Productivity Improvements are not Always Good as Productivity Growth driven by restructuring is Unlikely to Lead to Sustainable Economic Growth

Faculty Fellow, RIETI

Defining productivity as a main pillar of its growth strategy, the Japanese government has been stepping up its efforts to implement measures designed to improve productivity. Recent government policy packages - the New Economic Growth Strategy put forward in 2006 followed by the Basic Policies for Economic and Fiscal Management and Structural Reform 2007 and 2008 - have called for improving labor productivity particularly in the service sector. Specifically, the government has set a goal for the service sector to achieve a 50% increase in productivity while mapping out measures to promote the development and use of information technology (IT) and vocational programs to foster human capital.

Japan's population began to decline in 2005, which caused one of the three factors that support economic growth - labor input, capital input, and productivity - to collapse, thus making the slowdown in growth now inevitable. Throughout the course of economic growth since the end of the World War II, the continuous increase of these three growth factors has been presumed to be a natural course of events. But that presumption no longer stands, forcing the government to focus now on productivity improvement as a instruments to maintain economic growth in the future.

Concerns surrounding Japan's economic growth have been echoed by many economists outside Japan. The Japanese economy finally emerged from its prolonged doldrums in 2002 but Japan's growth has not been as robust as that of other developed economies. Many economists from international organizations such as the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) as well as those from other overseas institutes have said that productivity improvement is the key to the recovery of Japan's potential for growth.

The perception that improved productivity should lead to greater growth potential is not necessarily wrong. However, unlike in the case of fiscal and monetary policies, the government's policy role in terms of enhancing productivity is centered on creating an environment that facilitates private-sector initiatives to improve productivity. With respect to this particular policy area, insufficient data is available and the government has little experience in implementing a comprehensive set of policy measures. Against this backdrop, is the current productivity enhancement policy reasonable? In what follows, I will critically re-examine some of the "common beliefs" about productivity improvement in light of recent productivity trends and new findings in the relevant field of economics.

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First, based on recent productivity trends in Japan, I would like to question the government's current approach from the viewpoint of whether greater growth potential can be obtained by simply improving productivity.

As presented by Prof. Kyoji Fukao of Hitotsubashi University in this column dated May 9, 2008, both labor productivity growth and total factor productivity (TFP) were on a recovery course in the first five years of the 2000s, according to the 2008 edition of the Japan Industrial Productivity (JIP) Database.

Changes in growth and productivity of private-sector economy

When we take a closer look at the data and focus separately on the manufacturing and nonmanufacturing sectors, we can see that TFP growth for the manufacturing sector remained almost flat at 1.4% in the 1990s and 1.3% in the first five years of the 2000s while labor productivity growth improved from 2.3% to 2.7% in this same sector. In contrast, in the nonmanufacturing sector labor productivity growth increased from 0.9% to 1.8% and the TFP growth rate improved from negative 0.2% to positive 1.3%.

Although manufacturers continued to outperform nonmanufacturing companies in terms of growth rate, the degree of improvement is far greater for nonmanufacturing firms. As far as numerical targets are concerned, the government's policy objective of increasing productivity has been almost achieved.

What is important, however, is the background for the productivity improvement of each sector. In reflection of the export-driven economic recovery since 2002, manufacturers began to boost domestic capital investment particularly in areas where Japanese companies are internationally competitive. Indeed, among the listed companies, the percentage of those implementing large-scale capital investments has been gradually increasing since 2002 when the nation's economy began to recover. Because of these factors, the manufacturing sector has been able to increase value added and improve labor productivity. Although TFP growth remains almost unchanged, the quality of capital stock in the manufacturing sector has improved more significantly than that of the nonmanufacturing sector as a result of increased investment in new facilities. Productivity recovery through such a process can be referred to as "forward-looking productivity improvement."

On the other hand, in the nonmanufacturing sector, the growth of value added hardly improved from the 1990s through the early years of the 2000s but productivity indicators alone showed a favorable swing. Obviously, this is the result of efforts to improve productivity by cutting back on labor inputs and restraining new investment in the face of stagnant production.

