Annual Report on the Japanese

Economy and Public Finance


- No Gains without Reforms II -

November 2002

Cabinet Office

Government of Japan

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Chapter 3

   Issues for Vitalizing Japan' s Economy

Section 3 Economic Structure Outlook

   Structural reform to vitalize the economy should dramatically alter the economic system. Each economic unit, even if realizing structural reform as being indispensable for the revival of the Japan' s economy, may be worried about the future since reform may bring about great environmental changes. In order to eliminate such worries, we must specify the course of structural reform and implement it as early as possible to produce visible advantages. At the same time, we must specify the future economic structure that will emerge from the reform. If the future economic structure is specified, it will increase confidence in and help accelerate reform. This will lead economic units to promote economic activities that they have withheld due to worries about the future(60).
   Based on analyses given so far, we would like to attempt to specify the economic structure outlook in this section. It is not easy to specify economic structure after structural reform because there is no model, unlike in the past when Japan was trying to catch up with other industrial nations. The future economic structure is a new one that we must create.
   First, structural reform will alter the particularly Japanese economic system. The Japanese economic system consists of subsystems including main banks and lifetime employment. These subsystems supplement each other and a collapse of some subsystems can prevent the whole of the economic system from working well. It is impossible to reform only part of the subsystems. Basically, we must reform subsystems integrally and simultaneously.
   Second, the market mechanism, instead of a government-drafted chart, should lead the economic system reform under global influences. As discussed in Section 2, structural adjustments progressing in some sectors represent the achievements of structural reform and indicate that the market mechanism is gradually forcing the economic system to be reformed(61).
   In this way, the pending structural reform is thorough. Therefore, it is not easy to specify the future economic structure emerging from structural reform. As analyzed in Section 2, however, some points of the future economic structure have emerged amid progress in structural adjustments and can be used to outline the new economic structure. In the following, we would like to use this method to specify the future economic structure.

