Appeared in Nikkei Weekly, May 3, 1999.

Shrinking Labor Pool Will Undercut Pensions

Yasushi Iwamoto

  Japanfs labor force has been shrinking every month since June 1988, as shown by year-on-year comparisons. This trend is frequently blamed on the recession, which has kept unemployed women from finding jobs, but the situation will only worsen in the first decades of the 21st century as the effects of a falling birthrate ripple through society.

  According to a forecast by the Ministry of Labor, 2005 will be the point at which the working population will begin to contract in absolute terms. By 2020, the working population is expected to stand at 64 million, or 4 million fewer than today, with the percentage of workers in full employment to the total population contracting at a rate of 0.5% per year.

  In my opinion, the ministryfs calculations are valid only if the labor-force participation ratio ? the number of working people as a percentage of the total population ? rises substantially.

  For argumentfs sake, suppose labor-force participation by age group remains constant. A back-of-the-envelope calculation, based on this assumption, would establish that erosion of the working population will accelerate from around 2005, when the first baby boomers begin retiring. By 2030, the percentage of working population to total population will be shrinking by about 1.0% per year. By the ministryfs mark of 2020, the working population will have been trimmed by more than 6 million.

  Japanfs working population has expanded by about 1% per annum over the past 20 years. Therefore, if growth in labor productivity remains unchanged, the shrinking labor force will squeeze the gross-domestic-product growth rate by 1.5 percentage points each year until 2030. After that, the effects of a weakened labor force will exert downward pressure of 2.0 percentage points on annual GDP growth.

  To gauge the effects of a decreasing labor force on living standards, we must focus on labor productivity, or per-capita GDP. If the decline in the working population parallels a similar decline in the overall demographic count, the net result will be to neutralize the drop in production levels.

  However, declines in overall demographic count will lag behind those in the working population by more than 10 years. Since the overall demographic count is expected to remain relatively stable until 2015, the effects of a shrinking working population will have a considerable impact on per-capita GDP up to that point. The GDP growth rate will be suppressed by 1 percentage point, owing to proportional shifts in the demographic count will also show a significant reduction, and downward pressure on the GDP growth rate will ease slightly.

  Measures to counteract the negative effects of a reduction in the working population are those that boost labor, capital or productivity levels.

  The promotion of labor participation is of primary importance, but the governmentfs plan to encourage families to have more children will not effectively prevent a decrease in the working population in the first half of the next century. The coming generation is not about to join the labor force shortly, and even if the birthrate does rebound, the positive effects will not be seen for more than 20 years.

  Therefore, in the short run, a possible policy option is to raise the labor-force participation rate of the existing population by removing the obstacles that have prevented demographic segments with low labor-force participation rates ? namely, women and the elderly ? from joining the labor force.

  The employee pension scheme, which is a form of compulsory insurance, effectively places a heavier burden on senior citizens still in the work force. If the government made the program neutral to the retirement decision, more people in their early 60s might be willing to remain in the labor force.

  The government must also introduce better arrangements for working mothers, such as day-care and child-minding services.

  I estimate such schemes would create a working population of some 1 million people. But even if the government is swift in its implementation of new labor policies, current demographics could well preclude the success of such efforts to compensate for a dwindling number of employed.

Expert Solutions
  When a decline in the labor force becomes an undeniable fact, experts promote ideas for structural reform and improved worker productivity. But can these seeds of change actually be policies to tackle the declining labor force? And if there is room for the enhancement of living standards through structural reforms, shouldnft the government address this process regardless?

  According to a study by David Cutler, a Harvard University professor, developed nations have neutralized roughly 60% of the effects of a slowing in growth of the labor-force participation rate since the 1960s by boosting labor productivity. In advanced nations, the annual improvement in the labor-productivity ratio was 2.2%, while growth in the labor-force participation rate was a low 1.0%.

  But the data include the high-growth period of the 1960s. In Japanfs case, growth in the labor-productivity ratio over the last 20 years works out to 2.4%. The developed-nation average has been 1.7% for the same period, and if limited to the 1990s, 1.2%.

  In the future, therefore, growth in the labor-productivity ratio in Japan will be held to under 2.0%. Given that average annual growth in the labor-productivity ratio of developed nations is 1.7%, the GDP growth rate in 2010, when the labor-force participation rate increase is 1.5 percentage points lower that it is now, will be 2.1%. But considering the productivity drops of the 1990s, I predict that the potential growth rate will be under 2% each year until 2010 and even lower thereafter. This is considerably less than the above-3% years seen in the 1980s.

  In regard to boosting capital, it appears that strategies to promote financial resources for a graying society are not particularly popular. Recent economic stimulus plans have drained a large portion of savings to cover fiscal deficits. If savings directed overseas for lack of domestic investments contribute to a swelling current-account surplus, Japan will become the target of global complaints.

  Meanwhile, the Japanese are realizing that they must prepare for retirement with their own financial assets and not rely on subsequent generations. If their own funds are sufficient, the problems stemming from shifts in demographic composition will largely be resolved.

Financial Independence
  If each generation lives financially clear of other generations, the economy will acquire the capacity to intrinsically adjust to demographic changes. This latitude is important because the problems associated with fewer children and more senior citizens arise form the economyfs inability to adapt to changing demographics.

  To be sure, it is difficult to find capital markets flexible enough to absorb savings prepared for retirement. Moreover, so many rules and regulations have shielded Japanese financial institutions until very recently that most lack the skills to effectively manage financial assets. But these cannot be an execuse for not saving. We should instead try hard to seek for a new investment opportunity and to acquire better skills of asset management.

  Japanfs system of cross-generational support for dependents raises more problems. A smaller proportion of children in the total population will have a particularly strong impact on yields on pensions supported through the current compulsory insurance scheme. If the government had accumulated satisfactory reserves, the authorities would have had enough funds to meet the needs of senior citizens. Even at this late date, revisions aimed at increasing the size of reserves should still be put into effect.

  The first 20 years of the next century will likely be a period of trial for the Japanese economy in regard to working population. This predicament has been occasioned by poor judgment on the part of successive administrations which, over the past two decades, ignored a declining birthrate and neglected public pension reserves.

  To halt the downward shift in potential GDP growth requires accurate assessment of economic conditions and appropriate government responses. As well, the current administration must not use up all its resources to pull the nation out of recession, but rather should manage national finances with a view to the medium term and the creation of sufficient surplus reserves.

  For Japan to overcome the consequences of shifting demographics, each generation will have to look out for itself. The public is quickly realizing that self-reliance is crucial to a comfortable retirement. To make the most of the peoplefs response to this need for independence in old age, the government must set systems in place that facilitate more effective management of savings.

 (C) 1999, Yasushi Iwamoto