government and Real Exchange Rate

Expansion of government expenditures will possibly lead to an appreciation of the real exchange rate through increased demand for domestic goods or higher unit labor costs. With pooled data for industrial countries, we obtained the result that heavier burdens of direct taxation on households imply higher relative unit labor costs.

Public Regulations and Economic Growth

According to international cross-section data for industrial countries, lower prices (compared with overseas prices) of capital goods imply higher economicgrowth. Although international relative prices are not necessarily determined by public regulations only, deregulation will have favorable impacts on economicgrowth by stimulating investment if it leads to a removal of distortions in themarket of capital goods and therfore a reduction in the prices in those goods.

Postponement of Burdens and Economic Welfare

When we distribute burdens of taxation intertemporally, flatter tax rates produce smaller distortions. Under the assumption of the "status quo case" of "Welfare Vision for the twenty-first Century" (Ministry of Health and Welfare) anda repayment of net debt by 2040, the relative loss of the present value of welfare in the case of the pay-as-you-go financing plan is approximately 1% to the case of constant tax rates.

Concluding Remarks

Finally, to conclude this report, we will repeat the problems that the Japanese economy faces, and review the above discussion.

1 Prospects for Sustainable Recovery

First, we considered the issue "How is sustainable recovery realized?" and "How can we do it?"

From the analysis, it could be recognized that changing the driving forces to bring about moderate economic recovery toward sustainable recovery has not been easy.

In other words, while the extent of contribution to the recovery in public-sector investment and housing investment, which have been the main driving forces, has become smaller, fixed business investment and personal consumption,expected to be the next driving forces, have not yet accelerated their pace.

With respect to personal consumption, the pace of increase has been moderate, except for the buoyant increase in the middle of 1994 caused by the income tax reduction. This moderate recovery can be explained by the slower increase in real income while consumer propensity remained unchanged. The slower increase in income would reflect the continuing severity among the labor market conditions despite increased overtime hours.

Fixed business investment is still below the previous year's level, and hasshown quarter-to-quarter increases due to the improvement in capacity utilization. The characteristic features observed during the current recovery period arethat the lagging effect of the bubble (decline in asset prices and stock adjustment in construction) and existing structural changes such as "disinflation" would result in

  • 1) weaker investment than that forcasted by machine orders,
  • 2) less-rapid investment by smaller manufacturers, and
  • 3) weak recovery in non-manufacturing sectors.

Despite the appreciation of the yen since March 1995, which was forcasted to have restricted investment, a cyclical driving force --which will accelerate its pace at the level of capacity utilization of around 90-- can be expected.

As for "price destruction," it can be recognized as the phenomenon in whichmore competition in the distribution system would compel the exsisting distributors to return the profits derived from the appreciated yen to consumersand manufacturers to reduce their margins. In the sense that price destruction is expected to induce a further rise in productivity in the medium-run and to be sustainable, it should be appreciated positively and be promoted, easing short-term negative costs like bankruptcies in lower-productivity industries.

Concerned about the adjustment in the current account surplus, we considered various issues in this report.

First, the huge appreciation of the yen against the US dollar seems to be overshooting from a viewpoint of fundamentals. This appreciation was brought about by speculation relating to the US in addition to the increased current account surplus in Japan. Therefore, the key currency needs to return to accoutability.

Second, in order to further the adjustment in the current account surplus, both measures --exerting the adjustment mechanism of the exchange rate and stimulating domestic demand-- are needed in stead of setting the target level of the current surplus.

Finally, as for the prospects for the current surplus, a moderate decrease mainly led by outpacing increases in imports can be expected. The adjustment mechanism of the exchange rate is now appearing and the efforts to stimulate demand are being carried out by implementing the Emergency Ecomomic Measures (April and June).

