Japan's population is aging faster than that of any other country in the world. The unprecedented increase in retirees relative to the size of Japan's work force will force radical change if the nation is to avoid a fiscal crisis, or worse. These seemingly innocent demographic changes will force Japan to shrink its famously high savings rate, reverse its proud trade surplus, send more industry overseas, liberalize its tightly controlled markets, and take on a more active, high-profile foreign policy. Ultimately, these changes will shift the balance of power in East Asia.

Japan's demographic problem has its roots in decreasing birth rates and longer lifespans. The former have begun to starve the country for young workers to replace those retiring, while the latter ensure that a growing population of retired citizens will be dependent on a diminishing working population. Although every industrialized country faces this problem, Japan's situation is by far the worst, not least because Japan has no hope of an influx of youthful immigrants to mitigate the problem. According to Japan's Ministry of Health and Welfare, in less than five years the country's demographic trends will give it a population profile like Florida's. By 2015, one in four Japanese citizens will be 65 or older. In about 2010, according to official projections, Japan will have fewer than half the workers per retiree it has today, a mere 2.5 people of working age for every pensioner. And since not all of working age choose to work or can find employment, it is likely that in the early 21st century Japan will have fewer than two people at work for every retiree.

Such a large proportion of pensioners is unprecedented in history and will place a heavy burden on Japanese society. The huge elderly population will redirect increasing amounts of the nation's resources into geriatric health care, but more generally, the strain will grow because retired people continue to consume even as they cease to produce in the conventional sense of the word. Whether the retirees draw on well-funded pension plans, savings, or the public dole, everything they consume must be produced by the existing work force. It will be asking a lot of Japan's shrinking work force to support this large and growing pool of retirees as well as themselves, their children, and, given Japanese custom, their dependent spouses. Even if workers' productivity rapidly accelerates, the demands of these dependents will absorb much of the surplus.

Every two Japanese workers will effectively support the burden of about one retiree. And that support will exceed that of a dutiful child caring for aging parents (of which there are many in Japan). Since the burden is countrywide, there is no way for one group to pass it off on another. It will also be far-ranging in the economy, including all medical costs, not just insurance premiums and deductibles. In terms of aggregate income, this demographic situation could ultimately cut the average Japanese standard of living by 18 percent. This reduction would exceed a year's savings, a year of Japan's traditionally high level of exports, four years' growth in the boom years of the 1980s, and more than a decade of growth at the slowed pace of the 1990s. Even if increases in productivity ameliorate this shortfall, it will still leave the Japanese far behind where they would be otherwise and certainly far short of the success to which they have grown accustomed.

No nation can tolerate such a strain without a backlash. In the United States, for example, this pressure would push millions below the poverty line, and if it did not spark rioting or social unrest, it surely would threaten it. While the Japanese are generally less rebellious than Americans, the pressures will force an accommodation.


The aging crisis will erode the savings surplus for which Japan has become famous and on which it has based much of its remarkable growth. Private savings will suffer because the elderly put little aside, relying on pensions to support their retirement. This corollary to the growth of the retired population could cut Japan's personal savings rate by one-third of its present level of 12-15 percent of income. Meanwhile, the government budget deficit will swell as the authorities struggle to meet public pension obligations that, by all accounts, are even less well funded than Social Security in the United States. At present, contributions to the Japanese equivalent of Social Security and Medicare net the government surplus revenues equal to about 3.5 percent of GDP. While these contributions partially offset deficits elsewhere in the budget, they will disappear when the huge influx of pensioners takes its toll. The Ministry of Health and Welfare calculates that public pension obligations will swell the government budget deficit to 5 percent of GDP indefinitely. Public finances in Japan are already in deficit. The combined impact on public and private budgets could cut the nation's savings rate in half. While the Japanese savings rate would still exceed the U.S. rate of 5 to 6 percent, it would no longer retain the margins that enabled Japan to finance exports, invest in manufacturing and equipment, and modernize its industry.

Japan's trade surplus will not go unscathed either. The burden of supporting its aging population will shrink Japan's trade surplus along lines parallel to its savings rate. With a declining pool of workers as a percentage of its population, Japan will lose the surplus output that for years has fed its export machine. Indeed, the beleaguered state of Japan's work force will compel the country not only to constrict the flow of exports, but also to rely increasingly on imports. In time, Japan's once commanding trade surplus will shrink into the deficit column.

Labor shortages will compound the problem by fueling the upward drive in Japanese wages. Comparative labor cost figures are notoriously slippery, but by almost all indicators, Japanese labor is expensive already, even after the yen's recent decline on foreign exchange markets. Japanese industry will find it more and more difficult to resist the lure of setting up production in other Asian countries, where labor is cheap and markets are growing fast.

Indeed, the process has already begun. According to Japan's Ministry of International Trade and Industry, in 1995-96 Japanese industry invested $900 billion in overseas facilities, up some 50 percent from five years ago. About 15 percent of that money went into the rest of Asia, which is about double the percentage of five years ago, with a growth rate of almost 22 percent per year.

