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The Rich and The Rest 2: The High Cost of Low Wages

by Bennett Voyles

October 31, 2013

 

With Chinese executive incomes rising more rapidly than that of rank and file employees, it may not be too early for China to begin thinking about the challenges that arise when the boardroom keeps rising further and further away from the shop floor. (Image courtesy: iStockphoto)
With Chinese executive incomes rising more rapidly than that of rank and file employees, it may not be too early for China to begin thinking about the challenges that arise when the boardroom keeps rising further and further away from the shop floor. (Image courtesy: iStockphoto)

Rapidly rising incomes at the top of the scale mean that inequality has grown enormously in the past three decades–and critics argue that mature market companies and society are paying a high price for low wages.

Until the early 1970s, whenever productivity rose in the developed world, wages rose too, as in China today. Why average wages fell behind in the developed world after that is still hotly debated. Economists often point to the decline of unions in the US and the UK, the outsourcing of manufacturing to the developing world, particularly China, and the replacement of labor through automation and digitalization.

Whatever the causes, flat wages have had a number of effects for companies, positive and negative. On paper, paying less for labor would seem like a good thing for a company. Less for payroll means more for money to invest and lower costs for purchases–and more for investors and executives. However, rapidly rising incomes at the top of the scale mean that inequality has grown enormously in the past three decades–and some critics argue that mature market companies and society as a whole are now paying a high price for those low wages.

This kind of stasis is far from China Inc.’s situation now, but with Chinese executive incomes rising more rapidly than that of rank and file employees, it may not be too early for China to begin thinking about the challenges that arise when the boardroom keeps rising further and further away from the shop floor.

A Growing Divide

During the first three decades of the post-war era, Western growth looked somewhat like what China is experiencing now: a long boom that transformed much of society. In the US, for example, productivity and real income rose in lockstep from 1946 until 1973.

After 1973, the story changed. Wage growth has stayed well behind productivity growth every year since then, according to the US Bureau of Labor Statistics. Despite the fact that the US economy is 50% bigger than in 1990 and the average manufacturing worker more than 50% more productive, most workers’ incomes have stayed essentially flat and the bottom 20% have seen their real incomes fall.

This evolution has led many Western companies into a peculiar position: on the one hand, profits stand at 60-year highs, the stock market is climbing, and executive pay has soared. Many companies have even run short of investment ideas: US companies have built a cash reserve of over $1.7 trillion, according to a May 2013 Bloomberg survey. On the other, even the largest companies now cope with a surprising degree of precariousness: roughly a third of Fortune 500 companies drop off the roster every 10 years. Maintaining competitive advantage in a world where loyalty is scarce among customers, vendors or employees is not easy.

One of the most serious threats of the wage gap is that it further entrenches a managerial elite, insulating them from learning more about the company’s problems and their potential solutions. Robert Locke, an American historian based in Germany, argues that a separation that grew up between managers and workers in the 1970s hurt US manufacturing.

“Up until about 1970, the people who ran American manufacturing were people who had a lot of practical experience,” he says. “…they didn’t confuse the systems with what was going on in the factory floor. They had enough sense to be practical… but later on, when you had nothing but MBAs coming in there and they were reporting to top people about income and profit, the system of operation became more important than the realities of the shop floor and the map became the reality.”

Such educational elites, whether top-rung MBAs in the US or grandes écoles graduates in France, tend to form officers’ corps within companies that can cut off communications from the rest of the company, argues Locke, co-author of Confronting Managerialism, a caustic 2011 critique of US business school culture.

In Europe, he says, France’s business difficulties reflect the fact that top French managers are almost always products of the grandes écoles. This elite forms a glass ceiling that separates their caste from the rest of the company, in Locke’s view. And that ceiling may lead to a degree of cynicism among workers. “I think that has a lot to do with the kind of alienation of the French workforce from its leaders,” he says.

And top down too: “There is a sort of contempt, they wouldn’t use the term, for the people who don’t go to the grandes écoles… they think the decisions should be made by the best and the brightest, and that’s them,” says Locke.

