Japan’s productivity transformation: From within-firm stagnation to market-driven reallocation

Discussions on Japan’s ‘lost decades’ have long focused on sluggish demand and the survival of ‘zombie’ firms. However, new evidence from microdata suggests a fundamental shift. This column argues that Japan’s productivity dynamics are moving from internal firm improvements to market-driven reallocation and reveals that the country’s unique ‘negative exit effect’ is largely driven by the mergers and acquisitions activity of high-productivity firms.

The long-term stagnation of the Japanese economy, often referred to as the ‘lost decades’, remains one of the most scrutinised phenomena in modern macroeconomics. For many years, the primary focus of researchers was on the demand side: monetary policy, fiscal stimulus, and the collapse of asset bubbles. However, a landmark study by Hayashi and Prescott (2002) shifted the debate toward the supply side. They argued that the fundamental cause of Japan’s stagnation in the 1990s was not a liquidity trap but a significant drop in productivity growth and a reduction in working hours. Their work highlighted that, without a recovery in total factor productivity (TFP), the Japanese economy would remain trapped in a low-growth equilibrium.

Our own research programme has investigated the micro-foundations of this slowdown. Early work, such as Ikeuchi et al. (2013), provided seminal contributions by documenting that the TFP growth of Japanese firms did indeed decline across a wide range of industries during the 1990s. This line of research sought to understand whether the problem lay within the firms themselves or in the way the market allocated resources between them.

Subsequent influential studies, such as Caballero et al. (2008), added another layer to this narrative by focusing on the ‘zombie firm’ phenomenon. They argued that inefficient bank lending and government forbearance allowed unproductive firms to survive, thereby congesting markets and preventing the entry and growth of healthy competitors. This suggests the possibility that Japan’s market dynamism had withered, resulting in a dysfunctional process of ‘creative destruction’ (Foster et al. 2001).

Our latest research (Fukao et al. 2026) builds upon this decades-long debate. Utilizing a massive dataset, we examine how the drivers of Japan’s productivity evolved from the late 1990s through the ‘Abenomics’ era of the 2010s. We find that while the narrative of stagnation was once accurate, the internal machinery of the Japanese economy has recently begun to change in ways that challenge the conventional wisdom.

A new dataset: Capturing the full spectrum of the economy

To understand these shifts, we utilise an extensive firm-level panel dataset provided by Teikoku Databank (TDB), covering the period from 1999 to 2020 (Figure 1). This dataset is uniquely valuable because it includes over 230,000 firms per year. Crucially, it captures a vast number of small and medium-sized enterprises (SMEs) that are typically missing from official government surveys or listed-firm databases. This allows us to track the entire lifecycle of firms – from birth to exit – across both manufacturing and non-manufacturing sectors, providing the most comprehensive view to date of Japan’s firm-level dynamics.

Figure 1 Number of firms in the TDB database (by year)

Source: Authors’ calculations using TDB data.
Note: “TFP measured” refers to observations for which TFP is calculated using Equations (1) and (2) below.

The shift: From internal growth to reallocation

A standard way to analyse aggregate productivity is to decompose it into ‘within-firm’ effects (improvements within existing firms) and ‘reallocation’ effects (resources shifting from low-productivity to high-productivity firms).

Our analysis (Figure 2) shows that during the 2000s, aggregate productivity growth in Japan was almost entirely driven by the ‘within-firm’ effects. Large enterprises, particularly in manufacturing, were the sole engines of growth through internal restructuring and incremental innovation. During this period, the reallocation effect was often negligible or even negative, suggesting that the market mechanism was indeed failing to shift labour and capital toward more efficient players.

However, since the early 2010s, this pattern has reversed. The ‘within-firm’ growth of large corporations has diminished substantially, reflecting the stagnation of intangible investment, such as ICT and human capital, in large incumbents. In its place, the reallocation effect has emerged as a primary driver of aggregate TFP growth. For the first time in decades, the Japanese market is functioning more like a healthy, developed economy where competition shifts resources to where they are most productive.

Interestingly, this new dynamism is most visible among small firms. Contrary to the persistent image of stagnant, traditional SMEs, we find that small firms have exhibited higher TFP growth than large firms since 2010. While large firms struggle with organisational inertia, smaller players appear to be responding more nimbly to the digital transformation and changing global market conditions.

