What Holds Japan Back

And How Economic Reforms Could Overcome a Hidebound Old Guard

By Richard Katz

January 31, 2024

Many observers have come to believe—incorrectly—that Japan’s extended economic slump

is irreversible. The country’s GDP today is no higher than it was five years ago, and per
capita GDP growth has been limited on average to a measly 0.7 percent per year since 1991,
down from an average of four percent during the 1980s. South Korea, a country that was
only one-quarter as rich as Japan in 1980 in terms of real per capita GDP, surpassed it in
2018. China has just topped Japan as the world’s top auto exporter largely because Japan’s
automakers have resisted the shift to electrical vehicles. There has been disappointment
every decade since the end of the 1980s boom when assorted bursts in stock prices led
brokers and politicians to proclaim falsely that “Japan is back”—only for the resurgence to
falter.

That stalled growth rate has hurt much of the public, building political pressure for
meaningful reform. The average real wage of a full-time worker has barely increased since
1990. Social security benefits have been cut 20 percent since 1996, with reports of some
widows resorting to shoplifting. The share of nonregular workers—part-time and temporary
workers whose hourly pay is half, or less than half, that of full-time workers—has swelled
from 15 percent of the workforce in the 1980s to nearly 40 percent today. While 72 percent
of regular male workers in their late 30s have spouses, only 30 percent of nonregulars of
equivalent age can afford to get married.

Japan’s economic torpor has important consequences beyond its borders. A vibrant Japan
could provide a counterweight to China, for example, by helping countries in the global
South resist Beijing’s economic overtures and threats. More broadly, the world would
benefit if Japanese companies could regain their past innovativeness and dynamism. Firms
in Japan, for instance, pioneered decades ago the commercialization of three of the
technologies now critical to the fight against climate change: solar panels, electric vehicles,
and lithium-ion batteries.

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Revival requires relatively little political and social reform—and yet remains difficult. Japan’s
travails stem from holding on to once helpful, but now obsolete, twentieth-century policies,
practices, and institutions. One such impediment is the Japanese practice of so-called
lifetime employment, a policy that de facto guarantees recruits a permanent position within
a company but in the process reduces labor mobility and wages. Another is the domination
over the economy by once imaginative giant corporations that now block innovative
challengers. The overarching financial system also shores up weak incumbents to the
detriment of startups.

The good news is that shifts in attitudes, technology, and globalization, along with the
political fissures created by low growth, have facilitated the best opportunity for recovery in
a generation. These trends can resurrect the kind of entrepreneurial effervescence that
drove both modernization in the late nineteenth century and, after World War II, a quarter
century of nearly ten percent annual growth. That South Korea has grown so well, despite
sharing many of Japan’s business institutions and structural flaws, proves that fixing the
Japanese economy is possible.

Unfortunately, Japan’s positive currents cannot change the system unless they are amplified
by government support, which so far has been lacking. Powerful traditional companies fear
that too much entrepreneurship might unleash a bout of creative destruction that would
push them out of business. This old guard not only includes large corporations that remain
behind the times technologically but also hundreds of thousands of moribund small and
medium enterprises. A looming contest between entrepreneurs and those arrayed against
them will determine Japan’s economic future.

IN WITH THE NEW

All healthy economies need a continual inflow of new high-growth companies with fresh
ideas. In the United States during the 1980s and 1990s, firms less than five years old created
a stunning 60 percent of the growth in factory output per worker. Today, Silicon Valley’s
2,000 high-tech ventures are just a tiny sliver of the 50,000 or so dynamic new companies in
operation in the United States. These young firms supply the vitality that their older
counterparts lack, sometimes by replacing incumbent firms, sometimes by forcing them to
adapt, as the car maker Tesla has done to legacy auto giants.

In Japan, traditional companies have been insulated from this kind of disruptive innovation.
Only one of the country’s top two dozen electronics manufacturers was created after 1959.
Despite a 40 percent surge in global electronics sales between 2008 and 2020, all of Japan’s
top ten electronics manufacturers saw their global sales slump in that period because they
could not come up with competitive versions of products ranging from smartphones to
Internet networking equipment. Many economies grapple with this “old company disease,”
but Japan is distinguished by the scale of the impediments that block the emergence of new
firms with fresh ideas. The obstacles include difficulties with recruiting talent, reaching
customers, and acquiring external finance, as well as government policies that favor
incumbents. Among Organization for Economic Cooperation and Development (OECD)
countries, Japan’s small and medium enterprises are the oldest and have the lowest rate of
growth.

