Abenomics: Mandating Higher Wages Won’t Fix Japan’s Economy

Prime Minister Shinzo Abe of Japan has announced plans to request that Japan’s corporate leaders increase salaries and wages at an upcoming meeting of government, business, and nonprofit leaders in preparation for the spring labor negotiation period, or shunto. That would be the fourth straight year that Mr. Abe has proposed higher wages to strengthen Japan’s beleaguered economy.

The idea that higher wages can lead to economic recovery has become a core principle of what has come to be called Abenomics. But does the idea pave the road to another great depression?

The two main principles of Abenomics are a very loose monetary policy and a stimulative fiscal policy involving large government budget deficits. Japan has also raised its consumption tax. This policy agenda has been in place since the Tokyo stock market bubble broke in 1989.

Not surprisingly, this policy approach has failed to fix the problems in the Japanese economy. The policy probably looks familiar because it is also the standing policy in the US and most eurozone nations. It should also be familiar because it is really nothing new, but simply old-fashioned Keynesian economics with a new label.

This approach has resulted in the once vaunted Japanese economy of the 1980s becoming the world’s worst debtor nation. Its ratio of national government debt to the size of its economy, or GDP, is now close to 250 percent. Most countries that approach or exceed a ratio of 100 percent are considered to be economic basket cases. The last calculation for the US was 104 percent and growing.

Let us take a closer look at this idea of politically motivated increases in salaries and wages.

How would politically driven increases in salaries and wages lead to economic recovery? This notion has its foundation built on the observation that in growing economies workers generally experience higher wages, or at least increases in the purchasing power of their wages. Therefore, the idea is that higher wages will lead to economic growth.

Abenomics justifies this policy of increasing salaries and wage rates because it will increase consumption, which in turn will stimulate aggregate demand. The resulting increase in aggregate demand will lead to economic growth and higher levels of GDP.

If the economy were like a machine, such a scenario might be possible. However, politically driven higher wages do not increase jobs. In fact, they actually decrease jobs and retard job creation. When you raise the price of anything, including jobs, the number demanded will decrease, all other things the same.

It is lower wage rates that increase jobs. Entrepreneurs and businesses increase the number of employees they hire if market wage rates are lower. More jobs mean more production so that consumption per capita increases. Increases in production encourage price reductions, given a fixed money supply, so there will be a tendency for prices in general to fall. Falling prices mean that the real purchasing power of wages increases. This is how an economy recovers a boom-bust cycle induced by monetary inflation.

Keynesians and their Abenomics cousins have probably heard this explanation before and have just realized that I am writing about deflation playing a positive role in the corrective process of the economy.

Both of these groups have a psychological fear of deflation. They fear that even approaching a deflation of prices could result in a catastrophic depression in the economy from which you can never recover.

This psychological fear has no basis in theory or fact. It is based solely on a long-standing association made between price deflation and the Great Depression. (I have dubbed this fear Apoplithorismosphobia.)

In one of Murray Rothbard’s great books, America’s Great Depression, he showed that President Herbert Hoover’s policy of trying to maintain high wages in the face of economic depression was one of the important factors in making the depression “Great.” The other factors included protectionism, inflationism, and other forms of government interventionism.

According to Rothbard:

Wage rates “were maintained until the cost of living had decreased and the profits had practically vanished. They are now the highest real wages in the world.” But was there any causal link between this fact and the highest unemployment rate in American history? This question Hoover ignored.

Hoover had, indeed, “placed humanity before money, through the sacrifice of profits and dividends before wages,” but people found it difficult to subsist or prosper on “humanity.” Hoover noted that he had made work for the unemployed, prevented foreclosures, saved banks, and “fought to retard falling prices.” It is true that “for the first time” Hoover had prevented an “immediate attack upon wages as a basis of maintaining profits,” but the result of wiping out profits and maintaining artificial wage rates was chronic, unprecedented depression.

The Rothbard Thesis has been hailed by important intellectuals including the great historian Paul Johnson:

We now see, thanks to Rothbard’s insights, that the Hoover-Roosevelt period was really a continuum, that most of the “innovations” of the New Deal were in fact expansions or intensifications of Hoover solutions, or pseudo-solutions, and that Franklin Delano Roosevelt’s administration differed from Herbert Hoover’s in only two important respects — it was infinitely more successful in managing its public relations, and it spent rather more taxpayers’ money. And, in Rothbard’s argument, the net effect of the Hoover-Roosevelt continuum of policy was to make the slump more severe and to prolong it virtually to the end of the 1930s. The Great Depression was a failure not of capitalism but of the hyperactive state.

An important mainstream economist and advisor to the Federal Reserve, Lee Ohanian, has empirically verified the Rothbard thesis:

Herbert Hoover. I develop a theory of labor market failure for the Depression based on Hoover’s industrial labor program that provided industry with protection from unions in return for keeping nominal wages fixed. I find that the theory accounts for much of the depth of the Depression and for the asymmetry of the depression across sectors. The theory also can reconcile why deflation/low nominal spending apparently had such large real effects during the 1930s, but not during other periods of significant deflation.

If Shinzo Abe wishes to increase real wages and employment in Japan, he must abandon the failed policies of the past that have only served to prolong economic depressions.

This article was initially published on Mises.org.