More significant, the bulk of the outlays for manufacturing facilities went to Asia. Visitors to Manchuria, which was occupied by Japan from 1931 to 1945, report on the dominance of Japanese firms and managers in the region. Visitors to Thailand, Malaysia, and Indonesia say similar things. So far, these Japanese factories have concentrated on the re-export of goods and consequently offer a source of export demand for their Japanese parent companies. But this pattern will change as Japanese firms upgrade the role of these facilities. Matsushita, the Japanese electronics giant, has already begun to use Chinese production in its overseas operations. VCRs made in Manchuria bypass Japan and are sold in China, North America, and Europe. Matsushita has opened a research and development facility in Manchuria. Things have gone so far that recent public opinion surveys reveal considerable concern among Japanese businesspeople about the "hollowing out" of Japanese industry.

Ultimately, a substantial portion of the nation's industrial base will relocate abroad, accelerating the deterioration in Japan's foreign trade balance. Already, 1996's trade surplus of $77 billion is down from the $130 billion peak of early 1993. It is likely that within the next five years Japan will have a trade deficit. There is even a chance that consumer demand among the growing retired population and generally changing Japanese tastes will turn bilateral trade between Japan and the United States in America's favor.


With the shift of a significant portion of its manufacturing might abroad, Japan will eventually come under pressure to reorient its domestic economy, its financial markets, and ultimately its foreign policy. Japan's long-standing emphasis on production and exports will become less and less relevant to the country's circumstances. In time, Japan will resemble what some there refer to as a "headquarters nation," with a focus on management services, finance, design, and research supplanting the old emphasis on manufacturing. It is a pattern experienced in the United States during the last 30 years and in Great Britain before that.

Signs of this domestic reorientation are already visible. Manufacturing has shrunk from nearly half of GDP in the 1960s and 1970s to barely more than one-quarter by the mid-1990s. One-third of that drop occurred after Japan's economic resurgence in the late 1980s. Employment figures tell the same story. In the last five years, the number of workers in manufacturing has dropped 10 percent, while the number in services has risen almost 12 percent. For the last three years, Japan has employed more people in services than in manufacturing. Some of this shift reflects the natural slowdown in Japan's economy and its gradual maturing from its fast-growing developmental phase. But there is more at work here than a maturing economy.

For years, Japanese officials have used a thicket of rules and standards to keep out imports, while government policies have promoted exports and the industrial base. But as Japan's growing retired population reduces the nation's ability to produce goods for export and increases the need for imports, this policy will lose its rationale and eventually be reversed. Japan will want to clear the regulatory thicket to facilitate the needed flow of imports. Accomplishing that could actually be easy, since few of Japan's restrictive rules are specific laws but instead rely on red tape and quality standards administered with considerable latitude. To change the situation, officials need only the motivation to apply the rules differently, and the new circumstances should provide it. Similarly, Japan can accommodate its increased need for foreign products by dispensing with its Balkanized retail distribution system and informal agreements authorizing price markups. The rapid rise of superstores and discount stores in recent years shows how quickly these restrictive practices can change. Also, by reconsidering its long-standing law against holding companies, Tokyo has begun to accommodate business' need to shift its focus from production to management and finance subsidiaries.

A similar reversal of current practices will occur in Japanese financial markets. For years, Japan has striven to give its exports a price advantage by keeping the yen cheap on foreign exchange markets. Japan has resisted the currency's tendency to rise under the influence of its huge trade surplus by using financial means to increase the supply of yen on world markets and keep demand down. Thus official Japanese policy has encouraged the flow of yen overseas to purchase financial and real estate investments at the same time it has discouraged any tendency for Tokyo to develop into an international financial center. But in a future with a decreased ability to export, an increased need for imports, and an incentive to buy or build foreign industrial facilities, Japanese officials will want to cultivate the opposite environment. Japan will welcome a rise in the yen's value, making foreign products and facilities cheap. Also, since Japan will face a drop in its savings rate just as it needs financing to develop overseas production facilities, the nation will need increasing amounts of foreign capital. Instead of fighting Tokyo's rise as a financial center or the use of the yen as a reserve currency, Japan will encourage it. Ironically, the decline in the country's savings will help lure foreign money by putting upward pressure on Japanese interest rates. But Tokyo will also need to eliminate the many rules and regulations that currently restrict the practices and financial instruments dear to the world financial community. Bank of Japan policy studies have already begun to advocate wholesale deregulation. And Prime Minister Ryutaro Hashimoto seems to have taken this advice: he moved quickly after the 1996 election to promote financial deregulation as a major part of his new government's program.


A more active foreign policy will become unavoidable as the overseas expansion of Japanese industry establishes connections in the rest of Asia that Japan will need to secure. Though such a move goes against present Japanese instincts, no nation, including Japan, can afford to locate its production facilities abroad and not develop the capability to at least threaten to project power to protect those sources of wealth. This new security perspective will be all the more radical because it will run counter to Japan's long-standing reliance on U.S. protection of Japanese interests. The United States has not only provided Japan a nuclear umbrella and guaranteed the security of its home islands, but it has also secured the shipping lanes to Europe and North America and guarded the oil fields of the Middle East. While there is every reason to expect the United States to continue in this role, Japan, as its links in Asia become more complex and particular, will increasingly have security needs in which the United States has little common interest. In this realm, Japan will have to act for itself, diplomatically and, if necessary, militarily.

