Japan Enters a New Era of Risk and Reform

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Japan has entered a pivotal moment in its economic history, undertaking its most ambitious policy and structural reforms in a generation to escape from decades of stagnation. The nation’s post-war boom ended abruptly in the early 1990s, ushering in three "lost decades" of falling prices, anemic growth and a moribund stock market. Now, after a radical and long-waged battle against deflation, the frost is finally beginning to thaw.

For years, the Bank of Japan (BoJ) deployed an arsenal of unprecedented stimulus, culminating in a negative interest rate policy designed to shock the economy back to life. That experiment appears to have finally worked. Prices are rising meaningfully, and in a landmark policy shift in 2024, the central bank officially ended its era of extraordinary easing, confident that a virtuous cycle between wages and prices was at last taking hold. Savers and workers are feeling the effects, and with Japanese stocks recently hitting a 35-year high, a cautious optimism has returned. However, these efforts are pitted against the formidable and accelerating pressures of a profound demographic decline, heightened political uncertainty, and the complex risks associated with unwinding decades of monetary stimulus. The long-term outlook is one of modest but positive growth, a trajectory heavily dependent on deep-seated reforms gaining traction.

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Japan's New Political Wrinkle

Adding a new layer of complexity is a sudden bout of political instability. Prime Minister Shigeru Ishiba announced his resignation on September 7, 2025, after his ruling coalition lost its majority in the July upper house elections. The ensuing leadership race injects significant policy uncertainty at a critical juncture. To secure cooperation from opposition parties, all of which favor fiscal expansion, the next government will likely adopt a more generous spending stance. This raises the risk of looser fiscal policy, creating upward pressure on long-term bond yields and complicating the BoJ’s carefully laid plans for further interest rate hikes.

The Twin Policy Challenges

This political turmoil compounds Japan's two monumental and deeply intertwined policy challenges: managing the world's largest public debt burden while simultaneously normalizing monetary policy.

Japan's gross government debt stands at a staggering 264% of GDP, the highest among developed nations. For decades, this has been manageable for two reasons: The vast majority is held by domestic investors, and the BoJ's ultra-low interest rates kept borrowing costs negligible. But as the BoJ pivots, that stability is no longer guaranteed. With interest rates rising, the cost to service this colossal debt will inevitably increase, creating a direct conflict between monetary and fiscal stability. According to Ministry of Finance estimates, a sustained 1 percentage point increase in interest rates could nearly double the government's interest payment expenses within a decade.

This creates a contradiction. The BoJ's very definition of success — achieving its 2% inflation target, which requires higher interest rates — is the primary threat to the Ministry of Finance's ability to sustainably manage the national debt.

The Demographic Drag

The most formidable constraint on Japan's long-term outlook is its demographic crisis. The country is not merely aging; it is a "super-aging" society, with nearly a third of its population over 65. Having peaked at 128.5 million in 2010, the population is projected to fall below 100 million by 2048.

This has severe economic consequences. The shrinking workforce is the primary cause of acute labor shortages, with one study projecting a shortfall of 11 million workers by 2040. This demographic drag acts as a powerful structural brake on growth. Yet, this shift has also created a bifurcated reality. While the overall economy is constrained, a powerful "silver market" of consumers aged 60 and over has emerged, accounting for an estimated ¥115 trillion in annual spending — a remarkable 48% of all personal consumption.

Japan's Quiet Revolution

In the face of these headwinds, a quiet revolution is taking hold in Japan’s corporate sector. For years, Japanese firms were notorious for hoarding cash and operating under convoluted governance structures that shielded management from accountability. This led to the so-called "Japan discount," where solvent companies persistently traded below their book value.

Spurred by a "name and shame" campaign from the Tokyo Stock Exchange, a profound cultural shift is underway. The exchange has pressured companies to improve capital efficiency and enhance corporate value, and firms are responding. In fiscal year 2024, share buybacks surged to a record ¥10 trillion, while dividend payouts reached ¥16 trillion, marking a decisive move away from unproductive cash hoarding.

This is one of three interconnected pillars of a national reform agenda. The second is a push to remake the rigid labor market through the "New Trinity" of reforms: reskilling workers, transitioning from seniority-based to job-based pay, and promoting labor mobility. The third pillar is a national mandate for digital transformation, driven by stark warnings of a "2025 digital cliff" — a scenario where failure to modernize legacy IT systems could result in massive annual economic losses.

Geopolitical Realignment

Geopolitically, Japan is repositioning itself amid escalating U.S.-China tensions. Alarmed by supply chain vulnerabilities revealed during the pandemic, Tokyo is pursuing a "China Plus One" strategy to de-risk its supply chains, using subsidies to encourage firms to move production back home or to friendly nations in Southeast Asia.

Simultaneously, Japan is deepening its alliance with the United States. In a trade deal agreed in July 2025, Japan avoided a threatened 25% U.S. tariff, with a new baseline of 15% set for most goods, including cars. In exchange, Japan committed to investing over half a trillion dollars in key U.S. sectors like pharmaceuticals and semiconductors. While the deal reduces uncertainty, the outlook for Japanese exports remains fundamentally weak.

Ultimately, Japan's future will be the world’s first test case for whether an aging, highly indebted nation can innovate its way back to healthy and balanced economic growth.

This forecast first appeared in The Kiplinger Letter, which has been running since 1923 and is a collection of concise weekly forecasts on business and economic trends, as well as what to expect from Washington, to help you understand what’s coming up to make the most of your investments and your money. Subscribe to The Kiplinger Letter.

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