Commentary / Japan

Higher wages key to higher productivity

by Jesper Koll

Productivity. It’s one of those rare concepts on which there is broad-based consensus. Whether you’re a policymaker, a hard-nosed investor, corporate executive or just having a discussion with your friends about what is needed for a better future. Yes, we all agree that productivity is a good thing and a worthwhile goal, that raising productivity is key to unlocking future prosperity, growth and competitiveness.

Interestingly, this is true at all levels of economic life: the individual level, the company level, all the way up to the national economy. Yet while we agree that productivity is key to success, there is tremendous disagreement, debate and confusion about how exactly higher productivity can be achieved. All over the world, and increasingly in Japan, a growing industry of advisers, consultants and coaches thrives on giving productivity advice, each pushing their proven and sometimes patented method on how we can become more productive. The spectrum goes all the way from proven tricks and protocols — how to raise efficiency of corporate meetings, boost customer throughput and accelerate production output — to how you can lead a more productive personal life. So yes, productivity is good; but it’s also very complicated.

Economists are often ridiculed for making simple things complex, for hardly ever giving a straightforward answer. “On the one hand it’s like this, on the other hand it’s like that” is the often-quoted stereotype. So you may be surprised that on the issue of productivity in general, how to raise productivity in particular, macroeconomics offers a very simple and straightforward answer: If you want to raise productivity there is one thing you must do — raise wages.

Why? We’ll have to do some simple math, so bear with me. Productivity is defined as output per person. In economics, output is measured as GDP; and GDP in turn is the number of people working multiplied by the wages they receive, i.e. GDP is persons times wages. So going back to the definition of productivity (GDP divided by persons) we get: Productivity equals (persons times wages) divided by persons. Since “persons” is both in the nominator and the denominator, it cancels out. And we are left with, yes, Productivity equals Wages. So if you want to raise productivity, you have to raise wages. Simple, straightforward, no doubt about it.

No, this is not “socialist” economics but the very foundation of the same economic theory that won the Nobel Prize for libertarian free-market champion Milton Friedman.

In fact, one of the greatest capitalist entrepreneurs of all time, Henry Ford, instinctively grasped this truth when he famously declared, “There is one rule for the industrialist and that is: Make the best quality of goods possible at the lowest cost possible, paying the highest wages possible. It is not the employer who pays the wages. Employers only handle the money. It is the customer who pays the wages.” True to his word, Henry Ford went on to double the minimum wage at his factory from $2.25 to $5 so his workers had the purchasing power to buy his cars. They also became more loyal to his firm.

In Japan, it is particularly imperative that policymakers and national corporate champions begin to embrace the macroeconomic feedback loop between rising wages and rising productivity. After all, the declining population will put inevitable downward pressure on the “people” part of the GDP definition (GDP equals people times average pay); so the only way to grow GDP will have to be to raise productivity. Make no mistake: If Japanese wages do not rise, productivity will not improve and the optimists’ GDP forecast will become a flat line at best.

The good news is that corporate Japan has ample room to raise wages.

First, corporate Japan is incredibly stingy in a global comparison. OECD data suggests that, as a percentage of value-added, corporate Japan pays the lowest share to employee compensation — 32 percent for large listed companies and 40 percent for small and medium-size ones. In the United States, the numbers are 48 percent for large corporations and 65 percent for small and medium-size ones. So much for the claim that Japan Inc. is a model of “inclusive capitalism.”

Meanwhile, in Germany the same numbers are 78 percent for large, and 71 percent for small and medium-size companies, i.e., German employees for large companies get more than twice the share of their companies’ value-added than Japanese employees do. And yet Germany remains the world’s largest exporter (per capita) and the global leader in productivity. Yes, higher wages do deliver higher productivity and higher global competitiveness.

For the individual company level, Henry Ford makes the all-important point: Make the best quality of goods possible at the lowest cost possible, paying the highest wages possible. Yes, you must be very cost-conscious, but you must be focused on paying your employees the highest wages possible. Here, motivation and incentives play a hugely important role.

Why does productivity go up when wages go up? Because employees are happier at work when they see that the added value their work creates is shared with them. Japan used to have a world-leading wage and employment system that linked corporate well-being to compensation with the summer and winter bonus cycle.

Unfortunately, this positive feedback loop got cut by the increasing use of part-time and contract employees in the services sectors; and by increasingly regimented, formulaic “automatic” bonus allocation that got de-linked from corporate profit generation. To wit, the share of corporate earnings in national income is at a record high, but employee compensation is still stuck at levels last seen 20 years ago. And, not surprisingly to a macroeconomics expert as per the above, so is Japan’s productivity.

The policy prescription is straightforward: raise the minimum wage. This is the anchor rate for all other wages, and the one wage elected politicians can actually set. Of course, corporate executives will cry foul and complain of unfair intervention into private sector affairs. Just look at the fierce battle waging between Japan’s strongest advocate for higher minimum wages to boost productivity, Prime Minister Shinzo Abe’s adviser and former star financial analyst David Atkinson, and Keidanren (the Japan Business Federation).

Yes, higher base pay would force managers to rethink internal processes and their way of doing things, which may indeed lead to having to cut lower potential employees and replacing them with more modern equipment or a redefined new way of doing things. In other words, business as usual will be disrupted, human creativity and innovation will be stimulated and, before long, productivity will rise.

At the corporate level, raising the minimum wage would force Japanese managers to go back to Ford’s principle, would force them to focus on reinventing the corporate culture of paying employees the best wage possible and would produce the best quality at the lowest cost. Let corporate managers focus on that, their own area of control, and let politicians focus on what’s best for the national interest as advised by economics.

Make no mistake — raising the minimum wage would not just raise the purchasing power of the people, it would also force corporations to become more efficient and competitive. A forced hike in wages is both a powerful stick and nutritious carrot that will boost productivity, and thus the future prosperity of Japan.

Based in Tokyo, Jesper Koll is WisdomTree’s head of Japan. He is consistently ranked as a top Japan strategist/economist and publishes blogs at www.wisdomtree.com/blog .