Corporate reforms: How workers in boardrooms can boost productivity

When legendary physicist Richard Feynman was called in to help solve the mystery of the Challenger space shuttle explosion in 1986, he didn’t use advanced math. Instead, according to his own account of the incident, he went and talked to the engineers. The workers who actually built the space shuttle, he found, had a good idea of which parts were likely to fail. Talking to them helped point Feynman toward a flaw in the rubber O-ring joints, which everyone eventually realised was what brought the shuttle down.

This story illustrates a more general principle. Workers have a lot of knowledge about the day-to-day operations of the businesses they sustain. Clerks and salespeople know what customers want, and how buyers decide to make purchases. Assembly line workers know how to speed up manufacturing and prevent defects. Engineers know how to redesign products, and so on. These are things that executives and top managers, sitting in their offices and perhaps far from where much of their companies’ operations are located, may overlook. That means that if a business or product line is struggling, executives may sell it off or downsize instead of addressing the problems at the operations level.

Innovative solution by Germans

Germany has come up with an innovative solution to this problem — put workers directly in corporate boardrooms. Since 1976, German companies with more than 2,000 employees must reserve half of their board seats for worker-elected representatives, while those with 500 to 1,000 employees must set aside one-third. Referred to as co-determination, this policy — which has been proposed in the US by Senator Elizabeth Warren — is often touted as a way to give workers more power to demand better wages and benefits. But its primary benefit might be improving corporate productivity.

A number of economic studies have found this surprising effect. For example, there’s evidence that the 1976 reform boosted total factor productivity at companies subject to the new law. Worker board representation also probably improved shareholder value — an ironic outcome for a policy that reduces shareholder control. Economists generally cite greater worker input as the reason for these improvements.

Mandatory worker representation

Now, a new paper by economists Simon Jager, Benjamin Schoefer and Jarg Heining sheds even more light on the issue. Studying a 1994 German reform that abolished mandatory worker representation for some new smaller companies but locked it in permanently for older ones, the authors found that the companies that were forced to keep workers on the board ended up investing more in fixed capital (buildings, machines, etc), and becoming more capital-intensive. This added capital, they concluded, raised value added per worker.

Interestingly, Jager et al. did not find that co-determination had much effect on wages. They were unable to detect any change in the difference between the compensation of lower-end workers and top management, or in the division of income between shareholders and labour. In other words, they found that the main effect of worker representation was not to redistribute the corporate pie, but simply to expand it.

Boost in business investment

This research gives insights into what co-determination would and wouldn’t accomplish if it were implemented in the US. It suggests that worker representation on corporate boards might do little to reverse the decline in labour’s share of income, the divergence between wages and productivity, or the gap between executive pay and average worker salaries. For that, other reforms and institutions — expanded unions, workers’ councils and/or wage boards — may be necessary.

Instead, co-determination should be seen as a tool for reversing the long-term decline in business investment:

In other words, worker representation may be the antidote to downsizing. Worker representatives in corporate boardrooms may serve as an important counterweight to executives whose instinct is to sell or close a business or slash workers when the company hits a rough patch. In the long term, as Jager et al.’ s research suggests, that would create value and benefit shareholders. It would also increase job security for American workers, and perhaps even improve employment rates.

Benefits of co-determination

And it might even help the US to build up a base of efficient small and medium-sized manufacturing companies to rival Germany’s fabled mittelstand. These businesses are often cited as a factor behind Germany’s continued manufacturing and export prowess in an age of intensified global competition.

Finally, putting employee representatives in boardrooms might give American workers a greater sense of dignity and importance. In an economy increasingly dominated by large organisations, workers could benefit from a feeling that their input is valued at the highest levels. That increased sense of worker ownership might be part of the solution to rising political discontent.

So while co-determination can’t solve all of corporate America’s problems, it has great potential as a way to increase productivity, boost investment, improve job security and make jobs more dignified and meaningful. It should be considered in any broad package of economic reforms.

Noah Smith was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.