What is Japan known for economically

In the 1980s, Japan's economy was the envy of the world. It grew by leaps and bounds, seemingly ready to bypass the U.S. to become world's largest economy. But then it didn't. An asset bubble that had built up during the 1980's burst in 1990, causing Japan's economy to falter. This pushed Japan's economy into a period of prolonged stagnation and deflation, a period known as the "Lost Decade," now plural, which has continued to the present day.

Meanwhile, the Bank of Japan (BOJ) and the Japanese government have tried a host of different measures to get the economy moving. For instance, the BOJ was the first central bank to ever implement Quantitative Easing (QE), a monetary policy of asset-buying, which sought to drive long interest rates to near-zero levels. The second Shinzo Abe administration, which took office in 2012, introduced the three programs of Abenomics to try to revive the economy. These were an aggressively expansionary monetary policy, increased government spending, and changes to regulation to increase trade and growth.

While these policies kept the Japanese economy from sliding into a prolonged recession or even a depression, they failed to move it out of stagnation.

Compounding the woes of the Japanese economy was the spread of the Covid-19 pandemic in 2020-21, which badly damaged its economy. For instance, real GDP declined at an annualized rate of over 32% in the second quarter of 2020, before recovering by only just over 20% the next quarter with more muted rises and falls over the next few quarters. Japans GDP, as of Q3 2021, remains below pre-pandemic levels.

Looking into 2022, Japan's economy faces several challenges, like keeping the economic recovery going, diversifying investments away from China, and addressing its demographic problems.

Keeping the Recovery Going

As is the case with other developed countries around the world, Japan's policymakers have been trying to keep the economic recovery going with fiscal stimuli, like a $1 trillion stimulus ​package that was instituted by the Japanese government in the spring of 2021, which Kishida, has agreed to continue and supplement with a new $944 billion budget for fiscal 2022.

But keeping the economic recovery going hasn't been easy around the world due to the supply chain bottlenecks and labor market frictions, which create temporary mismatches between the demand and supply side of the economy. As a result, economic growth has slowed down, as prices of goods and services spike, especially the price of food and energy

While rising food and energy prices are a problem for every country, it's even more severe for Japan, which is highly dependent on oil imports for its energy needs. High oil prices take a big chunk of household budgets, depressing further consumer spending, the primary factor behind the country's three-decade-old stagnation. Nonetheless, overall inflation still remains low, verging on deflation. Consumer prices rose at an annual rate of 0.1% in October, the same as in September, and well below the 2% Bank of Japan target, which it has struggled to meet for years.

Diversifying Investments Away From China

For years, China was a focus of manufacturing investment for Japan. China's cheap labor force provided a solution to Japan's labor shortage, helping its manufacturers stay competitive in the global economy. Meanwhile, China became a significant market for Japanese products.

In recent years, things have changed for a couple of reasons. One of them is that China's labor is no longer cheap, as the country is facing its own labor shortages, eroding its competitive advantage. In 2018, China's manufacturing labor costs $5.51 dollars per hour, well above the $4.45 in Mexico, and $2.73 in Vietnam.

Secondly, renewed tensions between the two countries over China's aggressive expansion in the South China Sea and military exercises near Taiwan.

Addressing Japan's Demographic Problem

Demographics is a chronic social and economic problem for Japan. Since the 1970s birth rates in Japan have plunged. This means fewer young people are entering the labor force leading to a decline in the country's productive potential.

The lack of young people, combined with very long lifespans, creates a very unfavorable dependency ratio. That's ratio of people paying into the country's social security fund to the number of retired people collecting from it. As a result, the social security fund runs deficits, which the Japanese government must cover from its fiscal budget. For instance, the 2022 fiscal budget allocates 660 billion yen to make up for a shortfall in the social security fund, up from an initial estimate of 480 billion yen. This shortfall is covered by issuing debt, and Japan's national debt is currently at 266% of GDP, the highest ratio in the developed world

But addressing demographic problems isn't something that can be addressed quickly or easily. It requires structural changes to the Japanese economy and immigration system.

The Bottom Line: Outlook for Japan

Japan is facing both cyclical and structural challenges as it begins the new year. Its cyclical challenges are global supply chain bottlenecks and labor market frictions, which continue to put downward pressure on its economy as it strives to recover from the global recession.

Structural challenges are associated with the three-decades-long economic slowdown associated with the burst of multiple asset bubbles in 1990 and a decline in the birthrate, which create labor shortages and an unfavorable dependency ratio.