Japan’s “Digital Chasm” Hamstrings Growth
Source: https://tinyurl.com/39b6yx66 Note: See text for explanation of the chart
It’s not the companies that invent a new technology that do the most to boost its growth; it’s the multitude of companies that apply it in a myriad of ways the inventor could never have imagined. In America’s dot.com era, two-thirds of the big leap in labor productivity came not from the so-called “new economy” sectors that married digitalization and communications, but from all the “old economy” sectors that took advantage of it. “Rust belt” manufacturers, retailers, wholesalers, and even stodgy local banks. This was hardly a flash in the pan. Over the three decades from 1989 to 2019 in the US, there was a very impressive 70% correlation between the intensity of a sector’s digitalization and its productivity growth.
Japan is a leader in inventing new technologies, but its companies are not as adept at turning them into economic value. As I’ve mentioned many times, while Japan is a leader in generating important patents, it ranks 67th out of 67 countries in so-called “digital agility,” i.e., how much benefit in sales, profits, and productivity it gets from its investments in ICT (Information and Communications Technology) investments.
This is a big problem because in modern rich countries, mastering ICT is vital to economic growth. It is a “general purpose technology,” i.e., one that improves performance across sectors ranging from brain surgery to automotive manufacturing to retail sales. In the chart below, I compare the sources of growth in labor productivity, i.e., GDP per work-hour in private companies. During 1995-2007, Japan’s productivity grew at 1.2% per year, compared with 1.9% for the median OECD country. In both Japan and the OECD, 83% of the productivity growth came from giving each worker more tools. In Japan, 33% came from the application of ICT capital, close to the median OECD country’s 38% share.
Where Japan and other affluent countries differ is in the growth of Total Factor Productivity (TFP). TFP measures how much the economy grows for each percentage-point increase in capital and labor combined. In the long term, TTP is the primary driver of growth in labor productivity and GDP per capita. We can see in the chart above that TFP in the OECD grew twice as fast as in Japan, adding 0.4 percentage points to growth each year in the OECD and just 0.2 percentage points in Japan.
Now we come to the key issue. The chart at the very top of this blog divides the economy into ICT sectors and non-ICT sectors. In the OECD, both segments of the economy contribute more or less equally to TFP growth. In Japan, by contrast, only the ICT-producing sectors boosted the country’s TFP. There was no TFP growth in the rest of the economy. While ICT-consuming sectors invested in ICT, they failed to use it in ways that boosted their TFP. In Part II of this series, I discussed how half of Japan’s private economy suffered declining TFP. The failure to master ICT is one of the chief reasons. Without solving this shortcoming, Japan cannot restore its vitality. That needs to be one of the core planks of any sound industrial policy.
Failure to address this problem has made it worse. The data cited above is from 1995 to 2007. More recent data, 2005 to 2021, shows that labor productivity, i.e., GDP per work-hour, has actually declined in the ICT-producing sector (see chart below). Japan suffers the worst performance in the OECD. A recent Nikkei article shows a similar result.
Source: OECD https://stats.oecd.org/BrandedView.aspx?oecd_bv_id=pdtvy-data-en&doi=data-00687-en
This is particularly problematic since Japan suffers from a great shortage of ICT professionals, estimated at 500,000 to 800,000. The only way to overcome this problem, besides recruiting more foreign professionals, is for each individual to produce more output each year than the year before. If instead they produce less, that’s like having fewer workers.
Let’s look at the reasons for Japan’s subpar performance.
Failing To Exploit Digital For New Products, Innovation of Business Model
What gives digital technology its power to improve TFP is that it empowers firms to produce new and better products, adopt more efficient processes for making their products, and innovate their business models. One of the latter is “open innovation,” i.e., greater collaboration with other firms.
For example, Tokio Marine & Nichido Fire Insurance uses the Internet of Things (IoT), sensors, and “big data” to detect patterns in a driver’s behavior that lead to more frequent accidents. The purpose is to reduce the number of accidents and not just pay out when they occur. Unfortunately, it is the exception.
For most Japanese companies, the primary use of ICT is cutting the costs of doing the same tasks they’re already doing. They fail to recognize that ICT enables them to perform tasks they could never do before, at any cost. In the US, by contrast, cost-cutting ranks 8th, while the primary use is to produce new or improved products, and the second most-named purpose is innovating the business model. The latter ranks seventh among Japanese companies (see chart below).
Source: https://home.jeita.or.jp/upload_file/20131008113119_ATM6gyZCis.gif Note: respondents can name more than one goal
For more on this facet of Japan’s digitalization problem, see this piece.
Disparaging ICT Services
Japanese companies have tended to fetishize manufacturing and disdain the value of software and other intangible capital. As a result, they have terribly underinvested in those services and terribly underpaid software engineers, systems integrators, and other ICT professionals.
