While news in the United States and China has been largely positive in the last few weeks, Japan’s economy has shrunk by a shocking 3.5% in the third quarter. This announcement has deflated hopes for a strong recovery in Japan, and all but wiped out strong growth in the first quarter of this year. Japan is the world’s third largest economy and is heavily dependent on exports. Exports to Europe have taken a major hit and the on-going political snafu with China over the South China Seas is restricting trade between the two Asian powerhouses.

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Japan has suffered from the so-called lost decades from 1990 until now. From the post World War II period until the 1990’s Japan was one of the fastest growing economies and quickly came to dominant the global manufacturing sector. Then a combination of poor decision making among public leaders, a stagnant industry mindset, and a housing bubble brought the Japanese economy to its knees. The nation has yet to post a true recovery and has largely stagnated over the last few decades.

Once one of the world’s most innovative and productive economies, Japan’s manufacturing industry has not been able to compete with China’s low cost manufacturing. On the other hand many Japanese companies have been unable to compete with Western innovation, and in particular American multi-nationals, such as Apple Inc. (NASDAQ:AAPL) and Google Inc (NASDAQ:GOOG). This has left the nation in a tight spot of trying to find a valuable niche in a highly competitive global marketplace.

Japan has also had to contend with a “work for life” hierarchy, where seniority was has generally been embraced over new and innovative ideas. This model worked extremely well during Japan’s economic development and created an economic system that is excellent at perfecting and refining technology but often lacking when it comes to creating genuinely new and innovative products.

This has also created a focus on “hardware” performance, which is at odds with  user centric industries that focus on software and user experience. For example, Japanese cell phone manufacturers all but ignored Google Inc (NASDAQ:GOOG)’s Android and Apple Inc. (NASDAQ:AAPL) phones, believing that their comparably weak hardware features were ill-fitted for the Japanese domestic market. By 2011 the Apple Inc. (NASDAQ:AAPL) iPhone had grown into the largest single smart phone, controlling some 30 percent of the market.

The results of this stagnant economic model are now obvious. Since 1990, Japan’s economy has largely stagnated, yet the government has continued to try to drive the economy through heavy government interventions and social subsidies. Japan’s government is now the most indebted in the world, with debt levels at some 230 percent of the GDP according to the IMF.

That’s right, while the U.S. and many European countries are coming under fire for having debt levels at approximately 100 percent, the Japanese government has more than doubled it. Japan has been able to borrow at such absurd levels by borrowing from it’s own loyal people and financial institutions. These question now is whether or not these “IOUs” are actually worth anything.

Wages are plummeting for fresh graduates and younger generations. And yet it is these younger generations will be expected to support Japan’s rapidly aging population in years to come. With sky high living prices and near absurd housing costs its difficult to see how Japan’s younger generations will deal with a stagnant economy and large social commitments, while still having enough money left over to raise a family and afford a comfortable lifestyle.

While many people are looking to the U.S. or Europe to be the next economy to collapse, Japan’s economy is on just as unstable ground. Without major reforms, renaissance, or world-changing technological breakthroughs it’s difficult to see how the Japanese economy can continue on it’s current path. And with most of Japan’s debt owned by it’s own people, its the Japanese themselves who stand to lose the most.