The Cabinet Office regularly publishes its Economic and Fiscal Projections for Medium to Long-Term Analysis outline. The latest projection, released in July, said Japan’s GDP growth “is projected to rise gradually and reach 2 percent in real terms and 3 percent or more in nominal terms in the latter half of the 2020s.” Can we accept such a projection?

A nation’s demographic trend affects its economic growth over the long term. Also, from the experience of Japan’s economy, it is widely known that productivity growth is a key factor for its economic performance on the long run. Whether the government’s optimistic growth projection comes true or not will depend heavily on future productivity growth. It is necessary to discuss what the relationship is between demographic changes and productivity.

Studies of past economic growth provide many hypotheses about population and economic growth. As for productivity growth, there are some interesting hypotheses.

First, the larger the population, the higher the chance that great innovators will emerge. This is called the “genius hypothesis,” and since the innovation is the source of technological progress, a simple inference shows that economic growth will stagnate as the population declines.

Second, a larger population increases the opportunity for intellectual interchange with diverse human resources, which in turn promotes technological progress. Although it is difficult to clearly identify the causes of productivity growth, diverse human interchange is considered to be a necessary condition. A population decline reduces the chances of that happening.

Third, as the population declines, the number of people in research and engineering jobs falls, which negatively affects the nation’s R&D performance.

The aging of the population also impacts economic growth through changes in productivity. A nation’s population declines when the fertility rate drops, which results in the aging of the population and a reduction in the size of the young labor force. As a result, society gradually loses the creativity and aggressiveness associated with younger people.

A past study I conducted using data from about 20 OECD countries over a period from 1980 to 2010 pointed to a statistically significant negative relationship between population aging and productivity growth. If this negative relationship is strong, we can only be pessimistic about Japan’s future growth potential despite the government’s rosy projection. In the study I also found a positive relationship between population scale and the pace of productivity growth.

If we look at the demand side of the economy, its clear that as the population grows larger, so does the consumer market. A population decline means that the domestic market for consumer products and services shrinks. When this happens, Japanese firms will have no choice but to find more markets overseas. The solution, however, is not so easy. Other economies in the region, including China, South Korea, Taiwan and other emerging Asian powers, also face the same demographic situation as Japan, and in the future it will be difficult to find sufficient consumer demand in these markets.

A population decline also loses the advantage of economy of scale, in which an increased level of production results in a proportionate saving in costs. Population growth in the past promoted economy of scale and as a result contributed to productivity growth.

What will be lost is not just economy of scale, but also niche markets. It is widely known that a certain amount of demand is necessary to establish a niche market. So niche markets will disappear as the population declines. For example, all those shops in Akihabara that cater to the otaku culture won’t survive unless there are enough otaku customers.

Amid all these pessimistic forecasts, there may be some good news. A mathematical formula suggests population decline may result in a richer society. Some economists claim that economic prosperity should be measured at the per capita level. There is an interesting equation, as follows: Per capita economic growth rate is calculated by macroeconomic growth rate minus the rate of population growth. Using this equation, we can show that a declining population brings a richer economy on a per capita basis. Under the projection by the National Institute of Population and Social Security Research, the average annual rate of population growth through 2065 will be a minus 0.7 percent. So if the macroeconomic growth is zero, the rate of economic growth per capita will be plus 0.7 percent. Therefore, we need not worry about a population decline.

In truth, however, it’s unlikely this happy turnout will take place. As mentioned, the decline of the population will reduce the labor force, hamper productivity growth and erode the domestic market base. Therefore, there is a chance that the macroeconomic growth rate will be in negative territory and as a result per capita growth rate could also be negative.

Why are we obsessed with economic growth? There are at least three reasons. First, without sustained economic growth, it will be hard to maintain the present standard of living. As the labor force declines, and if productivity does not rise, the nation’s GDP will fall and the current level of prosperity cannot be maintained.

Second, the aging of the population will deepen as it continues to shrink, and social security expenses for the elderly will expand, putting an ever heavier burden on the younger working generations. Economic growth would help the younger generations and lighten their burden.

Third, economic growth is a necessary condition to sustain public finance, considering the huge public debt that must be repaid in the future.

How can we promote economic growth through higher productivity? First, labor-saving investment should be encouraged through new technologies such as artificial intelligence, robotics, big data and so forth. For example, the “society 5.0” promoted by the government — a supersmart society plan utilizing those new technology — will help increase productivity.

Some economists claim that population decline will automatically promote labor-saving investment, but that is not easy. The government should take proactive steps to push these investments forward. Inviting more highly talented and skilled workers from overseas will also be crucial. Currently the focus of discussion is on whether and how we accept unskilled foreign workers to fill the domestic labor shortage. What’s more important from a long-term perspective, however, is get highly skilled professionals to come to Japan and help raise its productivity.

Hisakazu Kato is a professor of economics at Meiji University and former senior research fellow at the National Institute of Population and Social Security Research.

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