The Japanese are good at innovation. It was their reengineering techniques that propelled them to a top world competitor in the 1980s. But since stagnation began 20 years ago, Japan’s skill of innovating is still only good. It needs to be great.

Most economies can be categorized by four characteristics: (1) labor markets, (2) capital, (3) natural resources, and (4) innovation. Japan has a rapidly aging population, which owns most of the domestic debt, negatively affecting both labor markets and capital returns. And as an island nation, Japan is already limited in its natural resources. As speakers Masa Ishii and Derek Scissors recently explained at Heritage, the weight of Japan’s success has rested, and will continue to rest, on its ability to innovate.

Heritage’s Index of Economic Freedom ranks Japan 24th in the world, while the International Institute for Management Development ranks Japan’s competitiveness at 27th.

Policies in Japan have been so protectionist toward older companies that starting a new business is exceedingly difficult. Established companies have become the leading source for new innovation due to a lack of startups. Policy needs to create an environment that allows failing companies to fail, thus creating room for newer, more innovative companies.

One way to foster a growth in Japan is to increase labor movement. Japan’s government currently gives companies subsidies to keep full-time employees who otherwise would be fired. And with pensions being as immobile as they are, it’s almost as if companies are holding employees hostage.

Prime Minister Shinzo Abe is on the right course in one aspect, and that’s getting more women into the labor force. In 2012, Japan ranked 101 out of 135 on the World Economic Forum’s Global Gender Gap Report.