Japan’s fiscal push leans too much on short-term relief
The Japanese economy remained generally strong in 2025 despite the Trump tariff shock. Growth reached the level of its potential and the output gap hovered close to zero. But despite these positive indicators, inflation and Japan’s declining population pose considerable challenges for Japanese policymakers.
Looking back on 2025, the biggest news was the emergence of the country’s first female prime minister. On 21 October, Sanae Takaichi was appointed as Prime Minister — after 103 terms and 65 male prime ministers since the position was established in the late 19th century.
Japan’s gender equality ranking remains strikingly low, ranked 118th out of 148 countries in the World Economic Forum’s index. Advancement is particularly slow in ‘political empowerment’ (125th) and ‘economic participation and opportunity’ (112th). But women are increasingly assuming top positions in both politics and business, including the Japanese Trade Union Confederation chair, the president of Japanese flagship airline Japan Airlines, the Communist Party leader and the Prosecutor General. While there is still ample room for improvement, it is encouraging to see some visible progress.
The advancement of women has significant economic implications beyond fairness or international status. Japan must harness the abilities of women, which have been vastly underutilised, to delay — or ideally, reverse — economic stagnation.
The number of births and the total fertility rate have reached record lows, accelerating population decline and ageing. Unless Tokyo takes bold measures, the Japanese economy will start to shrink. Previous administrations implemented various policies to mitigate this trend. But their effects are yet to be seen. As one of her major initial policy steps, Takaichi established the Population Strategy Headquarters to address this looming demographic crisis.
These demographic challenges place downward pressure on the size of the domestic economy. Germany overtook Japan’s GDP in 2023 and India is expected to surpass it in 2025, pushing Japan down to fifth place globally. This is often raised as indicative of Japan’s economic decline.
But sluggish or even shrinking GDP is not necessarily a problem for individual citizens. Even if the economy’s overall size contracts, if per capita income continues to grow, the population can still enjoy prosperity. It may seem reasonable to pursue policies aimed not at GDP growth but at higher per capita income. From this perspective, there is no need to try to compensate for a declining workforce with immigrant labour. As the labour market tightens due to a shrinking labour force, wages will naturally rise and per capita income will increase.
Yet such a policy choice is not feasible for Japan. With Japan’s public debt ballooning to immense levels, a shrinking GDP would reduce the tax base, undermining fiscal sustainability and increasing the risk of a fiscal crisis.
While it is unclear whether Takaichi recognises this point, her policy philosophy is clearly pro-growth. She has stated that she is mindful of fiscal sustainability, but also that ‘without economic growth, fiscal sustainability cannot be maintained’, advocating what she calls ‘responsible and proactive public finances’. The supplementary budget for fiscal year 2025 introduced in December reached a record high of 18.3 trillion yen (US$117 billion) in spending. About half of this expenditure is directed towards addressing the higher cost of living. This indicates that the greatest political challenge in Japan is inflation.
In mainstream economics, dealing with inflation is the responsibility of monetary policy. But the Bank of Japan has been cautious about correcting its ultra-loose monetary policy, even after inflation exceeded the 2 per cent target, for the reason that wages have not kept pace with inflation. As dissatisfaction over rising prices grew among the populace, the government has been compelled to respond through fiscal policy. This has continued over three consecutive administrations.
According to orthodox economics, declining real wages call for supply-side improvements, such as increasing the capital-to-labour ratio or enhancing productivity through technological innovation. Yet government measures have mostly focused on relieving households’ cost of living concerns, like tax cuts, cash benefits and subsidies for public utility charges. This remains true with the Takaichi administration’s supplementary budget.
The government’s policy package gives households short-term relief. But it fails to address the underlying problems of weak productivity and stagnant real wages. Instead, it adds to the national debt because most of the spending is funded by borrowing. This slows efforts to get the country’s finances back in order.
Since the Bank of Japan has already stopped the policy of forcibly suppressing long-term interest rates, the Takaichi administration’s proactive fiscal policies are leading to a steady rise in long-term interest rates. Whether Takaichi’s ‘proactive’ fiscal policy can be regarded as ‘responsible’ depends on future market trends.
Going forward, even if there is a sharp spike in market interest rates, the Bank of Japan — which must remain mindful of inflation — has limited room to step in to suppress the hike. The risk that Japan’s policy settings become unsustainable is gradually increasing.
Masahiko Takeda is Senior Fellow in the Australia–Japan Research Centre at the Crawford School of Public Policy, The Australian National University and teaches at Keio University in Tokyo.