Podcast Host: Farshad Fatemi
Guest: Hamzeh Arabzadeh

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Farshad: It seems that lately, there has been a wave of optimism surrounding Japan’s economy. We can see this reflected in Japan’s stock market—take the Nikkei index, for example, the country’s most important stock index, which this year reached its highest level in 30 years. There’s a growing discussion that Japan’s economy is undergoing a transformation, shedding its old skin. To start, can you give us an overview of Japan’s economic growth over the past two or three decades?

Hamzeh: In the 1980s, Japan’s economy was booming. The country was seen as an unstoppable industrial and technological powerhouse, experiencing rapid growth that led many to believe it would eventually overtake the United States. However, from the early 1990s, following the burst of Japan’s asset bubble and a stock market crash that wiped out over 60% of the Nikkei’s value, the country entered a prolonged stagnation that has now lasted for three decades. This period has been characterised by low economic growth, repeated recessions, and persistently low—sometimes even negative—inflation.

Since then, Japan has never regained the dynamism of its pre-1990 era and has instead become trapped in a cycle of sluggishness and financial conservatism. While it remains a major economy—still the fourth-largest in the world by nominal GDP and the third-largest by purchasing power parity (PPP)—its average annual GDP growth over the past three decades has been less than 1%, significantly lower than other developed nations.

Over the past 30 years, there have been multiple waves of optimism about Japan’s economic revival, but each time, these hopes have been dashed. The key question now is whether this time will be different—whether Japan can finally break free from stagnation, or whether it will once again fail to sustain a recovery and disappoint analysts and investors.

Interestingly, when Japan first entered stagnation, a well-known Japanese economist, Masahiko Aoki, predicted that a generational shift would be necessary for the country to recover. He suggested that it would take 30 years for Japan to fully emerge from its economic slump. Now, three decades later, some indicators suggest that this moment may have arrived.

To put this decline into perspective, in 1990, Japan accounted for 9% of global GDP (PPP-adjusted), but today, that figure has fallen to below 4%. Part of this is due to the rise of emerging economies such as China, India, and Brazil, which have increased their share of global output. However, few advanced economies have seen as steep a relative decline as Japan.

In fact, Japan’s economic growth has been weaker than most of its developed peers. Over the past two decades, among OECD countries, perhaps only Italy and Portugal have recorded lower GDP growth. A comparison with the United States illustrates this even more starkly: in 1990, Japan’s GDP per capita (PPP-adjusted) was 81% of the US level. Today, that figure has dropped to just 64%. This means that, on average, a Japanese citizen’s purchasing power has declined relative to an American citizen over the past three decades.

The decline of Japan’s global economic standing is expected to continue. According to forecasts by Goldman Sachs, by 2050, Japan will no longer be among the world’s five largest economies. By 2075, it may not even be in the top ten, overtaken by rapidly growing economies such as Indonesia and Mexico

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Farshad
What has caused Japan’s economy to struggle with stagnation and deflation for so many years?

Hamzeh
One of the core issue has been a lack of dynamism—stagnation, inertia, and an absence of economic momentum. This sluggishness is visible across different aspects of Japan’s economy.

For instance, we can see this in the behaviour of prices and wages. Over the past three decades, Japan has had the lowest inflation rate among OECD countries, with inflation often hovering near zero or even turning negative.

Persistently low or negative inflation signals weak demand, but it also reinforces itself by depressing future demand. When inflation remains low for long periods, it shapes consumer expectations—people start anticipating that prices will stay flat or even decline. As a result, they delay purchases, expecting better deals in the future. This, in turn, weakens overall demand and keeps inflation low.

Just as high inflation creates instability and economic distortions (which we have experienced firsthand in our own country), very low or negative inflation can also be problematic because it discourages spending and investment. That’s why, over the past two years, rising inflation has been a major concern for most developed countries, but in Japan, inflation moving higher has been seen as a positive development. However, even with this recent inflationary trend, Japan’s inflation rate peaked at just 4% and is currently around 3%—which is roughly the target level set by central banks in many other advanced economies.

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Farshad
So Japan’s persistently low inflation has essentially been a reflection of weak consumption and investment, right? Does this mean that, relative to supply, demand in Japan has been lower than in other OECD countries?

Hamzeh
Exactly. We can also observe this through Japan’s current account balance. The current account reflects a country’s total consumption—including government spending, household consumption, and investment—relative to its total production. A positive current account balance indicates that the country as a whole is spending less than it produces, meaning it is a net saver.

In most developed economies with integrated financial markets and independent central banks, there is usually a link between fiscal deficits and current account imbalances. This is because budget deficits are often financed through government bonds, which attract foreign investors and bring external capital into the economy. As a result, higher budget deficits tend to be associated with negative current account balances—what economists refer to as twin deficits.

