Wage Growth and the Exchange Rate

What does the historical record tell us about the link among alternative exchange rate arrangements and growth in nominal wages? From 1950 to 1971, Japan provided a useful case study of wage behavior in a very high-growth economy with its exchange rate securely fixed at 360 yen per dollar -the dominant international money.

First, keeping the fixed rate anchored Japan's price level for tradable goods as Japanese wholesale prices rose at about the same speed as those in the U.S. -only 1 percent per year (Table 1 [ PDF 89.4KB | 1 page ]). Because the bulk of world trade was (is) invoiced in dollars, fixing the exchange rate to the dollar was (is) a stronger anchor for the price level than the size of Japan's bilateral trade with the United States would suggest.

Second, Japanese money wages in manufacturing grew substantially faster- about 10 percent per year in Japan versus only 4.5 percent in the U.S. From the 1950s into the 1970s, Japan's catch-up phase, productivity growth in manufacturing was much higher than in the U.S. But international competitiveness was roughly balanced by Japan's much higher wage growth when the yen-dollar exchange rate was fixed. (In the PRC from 1994-2005 when the renminbi-dollar exchange rate was fixed, the same phenomenon was observed: the much higher productivity growth in Chinese manufacturing was matched by much higher growth in money wages relative to those United States (McKinnon and Schnabl, 2006). Thus a rough balance in international competitiveness was preserved.

Why, in a rapidly growing open economy, should wage growth better match productivity growth when the nominal exchange rate is fixed? From the old Scandinavian model of wage determination in high export-growth-led economies (Lindbeck, 1979), the tradables sector -with its much higher growth in productivity than in nontradables- naturally becomes the leading sector in wage setting. Employers in export activities bid vigorously for skilled and unskilled workers, subject to remaining internationally competitive at the fixed exchange rate. Thus workers in export-oriented manufacturing receive the main fruits from the high productivity growth there. But then, from "labor solidarity" (as the Scandinavian model would have it), these high wage settlements spread into the rest of the economy, largely nontradable services where productivity growth was much lower.

In Japan, the price of services rose relative to goods prices over 1950-71: Japan's CPI, which includes services as well as goods, increased more than 4 percentage points faster per year than its wholesale price index (which contains only goods) and faster than the U.S. CPI (Table 1). However, under the fixed yen/dollar exchange rate leading to rapid wage increases, Japan's international competitiveness in its high-growth tradables sector remained balanced with the United States -as reflected in the similar rates of price inflation in tradable goods measured by their respective WPIs.

In this bygone high-growth era, finding a purely domestic monetary anchor for Japan’s price level would have been difficult. As in the PRC today, restrictions on domestic interest rates and capital controls proliferated, and growth in the money supply was high and unpredictable as Japanese households rebuilt their financial assets after World War II. Thus having the Bank of Japan simply key on the dollar exchange rate conveniently anchored Japan's tradable goods price level while promoting high growth in money wages. By the end of the 1960s, however, American monetary policy became too inflationary for the dollar to provide a stable anchor, and the Bretton Woods system of fixed exchange rates collapsed.

How did the switch to a "floating" but ever appreciating yen affect relative wage growth in the two countries? After 1971, episodic Japan bashing led to ongoing yen appreciation as reflected in the dashed line in Figure 3 [ PDF 126.7KB | 1 page ]. The expectation of an ever-higher yen (from recurrent U.S. pressure) eventually undermined the system of relative wage adjustment. As employers began to anticipate further yen appreciation, growth in Japanese wages slowed - albeit with a lag. Before 1975, money wage growth in Japan remained much higher than in the United States; but then in 1975-76, Japan’s money wage growth slowed sharply- the bold line in Figure 3. Since then, wage growth in Japan has been even lower than that in the United States. While imposing general deflationary pressure on the Japanese economy, the erratically appreciating yen undermined the natural process of adjustment in relative wages for balancing international competitiveness.

In addition, the slump in Japanese absorption reduced imports, which offset the slower growth in exports from the higher yen. Thus Japan's large trade surplus, measured as a share of its own GDP, did not decline (McKinnon, 2007; Qiao, 2007). Although this earlier episode of Japan bashing to push the yen up failed in its principal objective of reducing Japan's trade surplus, it did cause severe deflationary disorder within Japan's macro economy that continues to the present day.

But why should wage stagnation continue 12 years after Secretary Rubin announced his strong dollar policy and the end of American arm twisting to get the yen up? The answer is twofold. First is the stagnation in Japanese GDP growth until from 1992 to 2002 -its "lost decade"- with only weak growth subsequently. Second, because of a currency mismatch within Japan's financial system (to be explained below), the threat of sudden upward ratchets in the dollar value of the yen is still very much alive -and heightened by the return of U.S, and European Japan bashing in 2007. Employers could face bankruptcy if they granted a generous wage settlement and the yen then shot upward. Thus risk-averse Japanese employers remain unduly timid in granting higher wage settlements- leading to the phenomenon of an ever-weaker yen, i.e., real exchange depreciation.

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