Japan's structural reforms may prove counterproductive, says report

New labor laws blamed for weak inflation and consumer spending.

With a strong mandate to pursue structural economic reform, the LDP has a good opportunity to raise productivity and boost labour force participation. However, reform proposals, particularly relating to the labour market, appear to be missing the mark, says BMI Research.

According to the research firm, following the Liberal Democratic Party's (LDP) Upper House victory in July, Prime Minister Shinzo Abe's government has a strong opportunity to implement structural macro and microeconomic reforms. This, it said, is in stark contrast to many Western governments at present, who are facing growing political pressure to rein in fiscal austerity drives.

"Despite the county's demographics largely condemning the country's real GDP growth, there is still scope to boost productivity and labour force participation and allow real GDP growth to increase to 1.0-2.0% from the 0-1.0% current trend," said BMI.

The research firm cautioned though that aside from the measures undertaken to improve corporate governance, the type of reforms that the government appears to be targeting are of questionable benefit, and in some case may prove counterproductive.

Here's more from BMI:

Abe has turned his focus primarily to reforming the country's labour market. The high level of job protection among full-time senior employees is an impediment to hiring and firing, while the government benefits received by part-time workers acts as a disincentive for (mainly females) to enter the full-time workforce. Tackling these two obstacles to the free market for labour would likely go a long way towards boosting labour force participation and productivity.

However, Abe's proposals appear to be missing the mark. Attempts to boost the social security system to prevent people from leaving employment to provide nursing care, for instance, are indeed likely to boost female participation by reducing the opportunity cost of women entering the workforce (as well as reducing the opportunity cost of having children in the first place). However, they will come at the expense of even greater welfare payments, which are already consuming roughly one-third of the country's budget.

Abe has also proposed new legislation aimed at lifting the pay of temporary workers to bring it in line with those in full-time regular positions, as the low wages of part-time workers have been widely blamed for the low level of inflation and consumer spending over recent years. Similarly, the government will put in place a floor of 3% on annual minimum wage increases aimed at boosting inflation and growth. Additionally, the government has touted replicating the successful 'comply or explain' approach adopted under the corporate governance reform to ensure that profitable companies raise wages by a certain percentage per year, while using tax incentives and penalties to ensure compliance.

Such policies would likely undermine productivity and investment by reducing the incentive of businesses to set up in the first place. Higher consumption is the natural result of higher productivity and economic growth, and attempting to raise workers' share of income by fiat will undermine incentives for entrepreneurs to create growth in the first place. As for creating inflation, rising prices are not a driver of strong real GDP growth, but are instead usually a symptom (due to the tendency for credit growth to be strong and cash hoarding to be low during periods of strong growth). Attempting to force up wages to raise inflation and in turn boost growth is putting the cart before the horse. To be sure, we are not saying that these policies will fail to create inflation. In fact, they most likely will as the business community increasingly becomes risk averse in response to greater government involvement in the economy and goods production becomes scarce relative to ever increasing money supply, but this will not be cause for cheer.