While necessary and natural, this shift in Japan's foreign policy will not come easy. Even now, three generations after World War II, Japan's population and most of its officials distrust diplomatic and military power. Nonetheless, attitudes are beginning to change. Ichiro Ozawa, secretary general of the main opposition party, the New Frontier Party, has discussed Japan's need to rebuild its diplomatic stature in his policy papers and especially in his 1994 book, Blueprint for a New Japan. Recognizing Japan's sensibilities, he and other reformers have couched their suggestions for change in terms of a heightened Japanese role in the United Nations: a permanent seat on the Security Council, greater use of Japanese troops in peacekeeping operations, even a permanent peacekeeping force built around a Japanese core. Although not a complete answer to Japan's ultimate security needs, these U.N.-centered actions would be a powerful first step. They would give Japan more leverage to protect its commercial and industrial interests in Asia and beyond. In time, however, expanded Japanese interests will force Japan to step out from behind the United States and the United Nations and push its own arrangements with its Asian neighbors. To do this, Japan will have to change the tone of its diplomacy and the nature of its armed forces. Such an approach will require Japan to change public attitudes and amend its constitution or find one of innumerable formulas to get around Article 9, which forbids the use of armed force except in self-defense.

Though contrary to long-standing Japanese attitudes, such a shift is not that far off. Asia caught a glimpse of Japan's new posture last summer in its dispute with China and Taiwan over the Senkaku (Diaoyu) islands. A private Japanese nationalist group landed on the uninhabited islands and built a makeshift lighthouse. A group of Chinese patriots from Hong Kong chartered a ship to counter this Japanese gesture. There was no official response from China or Taiwan, except to reaffirm their claims. But Japan sent ships from its Maritime Safety Agency -- effectively a light naval force -- to keep the Chinese away. Significantly, Japanese officials made no effort to remove the Japanese nationalists from the island. The Chinese had no stomach for a confrontation with Japanese naval power. While it was a minor issue in diplomatic circles, Japan's willingness to deploy those ships revealed a major change in official Japanese policy. It is doubtful that Japan would have resorted to such measures five years ago.


Japan's increasingly active foreign policy will cause friction in Asia and strain the U.S.-Japanese alliance. Although there is no reason to expect a particularly aggressive Japan, much of Asia still responds to memories of the Japanese military in the 1930s and 1940s. Nor is it hard to imagine U.S. objections to an increasingly independent Japanese foreign policy, especially if it creates links in China beyond purely commercial arrangements. From the Japanese perspective, the U.S.-Japanese alliance may begin to feel more restrictive than reassuring. Despite the strains, Japan and the United States have obvious interests in retaining strong ties. Not only will cooperation serve as a useful counter weight to China's rising strength and assertiveness, but it also offers perhaps the best means to bring stability to this rather explosive area of the globe. Moreover, both nations have an interest in cooperating to keep trade channels open.

Since the existing U.S.-Japanese relationship will become less and less suitable in the new environment, Japan and the United States will need to seek out new arrangements. To function effectively, the relationship must have two basic qualities. First, it must offer Japan room to move from its present status as a U.S. diplomatic client to pursue its newly enlarged, legitimate interests. Second, if the U.S.-Japanese arrangement is to help maintain stability in Asia, it must offer other Asian nations assurance of a continued American ability to impose limits on Japan's policy. While innumerable formulas could accomplish these dual objectives, they are probably best achieved by the United States shifting its primarily bilateral approach to the region toward a more multilateral strategy of the sort used in Europe. Admittedly, a Pacific counterpart to NATO seems inappropriate now that the Cold War is over and could raise Chinese suspicions. But establishing NATO-like multilateral arrangements that encompass Japan, the United States, South Korea, the Philippines, and regional associations might give Japan room to pursue its goals without alarming its Asian neighbors.

However the United States and Asian countries approach Japan, they must realize that this nation, known for so many years now for its constancy, cannot and will not remain in the primarily commercial patterns of the past 50 years. The demographic imperatives are too strong. Japan's transition will cost it many of the traits that made it a great economic competitor: an excessive trade surplus, rapid growth, and high savings. But Japan is poised to take on the mantle of a national power in a broader sense, with a diplomatic stature commensurate with its commercial and industrial interests. Provided that can occur without the sudden, threatening shifts that Japan has made periodically throughout its long history, the new Japan will be a stabilizing force in Asia, especially if it is involved in multilateral arrangements with the United States and other regional powers. By taking account of these changes, the United States can guide Japan along a constructive path. If, however, the United States remains oblivious to the implications of Japanese demographics, it will miss the chance to achieve a measure of security in this important and unsettling part of the world.

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