Policies Needed to Capture Benefits of Productivity Gains
Yukari SATO (Senior Economist, JP Morgan, Tokyo)
Summary: Japan's manufacturing productivity, as measured based on a model that focuses on value-added, has been rising since around 2000. This development disrupts the downsizing trend, but in a deflationary environment, the benefits are not recycled to the overall economy. Demand needs to be stimulated with permanent tax cuts that are financed by the Bank of Japan's (BoJ) liquidity provision.
"Demand creation" critical for breaking cycle of downsizing
It would be a mistake to believe that slashing costs is the only way to put Japan's economy back on track for the long term. To be sure, more than a few blue-chip companies have generated even better profit results than they did during Japan's bubble years by consolidating their operations over the past few years. The results of these moves are evident also in the accelerated reductions of excess capacity, with the manufacturing capacity index declining nearly 9% in the five years since 1998, to roughly the same level as in late 1988. Capacity reductions have been particularly significant in such sectors as transport equipment, electric machinery, glass/ceramics, and textiles.
However, cost reductions that do not constitute business restructuring in the conventional sense are nothing more than efforts to temporarily improve profits. Without the creation of new demand to offset the portion of business operations that have been discontinued, not only will the macroeconomy fail to turn around, but will shrink. This "fallacy of composition," in addition to deflation-stimulated hollowing out of industries, is one of the reasons for the current growing divergence between micro trends of corporate profits and macroeconomic trends.
In this downsizing model, "a market failure" occurs as an improvement in corporate profits leads to a contraction of the macroeconomy, which then leads to a corresponding deterioration in profit fundamentals to ultimately retaliate on profits. In other words, with two good profit growth projections, discerning the nature of the source of their growth is extremely important from the perspective of whether the economy is likely to get back on a revitalizing track.
In this light, there are now indications of some developments of a breakaway from this downsizing trend. Constant transformations are needed gearing the industrial composition increasingly toward technology- and knowledge-intensive industries in order to assure sustainable growth in a mature economy. Efforts are already under way to establish the new technologies required for such a transformation. Japanese companies have started to increase their prior investments domestically in such emerging growth areas as nanotechnology, biotechnology, next-generation semiconductors, new materials, optical materials, fuel cells, and wind-powered electricity generation. These and other companies have initiated strategic transformations away from a defensive management based on a debt-reduction focus by way of consolidating into core businesses and toward one with a forward-looking focus on capturing emerging new markets.
Such a strategic shift in part owes to a buildup of internally generated funds. Private non-financial companies' savings have been on the increase for several years, and were up by a net 7.8 trillion yen over the year at the end of FY2002. At the same time, the private capital investment deflator for the same fiscal year declined by an average 4%. In other words, deflation increased the purchasing power of companies' internal funds, to place them under financing conditions that will allow more active capital investment without triggering an increase in debt.
In this current shift toward high value-added industries, how "productivity" is measured also needs to be redefined.
In the Japanese economy through the 1980s, thanks to a steady rise in the capital-labor ratio due to stepped-up use of machinery, labor productivity increased, and so did workers' incomes, and thus further growth in demand followed. This was the growth-economy model that rested on the mass production that was widely adopted and foremost by the auto industry at the time. The concept of productivity, such as through higher output volume per hour of labor, was well suited for such a growing economy, and was well premised on growth of the capital stock.
However, this growth model that rested on an expansion in the capital stock came to an end when excess capacity emerged in the early 1990s, which forced Japan to revise its trajectory to become a more technology- and knowledge-intensive mature economy. For cost-conscious companies focused on using resources in growing overseas markets, a volume concept of productivity remains important. However, for domestic manufacturing and the knowledge-intensive service sector aiming to shift into more value-added production utilizing the latest high-tech technologies, a productivity measure based on the qualitative contribution of unit labor to the increase in value-added is becoming more important.
Indications of absolute improvements in efficiency
Despite the dullness of the trend growth in conventional, quantitative productivity measures, a total factor productivity model which redefines output in terms of value-added shows an absolute improvement in domestic manufacturing efficiency since around 2000. This absolute improvement can be regarded as increased contributions of both capital and labor to the value-added, owing to their internalization of the benefits of favorable changes in external production conditions. This simultaneous improvement in both capital and labor productivity is evident in a number of domestic manufacturing industries, as noted later.
