Economics: Japan turns around to face the future, and the day when our world grows old

Another incumbent political leader scrambled back to power last week - in the world's second largest economy, Japan. The election had taken place some weeks earlier, but it was only on Thursday, after lengthy negotiations with the minor parties, that Ryutaro Hashimoto was able to form a coalition government. The state of the economy, however, did not aid his return to power. For only now, after the longest recession of any of the Group of Seven countries, is Japan at last returning to growth.

We tend to pay much less attention to the Japanese economy than we do to the other large developed countries. While the state of Japan's external commercial empire is of enormous importance to the UK economy, the state of their domestic economy is not.

It matters that, for example, the European sales of Nissan or Toyota prosper, because that affects investment and employment in their UK factories. It matters less that, for example, the fragile state of the Japanese financial system remains a barrier to growth back home. Japan is an interesting export market for some specialist UK products, mostly in "craft" industries like high-quality textiles, whisky and entertainment products; but it is not a mainstream market like continental Europe.

We should pay more attention, though, for two reasons. First, Japan is importing more, particularly the sort of cultural products in which the UK is strong; and second, because the health of the world's second largest economy matters to the world as a whole. Here the news is at last encouraging.

The charts, drawn from a paper by US bankers JP Morgan, demonstrate some of these positive signs. The retail sales are the most important single indicator: on the chart they may appear a little disappointing, as they have fallen back since the beginning of the year. In fact they have been very volatile all year, affected among other things by the food poisoning scandal in Japan. The three-month moving average will be pulled up by good sales through September and probably October, and so should look stronger in another month's time.

Consumer confidence will be increased by rising overtime (middle graph) and by a rise in the ratio of job vacancies to applications. Finally, as the right-hand graph shows, there are at last some signs of recovery in the residential property market. The market as a whole does not look as cheerful as the Tokyo one shown here, but expect the Tokyo experience to spread through the rest of the country, rather like the way the London property market tends to lead the rest of the UK.

The domestic market in Japan is large in relation to the export market: Japanese exports of goods and services are just under 10 per cent of GDP, compared with 25 per cent for the UK. So exports do not help that much in stimulating additional demand. But the fall of the yen from 80 to the dollar 18 months ago to 113 this week has stimulated export demand.

Interestingly, a statement on Thursday from a Ministry of Finance official that the strength of the Japanese economy is being underestimated by the market, has been taken to mean that the ministry now feels that the fall in the yen has gone far enough. Whether that is the correct interpretation remains to be seen. But at least it shows that Japanese officialdom is more relaxed about the yen and the economy than it was even six months ago.

The Japanese recovery has been a long time a-coming, but it really does look more ready to begin expanding than at any time in the past three years. In cyclical terms the next six to nine months should show solid growth. The question is : can this growth be sustained?

The answer lies not so much in macro-economics as in micro-economics, and in particular how Japan prepares its economy for an ageing population. Most people here are aware that the entire developed world is ageing but most, perhaps, have not appreciated that Japan will have moved from being the youngest of the G7 nations in 1950 (in terms of the proportion of people over 65) to being the oldest by 2020. As a result, economic growth is bound to slow.

In one of those wonderful very long-range forecasts at which the Japanese excel, the Ministry of International Trade and Industry has estimated that the country's growth rate will slow to between 0.8 per cent and 1.7 per cent a year between 2011 and 2025. Nikko Securities reckons that this may be too optimistic and that GDP may stagnate during that period.

Coping with an ageing population demands a number of structural reforms. It requires reform in the labour market, so that Japan is not wasting so many of its young people by, for example, forcing women out of the job market when they marry, and by finding better ways of using the talents of the late-middle-aged and the elderly.

It also requires financial reform, in particular the building up of pension fund assets. Japan is now racing to do this. The government proposes that total pension contributions should rise progressively so that by 2025 they will reach 29 per cent of earnings. A fair proportion of these funds will be placed overseas, though how much at this stage is guesswork.

The planning that the country is doing is extraordinarily impressive, and is in marked contrast to the approach of continental Europe (bar the Netherlands) which has almost as serious a pension problem as Japan and is doing much less about it. But the planning does not change the arithmetic: for a generation there is going to be only slow growth in the Japanese economy.

There are further structural changes that need to take place and which the Japanese establishment now acknowledges will have to occur. These include tax changes to encourage the formation of small businesses, and cuts in income tax and (probably) inheritance tax. Finally, the banking system will have to be rebuilt at some stage in the next three years. And this rebuilding will be much easier when there is a little growth and some recovery in asset prices.

Now let's return to the position of the economy through the next 12 to 18 months. There is the prospect of a slow, steady recovery, driven by some rise in consumer confidence and reasonable export growth. There is a new government, or at least a government with a renewed mandate.

Anyone who meets senior mainstream Japanese business and financial people will be aware that they are thinking of the need for structural changes in a way that only the maverick fringe thought five years ago. The slow recovery gives a window of opportunity which will enable the reformers to push through change in a less painful way than two years ago.

For the rest of us, how Japan uses this time will be fascinating - the most interesting period since the bursting of the bubble economy at the end of the 1980s. In one sense all the country will be doing will be to carry through the type of market reforms familiar to anyone here in Britain. It is catching up, not pushing ahead. Where it is pushing ahead - where it has to push ahead - is in its planning for the old.

What Japan does matters as it is a very big economy, but it also matters because it gives us a taste of the sort of structural changes the rest of us must do to cope with our own demographic trends: it is a glimpse of all our futures.