According to a study conducted by Federal Reserve researcher Stephen D. Oliner et al., such restructuring-driven productivity improvement has also been observed in the United States since around 2000, particularly in service industries. Based on their perception, in an industry where the labor share increased and the capital share decreased in a certain business year, restructuring would be carried out the following business year whereby productivity improvement resulting from the decreased labor input would be observed. Using the JIP 2008, we examined factors behind the productivity improvement in the Japanese service sector from the 1990s through the early 2000s. Our findings, like those of Oliner et al., show that the Japanese service sector also improved productivity by means of restructuring.

In recent years, many service companies have pushed forward restructuring efforts. At the same time, they have substantially increased the number of non-regular workers such as part-time employees and temporary workers from staffing agencies. Job training for such workers can be kept to a minimum. That is, these companies have been pushing up productivity with little or no accumulation of human capital. Such "backward-looking productivity improvement," a pattern typically observed in the nonmanufacturing sector, does not necessarily lead to an acceleration in the growth of the economy as a whole. The government has set out measures to improve human capital through job training. However, in the service sector where job requirements are increasingly specialized, vocational training for working adults has its limitations. It would be thus necessary to develop drastic human resource development measures that include school education and can respond to the needs of global economy.

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It is also questionable whether the government recognizes the aforementioned sector-by-sector differences in the pattern of productivity improvement and fully understands differences between the characteristics of individual companies.

A research team led by Prof. Philippe Aghion of Harvard University has been examining how companies with different technology levels work to improve productivity in a competitive environment. According to their observations, in situations involving companies with a higher technology level, the greater the competition, the greater the effort devoted to improve productivity in order to remain one step ahead of the competition. However, companies lagging far behind advanced technology tend to lose their incentive to improve productivity because they see little chance of overtaking the competition and gaining an advantage by exerting the extra effort required to improve competitiveness.

This is easily observable when we look at the Japanese retail industry. Major supermarket chain operators, such as Ito Yokado Co., Ltd. and the AEON Group, have been making every effort to improve productivity by persistently reexamining store operations and striving to improve the efficiency of distribution. In contrast, small retailers without advanced technology may choose to maintain the status quo because introducing certain IT facilities would not lead to significant changes in the competitive environment surrounding them. Therefore, even if the government promotes the use of information technology or pushes forward deregulation in a uniform manner, not all companies will be able to improve productivity.

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An argument that competition policy helps bring about improved productivity is based on the assumption that inefficient companies with low productivity would be forced to exit the market. Unfortunately, however, given the consistently low market exit rate to date, it is hard to believe that the exit of inefficient companies has been occurring smoothly in Japan. In recent research, Prof. Kaoru Hosono, of Gakushuin University, has shown that financing constraints accompanying the financial crisis in the late 1990s have caused distortions in the entry and exit decisions of companies and, as a result, productivity growth has been reduced by one-third of what would have otherwise been achieved.

Rather than promoting uniform deregulation, the government should formulate policies to either significantly reduce the existing technology gaps among companies, or facilitate the exit of inefficient companies from the market.

Two years ago, the film "Hula Girls" became a big hit in Japan. It tells the story of how a northern mining town in Fukushima Prefecture, severely hit by the decline of the coal industry, struggled but successfully revived its local economy by building a recreational resort featuring hula dancing. Not only with the coal industry, but also with the textile and some other industries, Japan encountered and overcame the problem of declining industries by carrying through structural reforms and rebuilding the foundation for new businesses.

Japan has just begun its efforts to sustain economic growth through productivity improvement. Instead of simply announcing certain macroeconomic figures as targets, the government needs to take a persistent approach to steadily pursuing and implementing fine-tuned policy measures from a long-term perspective, while paying due consideration to differences among industries and individual companies.

As depicted in the film, there must be many people, particularly young people, who are willing to take on a new challenge in Japan. What they will need is an environment that enables them to break the stagnation plaguing today's Japan. The creation of this environment is exactly the role the government should be playing.

>> Original text in Japanese

* Translated by RIETI.

August 27, 2008 Nihon Keizai Shimbun

September 11, 2008

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