From the viewpoint of the difficulty of changing driving forces to bring the economy toward sustainable recovery, future developments of fixed business investment must be examined carefully; whether or not sustainable recovery is realized depends on when and how business investment accelerates its pace of increase. The current period seems to be similar to that after the first oil crisis in that fixed business investment has not accelerated its pace of increase even after public investment has shown a slower increase.

Although the economic recovery after the first oil crisis failed to move toward sustainable recovery, it should be noted that there are evidently diffetent features in the current period compared with the first oil crisis.

First, the potential growth rate is not likely to decline. Second, the merits of the appreciated yen --such as the increase in real income-- are expected.Third, housing investment, having peaked, is not likely to decrease considerably. Fourth, public-sector investment, having shown a slower increase, is expected to continue to contribute to the recovery due to the Emergency Ecomomic Measures implemented in April. Finally, the effect of monetary easing on the economy is also expected.

Based on the above circumstances, taking into account the fact that economic recovery has, fostering the currently observable favorable trends and making efforts toward appropriate and flexible economic management --including the steady implementation of the Emergency Ecomomic Measures (April and June)-- will allow us to bring the economy toward a sustainable recovery phase.

2 Industrial Adjustment and Supply Side of the Japanese Economy in the Face of the Appreciation of the Yen

The next subjects are whether the Japanese trade and industrial structures will still keep their dynamism and whether the supply side satisfies the requirements for revival of the dynamism.

Strong Yen is Equivalent to Strength of the Japanese Economy

The Japanese economy overcame the adverse effects of the appreciation of the yen by enhancing productivity of tradable goods. Conversely, the remarkable productivity growth caused the appreciation of the yen. The strong yen reflects the rising purchasing power parity of tradable goods and enables the Japanese people to enjoy the merits of free trade.

The appreciation of the yen occurs in line with changes in comparative advantages. When the productivity gap between industries is very wide, impacts resulting from industrial adjustment are quite diverse: industries whose productivity rise is very slow are conspicuously forced to operate at a disadvantage, when further productivity growth of industries with high productivity growth induces further appreciation of the yen. Those costs related to industrial adjustment should be considered as frictional costs which arise from a process of the sophistication of the industrial structure, and they are compensated by the merits of free trade when the Japanese economy succeeded in adjusting itself to changing advantageous conditions.

Misalignment of Exchange Rates and Difficulty in Industrial Adjustment

Exchange rates in the real world often deviate from the equilibrium level (misalignment of exchange rates). When exchange rates appreciate, deviating fromthe equilibrium level, industries lose competitiveness and are forced to confront an adjustment process. The Japanese economy was not damaged by the misalignment of exchange rates as much as it was in the past, since the period when the level of exchange rates was higher than equilibrium level didn't last very long; exchange rates worked effectively in adjusting current account balances, and sometimes depreciated before they appreciated; an industrial adjustment with changes in comparative advantages took place smoothly.

At present, when the yen is trading at 80 to the dollar, few tradable-goodsindustries are competitive with the existing cost structure. This unusual situation is possible in light of a difference in adjustment speed between the goodsand capital markets: price adjustment takes relatively long in the goods market, while prices in the capital market change instantly. However, it would be unrealistic to think that this situation can remain for long. Whether the industial structure changes are based upon comparative advantage principle or not depends on the speed of exchange rates in balancing the current account and on price-wage flexibility. First, changes in exchange rates seem to work effectively in reducing the current account surplus through an rapid expansion of imports due tothe strong yen, so that pressure toward additional appreciation is expected to be smaller. Secondly, price-wage flexibility should be promoted by reorganizingthe industrial structure and deregulation. Moreover, merits of the strong yen should be spread more quickly to lower prices; the market mechanism in production-factor prices should function well.

