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Japan's lost decades explained

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The ongoing Japanese recession has puzzled economists for decades. Here's the explanation. Part 1 of 2.

The 1990s were the "lost decade" in Japan. The country went into recession, unemployment reached unheard of highs by Japanese standards, especially among youth, and deflation set in. This did not end with the end of the 1990s, however - the 2000s were another lost decade, and Japan has yet to pull out.

It is becoming more and more clear that the lost decades have to do with the inversion of the population pyramid, with more retirees leaving the work force than young people entering it. However, the exact relationship is unclear. In a free market, a shrinking work force should decrease unemployment as labor becomes more valuable, rather than increasing unemployment as has been observed.

A political analysis may provide a better explanation. As the number of retirees grows, they become more powerful politically, and better able to insist on constant or improved living standards. However, economic output is limited by the falling proportion of the population still working, so the average living standard the economy can sustain for the population as a whole cannot keep up.

With the retirees' living standards fixed, those still working end up with lower living standards than before - essentially, they get paid less. The lower pay reduces the incentive to work, resulting in the higher unemployment rate. And this effect falls disproportionately on those just entering the work force, who have no existing living standards to insist on maintaining, and who have the least experience and thus the least leverage to negotiate salaries.

This leaves the deflation to be explained. In the U.S., where retiree benefits such as social security are protected by inflation adjustment, we would expect this political dynamic to result in increased inflation: the inflation adjustments would keep the retirees whole, while salaries would lag, resulting in reduced real income for those still working. That's not what's happening in Japan, where they're getting deflation.

An examination of the Japanese retirement system provides an explanation. The Japanese equivalent to social security, rather than being based on inflation adjusted entitlements, instead is composed of huge, monolithic pension investment funds. To maintain or improve retiree living standards, the retirement funds must earn interest at a rate higher than inflation. Having a negative inflation rate - deflation - makes this easier, since even the zero interest rate on cash is then higher than inflation.

Recent events provide an example of this political power in action. Under government pressure, the Bank of Japan has adopted an inflation rate target of positive 2%, compared to the negative 2% of typical recent years, in hopes of stimulating the economy through easy money policies. In response, however, the pension funds are considering reducing their government bond holdings. That reduced demand for bonds will act to increase the interest rate the government must pay on those bonds, keeping the interest rates above inflation as the pension funds require. However, higher interest rates will also act to keep the economy in recession in real terms, despite the inflationary monetary stimulus.

To break the logjam requires one of two things: either technology must improve much more rapidly so productivity improvements more than offset the labor force shrinkage, or retirees must be forced to accept lower living standards. Neither of these seems terribly likely in the near future.

Next week: implications for the U.S.

Population pyramids for Japan, 1920-2060:

Japan Government Pension Investment Fund reconsidering government bonds:
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On March 4th, 2013 09:02 pm (UTC), (Anonymous) commented:
Will advanced tech and higher efficiencies really help the new generation though? I agree that it would help the funds that support retirees. A tech revolution would increase intelligence based job demand, but increased manufacturing efficiency will definitely decrease blue collar job demand. Is it feasible to believe that the majority of the labor force can be sustained on white collar jobs?
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On March 11th, 2013 05:53 am (UTC), psychohist replied:
Technological improvement can help blue collar jobs, too. For example, suppose technology improved enough to provide delivered restaurant meals at a price competitive with home cooking - probably a factor of two decrease in my area. That would stimulate demand by likely more than a factor of 2 - our family would probably get delivery 5 times a week instead of just 1. Even if the technological improvement halved the amount of labor required per delivered meal, the total labor required to serve the expanded market would likely still increase - by a factor of 2.5 if our family is typical.
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