Commentary / Japan

Japan's labor shortage and low-wage puzzle

by Sayuri Shirai

Japan’s labor market has achieved full employment over the past two years. Unemployment has declined over the past two years to below 3 percent—close to the levels of the 1980s and early 1990s—after peaking at 5.4 percent in 2012. Currently, most unemployed people are either those who quit jobs voluntarily or who reached retirement age and/or completed temporary labor contracts.

The lower number of laid-off workers indicates a growing labor shortage, which is already prevalent among small and medium-size enterprises. The shortage stems from a steady drop in the working age population (15 to 64 years old) since the mid-’90s and moderate economic growth, inviting working age housewives and people over the age of 65 to participate in the labor market.

Japan has also been facing an important production capacity shortage for the past two years across most sectors. This reflects firms’ hesitance to invest in production equipment and structure after the global financial crisis. The recent rapid recovery in such investment has been a major driver of economic growth. However, investment in real terms has only recovered to the 2000 level, which suggests that capital stock accumulation has not yet eliminated firms’ production capacity constraint.

For these reasons, little economic slack is left in Japan. Labor and production capacity constraints have contributed to an improvement of output gap (difference between actual and potential output), which has been positive since late 2016 and exceeded 2 percent in late 2018. The Bank of Japan claims that the positive output gap or excess demand will eventually lead to higher inflation and move toward a 2 percent price stability target. So far, underlying inflation has remained persistently low despite massive monetary easing dating back to 2013.

The puzzling thing is why wage growth has been so sluggish despite the apparent labor shortage. It is true that average wages turned positive in 2014 and increased 1.4 percent in 2018. Nonetheless, regular pay, or permanent income, rose a paltry 0.8 percent in 2018. In real terms, average wage growth has failed to take off and recorded just 0.2 percent in 2018.

Two factors could explain low wage growth. First, most recently employed workers have taken part-time jobs, with wages that tend to be much lower than full-time work, either because of work-life balance needs or aging. Aging-related impediments include health conditions and the ceiling set by the government on employment income that enables full pension benefits. The average working hours of part-time workers has been steadily declining, exacerbating the sluggish wage growth.

Second, firms are reluctant to hire full-time or part-time employees for over 30 hours — 20 hours for large firms — a week, which requires mandatory contributions to the social security system. This is true for many small and inefficient nonmanufacturing businesses worried about shrinking domestic sales and tougher competition. Bonus payments, which can be adjusted flexibly in line with profits, are preferred by firms. This explains why households’ real consumption has been sluggish over the past two decades. In other words, Japan’s labor shortage more strongly reflects unfavorable demographics and structural problems than demand-driven dynamics.

Potential economic growth has dropped to less than 0.7 percent since 2017 from around 1 percent in early 2014. According to BOJ estimates, this drop is due to a decline in total factor productivity growth. Strong tourism, construction, real estate and wholesale/retail trade activities have contributed to employment growth without improving labor productivity growth. Moreover, growth dependent on labor-intensive or unproductive nonmanufacturing sectors may not be sustainable given that the recent liberalization policy to accept more temporary foreign workers will not be enough to offset the labor shortage.

By 2025, the labor shortage will begin to pose a severe constraint on Japan’s economic growth as many senior workers will reach the age of 75 and leave the labor market. Moreover, an expected shift of production locations in the automobile sector to the United States under pressure from Washington and to Asia where the potential sales market is large might push Japan’s productivity growth lower. Therefore, it is time for the government to acknowledge low economic growth and low productivity problems and consider more forward-looking policies to cope with mounting aging-related challenges.

Sayuri Shirai is a visiting scholar to the Asian Development Bank Institute and a professor at Keio University. She is also a former Bank of Japan Policy Board member.