How to Face the "Hollowing Out" Problem

The "hollowing out" of an industry is interpreted in various ways. In terms of a reduction of the manufacturing sector, for example, the share of the manufacturing sector in real terms has been modestly increasing in Japan, while the nominal share has dropped a little, because the nominal value of the manufacturing sector has been growing more slowly than the nonmanufacturing sector, reflecting higher productivity growth in the former. Another phenomenon of "hollowing out," a drastic reduction in trade surplus or manifestation of a trade deficit, is not found in Japan. Domestic investment is possibly replaced with foreign direct investment when other things are equal. The degree of replacement depends on the financing methods of foreign direct investment or on domestic demand. A steady growth in imports results in increased import penetration and in growing impact on domestic output, which reflects the process of the sophistication of the industrial structure. Foreign direct investment and trade promote each other. Where actual exchange rates are moving close to the equilibrium level, productivity growth in developing economies is likely to improve terms of trade and to raise real wages in developed countries.

Despite all those analyses, there are many problems to be concerned about in the adjustment process in the face of the appreciation of the yen. The employment situation is severe and further employment and wage adjustment is being carried out. Dynamism in the market economy brings about industrial and employmentadjustment, and such adjustment should be accepted when exchange rates are around the equilibrium level. On the other hand, with a big misalignment of exchange rates, production shifts abroad are likely to accelerate, which makes industrial and employment adjustment more serious. In fact, a recent acceleration of production shifts abroad in the face of the rapid appreciation of the yen causes afear of adverse effects on domestic production and employment. Therefore, elimination of misalignment of exchange rates is an important policy target.

Activation of Nontradable Industries

How can adjustment costs and the possibility of hollowing out be minimized?Some hints are found in the contrasting cases of the United States and Germany in productivity growth in the non-manufacturing sector. Although Germany has experienced continuous appreciation of the Deutschemark, "price differentials between Germany and the rest of the world" don't seem to be perceived as a big economic problem. One of the reasons lies in the higher productivity growth in the nonmanufacturing sector. On the contrary, productivity in the non-manufacturingsector in the United States grew very slowly in early 80s, when the US dollar appreciated, deviating from its equilibrium level, and growth in real wages in the United States remained low. From these facts we learned that to utilize the merits of a strong yen it's necessary to raise productivity in nontradable sectors which can more enjoy the merits of a strong yen. Promotion of competition in nontradable sectors is needed; this would give birth to new industries such as information & communication, medical, health care, housing and leisure, and it would lead to a reduction of the price gaps and to an increase in real wages.

At present, the Japanese economy is placed in a painful adjustment process in the face of the appreciation of the yen and more intense competition. There are two alternatives: to neglect structural reforms to avoid pain, and to carry out reforms with the recognition that those adjustment costs are inevitable for sustainable growth. Shortsighted-policy making --just nursing the pains of the hour-- would do harm in the long run; there would be no future for Japan with closed policies such as restricting imports, exports, foreign direct and domestic investment. In addition, as the supply side of the Japanese economy doesn't weaken, it's possible to reduce adjustment costs in a plus-sum world, which would result from productivity growth with these advantages in the supply side.

Longer-Run Prospects

As analyzed so far, misalignment of exchange rates and discrepancy between wages and productivity provide a background of deterioration of competitive power, price differentials, and a hollowing out in the face of the appreciation of the yen. To minimize adjustment costs, it's necessary to activate nontradable sectors; structural problems can be solved by strengthening the existing supply side. It is important to adjust the Japanese economic system and structure to exchange rates; we shouldn't cry over exchange rate movements. It is necessary to accept and make the most of the merits of a strong yen.

3 The Future Public Sector: What Kind of Changes Are Called for

The third issue for the Japanese economy in addition to "cyclical position"and "structural adjustment" is the response of the public sector undergoing changes in the domestic and overseas environments, including globalization and aging, and the problems of employment for the elderly. Specifically, the main themes here are: "Has the effectiveness of fiscal policy under globalization been declining?", "What are the conditions under which no dynamism is lost by aging?" and "What kind of changes are called for the public sector hereafter?"

