Relative productivity across the major economies

Real GDP per Japanese and American aged 15-64, 2013 price level, updated 2005 EKS PPP, detrended, 1970-2013


Source: Computed from OECD StatExtract and The Conference Board, Total Database, January 2014,

Note: When the line is flat, the economy is growing at its trend growth rate. A falling line means below trend growth; a rising line means of above trend growth. Detrended with values used by Edward Prescott.

The Japanese decline after 1992 are the Lost Decades. Japan recently returned to its 3.2% trend growth rate of the 1970s and 1980s for working age Japanese.

It could be argued that Japan is now on a permanently lower growth rate that implies no further catch up with the USA.

Japanese relative economic decline

Embedded image permalinkHT:

Zombie lending and lower Japanese productivity growth

The low Japanese productivity growth throughout the 1990s could have been the result of subsidies to inefficient firms and declining industries both directly and through a banking system rolling over loans in arrears to insolvent firms.

This policy is known as zombie lending, and it lowered productivity because higher cost firms kept producing a greater share of Japanese output than would otherwise have been the case (Hayashi and Prescott 2003; Ahearne and Shinada 2005).

  • Zombie firms are insolvent firms often propped up with new loans and loan rollovers from Japanese banks.
  • Zombie banks are insolvent banks propped up with loans from the central bank and by lax regulatory inspections of their weak loan portfolios and lack of adequate capital.

Japan’s economic policies have until recently kept insolvent banks operating, further encouraging zombie lending, which impeded the flow of capital to the more efficient firms.

The competitive process where zombies shed workers and lose market share was thwarted. The Japanese authorities subsidised insolvent banks and firms and provided credit to some firms and not to others (Prescott 2002; Hayashi and Prescott 2002; Caballero et al. 2005; Hoshi and Kashyap 2004).

The pervasiveness and long-term persistence of zombie lending as a shock to Japanese productivity growth cannot be understated. As Kashyap noted:

The government allowed even the worst banks to continue to attract financing and support their insolvent borrowers

By keeping these unprofitable borrowers alive, banks allowed the zombies to distort competition throughout the rest of the economy.

Caballero et al. (2008) estimated that 30 per cent of all publicly traded Japanese manufacturing, construction, real estate, retail, wholesale, and service sector firms were on life support from banks in the early 2000s, and that most large Japanese banks only complied with capital standards because regulators were lax in their inspections.

The percentage of zombies hovered between 5 and 15 per cent up until 1993 and rose sharply over the mid-1990s to exceed 25 per cent for every year after 1994 (Caballero et al. 2008).

Figure 1: Prevalence of Firms Receiving Subsidized Loans in Japan

Source: Caballero et al. (2008) Zombie Lending and Depressed Restructuring in Japan. American Economic Review.

Zombie lending is a more serious problem for Japanese non-manufacturing firms than for manufacturing firms (Caballero et al. 2008). Small and medium size firms were also major beneficiaries of zombie lending.

Zombie lending also discourages new investments that increase Japanese productivity, encourages inefficient firms to avoid making the decisions necessary to raise their profitability, and impedes the solvent Japanese banks from finding good lending opportunities (Caballero et al. 2008; Sekine et al. 2003). As Kashyap noted:

Usually when an industry is hit by a bad shock, many firms exit… In Japan, firms never exited. Given that they never exited, it is not surprising that new firms weren’t created.

Under normal conditions, higher cost firms would go bankrupt and be replaced by new and better ideas and firms. Instead, firms that were more efficient than the zombie firms tended to exit industries because their demise does not require the banks to acknowledge large bad loans. This exit of the firms of intermediate efficiency rather than the exit of the least efficient firms dragged productivity down even further (Nishimura et al. 2005; Okana and Horioka 2008). New Zealand in the 1970s and in the early 1980s also had a range of policy measures that supported high-cost firms and declining industries.

When bankrupt firms can stay in business, they retain workers who otherwise would be willing to work for lower wages at a healthy firm and depress market prices for their products. Low prices and high wages reduce the profits that more productive firms can earn which discourages entry and investment.

The creation of new jobs is a measure of industry dynamism. In manufacturing, which suffered the least from the zombie problem, job creation hardly changed from the early 1990s to the late 1990s. In contrast, there was a large decline in job creation in the non-manufacturing sectors, particularly in construction (Caballero et al. 2008; Hoshi 2006; Caballero et al. 2008).

There was less restructuring of employment and market shares in favour of the more productive firms. The gap in productivity growth between the Japanese manufacturing and non-manufacturing sectors more than doubled over the 1990s (Caballero et al. 2008).

Japanese R&D spending has also slowed down significantly since the start of the 1990s (Comin forthcoming). The gap in the rate of computer adoption between Japan and USA also increased in the 1990s. The speed of diffusion of new technologies slowed to the point that South Körea has now surpassed Japan in the diffusion of computers and the Internet (Comin forthcoming).

