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Wealth Generation --- and What Makes Wages Go Up

GDP per capita went up sharply during the 1950s, which was a good thing. We want the lot of the average person to improve as time goes by.

However, as much as we crave wealth generation, there is very little systematic thought into what really drives it.

Let’s establish a few basic principles.

There is a small community that consists of three families. They have organized themselves such that one family provides basic food for everyone, another basic clothing, and the third basic shelter. They trade basic food, basic clothing, and basic shelter, and everyone’s needs are satisfied.

However, in addition to the basic clothing provided by the second family, it makes especially good clothing for itself. This means that the overall wealth of the community is higher than it was before. The other two families decide that they would also like especially good clothing for themselves.

There are several alternatives. They could illegally take the clothing. But this would mean that the community’s total wealth is unchanged — they’re better off at the expense of the first family.

Another alternative would be to organize themselves politically and “legally” expropriate it. The argument could be that this family doesn’t deserve all the good clothing itself. It should be forced to share. But this would also mean that the total wealth of the community is unchanged.

Or the families could strike a bargain: If we offer especially good food and especially good shelter, would you be willing to exchange some especially good clothing? If the answer is “yes,” wealth is being created. Everyone wins. And it illustrates the single key point about wealth generation: It is achieved through voluntary exchange.

In this example, I’ve used goods rather than services. But the framework is the same. What if the first family, in addition to providing basic food, were particularly good entertainers? And what if they were willing to put on shows to enrich the lives of the other families in exchange for especially good clothing and especially good shelter? Moreover, what if the other two families would prefer to see an entertaining show than to have especially good food? Once again, everyone wins if everyone voluntarily agrees. There is no meaningful distinction between the provision of services rather than goods: The model holds.

On the other hand, what if the first family were terrible entertainers? And what if they spent an equal amount of time rehearsing, but the other families refused to exchange clothing and shelter to see them? Just because the first family spent a great deal of time in their artistic pursuits doesn’t mean that wealth is created.

Wealth creation isn’t a function of hours worked; it’s a function of hours worked productively.

This leads us to several key understandings:

 by definition, wealth-generation it is not a zero-sum game. Growing the pie benefits multiple parties;

 wealth generation works only if production is directly responsive to the needs and wants of other parties. This means it is the most selfless exercise known to mankind: to the extent you provide exactly what other people crave most, you benefit the most;

 wealth generation works best when executed through voluntary arrangements, allowing each party to customize the benefit it will receive.

The majority of Canadians are employed rather than self-employed. This means they rely on somebody making the voluntary decision to pay them more if they want to get ahead. Therefore, what drives real wage growth should be of acute concern.

I’m going to go back in history to demonstrate this process in action. In 1914 the average industrial wage in the United States was $1.75 a day. That year, Henry Ford shocked the business world by paying his workers $5.00 a day — almost tripling the average wage paid at the time.1

The question is why. Why did he do that?

I’m going to present two different interpretations. Just so you know in advance, one of them is mine. But I’m not going to tell you which one yet. I’ll let you read them first.

QUESTION 16

Which of the following statements provides the more reasonable interpretation of why Henry Ford paid his workers almost three times the prevailing industrial wage?

☐ Ford was neither a madman, nor a socialist, but a smart capitalist whose profits more than doubled from $25 million in 1914 to $57 million two years later.… Ford understood the basic economic bargain that lies at the heart of a modern, productive economy: workers are also consumers.2

☐ Ford was neither a madman, nor a socialist, but a smart capitalist whose profits more than doubled from $25 million in 1914 to $57 million two years later.… Ford understood that if you paid workers above-average wages, you would attract the best and they would be motivated to work hard.3

The choice couldn’t be clearer: Did Henry Ford pay his workers well because in doing so he would create a market for his products, or did he pay his workers well because he would get more work out of them?

☐ I agree with the first interpretation.

☐ I agree with the second interpretation.

I’ve tried to be as fair as I can. I’ve let you make your selection before I reveal which one of the two is mine, because there is a fundamental problem with the first interpretation: It makes sense only if one is incapable of performing simple arithmetic.

In 1914, Ford was a privately held company. That meant that every dollar of profit went into Henry Ford’s pocket. He could pay his workers $2 a day (a slight premium to the average wage), which meant $500 annually, or $5 a day, which meant $1,250 — a premium of $750. At the time, a Model T — the company’s flagship brand — retailed for between $450 and $550.4 Let’s split the difference and call it $500.

Ford chose to pay his workers $1,250 because this gave them the extra money they needed to buy one of his autos, thereby putting $500 back in his pocket, right? Well, not exactly. Because anyone who knows the first thing about business understands that owners keep the profit, not the revenue. Let’s be generous and imagine that the profit margin on a Model T was 25 percent. Ford gets back 25 percent of $500, or $125, while he paid out an extra $750 in wages that year! And that’s the first year. Because unless these workers buy a new car every year, from that point forward it’s pure expenditure on Hank’s part, with no benefit flowing back to him.

Then there’s the second interpretation, which is not only my argument, by the way, it’s the one you’ll find put forward as the “primary” motivation on the Ford Motor Company website!5 Because it’s the one that makes sense. There’s a term for it: the “efficiency wage.”

The premise of the efficiency wage is that it is enlightened business practice to pay workers more than the bare minimum because more generous pay packages result in greater output and higher profits. If you pay someone the absolute minimum needed to get a warm body, you’ll get an untalented person who will give you minimum effort. In a market economy, wages are determined by many factors, but the value-added component is decisive. The more value added that is directly attributable to your efforts, the more money you’ll make. It’s why athletes like Sidney Crosby and LeBron James earn more than the average player; they more directly boost their team’s revenue. And if I may paraphrase the words in the first interpretation, that is the basic economic bargain that lies at the heart of a modern, productive economy.

The first interpretation should be at least a bit troubling. In place of hard analysis, we have wishful thinking. It might be nice if everyone were paid more money (because we’re all consumers, aren’t we?), irrespective of whether anyone works harder and/or smarter and adds more value. But it’s not how any economy works. Wages move in lockstep with productivity and anything that enhances productivity leads to higher wages. And the reason why wages grew so robustly in the 1950s was a combination of capital deepening and a workforce that flat-out busted its @ss.

It just occurred to me. I haven’t told you who wrote the words for the first interpretation. It was Robert Reich, who is currently Chancellor’s Professor of Public Policy at the Goldman School of Public Policy at the University of California, Berkeley. He was formerly a professor at Harvard University’s John F. Kennedy School of Government and Mr. Reich served as Labor Secretary during the Clinton administration.6

You can’t make this stuff up.