But there is growing room for optimism because some of the existing hurdles are beginning
to break down. Consider recruiting. In the twentieth century, Japan created the system of
lifetime employment, in which leading companies hired new graduates, trained them in the
firm’s mind-set, and retained them for their whole career. Workers feared leaving a big
company to join a startup—many of which fail—because big companies rarely hired
somebody who had switched jobs; consequently, the workers were unlikely to ever regain
their previous wage level.

Today, however, talented younger workers are far more willing to take a chance on a new
firm than their parents were. Four decades ago, 70 to 80 percent of people in their late 20s
or early 30s who had worked for one employer for ten to 15 years stayed at that employer
for at least another ten to 15 years. By the early 2000s, that rate had dropped to 50 to 65
percent, and now statistics indicate that less than half of young workers stay at the same
firm for so long. The shift is also apparent in the hiring of people in the middle of their
careers. Back in 1994, only 35 percent of companies hired anyone in their 30s and 40s away
from another firm; now, 70 percent do so, and those that do are more profitable as a result.
In the lifetime employment system, workers tended to develop company-specific skills.
Given today’s rapidly changing and uncertain conditions, firms benefit from incorporating
new skill sets and perspectives through hiring midcareer workers.

Japan’s revival requires relatively little political and social reform.

A virtuous cycle has begun. Workers have greater leverage in the current tight labor market,
and now, with established firms more willing to make midcareer hires, they feel
emboldened to take risks. Newer companies have been able to recruit both veterans from
more established firms and recent college graduates. Take the recruitment firm Visional,
founded in 2009, which matches companies, new and old, with potential candidates. By
2023, it had found jobs at 20,000 companies for 2.3 million well-paid employees seeking
better opportunities, and in 2021, its founder became Japan’s newest billionaire. Visional is
now just one of many such recruitment agencies.

Newer firms have also been able to take advantage of a pervasive problem in employment
practices among traditional firms: the lack of equal pay and promotion opportunities for
women. I recently spoke to two female executives at Askul, a distributor of office supplies.
They had left household-name companies to join Askul in its early days (it now has sales in
the billions of dollars), lured not only by better opportunities for advancement but also by
the adventure of building something from the ground up. The newer companies do not yet
have sufficient weight to reduce the national gender gap in pay and promotion, but the
more talented women they recruit, the more pressure traditional firms will feel to close the
divide.

Technological advances are also increasing the market power of startups. In the past, new
firms had difficulty reaching customers because they had to use a distribution system for
products that was largely controlled by big legacy companies. E-commerce has changed
that. Take Rakuten, Japan’s flagship Internet mall. In 2023, some 57,000 small and medium
enterprises sold more than $40 billion worth of products to over 100 million customers
through the site, which functions much like Amazon. One of Rakuten’s merchants is Tansu
No Gen, a former furniture maker and now a seller whose founder was wary of e-commerce
and preferred using traditional retail stores. When he retired in 2002, his children joined
Rakuten’s network, and they saw sales explode from less than $1 million per year in 2002 to
$175 million today.

Digitization is putting enormous pressure on Japan’s more staid companies to look in new
directions. In a ranking done by IMD Business School of 64 countries in “digital agility”—how
much a company increases sales and profits for every dollar it invests in digital equipment
and software—Japan came in dead last. That struggle to master digitization is one of the
reasons Japanese giants have had trouble competing in world markets. As a result, some
traditional companies now feel compelled to work with digitally adept newcomers. In 2018,
for the first time, the number of software vendors exceeded traditional parts makers among
the top 5,000 suppliers to the automaker Toyota. Few of the software companies wanted to
join Toyota’s corporate group and be treated as subordinates rather than partners. They
cherished their independence, including the freedom to collaborate with anyone, even
Toyota’s competitors. Toyota’s need for outside technological expertise for all the
sophisticated electronic software and hardware in vehicles these days forced it to abandon
its long-standing reluctance to allow its vendors to work with the competition. In order to
innovate, it has accepted conditions that it had previously disdained.

