## SHRINKONOMICS — Lessons from Japan

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**Canonical URL:** [SHRINKONOMICS — Lessons from Japan](https://www.imf.org/-/media/files/publications/fandd/article/2020/march/shrinkanomics-policy-lessons-from-japan-on-population-aging-schneider.pdf)

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### Vanishing labor
- Japan’s potential labor force (those between ages 15 and 64 as a share of the total population) peaked in 1991–93 at just under 70 percent and has fallen to just above 59 percent.
- Given current low fertility and accelerating death rates, this ratio is expected to continue to decline well into the medium term.
- Labor demand pressures have spurred:
  - more women to join the labor force;
  - more elderly (those outside the traditional 15–64 working age) to join the labor force;
  - adoption of automation, artificial intelligence, and robotics to increase productivity per worker.
- IMF research (Westelius and Liu 2016) highlights competing effects of age on productivity:
  - older workers: higher productivity from accumulated work experience;
  - younger workers: advantages from better health, higher processing speed, adaptability to technological change, and greater entrepreneurship;
  - these forces imply an inverted U-shaped relationship between age and productivity.
- Additional demographic effects on productivity:
  - aging increases relative demand for services (e.g., health care), shifting activity to more labor-intensive—and less productive—service sectors;
  - population size and density may affect productivity (productivity rises with greater size and density of a working population).

### What makes Japan different?
- Postwar baby boom: short—only about three years—compared with other G7 members’ nine to twenty years, implying a dramatic demographic shift in a concentrated time window as boomers retire.
- Life expectancy: Japan leads the world and surpassed all Group of Twenty economies as early as 1978.
- Immigration: foreign workers accounted for only about 2.2 percent of Japan’s total labor force in 2018, compared with an estimated 17.4 percent in the United States and 17 percent in the United Kingdom.
- Demographic consequence: steady increase in the old-age dependency ratio (the number of retired people relative to the working-age population).

### Financing social security and fiscal pressures
- An older and smaller population implies:
  - relatively more retirees, a smaller labor force, and a shrinking labor-based tax pool;
  - rising public expenditure on health care, long-term care, and pensions.
- Japan’s specific timing pressure: the entire baby-boom population is passing the 75-year milestone in just three years (starting in 2022 and ending in 2025).
- Japan’s public debt as a share of GDP is already the highest in the world.
- IMF analysis of financing options (McGrattan, Miyachi, and Peralta-Alva 2018) finds:
  - a continuous and gradual adjustment of the consumption tax dominates other measures—higher social security contributions, delaying fiscal adjustment (debt financing), and increased health copayment rates—because consumption tax increases, which apply across age groups, have smaller adverse effects on long-term GDP and welfare.
  - postponing adjustment through debt financing results in a large crowding-out of private sector investment—by up to 8 percent—with detrimental effects on long-term GDP and welfare.
  - a uniform increase in health copayment rates for the elderly would have regressive consequences by shifting part of aging costs to current generations.
- Demographics may exacerbate income inequality between generations:
  - older generations are significantly wealthier than younger generations;
  - wealth poverty is significantly lower for older generations;
  - the wealth ratio of older to younger cohorts is relatively high in Japan compared with Germany and Italy, though lower than in the United States.
- Policy implication: the relative wealth of older generations questions costly fiscal redistribution mechanisms aimed at reducing elderly income inequality mainly via pensions.

### Monetary policy effectiveness and the natural rate of interest
- Demographic change can lower the natural rate of interest (the interest rate that supports the economy at full employment and maximum output while keeping inflation constant).
- IMF studies (e.g., Han 2019) find demographic change in Japan has had a significantly negative impact on the natural rate of interest in recent years.
- Findings suggest Japan’s natural rate has already fallen into negative territory.
- With working-age population growth projected to decline further by 2040, the negative demographic impact on the natural rate in Japan is likely to increase, potentially further limiting monetary policy’s role in reflating the economy.
- Policy implication: need to boost potential growth through structural reforms (including labor market reforms and more active immigration policies) to lift the natural rate.

### Financial sector implications
- Demographic trends influence saving and investment behavior, affecting demand and supply of lendable funds and financial intermediation by banks.
- Japan’s regional banks face acute challenges:
  - dependence on local deposit-taking and lending makes them sensitive to shrinking and aging populations at the prefectural level;
  - shrinking populations will lead to smaller balance sheets and declining loan-to-deposit ratios unless alternative sources and uses of funds are found, putting downward pressure on profitability.
- Expected behavioral shift: regional banks are likely to accelerate moves toward a more securities-oriented and fee-based banking model.
- Supervisory implication: the potential for pockets of financial sector instability needs to be incorporated into supervision and oversight as demographic trends impose significant changes to banks’ business environments.

### Policy recommendations and common lessons
- A long-term view on public finances is needed that fully incorporates the impact and cost of an aging population and shrinking workforce; early adjustment—particularly for public pensions, health care, and long-term care—is critical.
- Structural reform and innovation are essential to offset shrinkonomics’ negative impact on productivity and growth:
  - labor market flexibility;
  - strategies to ensure high productivity growth, including use of automation, robotics, and artificial intelligence;
  - a more flexible view with respect to aging and retirement (Colacelli and Fernandez-Corugedo 2018).
- Maintain intergenerational equity; business-as-usual approaches risk increasing generational inequality with implications for social security and public transfer programs.
- Monetary policy may be blunted by demographic forces, reducing its role in cyclical stabilization and placing more burden on fiscal policy and structural reform.
- Incorporate demographic-driven business-environment changes into financial supervision and oversight to manage risks in banks and other financial institutions.

*Gee Hee Hong and Todd Schneider — Finance & Development, March 2020.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2020/march/shrinkanomics-policy-lessons-from-japan-on-population-aging-schneider.pdf_