But in Japan, this relationship seems to have broken down. For example, in Anglo-Saxon economies like the US and the UK, both budget deficits and current account deficits tend to be high. In contrast, in Northern European countries and Germany, both tend to be close to balance or in surplus. Japan, however, is an outlier—it has persistently high budget deficits but a current account surplus. The most plausible explanation is that Japanese households and businesses are excessively cautious, spending and investing less than they produce. In other words, both consumers and firms in Japan exhibit a strong tendency toward financial conservatism.

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Farshad: Is this inertia you describe only visible in inflation and weak consumption, or does it appear in other areas of Japan’s economy as well?

Hamzeh: It’s a broader issue. We see this stagnation in corporate dynamics as well. Compared to most OECD countries, Japan has a lower rate of new business formation—meaning fewer new companies are being established, and the economy remains dominated by older firms. In a way, just as Japan’s population is ageing, so are its businesses.

A similar pattern exists in the labour market. Job mobility is low, meaning that workers in Japan tend to stay with the same employer for much longer than in other countries. This limits the exchange of ideas, skills, and technological know-how between firms.

One unique feature of Japan’s labour market is lifetime employment. Although not a formal contract, it is a strong norm in Japan, rooted in a culture of loyalty and commitment. Under this system, employees—particularly in large corporations—often spend their entire careers with a single company. For example, among workers aged 50–59 in large Japanese firms, around 40% have never switched jobs. They started their careers at one company and remained there until retirement. This is much higher than in most other OECD countries.

Lifetime employment has advantages: it fosters loyalty, enhances job security, and reduces fears of unemployment. But it also makes the labour market rigid. Companies struggle to adjust to economic shocks, and knowledge transfer between firms is reduced.

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Farshad: Let’s return to the main discussion. What has sparked renewed optimism about Japan’s economy? What specific changes are taking place that have led some to believe in its revival?

Hamzeh: Several factors have contributed to this renewed optimism—some are external shocks, while others are domestic changes occurring within Japan itself. One key factor is inflation. As we discussed earlier, Japan has experienced persistently low inflation for three decades. But over the past 18 months, inflation has consistently remained above 2%, which is a significant shift for Japan. The primary driver of this inflation has been global supply chain disruptions and rising global prices. However, the inflationary pressures imported into Japan have also had a psychological effect on pricing behaviour among Japanese companies.

For years, low inflation created an expectation among consumers that prices should remain stable. This, in turn, influenced businesses, discouraging them from raising prices out of fear of losing customers. But now, with inflation creeping into Japan from external sources, this mindset is beginning to shift.

If we look at the data, the shift is striking: two or three years ago, only 50-60% of goods saw price increases each year, while the prices of 40-50% of goods actually declined. In the past two to three years, this pattern has completely reversed. Last year, over 90% of goods in Japan experienced price increases.

So far, wage growth has lagged behind inflation, but there are growing expectations that next year’s annual negotiations between labour unions and employers will result in higher wages. If this materialises, it could provide a much-needed boost to domestic demand and economic momentum.

Another major external factor is geopolitical tensions between the US and China. In the past, the US viewed Japan as an economic competitor, particularly during the 1980s and early 1990s. But today, due to escalating tensions with China, Washington now sees Japan as a key economic and strategic ally. This shift has raised Japan’s importance in global trade and supply chains, making its economic development a priority for the US and its allies.

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Farshad: So far, these seem to be external factors. What domestic changes have contributed to a more optimistic outlook for Japan’s economy?

Hamzeh: One significant factor is a surge in investment. Since 1983, when data first became available, Japan has never seen investment levels as high as they are today.

A major driver of this investment boom is government support, particularly through industrial policy—a trend we’ve also seen in the US, Europe, and China. The Japanese government has started to actively support strategic industries, particularly semiconductors and green energy technologies.

For instance, the government has pledged to spend around $13 billion annually—equivalent to 0.3% of GDP—on green industries. Additionally, Japan has significantly increased military spending, another area where public investment has expanded.

Another major policy shift has been incentivising household savings to flow into investments. Through tax incentives, the government has encouraged savers to channel their money into the stock market and business investments rather than leaving it idle.

All of this is happening alongside a generational shift in Japan’s corporate leadership. A new generation is gradually taking over, one that does not carry the deep scars of Japan’s 1990 financial crisis. This change in leadership mindset could prove crucial in shaking off the cautious and risk-averse culture that has dominated Japan for decades.

For example, the average age of CEOs in companies listed on the Nikkei index has fallen by 12 years over the past decade. This generational transition has also been accompanied by reforms in corporate management, including the gradual fading of Japan’s traditional "lifetime employment" system.