Role of Fiscal Policy from Viewpoint of Stabilization and Efficiency

Stabilization and efficiency are two important objectives of economic policy, where fiscal policy plays a significant role. For the effectiveness of fiscal policy as stabilization policy, it would be allegedly curtailed if globalization induces higher mobility of capital flow. However, the analyses in this report have not concluded such a claim. Thus, we can concluded that the effectiveness of fiscal policy as controlling measures for effective demand has not been weekened.

From the viewpoint of the efficiency of resource allocation, the issue is whether taxation produces negative impacts on investment and international competition. In this regard, attention must be paid to avoiding distortions from taxation on resource allocation for investment. It's necessary that inefficient international competition on taxation be avoided; instead, international cooperation must be pursued, in consideration of globalization and worldwide aging.

Increase in Productivity and Labor-augmenting Technological Progress

One of the pessimistic views around an aging society is the concern about higher "burdens for support" and stagnant "economic growth." The former, higher "burdens for support" implies lower per-capita consumption in the future. The analysis in Chapter 3 has shown that a slightly higher annual growth of productivity over the growth of consumption needs is required to maintain the burdens at the current level.

Besides productivity growth, trends of aggregate savings and participation rates are key factors determining economic growth in the long run. The plausibility of a productivity slowdown due to a decrease in labor force is quite small.The speed of productivity growth ultimately depends on that of technological progress. The not-very robust rule of thumb is that scarcer labor due to the aging of the population structure induces development of production technology, economizing labor, thereby resulting in higher productivity. For these effects to be more fully utilized, it is necessary to promote the already-mentioned deregulation policy and technological development with an emphasis on software.

Although a large degree of uncertainty still remains for the future developments of aggregate savings, our analysis has shown that the life cycle hypothesis (population aging leads to lower saving rates) is applicable with high probabilities to household savings. However, noting that the current population distribution in Japan has a hump in the latter half of the 40s and that savings motivated by "strategic" inheritance play an important role in intergenerational transfer, household saving rates in Japan might remain high until those generations become older. Furthermore, household savings rates would necessarily increase asparticipation rates of the elderly rise. Thinking in this way, the future trend of economic growth is not pessimistic. On the other hand, the living standards of future generations can be maintained at the current level by a slight increase in productivity growth.

Invisible Government Debt

It is inevitable that the burdens on future generations with increase with the arrival of the aging society ("A burden gap between the current and future generations"). This is obvious, for example, from the size of the "invisible debt" estimated by the method of generational accounting on the relationship between intergenerational benefits and burdens. However, it should be reminded that population aging does not necessarily entail an expansion of public finance. We could call it instead a "problem of choice" to a large extent. Furthermore, thekeys in considering the growth of social security expenditures in the future are the trends of care services for the elderly, issues related to pensions and medical services, and on the trends of employment for the elderly. Based on the characteristics of the provision of care services for the elderly, a system of public care services should be established; the promotion of active use of privateservices is also important, and will contribute to a restraint on future socisl security expenditures.

Importance of "Simple and Efficient Government"

Japan has maintained a relatively small scale of public finance compared with other advanced industrial countries. This has contributed to its high economic growth and competitiveness. However, judged by the above-mentioned size of "invisible debt," Japan has the prospect of expanding the size of government, depending on the choice of its citizens. Given that one way for an aging society to be compatible with a vital market economy is by maintaining high productivity,efforts need to be made in further streamlining government consumption. Furthermore, in consideration of the rule of thumb that lower prices of capital goods lead to higher economic growth through stimulation of investment, and of the possibilities that higher productivity might correspond to a reduced current account surplus, pursuing a functionally simple and efficient government through further promotion of deregulation is called for.