THUMB ON THE SCALE

The biggest remaining obstacle for new Japanese companies is securing outside financing.
Unless would-be founders are rich, creating a successful high-growth company requires
seed money from “business angels” who, unlike venture capitalists, finance startups that
may never get big enough to join the stock market or even desire to do so. Japan has few
such angels, in part because it does not offer the tax incentives available elsewhere.
Moreover, Japanese banks are loath to lend to newer firms even after they have begun
growing at a healthy clip, and banks, like other traditional firms, often discriminate against
female founders. Far more than in other rich countries, Japan’s banks make loans
contingent not on projections of future profits but on physical collateral—such as land,
factories, commercial buildings, and equipment—and, even worse, the owner’s personal
guarantee to turn over their home and savings if the firm goes under. This makes it hard for
new firms to secure lines of credit, since they usually rent property and their founders may
not be rich enough to make a large guarantee. As a result, banks charge ten-year-old firms
that have a good track record of growth a higher interest rate than they do a 50-year-old
firm that may have a long record of mediocre performance because the older company has
committed more collateral. Firms that lack sufficient capital from the outset start off too
small and, as a result, are more likely to die prematurely or fail to reach their growth
targets. Hence, many would-be entrepreneurs go overseas, to places where securing such
financing is easier.

The Japanese government does not help matters by putting its thumb on the scales in favor
of older and bigger companies. For example, almost 90 percent of Japan’s government
support for R & D goes to firms with more than 500 workers, the worst ratio in the entire
OECD. Nor does Tokyo provide new private corporations with certain pivotal tax advantages
available in other rich countries, such as exemption from double taxation of income at both
the level of the company and that of the individual owner.
Japanese Prime Minister Fumio Kishida promised to reform this system as part of his 2022
“new form of capitalism” program, vowing that Japan would have a tenfold increase in
startups, to 100,000, by 2027. But he has done almost nothing to turn this rhetoric into
reality, save for one poorly designed tax break for angel investors that will not work.
Reformers urged that he raise the portion of public procurement set aside for new
companies from the 2018 goal of three percent to ten percent. But Japan has never even
come close to the three percent goal, and Kishida has not suggested he will do anything
other than try, like those before him, to meet the current low target. By contrast, the
government sets aside 55 percent of its public procurement contracts for small and medium
enterprises, most of which are old (and often weak), giving them an advantage over
younger competitors.

A MOVABLE OBJECT?

Unless the government changes its tune, Japan will miss this opportunity for revival.
Without a critical mass of successful new companies, the economy will continue to slumber,
living standards will deteriorate, and voters could eventually unseat the long-ruling Liberal
Democratic Party (LDP), just as in 2009 when the party temporarily lost power in a landslide
defeat.

Many analysts know what needs to be done. A government-convened panel of experts in

technology, business, and finance prepared a superb report for Kishida pointing very
concretely at the hurdles that needed to be overcome in order to promote more startups,
many of the same hurdles discussed above. Kishida more or less ignored it.

That is shortsighted politically as well as economically. The LDP remains in power today only
because the public is even more unconvinced by the opposition than it is by the ruling party.
Disenchanted voters stay home, and turnout in national elections keeps dropping. In the
absence of an economic recovery, however, the LDP has to fear that the opposition will find
a way to inspire voters and triumph in a future election.

Enterpreneurs must overcome the formidable barrier of a shortsighted establishment.

Under the surface, many entrepreneurs are rising and slowly gaining political clout and
access to key bureaucrats and politicians, some of whom are sympathetic to new
companies, given Japan’s dire economic needs. They sometimes succeed in coaxing small
reforms, such as the legalization of firms spun off from university research and the
legalization of online sales of over-the-counter drugs. These incremental gains help speed
the emergence of new companies that in turn accrue more political influence as their
numbers swell. In a snowball effect, small victories today can lead to greater victories
tomorrow.

Even the big traditional companies cannot simply oppose entrepreneurship since, like
Toyota, they need the newcomers as partners. Notably, Keidanren, the conservative big
business federation, has called for entrepreneurial revival, backing Kishida’s target of
100,000 startups by 2027. But it has failed to push for the measures needed to make such a
revival happen on the necessary scale, such as an effective tax incentive for angel investors
or the shift of government financial aid for R & D to startups from established companies.
There is no guarantee that future governments will enact the necessary reforms. But
without them, Japan’s economy and its global influence will continue to erode. Social and
technological forces are promoting entrepreneurship to a degree not seen in the country
since its postwar recovery, but the push for change must still overcome the formidable
barrier of a shortsighted establishment.