Japan's Lost Century

This article was originally published under the title Japan's Demographic Crisis Will Only Get Worse. Here's Why That's Bad News for America in The National Interest.

*****

If you want to see the future of the advanced economies, Japan might be a good place to start.  Despite full employment, Japan is showing muted wage pressures, minimal GDP growth, low interest rates, and continued high government deficits.  How do these seemingly contradictory elements fit together?  Are they unique to Japan, or symptoms of a more general malaise?

In Japan, demographics are largely responsible.  The country is facing an unprecedented meltdown in population.  After peaking in 2010 at 128 million, the country’s population has eased back to 126 million and will continue to decline.  Its population is set to shrink by 0.4% annually, with the decrease expected to accelerate to 1.0% annually by the 2040s.   By 2050, Japan will have 23% fewer citizens.  Not since the great plagues of the Middle Ages have we seen population collapse of this magnitude.  Nor does it stop in mid-century.   Demographers see current trends persisting to the end of the century, when Japan’s population falls to 50 million, only 40% of its all time high.   

Japan's Population 2010-2050 Japan National Institute of Population and Social Security Research

Japan's Population 2010-2050

Japan National Institute of Population and Social Security Research

In the medium term, not all age cohorts are similarly affected.  Japan’s 65+ age group continues to increase, but interestingly, is already almost at steady state.  (The 75+ age group continues to grow until the late 2020s.)   Most affected are the 14-and-under and the 15-65 age groups, the latter here being treated as the potential labor force.   From 2017 to 2050, the 14-and-under age cohort is forecast to fall by nearly 40%.  The workforce (15-65) falls by 34% in the same period.    Thus, not only is Japan’s population declining, its workforce is declining much faster than the population as a whole.

The loss of workers constrains GDP growth.  In essence, the loss of workers offsets productivity gains, such that Japan’s GDP in 2050 will be not materially higher than it is today.  Importantly, worker productivity gains are expected to continue at a reasonable pace, about 1.4% per year.   The average Japanese worker continues to produce more.  That’s not the problem.  The problem is that the number of workers declines by 1.2% on average during the forecast period, with greater declines closer to 2050.   Working smarter is negated by fewer people working. 

Japan Real GDP (2017 = 1.0); Annual Change in GDP / Worker and Working Age Population Source: IPSS, IMF, Prienga analysis

Japan Real GDP (2017 = 1.0); Annual Change in GDP / Worker and Working Age Population

Source: IPSS, IMF, Prienga analysis

Thus, we should expect GDP in Japan in the coming decades to be stagnant, with periods of gains alternating with periods of retrenchment, and no visible trend in either direction – much as we have seen for the last fifteen years or so.  Importantly, a decline in Japan’s GDP cannot be unambiguously interpreted as a cyclical downturn.  It is as likely to be a function of demographics.  The key number to watch will be GDP / worker, which will tell us more about the health of the Japanese economy than will GDP in aggregate.

Japan does have certain hidden reserves.  For example, an increase in senior employment, already high in Japan, would represent a modest hidden reserve of GDP growth.  The employment-to-population ratio could also move up a bit, although this too is fairly high by OECD standards.  Both these factors might make GDP growth a bit better than forecast, but probably not by much.

Demographics are a key driver of the national budget.  Japan has run hefty national budget deficits for the last quarter century.  The country’s working age population peaked in the late 1990s, and has been falling since.  With a decline in its workforce, Japan’s GDP growth also declined, and this appears in turn to have led to lower domestic interest rates.  At the same time, Japan’s elderly population has been soaring.  Given fewer workers, more retirees and lower interest rates, the Japanese government decided to load up on debt as the path of least resistance.  This is no surprise given the politics of the advanced democracies.

Japan National Debt / GDP Ratio, 10 Year Interest Rate, and Annual Change in GDP and Working Age Population Source: IMF, FRED, IPSS, Prienga Analysis and Scenario

Japan National Debt / GDP Ratio, 10 Year Interest Rate, and Annual Change in GDP and Working Age Population

Source: IMF, FRED, IPSS, Prienga Analysis and Scenario

Japan started to run sizeable deficits in 1995, and does to this day.  These cumulated into a national debt exceeding 200% of GDP, which will continue to grow until peaking at 225% of GDP around 2025 in most the scenarios we examined.  To put this in context, the IMF historically considered a debt / GDP ratio of 60% to represent the maximum prudent level.  Japan blew through this limit 20 years ago and continues to be able to operate.  But for how long? 

Without the prospect of meaningful GDP growth, Japan cannot count on continued expansion of the economy to fund a reduction in either absolute or relative debt levels. 

Our analysis suggests that Japan may nevertheless be able to thread the needle.  If real spending per dependent can be held flat in real terms, workers accept on-going tax rate increases, and no internal or external shocks hit the economy, then Japan can muddle through.  This would stabilize debt / GDP above 200%, but not much less than that. 

Neither taxpayers nor spending beneficiaries may be happy with this outcome – or almost any set of policies the Japanese government could conjure.   In the scenario above, real taxes per taxpayer would rise by 80% over the forecast horizon in an economy not growing at all in aggregate.  In addition, the government would have to hold real spending per beneficiary effectively flat for 35 years – and longer, if over-the-horizon projections were to be included.   Will Japanese taxpayers, who are already heavily taxed, accept another 15% rise in tax rates?  And will beneficiaries accept no real increase in benefits for decades?  Will the internal stresses on Japan’s citizens prove manageable, not only for a year or two, but for generations to come?