Treating the problem of employment of older people

An important point of view regarding the problem of employment of older people from now on is to grasp it as a problem of labor-market adjustment. That is, how to design a labor market which allwos various choice regarding labor conditions, including holidays, occupation, working style, wages etc. The labour market should enhance the incentives of enterprises to employ elderly people who have the desire and ability to work, and who have a wealth of experience and knowledge. This problem of market adjustment is the problem of recomposition of the practices and systems that form the market economy to apply to the new stage of the Japanese economy. One of the points is how to change employment practices; this is the "pyramid-shape" population structure. These practices have supported the high growth of Japanese economy, without hindering the dynamics of the market. For example, regarding the wage system,

  • 1) the labor cost of older workerswill rise increasingly, if
  • 2) the labor supply and demand for older people willbe loose and the labor supply and demand for younger people will be tight.

With the premise of the market mechanism, it is expected that the wage profile based on seniority will flatten, and that the wage scheme should be changed to respond to the degree of contribution. In this case, the damage by job turnover becomes small, so the menu of choice of employment will expand.

Also, with the expectation that, with the advance of an older labor force and the dull growth of labor supply, the mobility of manpower should increase with the industry-structure changes in the future, employment practices will be pressured toward change together. This is because, in the enterprises, the increase in wage costs and the shortage of posts will occur; the efficient re-allocation of labor will also be necessary, and its scarcity value will increasingly rise. It is necessary that, without denying the merits of the employment system at present, and while attempting to make practical use of middle-aged and older people in business, today's systems be reappraised so that they are not neutral about labor mobility (for example, job turnover is a disadvantage for workers). Inaddition, it is hoped that the surroundings for older workers will be adjusted,such as securing various employment opportunities and reducing work hours. Thesystems should also contribute toward reducing mismatches in the labor market.

Another important view to consider regarding the employment of older peopleis the future labor force participation rate. In relation to the future economic growth rate, we should consider the connection between pensions and the employment of the elderly. The latest improvements in the pension system (the improvement of employed old-age pensions etc.) can heighten the desire of older peopleto work. It can also be said that this contributes toward securing the balanceof payments and the share in public pension at the same time.

4 Viewpoints Regarding Future Policy Making

Bridging the Three Internal Gaps

The fifty-year postwar history of the Japanese economy is a success story of bridging gaps in economic power between Japan and the advanced Western world. Meanwhile, however, the Japanese economy faces a serious industrial adjustment in the face of the appreciation of the yen, price gaps and deterioration in expectation for the future --which arises from internal gaps such as a productivity gap among manufacturing industries and a productivity gap between the manufacturing and the nonmanufacturing sectors-- and a burden gap between the present and future generations. Whether the Japanese economy is able to continue to demonstrate dynamism through the market economy depends on how it fills these internal gaps. Keeping this in mind, viewpoints in policy making in the long run are summarized.

Pursuit of Continuous Growth

It is wrong to consider that the potential growth of the Japanese economy turns downward after the long recession following the burst of the bubble and thesubsequent slow growth. There is no objective evidence to show that technological development, which can enhance productivity, has decelerated. The present slow growth of the Japanese economy is attributable to a slow growth in consumption and investment; the supply side factors are not likely to hinder growth for the next several years, although the growth rate will possibly be lower to some extent due to the slower growth in labor force and lower savings rates in the longrun. It is important to ensure continuous growth at present by utilizing the supply side. In only twenty-five years, the population of those over 75 years old is estimated to reach 16 million. There is not much time left for Japan to be prepared for the future aging of its society.

For that purpose, at the macroeconomic level, it is necessary to sustain high savings and investment, to utilize domestic savings stock and to innovate both hardware and software technology. At the microeconomic level, it is importantto allocate human and physical resources to higher value-added areas based uponthe market mechanism. It is also important to prepare a policy system geared toward the sophistication and mobility of human resources.

Importance of Price Mechanism

It is necessary to build a market economy where adjustment is made by invisible hands of "price signals", where it is consumers who decide prices rather than producers. This is in contrast to the visible hands of "volume signals" suchas regulation, administrative guidance or noncompetitive cooperation among enterprises. Respect for the price mechanism leads to

  • 1) utilization of the merits of a strong yen and reduction of the price gap between tradables and nontradables,
  • 2) utilization of the merits of the so-called "price revolution" and inducingthe appearance of innovators,
  • 3) utilization of the factor-price equalization mechanism and establishment of a domestic price system compatible with the international standards, and
  • 4) reallocation of resources to areas which are expected to have comaparative advantages in the future and to produce higher added value.

