Tough choices ahead.

Photographer: Kiyoshi Ota

Japan's Productivity Puzzle

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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One of the most important jobs for Japan, and for the administration of Prime Minister Shinzo Abe, is to boost private-sector productivity. Japan has been a productivity laggard for years: Outdated business practices are endemic, especially among companies that serve the domestic market and are shielded from international competition by trade barriers.

Abe just announced a new raft of measures to boost productivity, but they don't look very significant. The new corporate governance code, however, is more encouraging. Shareholder capitalism is already making inroads in Japan, and there is an increasing focus on profitability. The Economist has a great rundown of the ways in which Japanese corporations are finally starting to act more like corporations in the rest of the world. One promising sign is that many companies are finally looking to unwind their cross-shareholdings, which discourage corporate shakeups and lead banks to prop up zombie companies.

This comes at a time when activist investors are starting to make inroads in Japan. Until recently, it was thought that activists, especially foreign ones, had just bounced off the impenetrable wall of Japan Inc. solidarity and conservatism. But a number of activists have managed behind the scenes to get Japanese companies to increase payouts to shareholders.

This is very good news. Japan definitely needs a dose of shareholder capitalism. A focus on profitability will speed the updating of obsolete management models and the adoption of new technology. But there is one huge piece of the productivity puzzle that the new reforms fail to address, and which, if left unresolved, will substantially limit the gains from improved corporate governance.

I'm talking, of course, about labor reform.

Watching private equity tells us something about how corporate productivity can be improved. Private equity firms do, in fact, tend to raise the productivity of the companies they acquire. When we look at how they do it, we see that cutting jobs is a big part of what they do. Although downsizing doesn't always boost productivity, effective productivity increases often require downsizing.

This is going to be a very bitter pill for Japan to swallow. Lifetime employment and seniority pay, though never universal, have been a deeply valued symbol of corporate Japan for most of the postwar period. Lifetime jobs, especially for men, formed an integral part of the social contract. Nationalist writers such as Masahiko Fujiwara, author of "The Dignity of the Nation," often pine for the halcyon age of the lifetime employment system.

The lifetime employment/seniority pay system cracked with the globalization of the 1990s and the economic stagnation in the second half of the following decade. It had to. What replaced it, however, wasn't a flexible labor market like that of the U.S., but something more dysfunctional -- a two-tiered market. One group of Japanese workers, called seishain, retained their privileged, old-style jobs, along with job security, benefits and regular raises. The other group, however, was put into low-security, low-pay, low-benefit, dead-end jobs, with very little chance of ever jumping up to the seishain track. This new floating labor force, Japan's own "precariat," now makes up the majority of new hires.

Japanese companies can fire their non-regular workers. But that doesn't much help, since these workers are very, very cheap relative to what they produce. The real problem is getting rid of the entitled seishain, whose salaries are often swollen from decades of seniority-based raises, even as their productivity has fallen. Laying off these privileged workers -- often men, often middle-aged -- goes strongly against Japanese corporate culture, and is often thought of as the violation of a social compact. Hiroko Tabuchi, a reporter for the New York Times, wrote a great piece about this in 2013, which I highly recommend.

It isn't just culture that keeps Japanese workers in overpaid jobs, however. The law is on their side. Abe tried last year to change regulation to make it easier to fire workers, but labor unions blocked most of his efforts.

So unless Abe can restart his so-called drill bit of reform to change this unfair and stultifying labor system, Japan's efforts to boost productivity will be in trouble. To raise productivity, old businesses have to shrink and new businesses have to grow. But shrinking old businesses will be very hard if there is a huge overhang of well-paid old men who can never be laid off.

Corporate Japan has long been trapped in a bad equilibrium -- zombie corporations, supported by cheap bank loans, preserving unproductive business lines and unproductive jobs for a privileged subset of workers. Abe's government has made big strides in attacking some of the supports of that equilibrium. But until and unless he can make progress on labor reform -- in the legal and the cultural sense -- it may be difficult to dispatch the status quo and replace it with something better.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net