Over the 1990s, there were ten massive fiscal packages to maintain employment and investment. Much of this additional Japanese government spending was on public works and other projects whose social payoffs have been queried by independent observers. The consumption tax was increased from 3 per cent to 5 per cent in 1997. There were two rounds of temporary tax cuts – for 2 years only.

Japan pursued economic policies in response to a recession that stifled total factor productivity by providing bad incentives to the private sector.


The unproductive firms depressed Japanese productivity because they competed for labour and capital that could have been used by the more productive firms. Zombie lending allowed many firms to stay in business long after the monetary policy changes that uncovered their unprofitable petered out. The diversion of resources to these insolvent firms prevented a productivity recovery. The lack of a productivity recovery depressed wages, incomes and consumer demand.

The zombie lending and fiscal packages compounded the 1990 monetary contraction into the highly persistent shocks that were required to be able to depress Japanese productivity growth for more than a decade.

More and more resources were tied up in high cost firms and in declining industries. This was rather than be reallocated to more productive uses by the normal market processes of relative price and wage changes, free entry and profit and loss.  Kashyap argues that:

The experience in Japan definitely shows that providing subsidized credit to dying firms will be costly over time. Keeping an industry from restructuring only delays the day of reckoning and raises the cost substantially

…There are many examples besides Japan where people fail to recognize that it is dangerous to keep people attached to businesses that are fundamentally unprofitable

The massive Japanese government investments have echoes of the ‘Think Big’ energy investments in New Zealand in the late 1970s.

The productivity impact of ‘Think Big’ was suspect. In addition, state-owned enterprises offering a net return of zero to the Crown in the 1980s has Japanese parallels.

The propping up of high cost state owned and private firms in the 1970s and 1980s in New Zealand helped to depress productivity growth rates. State-owned enterprises offered a net return of about zero to the taxpayer, even as recently as last year in New Zealand.

More and more resources were tied up in New Zealand in the high cost firms and declining industries than be reallocated to more productive uses by the market processes of price and wage changes, free entry and profit and loss. The lack of productivity growth depressed wages, incomes and consumer demand in New Zealand.

The productivity based explanations for the slumps in New Zealand from 1974 to 1992 and in Japan from 1990 to 2003 have a number of common threads.

The role of the introduction of a five day working week in Japan’s Lost Decade

When I lived in Japan between 1995 and 1997, they are undergoing the transition from a six-day week to a five day week. At the time, workers at my University had to show up on Saturday morning. They then went home at lunchtime. Saturday morning at the office was phased out a few years later.

In explanations of the Lost Decade of growth in Japan dating from the early 1990s, with the exception of Ed Prescott, the explanation that the Japanese simply chose to produce less per worker over the course of the 1990s does not figure highly.

The Japanese working week was reduced by law from 48 to 44 hours per week in 1988 and further reduced by the same labour standards law to 40 hours per week from 1993 (Prescott 1999; Hayashi and Prescott 2002). The Japanese stopped routinely working on Saturdays over the 1990s. The number of national holidays was increased by three and an extra day of annual leave was also prescribed by law.

Figure 1 shows this regulatory change about the length of the standard working week that started in 1987 was followed by a sharp drop in hours worked per working per working age Japanese over the period 1988 to 1993. The Japanese working age population is defined as those aged 20 to 69 (Hayashi and Prescott 2002).

Figure 1: Weekly hours worked per Japanese aged 20 to 69, 1970-2000

Source: Hayashi and Prescott 2002.

The regulatory process to end the standard six day working week in Japan straddled the start of the Lost Decade. This major change in the regulation of the supply of labour per week in the number of hours worked and the stagnation of GDP growth soon after could be more than a coincidence (Prescott 1999; Hayashi and Prescott 2002).

More employment did not fill the short-fall in weekly labour supply per worker after the introduction of the 44 hour week and then the 40 hour week in Japan. Many offices and factories closed on Saturday rather than employ more to make up the hours. The regulatory change was a clear cut constraint on the length of the working week that was hard to get around because of the need to recruit a separate set of workers to come in on Saturday afternoon and then all day Saturday.

During the transition to a five day working week, Japanese real GDP growth should slow down because output levels must taper during a transitional period because one day per week less in labour is supplied in production and capital is being worked for one day a week less than before (Prescott 1999; Hayashi and Prescott 2002).

Output per working age person depends on capital-labour ratios, on hours worked per week and on changes in total factor productivity due to factors such as technological progress and changes in institutions and economic policies.