But does the real value of TV lie in the TV set or in all the programs it lets you watch? Similarly, in ICT, most of the value lies not in the equipment, but in the embedded software and digital services like cloud computing, communications, data storage and manipulation, etc. In the US in 2021, hardware sales—computers and network infrastructure—account for only 16% of the value of the digital economy. Software accounts for another 26% and 58% of revenues come from paid digital services. This doesn’t even include e-commerce. Sales of software and services are growing more than 10% per year.
Despite all this, Japanese companies have not increased their real (price-adjusted) investment in software and services since 2005, whereas European companies have more than doubled their investment (see chart below). Instead, Japanese companies are putting their money into hardware, having doubled real investment between 2000 and 2022. That’s the same rate as the Eurozone.
Source: https://tinyurl.com/5d9ffenm
Japan’s underinvestment in services not only harms the performance of ICT users but also prevents ICT producers from taking advantage of a global digital services market that is growing far more rapidly than hardware exports. In 2000, global exports of ICT services were only 10% as large as exports of ICT goods. By 2022, they were 36% as large. They’ve grown very rapidly over the last couple of years, so their proportion is likely to be greater than 40%. Yet Japan’s global market share of ICT service exports is only 1%. That figure is dwarfed by the 10% share for the US, 7% for the UK, and 6% for both Germany and Israel.
In 2024, Japan ran a ¥7 trillion ($44 billion) trade deficit in digital goods and services, an amount equal to 1% of GDP. The Ministry of Economy, Trade, and Industry (METI) says the deficit could reach 10 trillion yen by 2030, roughly equal to what Japan paid for crude oil imports in 2024.
Digital Chasm For SMEs
In Part I of this series, I detailed how much Japan’s small- and medium-sized companies (SMEs) lag behind large ones in productivity. Underuse of ICT is one of the biggest reasons. There is a “digital chasm” between the larger companies and SMEs, as well as between Japan and other OECD countries.
Most SMEs use the Internet, but primarily for simple tasks like receiving customer orders via email. They hardly use it for tasks that can really improve performance. There are exceptions, of course. Nitori, a leading furniture retailer, doubled its sales between 2012 and 2022 by shifting to e-commerce and using a tool called “augmented reality” (AR). The latter allows customers to experiment “virtually” with different types of furniture on their phone or PC.
The two charts below compare the use of cloud services and “big data” between Japan and the median OECD country, by company size. In cloud services, Japanese companies with fewer than 250 employees lag far behind their OECD counterparts. When it comes to “big data”—the insights picked up by Tokio Marine through its monitoring of driving data—Japan lags behind the OECD in companies of all sizes (see the two charts below).
Source: OECD https://tinyurl.com/23xz56wr
When you consider that three-quarters of all Japanese employees work in firms with fewer than 250 employees, the digital chasm has an immense impact on overall business productivity.
Why don’t more SMEs take advantage of ICT? When METI surveyed them, the biggest reason, at 43%, was “a lack of personnel who can introduce IT.” A close second at 40% was “The effects of introducing IT are unclear or are not sufficient.” In short, they either don’t know what they’re missing or, if they do, they cannot access a solution. If Japan had enough software professionals who could act as consultants, this problem could be remedied. Europe has moved aggressively to address the issue (see Chapter 12 of my book, “The Contest For Japan’s Economic Future”), and a modern industrial policy in Japan would do the same.
Human Capital
The root of all these problems is insufficient “human capital.” On one level, that means outmoded attitudes about digitalization among corporate leaders. At another level, it means a woeful shortage of ICT professionals and poor digital skills among ordinary people.
Out of 67 countries, Japan ranks dead last in its population’s digital skills. According to the World Bank, one-third of Japanese workers cannot perform a simple “copy and paste” operation in a document. All Korean workers can do so. Whereas 10% of Koreans can write a simple software program, only 5% of Japanese can. All this limits not only the people available to hire as employees and/or consultants, but also the kind of programs that millions of SME employees can handle. Moreover, unless household consumers have the confidence to use digital products, companies cannot sell them.
How is this possible when Japan’s high school students rank at or near the top in international tests in math, science, and collaborative problem-solving? It’s because they come in last in several digital areas, including teachers’ ICT skills and the resources to train them. Since companies have exhibited little demand for university-trained software professionals, universities until very recently have not included those skills in entrance exams, and so high school teachers felt little incentive to teach them.
The government’s Digital Agency is only mandated to work on goals like having government agencies use email instead of FAX machines, but does nothing to improve digitalization in the private sector. This can, and should be, remedied.
For more details on the digital divide, see Chapter 12 of The Contest For Japan’s Economic Future.
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