For all those purposes a strong competition policy, as well as deregulation, should be promoted. Hollowing out occurs when regulated industries stay in Japan, while competitive industries are shifted abroad. Such a situation should be avoided at all costs.

Economic Management in Consideration of Future Generations

An aged society accompanies concern about its unforeseeability. However, this should not imply our ignorance or disregard to the outcome of such a society. As analyzed in Chapter 3, burdens on the current generations to support future generations will necessarily increase with the aging of the population. Giventhese inevitable changes in our environment, assuring the living standards of future generations through high-capital accumulation is the greatest legacy that the current generations can leave for their future offspring. Incidentally, theJapanese economy must pay the costs of severe adjustment in "cyclical" and "structural" aspects. In addition, costs of aging will increase in the twenty-firstcentury. What is important for the current generations is never leaving the costs --which they may themselves have produced during the last decade of the twentieth century-- as their legacy for future generations. From this viewpoint, itis necessary, as mentioned earlier, to pursue further sustainable growth as well as to consider further a fiscal system encompassing the relationship between the benefits and burdens of the current and future generations .

Emphasis on External Policy with Expansionary Equilibrium

From an external aspect, expansionary equilibrium must be pursued. Choosing a "closed policy" by paying attention only to the short-run is just like the old saying "the remedy is worse than the disease." Our country should choose to promote an open policy toward the world as a promoter of the global free trade system after the establishment of the WTO. It should be reconfirmed that the right policy is open trade, being an "import superpower," "direct investment superpower," and a country with few regulations as well as an active participation in the renewed international division of labor based on the new system of prices.

Securing Equity through Pursuit of Efficiency and Social Safety Net

We have made unprecedentedly rapid growth and an egalitarian society compatible during the postwar period. One of the factors which made this possible is the variety of institutions and regulations regarding distributional aspects. However, it is increasingly obvious that sticking to obsolete institutions and regulations emphasizing distributional equity in an era of rapid changes of environment makes us fall into a trap of inefficiency. On the contrary, it is necessary for us to change our way of thinking toward further pursuit of efficiency through deregulation that will eventually lead to equity. To make such a relationship more grounded, it is necessary to guarantee equal opportunities as well as to increase further the mobility of human resources. Nevertheless, the pursuit of efficiency does not solve all the problems of distribution. Specifically, further investigation is required as to what kind of social mechanisms will allow those people who have dropped out from the market competition --due to severe adjustment in industrial structure and employment-- to be relieved and relocated tothe market. Meanwhile, the reform of a variety of mechanisms and rules which have been institutionally bolstering the success of the Japanese economy is imminent in the industrial adjustment under the appreciation of the yen and the adjustment to an aging society.

Toward a "Simple and Efficient Government"

The Japanese economy today is the end of one era and at the beginning of another. It is at a crossroads as to whether it can regain the dynamism through the market economy. However, we do not have to be pessimistic. The condition ofthe revival of such dynamism is the removal of the "three internal gaps" through making the current gradual economic recovery full-fledged in the short run, making efforts in accelerating the adjustment in goods and labor markets as well as rearranging the framework of markets and the public sector compatibly with thedomestic and overseas environments in the medium- and long run. The supply side of the Japanese economy is capable of realizing this condition. At the same time, an aging society may give rise to a "bigger-spending" government, but any increase over and above the absolutely necessary should be discouraged. Based onthese points, the consensus on the public sector toward the next era should be formed in the direction of

  • 1) streamlining government consumption in the future;
  • 2) avoiding as much as possible financing methods which preclude productivity growth or deteriorate efficiency of resource allocation; and
  • 3) pursuing a functionally simple and efficient government through, among other things, further promotion of deregulation.