On the down escalator

FOR several decades after the second world war it was boomtime for Japan's economy as a new generation of workers entered the labour force. Brilliant entrepreneurs like Soichiro Honda and Akio Morita at Sony set about building the future. A pioneering baroness, Shidzue Kato, forced a male-dominated parliament to legislate for easier birth control. Condoms became so widely available that the birth rate halved in the decade from 1947-57.

That meant fewer young mouths to feed on rising salaries, thanks to a seniority-based system under which pay automatically increased with age. As the working-age population rose from 50m in 1950 to 75m in 1975, savings boomed and companies channelled them into breakneck growth. That was more or less the pattern of Japan's economy into the 1990s, even beyond the bursting of the financial bubble in 1990. Growth did not peak until 1996.

Now turn this picture on its head. In 1995, just before the economy started to lose steam, the working-age population hit its high point, at 87m. Since then it has fallen sharply. If current trends continue, in 20 years' time it will have dropped by 20m, according to the National Institute of Population and Social Security Research. By 2050 it will have fallen below 50m, forming an almost perfect bell curve in one century. Among rich nations, only Germany will suffer a similar fall (see chart 3).

Labour is one of the two main sources of economic growth. If the number of workers drops, output per worker has to rise to maintain the same level of production. There are ways to ease the demographic strains, such as encouraging more women, foreigners and older people to join the labour force, or seeking out fast-growing markets abroad. But if productivity does not increase enough to counteract a shrinking workforce, output—and eventually living standards—will decline.

For now the fall in Japan's labour force is still accelerating. At the same time cheaper competitors in the region are forcing Japanese exporters to cut labour costs. And Japan has yet to recover fully from the withering effects of the 2008 global financial crisis.

Japanese companies have been substituting capital for labour for two decades, causing the overall number of hours worked to drop, writes Richard Katz of the Oriental Economist, a newsletter. “Since 1991 all of Japan's growth in GDP has been due to higher productivity…If Japan wants to grow faster, it has to increase productivity. Demography and lack of immigration rule out any other path.”

In that sense, the two “lost decades” of economic stagnation in Japan since 1990 may turn out not to be an aberration but a taste of things to come. “What goes around comes around, and the same demographic profile that supported economic growth will now begin to weigh heavily on Japan's economy. In fact, it will leave Japan with the lowest rate of economic growth among the large industrialised nations,” wrote Akihiko Matsutani of the National Graduate Institute for Policy Studies in his 2004 book, “Shrinking-Population Economics: Lessons from Japan”. He believes the unprecedented speed of the decline in Japan's working-age population has made the slowdown worse, and having fewer young workers may be affecting Japan's ability to innovate.

Argentina of the east

Mr Matsutani is not the only bear about Japan's future growth rate. Japan has just been overtaken by China as the world's second-largest economy. By 2050 Goldman Sachs expects it to have been overtaken by India, Brazil, Indonesia, Mexico and Turkey too. Takashi Inoguchi, a Japanese political scientist, bleakly refers to Japan as a potential “Argentina of the east”. Like the Latin American country, it might go from being one of the richest countries in the world to becoming sadly diminished only a few decades later.

Already there are signs that companies may be trimming investment because they lack confidence in the future. As Mr Matsutani argues, when your workforce is growing you can cover up for overinvestment because the excess will eventually be soaked up. But when populations shrink, overinvestment gets worse over time, creating a deflationary spiral.

In recent years Japanese companies have hugely increased their saving rate, which is now close to 10% of GDP, according to Takuji Aida, an economist at UBS in Japan. Some argue that this is a hangover of the excessive debt built up during the bubble years. But Mr Aida says it may reflect caution over the shrinking population, the strong yen and poor economic prospects. One of his scenarios is that in 15 years' time companies will have saved so much that they will have no net debts. That would be very bad for Japan's future growth. To compensate, the government may have to borrow even more.

Japanese managers say they are already feeling the strain from a shrinking consumer base. Convenience and department stores have merged to achieve greater economies of scale. Last year two large drinks companies, Kirin and Suntory, tried to join forces to offset declines in their home markets, though the merger talks collapsed over ownership disputes.

GE Japan's boss, Yoshiaki Fujimori, notes with exasperation that his company has not grown in the past five years, largely because of ageing. Elderly people go to bed early, so they use less electricity. That affects GE's utility business. They travel less, which hits its airline business. Even its health-care business is slow, he says, because the elderly are not keen to adopt new information technology.

When deflation can be good for you

There is a further effect: the more that society ages, the more it may unconsciously encourage deflation—at least the gentle sort prevalent in Japan. People with savings get more in real terms as prices fall. Robert Feldman, chief economist of Morgan Stanley MUFG, has recently shown that older people have a tendency to tolerate deflation. He has also found that the Japanese electoral system favours older voters, who tend to live in rural areas that are over-represented in parliament. That gives them disproportionate influence over economic policy.

Perhaps this is one explanation for the government's and the Bank of Japan's (BOJ's) failure to end Japan's long run of falling prices. The BOJ itself appears to believe that deflation is not a monetary problem but one of low productivity. It has doubts about the effectiveness of quantitative easing, which it pioneered and which the Federal Reserve has used to inject liquidity into the American economy since the 2008 financial crisis. In October the BOJ took some steps to increase liquidity, but the main reason for that seemed to be to try to appease politicians who were concerned about its independence.

To help with fighting deflation, parliament is mulling whether to set the bank an inflation target above its current range of 0-2%. However, Andrew Smithers, a British economist with long experience of Japan, argues that setting an impossible target may be no more productive than keeping the existing one. If ageing has helped make deflation endemic, tinkering with inflation targets will make little difference.