Crisis in slow motion

Consequently, output growth is projected to remain below 1% during 2010, resulting in entrenched deflation and a continued rise in the unemployment rate. While a stronger pick-up in world trade could lead to a faster rebound in Japan, there are a number of downside risks, particularly from the deteriorating labour market and possible negative second-round effects from the financial sector. In addition, Japan’s huge public debt makes it vulnerable to a rise in long-term interest rates.

A sustained and robust expansion depends on economic reforms. A s the impact of the stimulus packages wanes and the focus shifts to fiscal consolidation, sustaining growth will depend increasingly on private domestic demand. T he 2002 07 expansion, the longest in Japan’s post-war history, was driven primarily by the export-oriented manufacturing sector and failed to spark strong domestic demand growth. T he result was an unbalanced upturn that exacerbated gaps between sectors, regions and small and large firms.

C reating a new growth model depends on reforms to boost domestic demand. T he previous government’s Medium to Long-term Fiscal Policy and an Economic and Fiscal Policy Outlook for the Next Ten Years recognised the importance of «pursuing economic growth through reform in the medium to long-term». It is important to implement reforms promptly, given that their benefits often take considerable time to materialise. I ndeed, OECD experience shows that key reforms are most often implemented during deep recessions.

Reform, focusing on the labour market and the non-manufacturing sector, should be a top priority for the new government.

P articularly in the labour market. T he rise in the share of non-regular workers, from 20% in 1990 to 34% in 2008, has put downward pressure on wages and private consumption, as they are paid substantially less than regular workers.

T he increasing proportion also has negative implications for long-term productivity as firms invest less in training non-regular workers. E quity problems are a concern as well, given that the difference in productivity between regular and non-regular workers is much smaller than the wage gap. I n short, the dualistic labour market traps a large proportion of the labour force, especially youth, in low-paying jobs with little employment security and limited access to training.

M oreover, non-regular workers receive only limited coverage from the social insurance system. R eversing dualism requires addressing the factors that encourage firms to hire non-regular workers, notably the savings in labour costs, in part due to lower social insurance contributions, and enhanced employment flexibility.

A comprehensive approach is necessary, including increasing the coverage of non-regular workers by social security insurance schemes, reducing employment protection for regular workers and upgrading training programmes to enhance the job prospects of non-regular workers. A t the same time, it is important to raise female labour force participation by reducing or eliminating aspects of the tax and social security system that discourage full-time work by women, providing more attractive job opportunities and encouraging flexible working arrangements, including by expanding the availability and quality of child care.

Such changes would make for a better «work-life balance» and could help end the downward trend in the fertility rate.

During the export-led expansion beginning in 2002, labour productivity growth accelerated to more than 7% per year in manufacturing while remaining below 2% in services. As services account for 70% of value-added and employment in Japan, boosting productivity in this sector is essential to sustain output growth and narrow the gap with the top OECD performers. The weak productivity performance in services highlights the importance of strengthening competition through a number of policies:

Competition policy should be further upgraded by reducing exemptions to the Anti-Monopoly Act, increasing administrative fines and phasing out the special treatment of SMEs, which play a dominant role in services.

Regulatory reform should be accelerated, focusing on reducing entry barriers, as international comparisons indicate that starting a business in Japan is relatively complicated, costly and time-consuming. In addition, the reforms introduced in the special zones should be expanded nationwide.

International competition should be enhanced by reducing barriers to service imports and encouraging inward foreign direct investment (FDI). Increasing inflows requires removing barriers to FDI and product market regulations that discourage potential foreign investors.

In addition, competition in key service industries, such as retail, energy, transport and business services, needs to be strengthened through wide-ranging reforms. In particular, an independent sectoral regulator should be established for both the electricity and gas sectors and more consumers should be allowed to choose their supplier. Finally, reform of agricultural policies would bring significant benefits to consumers as the high level of assistance to farmers boosts the average price received by agricultural producers to a level nearly twice as high as the world price. Market price supports, which distort trade and production decisions, should be replaced.

The policy interest rate should be kept near zero. In addition to promoting financial market stability and facilitating corporate financing, the Bank of Japan should support economic growth by keeping the policy interest rate close to zero, given entrenched deflation and downside risks to economic activity, while taking into account the risk of financial imbalances in the medium term. Once deflation has been overcome, the central bank’s Policy Board should revise the understanding of price stability as inflation between 0 and 2% by increasing the lower end of the range to ensure an adequate buffer against renewed deflation. The course of monetary policy will need to take into account the pace of economic growth and the evolution of inflation, which will depend in part on progress in fiscal consolidation.

Conclusion. In summary—like the rest of the world—Japan faces a difficult set of immediate and longer-term challenges. The authorities are taking appropriate steps to support the economy in the face of the export collapse and financial spillovers from the global crisis. In the near-term, policies should continue to be aimed at supporting growth, while preserving financial stability. Over the medium-term, reforms to restore fiscal sustainability, deregulate the service sector, and enhance labor and product market flexibility will help Japan to rebalance growth and lay the foundation for a sustained expansion.