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The latest consumer price data released earlier this month show that Japan is again at risk of falling into deflation. The Bank of Japan has revised down its inflation forecasts accordingly and now expects growth to be lower than previously forecast for 2015 and 2016. For many observers, one of the main reasons for the continued low inflation and economic stagnation is the slow increase in wages. Since the launch of “Abenomics,” wages in Japan have been barely rising and have even fallen in some sectors. Stagnant wages dampen domestic demand, undermining efforts to jump-start the Japanese economy.

A closer look at the recent trends in the Japanese labor market reveals why wages are not increasing. Over the past decade, regular employment has been increasingly replaced by temporary jobs at low wage rates. More and more young Japanese are drawn into low-wage jobs with low productivity. The centerpiece of economic reform should therefore be the labor market. Japan has a well-educated labor force that should be employed more efficiently to give young Japanese more prospects for growth.

At first glance, the Japanese labor market looks in rather good shape. Economic stagnation typically goes hand-in-hand with a fall in labor force participation. However, in Japan, the dynamic is different—labor force participation has increased from 62.9 million in March 2013 to 63.7 million in March 2015. Given that Japan’s population is shrinking, this expansion of the labor force by 1.2 percent might appear to be an impressive achievement by the current government. However, a closer look depicts a less rosy picture. The growth in employment has happened thanks to a rapid expansion of non-regular and part-time jobs by over 5 percent. In contrast, the number of regular permanent jobs has fallen slightly, by 1.6 percent.

Japan also seems to defy the laws of economics in a second way: Despite the fall in unemployment and the thus tighter labor market, wages have not risen. According to national statistics, inflation-adjusted wages even fell by 3.6 percent between December 2012 and December 2014. The wages that enter into these estimates are based on surveys of permanent jobs. Thus, it seems that the wages of permanent jobs have been depressed partly due to the emergence of non-regular workers, who are paid considerably lower wages than regular workers. The rapid expansion of non-regular jobs therefore has a double-sided effect. First, existing regular jobs are replaced by non-regular ones. And second, candidates for regular jobs see their negotiating power with employers weaken as competition from non-regular positions increases.

Such a scenario was certainly not expected when the low-paid segment was introduced into the Japanese labor market with the introduction of the Worker Dispatch Law in 1985. With Japan’s economy running at its full potential, the initial objective of the law was to quickly fill temporary jobs for high-skilled workers (haken in Japanese) in 13 well-specified occupations. Given this restriction, the impact on the labor market was initially limited. In subsequent revisions, the law was extended to more sectors, and in 2004, almost all industries were allowed to hire non-regular workers. As a consequence, the hiring of non-regular workers soared, and by early 2015, 4 out of 10 employees were non-regular employees.

What have been the effects of this transformation of the Japanese labor market? On the positive side, the haken law has helped Japan keep its unemployment rate at a moderate level, limiting the negative social effects of prolonged economic stagnation. It has also allowed Japanese firms to navigate more smoothly through uncertain economic times in the aftermath of the global financial crisis. However, the introduction of the low-paid segment has also come at a high cost for the Japanese economy and society.

First, the increasing share of non-regular workers with low pay has led to a decrease in domestic demand (i.e., consumption) and contributed to sluggish economic growth.

A less obvious, but probably even greater, cost to the Japanese economy has resulted from a peculiarity of the law: Non-regular employees in Japan are only allowed to stay in the same company for up to five years, otherwise the contract needs to be transformed into a regular one. As regular positions come with many benefits and cannot easily be revoked, companies are hesitant to make such offers.

According to a recent study by the Japan Institute for Labour Policy and Training, only 25 percent of temporary workers are able to become permanent workers. This rate is by far the lowest among Organization for Economic Co-operation and Development countries, where many large economies have rates typically far above 50 percent, such as Germany at 60 percent and the United Kingdom at 63.4 percent.

As a consequence, the vast majority of non-regular workers must constantly change jobs. This is a deleterious outcome from a labor market perspective as short contracts mean less time to learn on the job. Furthermore, few firms offer education or training for non-regular employees. Finally, as non-regular workers start new jobs, their responsibilities and wages typically do not increase. Many non-regular workers are thus stuck in jobs with low responsibilities and low wages. As these workers become older and need to provide for their families, the risk of falling into poverty becomes a reality. The initial intention of the labor law, which was to protect employees, is thus having detrimental effects on many workers and the economy as a whole.

The labor market in Japan is in urgent need of reform. The two-tiered labor market has produced adverse effects that need to be reversed. A first step would be to make the labor law more flexible. Instead of a strict three-year cut-off period, employees should be allowed to stay longer in a company with limited benefits. Having the opportunity to stay for an infinite time in the same company will increase their incentive to learn on the job and develop their skills, and thus increase productivity.

Prime Minister Shinzo Abe’s government seems to have recognized the dangers stemming from the rigidities of the haken law and has recently submitted a bill to the Diet. However, instead of facilitating the shift of non-regular workers to regular jobs, the proposed bill would have the effect of keeping temporary workers in their precarious employment situation indefinitely.

Whatever the final reform will be, the Japanese government should do its best to ensure that workers are employed to their full potential with proper career perspectives and remuneration. In every economy, a well-functioning labor market is crucial for economic success. Given the high average skill level in Japan, it is wasteful to push young workers into non-regular jobs with little opportunities for learning and growth. Changing it would not only be to their benefit, but to the benefit of the entire country.

Matthias Helble joined the Asian Development Bank Institute as a research fellow in August 2013. His research interests include international trade, health, the environment and urban economics.