Some progressives complain that American CEOs are overpaid. They point to the fact that the spread between the highest and lowest employee in a Japanese corporation is far lower than in the US. The implication is that if only the CEOs in the US would accept smaller salaries, the shareholders would gain larger profits. In fact, as the Japanese case shows the exact opposite is far more likely. Here’s a graph from a recent article in The Economist:

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The performance of Japanese corporations in recent decades has been abysmal.

Obviously there is no single factor involved, but the Economist does a nice job of explaining many of the peculiarities of the Japanese labor market, such as the lifetime employment system (which increasingly excludes younger workers), rigid promotion by rank and tenure, and fixed pay scales. Here’s one company that is beginning to change:

There is no firm that better embodies the results that reform can achieve than Hitachi. It was formerly one of Japan’s most conservative: the consummate “community” firm, at which employees and their families, and suppliers and their dependents, all took precedence over shareholders. In 2008 it notched up the largest loss on record by a Japanese manufacturer. Since then it has spun off its consumer-related businesses in flat-panel TVs, mobile phones and computer parts to refocus on selling infrastructure such as power plants and railway systems. More recently Hitachi has made efforts to change its internal culture. Last year it all but abandoned one of the central pillars of Japanese business: the seniority-wage system, in which salaries are based on age and length of service rather than on performance. The results of all this have been stellar. Its operating profits in the year to March rose by 12% to ¥600 billion ($5 billion).

Now, says Kathy Matsui of Goldman Sachs in Tokyo, stockmarket investors are all searching for the next Hitachi. Activists and private-equity firms are sensing an opening up of opportunities. Seth Fischer, an activist investor, says the government’s backing makes all the difference when it comes to shaking up firms. He is preparing to take on two industrial giants, Canon, a camera-maker, and Kyocera, an electronics and ceramics manufacturer, over their complex corporate structures.

The growing proportion of shares in Japan’s listed companies owned by foreigners (see chart 2) has undoubtedly added to the pressure on firms to change.

The traditional system was well-intentioned, but simply doesn’t work in the modern world:

Japanese firms have clung to their traditions of lifetime employment in a single workplace, and of paying and promoting people according to seniority, because they believe those traditions have merits. Indeed, they foster loyalty, and thereby encourage firms to invest in training graduates without fear of them being poached by rivals, argues Yoshito Hori, the founder of GLOBIS, a business school. However, it is no way to produce the sort of managers needed to lead modern, knowledge-based industries. “Imagine if you took managers at Apple, Google and Amazon and replaced them with people promoted on the basis of length of service rather than merit,” says Atul Goyal, an analyst at Jefferies, a stockbroker. “How long do you think those companies would last?”

Young and frustrated
The voice of Japan’s young workers, who are generally underpaid and underpromoted, recently found an outlet in a surprise hit television drama, set in a fictional version of Japan’s largest bank. Much of the country seemed to identify powerfully with the show’s talented hero, Naoki Hanzawa, a loan manager, who kicks back against the bank’s higher-ups and refuses to take the blame, as Japanese corporate culture dictates he ought, for the bosses’ many profit-destroying blunders.

Hitachi’s salarymen are similarly cheering the firm’s shift to performance-related pay and promotion. If you are in your late 40s you might be nervous, since the ascent of the corporate ladder now comes with some uncertainty, says one. But younger hires are ecstatic. It won’t even matter as much if you went to the wrong university as long as you work hard, exults another employee. Panasonic, Sony and Toyota are also moving towards more performance-related pay and promotion.

Those who plod their way to the top of Japanese firms tend too often to be conservative and narrow-minded. The way they are rewarded does not provide much incentive to try hard: not only is their pay smaller than that of their peers in other developed economies, it is less tied to their performance (see chart 4). When it comes to aligning the interests of bosses and shareholders, Japan is stuck roughly in the 1970s, says Jesper Koll, an economist and adviser to the government.

There is much more, highly recommended.

It’s tempting to think that we’d be better off if we severely limited the ability of bankers and businessmen to amass large fortunes. But so far no one has figured out how to achieve a dynamic modern economy without rewarding merit. The sad decline of the once dynamic Japanese economy is a case in point.

Of course Japan is far from being the worst off country in the world. But giving its rapid growth in the period leading up to 1991, its quite well educated and highly disciplined population, its relatively long work hours, and its 3.2% unemployment rate, it should not have a per capita GDP (PPP) 30% lower than America, Singapore and Hong Kong, and productivity levels far below those of Germany. Something is wrong.