The effects of the change in the length of the working week on output per working age Japanese will persist for a significant time because investment plans and the capital stock must also adjust to a shorter working week. This is another example of a highly persistent shock that can partly account for the Lost Decade. As Prescott (1999) observed:

Given the change in Japanese law and the resulting drop in normal market hours, growth theory predicts the almost stagnant output of the Japanese economy in the 1990s. This reduction in market hours lowered the marginal product of capital, making investment unprofitable.

Given the lack of profitable domestic investment opportunities, the Japanese began saving by investing abroad. This explains Japan’s large trade surpluses

…The Japanese economy in the 1990s is not as depressed as the U.S. economy was in the 1930s. Market hours in Japan in the 1990s have fallen only half as much as market hours fell in the United States during the Great Depression.

More importantly, the reduction in market hours in Japan in the 1990s was the stated objective of policy.

The reduction in weekly hours worked will also reduce the working week of capital because labour and capital are usually complementary inputs. The reduced length of the working week will see some existing capital producing less, some capital will go spare, and the rate of wear and depreciation will fall.

The drop in weekly hours worked will lower the marginal productivity of existing and new capital which will make new capital investments in Japan less profitable than before. Net investment will be less while the Japanese capital stock is adjusting down to the reduced working week for capital and labour.

Measured total factor productivity will fall because of an under-utilisation of a capital stock that is now larger than required for the available labour force. Net investment will decline by a large amount because investment demand is a small yearly addition to the capital stock.

For example, if annual investment demand is 5 per cent of the capital stock, and the desired capital stock becomes 1 per cent smaller than previous, annual net investment will fall 20 per cent. GDP growth will resume at the trend rate once the lower level of output per working age person is reached.

For those that still doubt, consider the contrary, what would you expect to happen in your country moved from five day week before day working week? Do you expect workers to produce as much as before? Britain was on a three day working week during the coal miners’ strike. As expected, output fell because the working week was shorter.

The main gap in the English language literature about the reduction in the working week in Japan is a lack of publications I can find by Japanese economists discussing what predictions of a made about the likely consequences for output, investment and productivity before the reduction in the length of working week was legislated. Did the reduction in the length of the working week in Japan turn out as planned and predicted before it was implemented?

France introduced a 35 hour week some years ago. Although there were various options for over time, albeit strictly regulated, a uniform prediction was that the 35 hour week would reduce productivity. The new workweek was phased in slowly, with large firms adopting it in February 2000 and smaller firms doing so only in January 2002.

French employees were expected to bear only a small part of the cost of the working-time reduction, continuing to earn roughly the same monthly income – in line with the unions’ slogan ’35 hours pays. To ease that transition, the law reduced the overtime premium for small firms and increased their annual limit on overtime work compared with large firms.

The reduction in the length of the French working week failed as work sharing strategy and reduced productivity. This was a fair summary by the IMF:

The 35-hour workweek appears to have had a mainly negative impact. It failed to create more jobs and generated a significant—and mostly negative—reaction both from companies and workers as they tried to neutralize the law’s effect on hours of work and monthly wages.

While it cannot be ruled out that individuals who did not change their behaviour because of the law became more satisfied with their work hours, simple survey measures do not show increased satisfaction.

Between 1997 and 2000, Quebec reduced its standard workweek from 44 to 40 hours to stimulate jobs growth – the old work sharing ideal. The Quebec policy contained no suggestion or requirement that employers provide wage increases to compensate workers for lost hours.

Despite a 20% reduction among full-time workers in weekly hours worked beyond 40, the policy failed to raise employment at the provincial level or within industries. If anything, there were job losses.

Japan was the only case where a reduction in the length of the working week met with wide approval by the public and people simply stopped working on Saturdays. The law succeeded simply because it did but it was designed to do: reduce the number of days existing workers worked. Japan was undergoing mild deflation at the time, so the need to reduce wages was minimal.

Annual hours worked per employed Japanese has continued to slowly taper down since the late 1990s, which may be a further explanation of its continual slow growth.

David Andolfatto wrote a nice paper explaining the consequences for the financial and monetary sectors of this reduction in the length of the Japanese working week:

  • a steady decline in bank lending;
  • the money multiplier declines;
  • nominal interest rates that are close to zero; and
  • massive infusions of liquidity by the Bank of Japan that seem to have no effect at all.

In his analysis, David Andolfatto referred generally to a productivity slowdown as discussed by Prescott rather than to the specifically to the reduction in the length of the Japanese working week. Nothing detracts in his analysis, as Andolfatto said, that Japan has a problem: lagging productivity growth and as Andolfatto concluded:

…monetary and fiscal policies, or reforms directed exclusively at the banking sector, are unlikely to re-establish productivity growth. What is likely needed are economy-wide reforms that enhance the willingness and ability of individuals to adopt potentially disruptive technological advancements and work practices.

Japan and Finland in the 1990s

Source: Edward Prescott


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