Forever Zero Interest Rates Won't Solve Japan's Big Problem

Forever zero interest rates may help Japan avoid the slide into another recession. They will provide free money to finance its large government debt, too. But they won't solve the country's chronic problem: a crumbling population pyramid.

Zero interest rates are a policy of the past for most central banks worldwide, as they have been lifting interest rates to fight the resurgence of inflation. But not for the Bank of Japan (BOJ), which strives to help the country's economy get out of three decades-long stagnation.

In its last meeting, BOJ made no changes to its long-standing policy, pledging to print enough money to keep the benchmark 10-year Treasury bond around 0%, continuing its forever zero interest rate policy.

BOJ was a pioneer of Quantitative Easing (QE). This unconventional monetary policy seeks to drive long-term interest rates near zero by buying assets with long maturities, like Treasury bonds.

This time around, the maintenance of zero interest rate policy by BOJ raised the gap between Japan and its overseas counterparts including the U.S., where the 10-year Treasury bond is hovering over 4%. Thus, the rapid depreciation of the yen against the dollar, as Japanese investors are seeking better returns for their money in U.S. assets.

But the falling yen has a good side, too. It has helped the Japanese economy remain competitive in a new global landscape where its companies compete head-to-head against their Chinese and South Korean counterparts. Thus, it has stayed off another recession.

Still, the positive effect of the weak yen on the country's economy could be limited — partially offset by lower consumer spending due to imported inflation, which squeezes family budgets.

Moreover, in what is commonly known as financial repression, the zero-interest rate policy provides free money to pay for the government's massive debt. But it doesn't help lift a serious constraint that limits the country's long-term growth prospects: poor demographics.

Graphically described by the population pyramid, demographics are critical for a country's long-term growth prospects. A normal population pyramid, which includes large numbers of younger people at its base and a smaller number of people at its top, is a tailwind to economic growth. It provides the economy with a growing labor force that expands its potential output and a large tax base to pay for social programs, including retirement.

By contrast, an abnormal or crumbling pyramid, which includes a shrinking base and an expanding top, is a headwind to economic growth. It results in a declining labor force that limits the economy's potential output and tax base and soaring wages and government debt.

That's the case for Japan's economy these days. As a result, its demographic pyramid is crumbling. The number of people above 60 is swelling, while the number of people below twenty is shrinking due to a combination of rising longevity, low birth rates and tight immigration.

The shrinking of the younger ages has resulted in the shrinking of the country's labor force. It declined from roughly 68 million in 1997 to 66 million in 2013 before recovering and returning to where it was in 1997.

Then there's the soaring of the minimum hourly wage, from 749 yen in 2012 to 961 in 2022, making the country less competitive in world markets. Thus, the need for a weaker yen.

And there's the country's massive government debt. It has increased from 190% of GDP in 2011 to 225% in 2021, the highest in the developed world.

While zero interest rates could ease the pain of the Japanese government in financing its soaring debt, it won't address the root of the problem: poor demographics.

That requires different policies, like opening up the country's borders to gaijins — foreigners. But Japanese society has to get ready for it.