By Luc Everaert and Giovanni Ganelli

(Version in 日本語)

Everybody agrees: wages need to grow if Japan is to make a definite escape from deflation. Full- time wages have increased by a mere 0.3 percent since 1995! For example, despite its record profits, Toyota increased its base salary only by 1.1 percent last year. The average of 219 Keidanren firms managed just 0.44 percent. Clearly, an increase in base wages, colloquially referred to as “base up”, is long overdue.

For quite some time now, Japanese authorities have attempted to reinvigorate growth and generate more inflation. This is important because debt can become quite burdensome when prices and incomes fail to grow. This is exactly what has been happening in Japan during the couple of decades of deflation. Nominal GDP fell throughout most of the period while public debt rose to nearly two and a half times the country’s GDP, the highest debt in the world.

The dual labor market limits wage growth

Our analytical work shows that lack of wage growth may have some structural causes that in turn contributed to secular deflation. First, most workers are employed under life-time contracts and hardly move jobs between companies. In exchange for life time employment, employees accept to temper wage demands, which means that tight labor markets do not translate into higher wages. In addition, a large share of workers (37 percent) are employed under non-regular contracts, a much higher share than in comparable economies. Companies scrambled to restore competitiveness after the sharp appreciation of the yen in the 1980s by moving production offshore and hiring nearly exclusively under much lower paid non-regular wage contracts. And at the same time, unionization declined and wage bargaining power of labor unions all but disappeared.

The tighter job market does not do it

Abenomics—a combination of monetary easing, flexible fiscal policy, and structural reforms—was designed to boost both real growth and inflation. In 2013, the monetary arrow was launched in force, depreciating the yen and boosting corporate profits in the process. The ensuing record corporate profits were expected to be passed through to increased prices for subcontractors, dividends, and higher wages for all workers.

It has helped in stirring nominal GDP. Over the past two years, nominal GDP has risen by 3.7 percent. Tax revenues especially from corporate profits have also increased. And the labor market has continued to tighten and participation reached a historic high. By end 2015, only 3.3 percent of people looking for jobs were unemployed. Some sectors are facing, acute labor shortages.

Yet the current wage negotiations are hardly aggressive at all. For instance, Toyota’s union is asking for only half as much as in 2015. Overall wage demands are likely to lead to an increase of only about 0.5 percent, well below the Bank of Japan’s inflation target, ignoring any productivity improvements. The lagging of real wages to labor productivity appears to continue a long standing trend which has been affecting Japan more than other similar economies (see chart).

True, the global and the domestic outlook remains weak. Corporations are not keen to boost wages or prices. Yet, wage and price inflation need not lead to loss in competitiveness or profitability. For instance, if inflation was at two percent and productivity grew by one percent, then increases in wages and social security benefits by 3 percent would leave everyone equally well off. And collectively the economy would benefit from lower real interest rates and more effective monetary policy.

Wage increases could be the missing arrow

Abenomics rightly aimed to end Japan’s entrenched deflationary mentality. The monetary arrow was meant to raise inflation expectations to 2 percent, and thus provide a mechanism to coordinate wage and price inflation. However, this has proven to be a hard struggle because companies and workers alike seem to look backward rather than forward in setting their expectations. As a result, they fail to do their part to solve the coordination problem that would leave all better off.

More recently, Prime Minister Abe has shown leadership by increasing minimum wages. But this affects directly only about one tenth of the work force. The impact is limited at best. We are not sure that relying on moral suasion for the rest will deliver results.

Rather, a fourth arrow needs to be loaded:

The government could replicate the success of the corporate governance reform by introducing a “comply or explain” mechanism for profitable companies to ensure that they raise wages by at least 2 percent plus productivity growth.

The authorities could strengthen existing tax incentives to raise wages.

Policymakers could even go a step further by introducing tax penalties for companies not passing on excessive profit growth.

Another option is to set the example by raising public sector wages in a forward looking manner.

At the same time, these steps would be reinforced by the existing arrows. In particular, Prime Minister Abe’s third arrow needs to cut much deeper through labor market duality by ensuring that new hiring takes place on contracts that strike a middle ground between the currently prevailing life-time and non-regular contracts. This would restore some healthy wage bargaining power to workers.

Along the way, “base-up” should again become a household word.