Figure 2 Decomposition of TFP growth by period

Source: Authors’ calculations using TDB data.
Note: The Foster, Haltiwanger, and Krizan (2001, FHK) decomposition method is employed.

Unravelling the ‘negative exit effect’ and the role of mergers

A long-standing puzzle in Japanese productivity data is the ‘negative exit effect’. In most economies, the exit of firms boosts aggregate productivity because those leaving are the least efficient (Baily et al. 1992). In Japan, however, our data frequently shows that exiting firms have higher productivity than the industry average, resulting in a statistical drag on aggregate growth.

To solve this mystery, we disaggregated exits into four types: bankruptcy, closure, dissolution, and merger (M&A). Our findings (Figure 3) reveal a nuanced and ultimately optimistic picture:

1. Inefficient exits: Firms that exit through bankruptcy or involuntary closure are indeed highly inefficient, as theory would predict.
2. The merger anomaly: Crucially, firms that exit via merger exhibit TFP levels 6–8% higher than those of surviving firms. These are often productive ‘stars’ being acquired by larger entities to secure talent, technology, or market share.
3. The real driver: Our analysis shows that nearly half of Japan’s overall negative exit effect is explained by these mergers of high-productivity firms.

This explains why the ‘shadow of death’ (the gradual decline in productivity before exit) seen in US firms is absent in some Japanese exits. Firms destined for merger maintain high TFP right up to the point of their disappearance from the database.

Figure 3 Contribution to the exit effect by exit type

Source: Authors’ calculations using TDB data.
Note: FHK decomposition of TFP growth. Exits for unknown reasons (N/A) are excluded.

Post-merger dynamics: Does it lead to growth?

A critical policy question is whether the ‘exit’ of a productive firm through a merger is a loss for the economy. If a productive firm is absorbed by a lethargic acquiring entity, the negative exit effect would indeed be a cause for concern.

To investigate this, we conducted a post-merger analysis of the acquiring firms. We found a divergence between TFP and labour productivity. While TFP often stagnates in the short term – likely due to the high organisational costs of integration – labour productivity shows a significant and sustained increase, remaining 10–20% higher than pre-merger levels in the long run (Figure 4).

Figure 4 Post-merger labour productivity

Source: Authors’ calculations using TDB data.
Note: Coefficient estimates and 95% confidence intervals. The horizontal axis indicates the number of years since the first merger.

Our research indicates that this boost is driven by capital deepening (Figure 5). Acquiring firms tend to significantly increase their tangible fixed capital following a merger. This suggests that mergers in Japan serve as a catalyst for large-scale capital investment, allowing the combined entity to operate with a much higher capital-labour ratio than either firm had previously.

Figure 5 Post-merger tangible fixed capital per employee

Source: Authors’ calculations using TDB data.
Note: Coefficient estimates and 95% confidence intervals. The horizontal axis indicates the number of years since the first merger.

Policy implications: Embracing a new era of dynamism

Our findings provide a new perspective for the ongoing debate over Japan’s structural reforms. The Japanese economy is not as stagnant as aggregate figures suggest; rather, its internal machinery is undergoing a fundamental shift.

First, since productivity growth has moved from the ‘internal efforts’ of large incumbents to ‘market-driven reallocation’, the role of policy must shift accordingly. Rather than focusing on direct subsidies or protections for specific large industries, the government should prioritise maintaining a fair and competitive environment that facilitates the fluid movement of labour and capital.

Second, the ‘negative exit effect’ should be re-evaluated. It is not necessarily a sign of economic dysfunction but often reflects a healthy restructuring process. The current policy focus on protecting all SMEs regardless of their performance may be counterproductive if it hinders the natural M&A process that leads to capital deepening and higher labour productivity.

In conclusion, Japan’s path to growth lies in embracing this new era of market-driven reallocation. Policymakers should focus on institutional frameworks that facilitate the smooth transition of high-growth potential firms into larger, more capital-intensive entities, such as streamlining M&A regulations and improving corporate governance. The supply-side recovery that Hayashi and Prescott called for two decades ago may finally be taking shape, but through market reallocation and M&A, which requires a new set of policy tools.

Source : VOXeu