Japanese employment practices, including long-term employment guarantees and seniority-based wages, contributed a great deal to the efficiency and equity of the labour market.

But much has changed since the bubble burst in the early 1990s. The long-term stagnation of the economy has caused unemployment rates to increase to 5 per cent, and persistent deflation has been an obstacle to real wage growth. Traditional employment practices are changing too. The share of non-regular workers — those who have no employment guarantee and whose wages are consequently lower — increased from 16 per cent in 1985 to 34 per cent of the workforce in 2010.

So why has the Japanese labour market, which was once hailed as a model in the OECD, fallen into a trap of inefficiency and inequity? A simple answer is that both firms and labour unions have failed to adapt to new employment conditions caused by the rapidly changing age structure of the labour force and decelerating economic growth. The government has responded to this situation by tightening regulation of the labour market to discourage fixed-term employment contracts with no guarantee for renewal, in particular for temporary or dispatched workers, who are employed by one firm but actually work in another firm. The contrast with Europe and Australia is instructive: reforms there have gone in the opposite direction, liberalising the labour market while protecting workers in disadvantaged positions.

Past Japanese employment practices were suitable for an expanding economy that experienced short periods of recession around a long boom. Companies invested to develop their workers’ skills, and kept them on during recessions. In turn, employees accepted new labour-saving technology without fearing dismissal, and shared in their firms’ profits via bonuses under firm-based labour unions. Wages based on seniority covered increasing living expenses over a worker’s life and were less costly for firms, which typically had a pyramid-like age structure of employees. Harmonious employer–employee relations have been a defining feature of the Japanese labour market for many decades. The rigid employment guarantee encouraged workers to transfer from declining to growing industries within the internal labour market of large corporate groups. Many firms established subsidiaries in growing sectors and shifted employees from the parent company in declining industries, such as mining or textiles, to the growth sectors within their operations. This movement of labour across industry without causing unemployment was the Japanese success story of the 1980s.

The merits of Japanese employment practices under more propitious circumstances became its demerits under decelerating economic growth and a rapidly ageing population. As GDP growth fell from an average of 3.7 per cent in the 1980s to 1.1 per cent in the 1990s and 2000s, the recessions have become longer and the booms shorter, so firms can less afford to hoard excess labour. In order to keep the employment guarantee, large firms have reduced their intake of new regular workers in favour of increasing numbers of fixed-term workers who are easily retrenched in recessions. This has created inequality between decreasing numbers of regular workers with guaranteed jobs, and increasing non-regular workers who absorb the shock of business fluctuations.

Like the retirement pension system, the seniority-based wage schemes favoured by large firms generate conflict between younger and older generations. Older workers get the lion’s share of a firm’s wage fund at a time when younger workers’ chances of attaining seniority-based wages in the future are getting lower. In consequence, Japanese employment practices are no longer efficient or equitable. Seniority-based wages are inefficient because excess workers in large firms are discouraged from establishing their own businesses by the high opportunity cost of leaving the firm. This traditional wage scheme also tends to generate inequality between insiders and outsiders, and between a firm’s younger and older workers.

Labour unions in large firms typically share the interests of the firm and tend to protect the interests of senior regular workers, so they are largely ineffective in resolving conflicts between workers. For instance, the unions’ strategy for preventing disparity between regular and non-regular workers is to coerce firms into employing more regular workers, either by prohibiting short-term employment arrangements altogether or by limiting the type of work that can be done under those conditions, or the period during which temporary workers can be employed. Earlier this year the Diet passed a law outlawing dispatched employment contracts shorter than a month, and another law for limiting fixed-term employment contracts to five years in August 2012. Neither the legislator nor the unions who support the tightening of labour market regulations seem to have considered the possibility that those who currently work in fixed-term contracts may well lose their jobs without getting new regular employment.

Alternative policies for reforming the labour market include reconsidering the regulatory framework for fixed-term contracts, including dispatched workers, in order to widen their employment opportunities. Japan must follow the path of other OECD countries and establish a principle of ‘same wage for the same job’ in order to protect the rights of non-regular workers. Assigning a monetary compensation for non-renewal of those workers who have held fixed-term contracts for a long time will make for a more equitable labour market. Reform must aim to match the situation of non-regular and regular workers so the disparity between them is reduced. Recent reforms of the Italian labour market suggest that allowing firms to dismiss regular workers who receive monetary compensation when employment adjustment is necessary is an effective way of reducing disparities between workers.

Creating a better work–life balance has also become a policy priority as the number of highly educated women continues to grow. They face a trade-off between child-rearing and full-time work, leading to both a low level of women’s participation in the labour force and a declining fertility rate. The government has tried to help working mothers by increasing the number of nursing schools and extending maternity leave to two years, to little avail. Traditional family patterns are closely associated with Japanese employment practices, and are premised on the man working full time and the woman being a homemaker. Long working hours are a frequent occurrence for workers under an employment guarantee; intensive on-the-job training often requires employees and their families to relocate. Families with two full-time earners have completely different needs: they prefer no overtime or job relocation, even if that means less job security. But this preference is not seriously considered by Japanese labour unions or employers, who still believe the traditional work and family style is best.

Devising new employment practices will go a long way to fixing the Japanese labour market, but this will not be done until employers and labour unions can agree on what those practices will be so that they can work in the current economic and social circumstances.

Naohiro Yashiro is a visiting Professor of Economics at the International Christian University, Tokyo.

This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Japan: leading from behind’.