Is Downward Wage Flexibility the Primary Factor of Japan's Prolonged Deflation?

• Published date: 01 January 2014
• Date: 01 January 2014
• Author: Isamu Yamamoto,Sachiko Kuroda
• DOI: http://doi.org/10.1111/aepr.12056

Is Downward Wage Flexibility the Primary

Factor of Japan’s Prolonged Deflation?

Sachiko KURODA1† and Isamu YAMAMOTO2

1Waseda University and 2Keio University

By using both macro- and micro-level data, this paper investigates how wages and prices evolved

during Japan’s lost two decades. We find that downward nominal wage rigidity was present in

Japan until the late 1990s, but disappeared after 1998 as annual wages became downwardlyflexible.

Moreover, nominal wage flexibility may have contributed to Japan’s relatively low unemployment

rates. Although macro-level movements in nominal wages and prices seemed to be synchronized,

such synchronicity is not observed at the industry level. Therefore, wage deflation does not seem to

be a primary factor of Japan’s prolonged deflation.

Key words: deflation, downward nominal wage rigidity, Japanese labor market, Japan’s lost two

decades, unit labor cost

JEL codes: J60, J30

1. Introduction

Most central banks are now targeting a positive inflation rate of a few percentage points.

One of the reasons for not targeting a zero inflation rate is the downward rigidity of

nominal wages, which could cause huge inefficiencies in the allocation of resources in

the labor market (Akerlof et al., 1996). By creating an environment where real wages can

be adjusted, a positive inflation rate, thereby, serves as a “safety margin” against the risk

of declining prices.

Bewley (1999) finds that the key reason for the reluctance to make nominal wage cuts

is the belief that wage decreases in nominal terms damage worker morale, which is a key

determinant of worker productivity (see also the related literature on behavioral econom-

ics such as Kahneman et al., 1986).1Manystudies also repor t the scarcity of nominal wage

cuts relative to nominal wage increases,including McLaughlin (1994), Lebow et al. (1995),

Card and Hyslop (1997),Kahn (1997), and Altonji and Devereux (2000) for the USA; Fehr

and Goette (2005) for Switzerland; and Kurodaand Yamamoto (2003a,b) for Japan.2

Empirical evidence on nominal wage rigidity continues to be reported even after the

global financial crisis in 2008. For example, Fabiani et al. (2010) report that the incidence

of wage cuts has increased little despite the global crisis in the Euro area. Similarly, ECB

The authors wish to thank Ken Ariga, RyoKambayashi, participants at the Seventeenth Asian Eco-

nomic Policy Review (AEPR) Conference and the Editors of the AEPR for their valuable com-

ments. The remaining errors are solely our own. This research is supported by the Murata Science

Foundation.

†Correspondence: Sachiko Kuroda,Faculty of Education and Integrated Arts and Sciences, Waseda

University,1-6-1 Nishiwaseda Shinjyuku-ku Tokyo 169-8050 Japan. Email: s-kuroda@waseda.jp

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doi: 10.1111/aepr.12056 Asian Economic Policy Review (2014) 9, 143–158

© 2014 The Authors

Asian Economic Policy Review © 2014 Japan Center for Economic Research 143

(2012) suggests a lower responsiveness of wages to rising unemployment during eco-

nomic downturns. Daly et al. (2012) also report that the proportion of US workers

reporting a wage freeze at the end of 2011 was higher than at any other point in the past

30 years. Therefore, nominal wages seem to be rigidly downward in many countries.

Looking at aggregate data, however, Japan seems to be an exception. Until the mid-

1990s, average nominal wages had been increasing in Japan. However, they started to

drop in 1998 and until now, this declining trend continues. These observations suggest

that Japan’s typical response to negative shocks since the late 1990s has been to cut wages

in nominal terms. This may imply that the resource inefficiency due to downward rigid-

ity is no longer an issue in Japan. However, the alternative view suggests that wage flex-

ibility may actually be a serious handicap since it makes it difficult for the economy to

escape deflation (see, e.g. De Grauwe, 2009; Krugman, 2012).3Yoshikawa (2013), for

instance, points out that wage cuts are the major cause of keeping the Japanese economy

trapped in prolonged deflation. Wage cuts trap companies in a negative spiral by lower-

ing the prices of goods and services, while protecting employment at the micro level.

Since each firm adopts the same strategy, however, their individual competitiveness does

not improve, which leads to further cuts in wages and prices, and results in a deflationary

trap. From this perspective, an economy that has greater wage flexibility must rather

target a higher inflation rate to create a larger safety margin against such a deflationary

trap.

Based on Japan’s recent experience, this paper examines how nominal wages evolved

during Japan’s lost two decades. In particular, we aim to answer the following questions.

Did nominal wages really decline during these two decades and did downward nominal

wage rigidity disappear in Japan? If so, which groups were more likely to experience wage

cuts? What were the effects of the wage cuts on the unemployment rate? Furthermore,

are wage cuts or nominal wage flexibility the reason behind deflation?

The remainder of this paper is organized as follows. In Section 2, we describe how

nominal wages at both the macro and the micro levels have fluctuated during the lost

two decades, using aggregate and longitudinal data. In Section 3, we assess how down-

ward nominal wage rigidity or flexibility affected Japan’s unemployment rate during this

period. In Section 4, we investigate whether movements in wages and prices are synchro-

nized by industry. Section 5 concludes.

2. Wage Fluctuation since the Bubble Burst

We start by examining how nominal wages and prices at the macro level evolved in the

lost two decades in Japan. Figure 1 shows the year-on-year change in nominal wages (in

terms of average wages per worker calculated from SNA), the consumer price index

(CPI) inflation rate, the gross domestic product (GDP) deflator, and the unemployment

rate. Figure 1 indicates that the annual change in nominal wages remained positive until

1997 but fell below 0% thereafter. Following the bursting of the bubble in Japan in the

early 1990s, the Asian financial crisis of 1998 further dampened the economy. At this

time, the Bank of Japan introduced a zero-interest rate policy to prevent the economy

Downward Wage Flexibility and Deflation Sachiko Kuroda and Isamu Yamamoto

© 2014 The Authors

Asian Economic Policy Review © 2014 Japan Center for Economic Research

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