An increase in capital input typically leads to an increase in labor productivity but with an inevitable decline in capital productivity due to the addition to capital; in other words, the correlation between capital and labor productivity is typically negative. However, the productivity trends have risen in tandem with each other recently due to the occurrence of external shocks.
In all the industries in which both capital and labor productivity have risen, changes in the external production conditions are first observed, and then later on trigger improvements in efficiency. The adoption of supply management systems such as the supply chain management (SCM) which has become widely used with more prevalent use of IT, substantial reductions in communications costs owing to deregulation, and enhanced economies of scale and scope from industry consolidation and realignments can be considered some of the triggers of these efficiency improvements. The confluence of these environmental changes that apparently occurred centering around 2000, and the internalization of their benefits by both capital and labor through the production process, is considered to have led to absolute improvements in efficiency.
In addition, these external factors led to a domino effect across industries, with the so-called IT revolution likely a major factor. The effects were first evident in such IT-related industries as electrical machinery, glass/ceramics, and, somewhat later, nonferrous metals, and then spread to general machinery, retail, real estate, and other non-IT-related industries.
Recycling productivity gains into the economy
Returning to a macro perspective, such a secular increase in productivity in a deflationary economy can be accompanied by greater deflationary pressures than usual. In other words, when companies that have realized productivity increases try to rationalize operations further, the economic rent of the productivity improvements is unlikely to feed back into the macroeconomy in the near term. It is possible that rationalization moves in the deflationary economy have gone too far, in which case an effective countermeasure would be demand stimulus.
An increase in domestic supply capacity resulting from productivity improvements can be partially absorbed by export growth, but without a sufficient expansion of domestic demand in the short run, the tendency is for deflation to worsen. Moreover, if this output gap looks likely to widen, suppliers' expected selling prices decline, resulting in incentives not to increase output at a given selling price, but rather to keep up with existing output and aim to raise profitability by further rationalization and cost cutting.
The "productivity rent" that guides the economy to an expansion is thereby retained in companies, and it becomes difficult for this rent to be fed back into the macroeconomy. Thus, deflationary pressures tend to become greater than usual as a result of increased supply capacity compounded by a demand fall stemming from accelerated rationalization.
With the new Industrial Revitalization Corporation of Japan set to begin revitalizing companies, productivity improvements could very well be a tailwind for target companies' rationalization efforts. The latest BoJ Tankan survey, however, suggests that companies plan to further reduce their payrolls this fiscal year, presenting risks to trigger "a market failure" as even financially sound companies remain inclined for further rationalization.
In conclusion, what is clear is that decisive measures to stimulate demand, centering on investment tax breaks and income tax cuts, are needed to sufficiently capture the economic rent of productivity improvements. What is important is that JGBs issued to finance tax cuts today should not be redeemed with future tax increases, but rather the BoJ should purchase them permanently. The government and the central bank should jointly and publicly announce their commitment to such a policy direction. This policy coordination would lead to two solutions to the current fiscal and monetary challenges that are faced independently now.
First, with the policy coordination with the BoJ in which current-period tax cuts are not financed by future tax hikes, households' and companies' permanent incomes will increase, thereby indirectly stimulating current demand. In this way, the tax cuts will become more efficient.
Second, the "liquidity trap" dilemma for monetary policy will come close to being resolved. The BoJ has injected huge amounts of liquidity into the financial system, but the liquidity has been trapped in the banks since their massive nonperforming loan problem has impaired banks' financial intermediation ability and, at the same time, corporate demand for funds has been weak. By having the BoJ finance the tax cuts, liquidity will start flowing from the central bank to the government, and then on to the private sector in the form of tax cuts. In this way, a powerful monetary policy transmission mechanism will be established, that actually give a boost to private-sector spending.
Federal Reserve Board Governor Ben Bernanke has proposed that Japan adopt such policy coordination along with price targeting. He argues that with the economic stimulus impact of tax cuts, with the tax cuts financed by the BoJ, the ratio of the government debt to the private sector to GDP would fall, and the introduction of price targeting will then become a realistic option.
(A Japanese version of this paper, "Seisansei Josho Ikasu Seisakuwo," was published in the July 22, 2003 issue of Nihon Keizai Shimbun, and the English version is posted here with the permission of the author and Nihon Keizai Shimbun)