By contrast, lines of communication are much more open in German companies, Locke notes. Others also see it as one of the key advantages of Europe’s most competitive economy. Hermann Simon, chairman of Simon-Kucher Partners, a global management consultancy headquartered in Germany, and a leading German management thinker, notes that French and US executives are part of an elite that tends not to focus on technical issues, German corporate leaders stay much more focused on their product. He notes that the “CEOs of all German car manufacturers (BMW, Mercedes, Volkswagen) are engineers.”

These traditions go back a long way in Germany, according to Locke, who says that even in World War II, better communications up and down the ranks in the German Army gave it an advantage over the French Army. French military leaders “didn’t have any rapport with the enlisted men and with what we call noncommissioned officers. In Germany, they were highly integrated,” he says.

Others argue that the economic damage may be even deeper when the company is considered as part of the larger society. Although on an individual basis, a company might benefit from keeping wages flat, activist and venture capitalist Nick Hanauer  of Seattle argues that overpaying at the top leads to lost gains to the market because the wealthy consume less of their income than the lower and middle classes–and it’s purchases, in the end, not capital, that drive economic growth.

Hanauer, a partner at Second Avenue Partners, a Seattle-based VC firm, whose dossier includes a number of successful start-ups and the distinction of being Amazon’s first non-family investor, argues that this wage discrepancy has led to skewed thinking about the sources of economic growth, and as a result, misguided tax policies. Entrepreneurs are wrongly lionized as job creators, he says: in fact, the true job creators are the customers. “If workers have no money, businesses have no customers,” he explains.

Bridging the Gap

In the wake of the Western financial meltdown of 2008, gigantic bonuses in the financial industry were seen as a driver of risk-taking by major banks, and US, UK and European legislators proposed a variety of measures to bridge the gap between executive pay and the pay packets of the other 99%, largely focusing on taxes and surcharges to keep stratospheric paychecks down.

However, other critiques suggest that there are better ways to attack the problem.

Locke argues that one beneficial move would be the formation of a workers’ council, a form of direction unknown in the US but a key institution in Germany. Whatever the deeper roots of Germany’s tendency toward workplace egalitarianism, its post-war foundation is the workers’ council system, which helps keep lines of communication open between employees and management. Not a union but a kind of second sphere of management, the councils tend to forge much closer communication between the company and the workforce, and enforce some level of solidarity between management and labor.

Simon agrees that the worker’s councils have been helpful to German business. The council “introduces an additional element of control and insures that there is more communication between the boardroom and the employees”.

Perhaps more provocative and counterintuitive, however, is a proposal that focuses instead on raising incomes at the bottom of the scale through a sharp increase in the minimum wage.

Classical economists have argued that raising the minimum wage simply increases unemployment but Hanauer, a major proponent of the idea, argues that it would instead increase consumption and make everyone more prosperous in the end.

Hanauer says his support stems from an insight that businesses aren’t built by “job-creating” entrepreneurs but by customers, and that sharing today’s high profits with those customers would not hurt businesses but instead spur new demand. “When every business pays every worker more, then every business benefits from the increased demand that all those workers represent, and when every business pays every worker more, the necessity to raise price isn’t an existential threat to your business,” he says.

This idea undercuts a keystone of US policy for the last 40 years, more or less tacitly agreed to by both parties: that businessmen, as job creators, should be given almost everything they need to facilitate that task, even to the extent that a billionaire’s tax rate should be lower than that of a middle class person.

Some critiques have called the idea “near-insane”, and the popular TED video program refused to broadcast a controversial talk Hanauer gave on the subject in 2012, but Hanauer notes that President Obama has started using his catchphrase “Middle-out growth” and he predicts that the idea will soon gain greater popularity.

“It’s counterintuitive but it is correct, as counterintuitive things can sometimes be,” says Hanauer.

 (This is part 2 in a two-part article series. You can read part 1 here.)

 

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