In total size, Japan’s economy is fourth-largest in the world, just behind Germany for third-largest.

In per capita GDP, Japan is ahead of Spain and South Korea, although well behind Italy and France. With a life expectancy at birth of 84 years, ,Japan has one of the highest levels in the world. Clearly, Japan has some considerable economic strengths.

But there is a puzzle here. In the late 1980s and early 1990s, Japan’s economy experienced a dramatic boom-and-bust in stock market and real estate prices. For example, the Nikkei stock market index rose from about 10,000 in 1984 to almost 38,000 in 1989, and then fell back to 17,000 by 1992. In the early 2000s, the Nikkei had fallen to under 10,000, and it was under 10,000 in 2012, too. Since then, the Nikkei has climbed again, and in early 2024–35 years later–it exceeded the level it had reached in 1989. In short, Japan’s economy crashed about three decades ago and growth has been slow and halting ever since.

Japan faces ongoing demographic challenges, too. The “working-age” population in Japan, from ages 15-64, peaked back in the mid-1990s at about 87 million, but now has fallen to 73 million. Japan’s population is aging. Back in the mid-1990s, Japan had about five working-age people for every person over the age of 65; now, Japan has one working-age person for every person over the age of 65.

Japan has very high levels of government debt, too. According to IMF calculations, the US ratio of government debt to GDP ratio is about 120%; Japan’s ratio of government debt to GDP is about 250%.

So how is Japan’s economy adjusting to these underlying factors? Dany Bahar, Guillermo Arcay, Jesus Daboin Pacheco, and Ricardo Hausmann explore some of the underlying patterns in “Japan’s Economic Puzzle” (The Growth Lab at Harvard Kennedy School, CID Faculty Working Paper No. 442, revised July 2024). They focus in particular on the evolution of Japan’s interaction with the global economy. They write:

Our main findings put together suggests that in response to the enormous domestic challenges in the economy, Japanese firms have sought to offset these constraints by expanding their operations internationally through foreign investments. By investing in foreign markets, Japanese firms can access larger and more diverse labor pools, enabling them to continue growing despite domestic labor shortages. These Japanese investments abroad, accompanied by the unique accumulated knowledge of the Japanese economy (i.e., technology, best practices, and more), has resulted in very high returns to these investments. The subsequent increase in wealth to the economy has inevitably resulted in a domestic expansion into non tradable, less productive, sectors of the economy which lowers aggregate productivity growth. Overall, we argue, the sluggish productivity growth in Japan is a result of these dynamics.

In the last few decades, Japan’s share of global exports of goods has plummeted, in substantial part because of China’s rising share of global exports of goods. From a US perspective, a lot of the imported goods that were made in Japan back in the 1970s and 1980s are now being made in China.

But when it comes to exports of services, Japan has continued to do well. In particular, the “service” that Japan exports is often intellectual property, which refers to licenses to use Japanese patents elsewhere.

In addition, Japanese firms are building up their investments abroad. One way to think about this is that Japan’s firms are dealing with the declining labor force in Japan by finding workers in other countries. The authors write:

Japan has significantly increased its net foreign asset positions, particularly after the turn of the century. In fact, between 1996 and 2022, Japan nearly quadrupled the value of its assets abroad from USD 2.7 trillion to USD 10.3 trillion. An important driver of this growth is reflected in Japan’s stock of outward direct investment, which increased by a factor of almost 8 from USD 263 billion to USD 2.1 trillion during the same period. Moreover, the returns to those direct investments have grown significantly, too, with abnormal returns consistently much larger than for any other investment positions. The data shows that dividends stemming from direct investment abroad … [have] grown by a factor of almost 15 from USD 14 billion in 1996 to USD 206 billion in 2022.

Putting this together, the authors argue that Japan’s companies are involved in high productivity growth–it’s just that a lot of that productivity growth is happening outside the borders of Japan, in industries where Japanese firms end up exporting to the rest of the world. Japanese workers who work for a company that is involved in international trade and has rapid productivity growth have wages rising more quickly than those who work for companies in non-tradeable goods like retail, hotels, and services, which have lower or even negative productivity growth.

Is this Japanese economic model sustainable? The authors speak gently of “challenges.” With a declining domestic labor force and high-productivity firms operating abroad, Japan’s economic future seems intimately tied to a combination of technological and managerial know-how, along with global supply chains. Success for this economic formula requires that Japan’s export-oriented firms remain on the technology frontier, which can be easier said than done in the 21st century global economy. Also, as the size of Japan’s domestic workforce declines, it would help if Japan’s low-productivity domestic production sectors could find ways to make better use of technology to improve productivity.