Japan should be doing well. It boasts a well-educated and disciplined workforce, and outdoes most other industrialized countries on both investment and spending on research and development (R&D). In fact, at 3.3% of GDP, Japanese research and development expenditure was higher even than that of the United States until recently. And yet, Japan’s relative decline continues.

In the 1980s and 1990s, Japan was the world’s second-largest economy, not least because of its seemingly unbeatable industrial sector. Today, however, it is the world’s fourth-largest economy, with data showing that it recently fell behind Germany, a country with a much smaller population – 83 million, compared to 123 million – that is subject to unfavourable demographic trends, much like those seen in Japan.

To understand Japan’s economic decline, consider the story of the videocassette recorder (VCR). Requiring very small and reliable mechanical elements, these technological marvels were once the pride of Japanese precision manufacturing. Japan had a near-monopoly in the global VCR market, as there were no American producers, and European firms could not compete with Japan on quality-to-price ratio. In their heyday – the mid-1980s – many millions of units were produced and exported, with Japanese exporters charging relatively high prices and earning a good margin.

But the VCR’s analogue technology could not compete with the digital substitutes that emerged in the 1990s and became ubiquitous in the early 2000s. Production of VCRs declined, forcing firms to lower prices and shave profit margins until, one after the other, they abandoned the product altogether. Today, not a single company in Japan produces VCRs. Many other consumer electronics, like tape recorders and the Walkman, followed a similar trajectory.

Consumer electronics were a cornerstone of Japan’s export industry. But the new solid-state digital consumer electronics did not require the precision engineering at which Japan excelled. So, it was cheaper to produce their components elsewhere in Asia and assemble the products in China, with the US providing the software. Meanwhile, demand for – and prices of – Japanese exports continued to fall.

Economists tend to look at a country’s export prices not in isolation, but relative to its import prices – the so-called terms of trade. Japan is an outlier among developed economies, in that its terms of trade – which stood at nearly 160% in the mid-1980s – declined through the late 1990s and crashed in the early 2000s. By 2008, the ratio had fallen below 100%. For comparison, the terms of trade in both the European Union and the US remained at a roughly constant level (around 100%) over this entire period, almost always remaining within a narrow range of plus or minus ten percentage points.

Factors like the deterioration of Japan’s terms of trade have played a far larger role than unfavourable demographics in the country’s relative economic decline. Yes, the Japanese population is aging and shrinking. But the US population has increased by only about a quarter more than that of Japan since 1995, and yet its GDP has expanded by over 300% more.

While Japanese living standards have continued to improve, the pace is slow, and Japanese consumers are doing less well overall than their counterparts in other developed economies. Take per capita GDP: if you adjust for the cost of living, Japan has lost some ground to Europe, which has tended to follow the US closely.

The big question is why Japanese producers did not abandon – and were not urged by the government to abandon – products like VCRs sooner or attempt to lead on the cutting-edge technologies that were replacing them. Path dependency is undoubtedly part of the answer: when firms have acquired know-how in a particular area, they often find it more profitable to further improve their skills in that area, rather than moving into a new field.

But psychological factors probably also played a role. The top Japanese firms – and, indeed, Japanese society at large – were proud of their engineering prowess, so they found it difficult to accept that these admirable capabilities were losing value. The same was true of government bureaucrats, including those in the Ministry of International Trade and Industry, an institution that had gained an almost mythical reputation for its success in piloting Japan’s growth. Japanese leaders and producers effectively chose economic decline over admitting that their key technical competence had become worthless.

This brings us to the first key lesson from Japan’s experience: an economy, no matter how successful it has been in the past, must be ready to adapt to new ideas, technologies and circumstances. A second key lesson is that relative decline, even if well managed, leads to a loss of global influence.

Europe – with its aging population and weakness in emerging technologies – should take note. For almost 20 years, the EU has sought to increase spending on R&D to 3% of GDP and support investment. But reaching Japanese levels on these two measures might not solve Europe’s growth problem, if the resources go toward sunset industries.

Daniel Gros is the director of the Institute for European Policy-making at Bocconi University.

Copyright: Project Syndicate