Moreover, because the workforce is declining, government debt per worker will continue to rise in constant dollars over the forecast horizon, from the equivalent of $50,000 in 2000, to $128,000 this year, and rising to $208,000 in 2050, all in a stagnant economy.  For purposes of comparison, the equivalent in the US today is about $75,000 federal government debt / person of working age, and the US has higher per capita GDP than does Japan.

Japan Index of Real Taxes per Worker and Spending per Government Beneficiary (Youth + Elderly), Pro Rata Government Debt / Working Age Person in Constant 2014 US Dollars Source: IMF, IPSS, Prienga analysis and scenario

Japan Index of Real Taxes per Worker and Spending per Government Beneficiary (Youth + Elderly), Pro Rata Government Debt / Working Age Person in Constant 2014 US Dollars

Source: IMF, IPSS, Prienga analysis and scenario

Even in the best case scenario, the government will require extraordinary and enduring forbearance from the population.  Neither taxpayers nor spending beneficiaries can revolt if the government is to remain fiscally viable.

It is easier to foresee it all going bad.

Any portion of society – either the ‘makers’ or the ‘takers’ – may find the necessary social compact unacceptable, and may turn to a populist leadership offering easy solutions like debt default, money printing, or any variety of destructive policies which look appealing on the surface, but are counter-productive in practice.  Raising tariffs would be an example.

Further, Japan’s economy will be vulnerable to external shocks and global credit conditions.  Japan may find it increasingly difficult to respond to global recessions, major weather events or earthquakes, and any rise in global interest rates.  A one percentage point rise in interest rates would imply an increase in Japan’s government outlays of 2% of GDP (if all debt were re-financed promptly).  Without economic growth as a cushion, the adjustment would have to come in short order from increased taxes or reduced spending.

Japan could also prove vulnerable to international meddling.  Even the cost of a small war could prove too much, and domestic constituents could prove amenable to the blandishments of populists backed by foreign powers trying to destabilize Japanese democracy.

On the other hand, not all trends are negative.  Unemployment should be minimal throughout the period, and wage gains should be solid.  Real estate should be falling in value year after year, increasing the purchasing power of those with jobs.  Moreover, older societies – and by 2050, the average Japanese will be well over 50 years of age – are less amenable to revolutionary promises.  The fervor of impressionable, unemployed youth will be lacking, and this may stabilize Japan’s society and protect it from various forms of domestic extremism and foreign meddling.

At a guess, Japan will go down in a Chinese financial crash sometime before 2025.  China’s debt situation is hardly more enviable than Japan’s, and a corrective meltdown is likely sooner or later.  Japan could easily end up as collateral damage in such a crisis, as banks and investors withdraw from Asia more broadly, much as they did in 1998.  

The implications for the US are myriad.

Over time, Japan’s internal politics may become unstable and more populist.  In addition, Tokyo may find itself in a major fiscal crisis.  And in all certainty, Japan will have fewer resources, both in men and money, to devote to its defense.  In all these cases, Tokyo will be less willing or able to contribute to collective defense with the US, and may as likely require active US support to right its fiscal ship.

Nor is Japan the only country with unfavorable demographics.  Japan’s fertility rate, at 1.4 children per woman, is only slightly below the OECD average of 1.5.  Japan’s problems are unique in their timing and magnitude, in substantial part due to Japan’s reluctance to allow in immigrants.  Most OECD countries, however, are unable to replace their own populations.  South Korea is even worse than Japan, and Germany is no better.  Japan is the canary in the advanced economies’ coal mine.  The difference is simply a matter of time.

Nor is the US immune.  Like Japan, the US now runs structural fiscal deficits, even at the top of the business cycle.  These deficits are coming in higher than forecast, just as America’s 65+ age cohort is set to increase by half to 2025.   The Obamacare repeal and replace dilemma reflects just this tension.   On the one hand, ‘compassionate conservatives’ – and voters – want universal healthcare coverage.  On the other hand, the funding for such coverage is not readily available from tax revenues.  Thus, the US social safety net appears to be at a turning point, with enormous pressures to solve the problem by resorting to ever-increasing debt.  If inflation and interest rates are low, why not borrow more?  That’s what they did in Japan.  Like Japan, the US may find itself in a trap of unrealistic expectations meeting the reality of a thinning workforce and a slow-growing economy.   This is already visible in states like Illinois, New Jersey and Connecticut, which are finding that they are unable to meet the pension promises made in the last thirty years.   Within a decade, these pressures may be manifest on a national level, too.

Since 1980, the elderly have benefitted at the expense of the unborn.  Lives have become longer, healthier and more prosperous, even as education has become unaffordable and families are raising too few children to maintain society’s numbers.  At some point, either the trend line turns, or it doesn’t.  If fertility rates are to be raised to replacement level, the price may well be greater support of families without increasing taxes (which are paid principally by the working parents of families).  Thus, social spending will be redirected from the elderly to the young and unborn at a time of slow economic growth.  Today’s young elderly, those in their fifties, may find a vastly more hostile world when they reach their eighties.

Conversely, society may continue to exist for the living and birth rates may continue to fall back.  The US posted record low fertility this past year, for example.  In such an event, society will continue to consume itself, with each passing generation smaller than the previous – exactly the path demographers have forecast for Japan, and not only until 2050, but until 2100.

In the last twenty years, it has been customary to refer to Japan’s weak economic performance as a 'lost decade'.  Demographics tell us that we are moving well beyond that.  Japan is looking at a lost century. 

It may not be the only advanced economy to suffer such a fate.