As we discussed earlier, lifetime employment is not a formal contract but rather an informal cultural norm, where companies offer employees long-term job security, often hiring them at a young age and keeping them until retirement. While this system has its benefits—fostering loyalty and job security—it also reduces labour market mobility and makes it harder for companies to adapt to economic shocks.

Now, as this system gradually fades, Japan’s labour market is becoming more dynamic, which could boost productivity and innovation. We are also seeing increased entrepreneurial activity. Although Japan’s startup ecosystem remains relatively small compared to its economic size, it has been expanding rapidly in recent years. To put this into perspective: In 2013, total investment in Japanese startups was just 88 billion yen. Over the past decade, that figure has grown nearly tenfold, reaching 877 billion yen. This surge in startup investment is a sign that Japan’s economy is beginning to embrace innovation in a way it has not done for decades.

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Farshad: So, overall, does this mean that the outlook for Japan’s economy is positive?

Hamzeh: I think we need to be cautious in discussing Japan’s future. While there are many reasons to believe that this time could be different and that Japan has the potential to return to economic dynamism, there are also significant risks that could once again cloud its outlook. One concern is that Japan’s post-pandemic recovery has been weaker than expected. In Q2 of this year, Japan’s annualised economic growth surged to 4.5%—a remarkably high figure by Japanese standards. But in Q3, based on data published in November, annualised GDP growth fell to -2.1%, which was deeply disappointing.

Despite rising prices, wages have not increased significantly, meaning domestic consumption—one of the key drivers of economic growth—has yet to show a meaningful recovery. However, as we mentioned earlier, there are expectations that wage growth will accelerate next year.

Another major concern is monetary policy. Japan’s government debt as a percentage of GDP is extremely high. For years, Japan has relied on ultra-low interest rates—either negative or near-zero—to manage this debt burden. However, speculation is growing that the Bank of Japan may raise interest rates next year. If that happens, it will increase government borrowing costs, forcing the government to either cut spending or raise taxes—both of which could hurt economic growth.

At the same time, Japanese businesses have become highly accustomed to low borrowing costs. A sudden shift to higher interest rates could create serious challenges for Japanese companies, particularly those heavily reliant on cheap credit.

And, of course, Japan’s ageing population remains a persistent structural issue that poses long-term economic challenges.

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Farshad: How significant are the costs associated with Japan’s ageing population? To what extent could this challenge limit the prospects of Japan’s economic revival?

Hamzeh: Japan has the oldest population in the world. As of 2023, nearly 30% of its citizens are aged 65 or older—a figure that is expected to rise further in the coming decades. This is significantly higher than other advanced economies like Germany (22%) and the United States (17%). The demographic challenge is particularly severe because Japan also has one of the lowest birth rates globally, with only 1.26 births per woman in 2022, far below the replacement rate of 2.1. As a result, Japan’s working-age population has been shrinking for years, placing increasing pressure on its economy.

At the same time, Japan is also one of the most indebted countries in the world. As of mid-2023, its government debt stands at roughly 260% of GDP—the highest among advanced economies. For comparison, the US debt-to-GDP ratio is around 120%, and the eurozone average is roughly 90%. Japan’s debt burden is particularly unique because a significant portion of it is held domestically, primarily by the Bank of Japan and domestic institutional investors.

These two factors—an ageing population and massive public debt—are closely intertwined. A rapidly ageing society means government spending on pensions, healthcare, and elderly care services is expected to rise sharply. Currently, nearly a third of Japan’s government budget is allocated to social security, a figure that will only increase as the number of retirees grows. By 2040, projections suggest that social security costs could exceed 25% of Japan’s GDP annually.

This creates a major fiscal challenge. With such high debt levels, the government already has limited room for additional borrowing. If spending continues to rise, Japan will either have to cut spending elsewhere, raise taxes, or find ways to boost economic growth significantly. Higher taxes, particularly on a shrinking workforce, could further strain the economy, while drastic spending cuts could undermine growth and social stability.

This delicate balancing act means that while Japan is showing signs of economic revitalisation, its structural issues—especially the ageing population and public debt—remain serious long-term obstacles. How policymakers manage these challenges will be crucial in determining whether Japan’s recovery is sustainable or short-lived.

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Farshad: Since we’re running out of time, can you summarise your final thoughts on Japan’s economic future?

Hamzeh: The convergence of domestic and external factors—from generational leadership changes and geopolitical shifts to price shocks and structural reforms—has created a unique window of opportunity for Japan. This moment could be the turning point where Japan reinvents itself and regains its economic dynamism.

Whether or not Japan fully seizes this opportunity remains to be seen. Much will depend on external factors, as well as on whether Japan’s policymakers can effectively capitalise on the country’s newfound momentum. What seems certain, however, is that Japan now has a clearer path to transformation than at any time in the past three decades. And as always, the role of policymakers will be crucial—steering the economy in the right direction and making the most of the opportunities at hand.