Contemplating the Relationship between the Deflationary Economy and the Labor Market of Japan

TSURU Kotaro
Program Director and Faculty Fellow, RIETI

The House of Representatives election that just ended was full of anomalies. With a total of 12 parties that contested under the single-seat constituency system, some parties committed to specific monetary policy measures (e.g., setting an inflation target, purchasing of foreign bonds) and changes to the way the Bank of Japan (BOJ) operates (e.g., amendments to the BOJ Act, forming an accord between the government and the BOJ) as part of their campaign promises. These would be a natural topic for economists and monetary experts. However, this is probably the first time that such technical matters have become a contentious issue in an election, an occasion in which people—mostly non-experts—vote to elect their government. It may be considered as a reflection of the growing frustration among a broad range of people over the never-changing situation with the prolonged deflation and continuing appreciation of the yen.

Monetary policy alone cannot provide the fundamental solution to deflation

However, it may be that the more the issue of monetary policy or the role of the BOJ is focused, all the more is it giving an impression to the people that monetary policy is a "magic wand" with which we could freely manipulate the Japanese economy. The ultimate form of bold monetary policy would be the outright purchase of high-risk assets by the BOJ. However, when such risk manifests itself in the form of actual losses, the government must make up for them. The greater the degree of boldness of monetary policy, the closer it becomes to fiscal policy in nature as is the case with the outright purchase of government bonds by the BOJ, a scheme that is in principle prohibited under the Public Finance Act (Note 1). Meanwhile, guiding the yen lower by means of monetary policy is a classical beggar-thy-neighbor strategy and may cause diplomatic friction. Without ensuring that people understand these odd aspects, the Liberal Democratic Party (LDP) has been advocating bold monetary policy as the centerpiece of its economic policies. I cannot avoid the same sense of apprehension as I felt when the Democratic Party of Japan (DPJ) won the previous lower house election, claiming that it would implement new policies such as child allowances using some 16 trillion yen of funds to be generated by eliminating wasteful government expenditures.

Can deflation be solved by monetary policy alone? Presumably, various factors are affecting and being affected by the current deflationary economy, making it difficult to analyze the situation. Just like a person's body temperature, the overall level of prices in an economy is a barometer of soundness (health). Suppose that a person is suffering from low body temperature. In this case, trying to raise it by taking whatever measures available is obviously not a good remedy. We must first diagnose and identify the part of the body with the problem. No fundamental solution can be found unless we focus on the nature and structural factors of the problem.

In considering ways to address the problem of deflation, I cannot help but be concerned about changes in the labor market, particularly, those in wage conditions. Contrary to the situation today, Japan was struggling with inflation in the 1970s. What was learned from that experience was that cutting the wage-price spiral is crucial to containing inflationary expectations. In the wake of the first oil crisis in the early 1970s, wages went up in tandem with prices, thereby fueling inflation. Learning from this bitter experience, Japan managed to navigate through the second oil crisis fairly successfully. That is, when prices went up, both employers and employees accepted falls in real wages, reckoning them as an outflow of real income triggered by the deteriorated terms of trade. Back in the 1980s when I started out on my career as a government economist, this experience was taught as one of the most important lessons to be kept in mind.

Applying this idea to the current situation, we can say that deflation is continuing—i.e., inflation expectations do not arise—because people cannot expect their wages to rise. Although the rate of wage growth basically moves in tandem with the nominal growth rate of the economy, it is also affected by changes in the overall employment system. The practice of permanent employment has not changed significantly in Japan, except for that concerning the young generation. However, as a consistent trend over the past 20 years, the steepness of the slope of the wage-tenure profile has fallen, reflecting a shift from the conventional seniority-based promotion and skills-based pay system to performance-based promotion and a task- or role-based pay system, and even to the scrapping of the annual pay increase system (Note 2). That is, pay scales are steadily becoming less seniority-oriented. Furthermore, the proportion of non-permanent workers—those who are outside the seniority-based pay and promotion systems—has increased over the years to account for one-third of total employment in Japan today. Given this reality, it is difficult to expect a continuous increase in wages in terms of a framework for the overall employment system. In the past, annual collective wage bargaining between labor unions and employers usually held in the spring—referred to as shunto (literally, spring fight)—used to serve as a mechanism through which wage hikes in the nation's leading industries trickled down into other industries and companies. Today, however, even shunto has lost its substance.

Does this mean that the government should implement measures to force companies to raise wages in order to create inflation expectations? Recent analyses have shown that such government policy may have various adverse effects on the economy. For instance, it has been found that raising the statutory floor for wages might cause job losses among those working at or slightly above low-end rates and, even if such is not the case, would hit consumers in other forms as companies would have lower profitability and try to pass the higher cost of labor onto prices (Note 3). This is akin to putting an undue burden on the monetary policy as a way to create inflation expectations in that they are both accompanied by various kinds of risk and side effects.

An efforts-rewarding employment system is the key to saving the Japanese economy

Then, what should be done? A skills-based grading system, which served as the theoretical backbone of the seniority-based pay system, has now become unpopular. However, we must not forget that the rhetoric that employees' skills and knowledge should improve with the number of years of service has been providing both labor and management with an incentive to improve employees' skills over a long period of time based on the premise of long-term employment. If we use skills as a standard for measurement and assume that they do not deteriorate, employees' wages would not fall. As such, the skills-based pay system is almost equal to the seniority-based one, at least, in appearance. In contrast, in the case of the task-based pay system, the wage rate to which an employee is entitled to remains unchanged so long as he or she is assigned to the same task. Meanwhile, under the role-based pay system, a change in the role may result in lower wages. That is, we are shifting from the world in which we can expect a steady increase in wages so long as we work hard to one in which wages do not necessarily rise and may fall in cases. This may be a result of both labor and management shying away from making commitment to skills improvement over a long period of time. How can we enhance individuals' abilities and human capital—regardless of whether they are permanent or non-permanent—over the period of their long career life? And how can we rebuild the existing employment system into one in which people will be rewarded for their efforts toward the future? The long-term future of the Japanese economy hinges on whether we can find answers to these questions. In doing so, we can also probably find ways to end the ongoing deflation.

What I have been worried concerning the economic debate over the past several years is that too many arguments have been made for the sake of putting blame on someone else or counting on others to solve the problems. Therefore, I find it quite impressive that against such an odd backdrop, the DPJ, the LDP, and the New Komeito managed to agree to raise the consumption tax rate, resolving the long-pending issue. We must pay the past bills, endure burdens and often pains, and strive to cultivate our skills and ability. Only when each of us takes on this challenge can we expect to improve our living standards. I hope that the incoming government will make and implement such down-to-earth policies.

December 18, 2012
  1. ^ Article 5 of the Public Finance Act stipulates that the government shall neither have the BOJ underwrite government bonds nor borrow from the bank; provided, however, that this shall not apply where special circumstances exit and the government does so within the limit of an amount approved by a resolution of the Diet. It should be noted that the proviso provides for an exception to the general prohibition.
  2. ^ For instance, see the presentation by RIETI Faculty Fellow Daiji Kawaguchi (in Japanese: at RIETI Policy Symposium on Pay and Benefits System Reform and Post-3/11 Labor and Employment Policy on December 2, 2011.
  3. ^ For recent analyses, refer to the presentations at the RIETI Workshop on Minimum Wage Reform (in Japanese:, particularly, the one by the author (

December 18, 2012