1. Outlook for New Economic System

   The new economic system emerging from the completion of structural reform is expected to have the following features:
Growing dominance of market-oriented transactions
   Market-oriented transactions will have a greater role to play in the new economic system as structural reform helps expand such transactions in the following areas:
(i) Elimination or reduction of regulations will ease restrictions on competition and expose a wider range of areas to the principle of market competition. Businesses that the public sector has undertaken will be privatized to help expand the scope where the principle of competition can work.
(ii) Goods and services that have been procured internally will be increasingly subjected to external procurement to expand external market transactions. This will stem from the following changes:
   - Companies are spinning off or outsourcing internal services by introducing equipment leasing, temporary staff, outside management of buildings, outside development of software and other systems in order to transform fixed costs into variable costs and save overall costs.
   - Households are increasingly depending on restaurants, convenience stores, house cleaners, nursing care providers and others for services that they had covered domestically. This is the result of women' s growing participation in society and has prompted women to take part in society. This is also attributable to an increase in the aged population that has triggered new commercial services.
   - The growing labor mobility is allowing job changes to become a career path option. This will expand the job-hopping market.
(iii) Companies will escape from indirect financing through personal transactions to direct financing through market-oriented transactions among an unlimited number of people.
   In this way, the new economic system will be based primarily on market-oriented transactions. This means that the incentive structure will change for each economic unit. The past incentive structure has been based on long-term stable relations. Under the new economic system, however, dominant incentives will be based on competition and include price signals that can be exploited to find new business areas.
   The government' s roles in the new economic system will be limited to supplementing market forces in areas where market-oriented transactions cannot work sufficiently (areas where market failure is found) and developing legal and other institutional infrastructure for the system based on market-oriented transactions.
Distribution of high-quality information
   The economic system' s shift from internal or personal transactions to market-oriented transactions means that information for distribution will increase dramatically, the quality of information for distribution will grow more important as will transparency and accountability. Specific examples follow:
(i) Labeling of prices and quality, the most fundamental information for trading in goods, will grow more significant. Ways to secure the reliability of such labeling will thus become more important.
(ii) Sufficient disclosure and quality of corporate information will grow more important. Especially, corporate accounting standards as the base for balance sheets should be appropriate for depicting real pictures of corporate financial conditions. At the same time, individual companies' information should be prepared appropriately in line with such standards. To this end, certified public accountants and auditors should sufficiently scrutinize such information.
(iii) Information on banks' financial conditions is growing more important not only for their shareholders but also for households. Depositors will use such information to select banks under the payoff limited deposit protection system.
(iv) In the job market where job-hopping is increasing, information on workers' knowledge and skills is growing more important. Education and careers have so far served to illustrate such information but in the future information on workers should include various qualifications.
   While a variety of information is distributed, one individual alone cannot process information. In this respect, information intermediaries (including information magazines, analysts and consultants) will have to play a key role in selecting, analyzing and assessing information for specific purposes on behalf of economic units.
Realization of and challenge against risks
   The traditional Japanese economic system has been based on long-term stable relations. If the system is reformed to the degree where market-oriented transactions are dominant, various risks, which had been relatively small, will emerge and the appropriate realization of these risks will grow more significant. For example, households must consider job-changing risks in selecting jobs and payoff risks in making deposits.
   As the weight of risks increases, relations between risks and returns will have to be reconsidered. Basically, low risks lead to low returns, and high risks lead to high returns. But such basic equations have so far failed to work in Japan. For example, working for a large company has guaranteed high wages as well as lifetime employment. Deposits and savings, while having little risk, have guaranteed relatively higher returns. Under the new economic system, such distorted relations between risks and returns will be corrected.
   Risk realization is closely linked to risk management. In particular, the question of how to disperse or avoid risks will grow more important. Risk management is becoming important even for households. Householders may consider financial products for investment of savings, management of house, land and other real assets, and job selection for themselves and their families. But they will have to realize all these financial, real and human assets as an integrated portfolio and select an optimum combination of risks and returns.
Establishment of self-responsibility principle
   Ultimately individuals support the economic system and in an economic system based on market-oriented transactions, individuals will be required to act under the principle of self-responsibility. While being allowed to freely choose from various alternatives, individuals must be responsible for any result of their decisions.
   In order to stick to the self-responsibility principle, individuals must be capable of grasping and responding to various conditions. High-quality information may be increasingly distributed. In order to take advantage of such information, however, individuals must develop their ability to collect and understand a variety of information. While being exposed to various risks, individuals must realize and manage risks appropriately.
   Individuals must also increase self-development efforts in order to positively respond to rapid technological progress and growing job-changing opportunities on the increasing mobility of labor. If individuals were to secure job opportunities, they would have to keep themselves up to date with the skills required for the economic society in line with economic environment changes and technological progress. Such individual efforts are indispensable for improving the productivity of the economy as a whole.
   Individuals must support the principle of self-responsibility by constantly keeping themselves abreast of change. This means that individuals continue to make efforts by themselves throughout their lives or, in other words, individuals' should be expected to continuously explore new possibilities by self-training and self-development.
Development of safety nets
   Society must develop health insurance, pension insurance, nursing care insurance and other safety nets to cover uncertainties regarding health and aging. At the same time, society should develop safety nets to cover economic uncertainties in line with the principle of self-responsibility.
   For example, safety nets are important for people who lose income temporarily as separations and job changes are growing more likely on the increasing mobility of labor. These safety nets should help them escape from unemployment as far as they make efforts to keep themselves abreast of change.
   In order to secure the effectiveness of competition in the market, positive accessions to and exits from the market should be ensured. If exits from the market cause large economic losses, it may eliminate the potential of revival for those who are exiting. This may also discourage people from acceding to the market. Safety nets should be developed for those who are exiting from the market.
   While growing more important, safety nets always have moral hazard risks. Moral hazards can affect the efficiency of the economy. Safety nets must be designed to avoid moral hazards.
Tolerance of diversity
   The Japanese-style corporate management system is destined to change dramatically. In Section 2, we outlined the Japanese-style corporate management system based on long-term stable relations. The system has demonstrated various limits and has been changing gradually. Changes include the introduction of key points of the American corporate management system.
   But we should not simply replace the Japanese-style corporate management system with the American style, even though the Japanese style has various limits. The Japanese system, though currently inefficient, has at times worked well in the past. The American system had worked well until recently, but it has come under fire. An optimum system differs from time to time, from environment to environment, or from sector to sector. Rather, each company should be allowed to choose a system meeting its industrial characteristics and market conditions.
   Therefore, what' s important here is to refrain from imposing any specific system, like the American system, when considering system changes. In order to allow each company to choose a suitable system, Japan should tolerate the diversity and flexibility of choices.
Active participation in global economy
   By forming the new economic system as outlined above, Japan can shift its relationship with the global economy from passive to active relations.
   Japan has so far tended to take negative views of and make passive responses to changes in the international division of labor amid the growing presence of developing countries and former socialist nations in transition to market economies, because these changes have been taken as forcing economic adjustment costs. As market-oriented transactions improve the efficiency of resource allocation in future, however, Japan' s new economic system is expected to make active responses to changes in the international division of labor and take advantage of them for improving its economic productivity. This means that Japan will try to improve the value of industry and positively establish international standards while accepting imports aggressively. If such a dynamic economy is formed in Japan, foreigners will view Japan as a country where they want to live or as an attractive market. This will stimulate international personnel exchanges, including knowledge flow into Japan, and foreign direct investment in Japan. The new Japanese economic system will thus be open to foreign countries.

