From 2012 to late-2018, Japan’s working working-age population (15 to 64 years of age) shrunk by 4.7 million. However, its total workforce increased by 4.4 million during the same period, after accounting for three major sources of labor-force growth: the elderly, women and foreigners. Nevertheless, the share of the working-age population that is employed is now at its highest level since the 1960s, with the ratio of job offers-per-applicant near its all-time high of 1.6, registered in 1963. And, according to the latest projections by Japan’s health ministry, Japan’s workforce will fall from 65.3 million in 2017 to 52.5 million in 2040, a decline of 22%. Demographic headwinds will be a persistent feature of the Japanese economy for decades to come.

On the other hand, despite the tightest labor supply conditions in over 40 years, the core consumer price index (CPI), which excludes volatile fresh food costs, rose only 0.9% year-over-year last November. Moreover, inflation has disappointed consistently, despite the country’s second-longest economic expansion under Prime Minister Abe, from late-2012 through the present.

Greg Ip of The Wall Street Journal wrote an article published May 23, 2018, and headlined “In Booming Japan, the Phillips Curve Is Dead,” which said: “By several measures, the economy is overheating. Total activity is now 1.5% above normal capacity…Unemployment, at 2.5%, and businesses’ spare capacity are both the lowest since 1993, when the 1980s property and stock bubbles were still deflating…In defiance of the Phillips curve, these intensifying bottlenecks have had only limited impact on wages, and none on prices. Inflation in the year through April was just 0.4% when fresh food and energy are excluded…it’s a far cry from the Bank of Japan’s 2% target. This is a problem, because if inflation gets stuck at or below zero, interest rates also get stuck at zero, robbing the central bank of its ability to stimulate the economy by cutting rates.”

It has often been said that solving Japan’s labor force problem would require huge changes in immigration policy. But, Takeo Hoshi, a Senior Fellow in Japanese Studies at the Freeman Spogli Institute for International Studies at Stanford University, highlights a more likely cause of Japan’s problems: productivity. In a February 8, 2018, article published by The Tokyo Foundation for Policy Research, with the counterintuitive headline “Japan’s Demographic Advantages,” Hoshi wrote:

In thinking about how population decline affects economic activity, it is useful to examine each of the three factors that contribute to GDP growth, namely, the growth rates for population, labor participation (the labor force as a percentage of the total population), and productivity (output divided by labor force). The economic growth rate is the sum of these three components.

The table below gives the figures for these components from 1956 to 2015. Clearly, there has been a significant dampening of economic growth over the past six decades. The economy expanded by around 8% during the 1950s and 1960s before leveling off to 3%–4% in the mid-1970s and slowing further to around 1% since the mid-1990s.

Population and Productivity as Factors Contributing to Economic Expansion (% growth) Source: Takeo Hoshi, The Cabinet Office, the Statistics Bureau, Ministry of Internal Affairs and Communications, et al.

Even during the period of high economic growth, higher population (the sum of the figures for “population” and “labor participation”) directly contributed only 1 to 1.5 percentage points. The remaining 7 percentage points or so came from gains in productivity. The growth rate dwindled substantially between 1976 and 1995, but increases in the labor force and total population remained largely unchanged during those two decades...

After reading Hoshi’s views, one could argue that population growth has not been the most important factor explaining Japan’s economic weakness in recent decades. Although demographic factors have been a drag on GDP growth since the late-1990s, that impact is estimated to be about 0.1 percentage point per year. The two “lost decades” of economic stagnation (1996-2015) in Japan, after its classic late-1980s asset bubble, were largely due to the chronic slowdown in productivity growth during the same period, as shown in the table above.

Jesper Koll, who is WisdomTree’s head of Japan, argues that productivity trends may be on the verge of a significant positive shift. He wrote an Op/Ed for The Japan Times, published August 3, 2018, and headlined “Japan’s Coming Productivity Miracle.” We quote:

So why my optimism? It stems from the next layer of detail and analysis. Japan’s overall productivity is being held back by a huge difference in sectoral productivity: While Japan’s manufacturing sector has remained a clear global productivity leader, the domestic service and non-manufacturing sector has fallen behind.

Non-manufacturing companies managed absolutely zero productivity growth in the past two decades…Between the year 2000 and 2017, manufacturing sector workers’ value added produced per hour surged from about ¥4,000 to approximately ¥5,800; but non-manufacturing sector workers’ value added per hour stayed absolutely flat-lined at about ¥4,600—no growth whatsoever.

Make no mistake—for an economist, this stagnation of service-sector productivity is the very core reason for Japan’s two-decade-long stagnation and global under-performance. Fortunately, economists also can explain what exactly forced the stagnation in service sector productivity—chronic underinvestment: Since 2000, the amount of productive capital employed per worker has fallen from approximately ¥24 million to just below ¥22 million in the non-manufacturing sector.

Yes, service companies did hire more employees—service-sector employment has risen by more than 5 million people since 2000; but those employees were not given more modern or upgraded machines and technology to do their job. Incredibly, capex spending in Japanese services has flatlined since 2000, which suggests basically that Japan’s service sector completely ignored the IT revolution. In contrast, Japanese manufacturers increased capital investment spending steadily, so the capital intensity in manufacturing rose from approximately ¥20 million to just above ¥26 million between 2000 and 2017...Japan’s industrial workers do work with the best machinery available while service sector workers work, at best, with last-generation technology.

Koll’s argument has merit. For instance, the healthcare services sector has benefited from a nascent increase in capital spending, as the Japanese government has begun cooperating with businesses and academia to build hospitals that are enabled by artificial intelligence (AI) that is designed to address the chronic labor shortage in healthcare. The government plans to invest more than $100 million over half a decade, with a target of establishing 10 model AI-enabled hospitals by the end of fiscal 2022.

Heroz Inc. (4382 JP, JPY 7,080.00), a leading provider of AI solutions in Japan, appears to be in a position to capitalize on these trends. Although it is a relatively-new company carrying a high valuation, with a price-to-book ratio of 31x, Heroz has a huge opportunity to help Japan enhance productivity in the service sector. Using its deep learning and machine-learning knowledge developed by playing professional Shogi (Japanese chess), Heroz developed an AI platform named “HEROZ Kishin,” which can be used by various industries, from construction to financial services.

The company has been working with Takenaka Corp., one of Japan’s largest construction companies, to create an AI system to help design buildings. The system will take Takenaka’s existing design data and learn from its architects to provide various patterns for how buildings could be designed. Architects then compare the patterns and consult with clients to decide which designs are to be used. Heroz has also tied-up with Monex, a major online brokerage, to provide robo-advice for currency traders.

Since Japan is the global laboratory, its experience in bolstering productivity in services will have far-reaching effects as other countries encounter their own demographic headwinds. If Japan can enhance its labor productivity through more capital spending in services, it would have very encouraging implications for East Asia, and perhaps for most of the OECD economies that are now aging rapidly.