Heterogeneity in Japanese TFP, Part 1: Why Overcoming Deflation Alone is Not Enough

The first in a two-part series on Japanese total factor productivity, this paper presents an analytical argument for a non-monetary structural reform policy pillar based on the assumption that overcoming deflation, while arguably a necessary precursor to reform, is not in its own right a solution to Japan’s structural ailments. Our analytical evidence takes the form of comparative calibrated simulations of aggregate Japanese growth accounting using the neoclassical growth model, first with and secondly without accounting for Investment Specific Technology (IST). We find that the IST-adjusted model better explains Japanese growth accounting during the “lost decades” than the base-case model. The implications of this outcome are as follows: IST represents a type of relative deflation – the decline in capital goods prices in terms of consumption units. Structurally, this contributes positively to total factor productivity. We supplement this with counterfactual analysis: were deflation the primary causal trigger for Japan’s structural decline, sector decomposition of growth accounting should show leading price declines in the worst performing sectors in terms of TFP. This is not the case. When we decompose Japanese growth accounting by sector, we find that the sectors responsible for the slowest TFP growth and those furthest from the “balanced growth path” characterized by theory neither showed the first, deepest, nor most consistent negative growth in deflators. Rather, the most deflationary sectors were out-performers in terms of TFP and those that demonstrated characteristics of a “balanced growth path,” tending to belong to manufacturing (rather than nonmanufacturing) and IT (rather than non-IT) industries