2. Outlook for New Economic Growth

   Structural reform to eliminate the problems that have caused Japan' s economic slump will change the details of economic growth. We now would like to consider (i) details of economic growth during structural reform and (ii) details of economic growth after the reform.
Structural reform and economic growth
   Structural reform is designed to vitalize the Japan' s economy, as discussed in Section 2, and increase its potential growth that declined in the 1990s. Structural reform usually strengthens the supply side and may be criticized for expanding a demand-supply gap and failing to stimulate real economic growth. But this is not necessarily true because structural reform, though primarily targeting the supply side, can stimulate new demand.
(i) Regulatory reform will open business areas wider for the public sector and a limited range of private sector players, giving new business opportunities to private companies. Entrepreneurs who are willing to aggressively take advantage of such new business opportunities will start up companies and expand business investment and employment. The introduction of special zones for structural reform will lead to the demonstration of successful examples of structural reform in specific areas, and through thorough assessment, erase worries about structural reform and stimulate challenges.
(ii) Disposal of non-performing loans means that funds fixed in low-productivity sectors may be shifted to high-productivity sectors. This could help vitalize business activities.
(iii) Structural reform like urban redevelopment means public investment expansion that may induce private-sector investment.
(iv) Fiscal and social security structure reform can affect demand by cutting fiscal spending and social security benefits and by increasing public contributions. But such reform can stimulate personal consumption by eliminating worries and reducing uncertainties about the future.
(v) These effects may serve to increase expected growth rates for the future and stimulate spending by business and household sectors. A rise in expected profit ratios may also support spending by boosting asset prices.
   Through these effects, structural reform is expected to stimulate demand and increase economic growth.
   In the Annual Report on Japan' s Economy and Public Finance 2000-2001, we analyzed the extent to which structural reform could boost potential economic growth. The analysis indicated that structural reform could boost Japan' s potential growth rate from the current 1% to 2% over the medium or long term. Especially, TFP' s contribution to potential growth is expected to increase by 0.5 percentage point. TFP growth will rise as increased efficiency in allocation of resources serves to shift resources from low-productivity sectors to high-productivity ones and as information and other new technologies are developed and exploited. Especially, information technologies, which greatly contributed to accelerating labor productivity growth in the United States in the second half of the 1990s, could afford to do the same in Japan.
Technological progress and economic growth
   Technological progress is expected to play a key role in generating new economic growth.
   Labor and capital input led economic growth in the 1990s, with technological progress' s contribution to growth remaining limited. In future, however, technological progress, as well as efficient exploitation of resources and improvement of labor quality, will play a key role in generating economic growth. In this respect, Japan should increase the efficiency of research and development through the positive implementation of measures cited in Section 2 in order to boost potential for technological progress.
   The technological progress-led economic growth will be important for overcoming some constraints that are expected to increase in future. The constraints are (i) the declining and aging population, and (ii) requirements for environmental conservation efforts. Let' s outline these constraints:
(i) The declining and aging population will become a great constraint on economic growth that comes through the accumulation of productive factors. The declining and aging population will lead to a fall in the working population and in savings.
   The working population decline may be partially covered by women' s and aged people' s greater participation in the labor force. A savings decline may be covered by foreign savings through active international capital flow. In addition, technological progress will increase TFP growth to help Japan maintain economic growth.
(ii) In environmental conservation efforts, we should reconsider waste disposal and try to recycle waste as much as possible, instead of disposing of it. We should take the "from the cradle to the grave" approach on materials flow. In other words, we should give consideration to the resource input into the economy and try to achieve economic growth while minimizing environmental impact. For waste disposal, we should consider introducing economic means in addition to regulations.
   As for measures against global warming, we should enhance efforts under the Kyoto Protocol to reduce greenhouse gas emissions. In this respect, Japan can be expected to take advantage of trading in emission credits.
   At the same time, we should build an optimum social system regarding waste disposal and global warming. In order to simultaneously achieve economic growth and cuts in greenhouse gas emissions, we should alter life styles and promote technological progress through research and development.
   Technological progress is the key to economic growth under such constraints. We must remember here that "necessity is the mother of invention." These constraints can become a trigger for technological progress. Sciences and technologies that are closely linked to specific needs and wants regarding the aging population and environmental problems will be the seeds for new kinds of industry and lead economic growth. If Japan successfully achieves such economic growth, it may be able to provide the world with the Japanese model for overcoming population decline or for achieving both environmental conservation and economic growth.
   In order to maintain economic growth in future, Japan will have to increase aggressive research and development efforts in addition to the efficient exploitation of resources and the improvement of labor quality.

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