How well a country uses its capital ought to be extremely important to its citizens and policymakers. While labor productivity is a topic of constant debate and was the subject of earlier McKinsey Global Institute studies, far less attention has been paid to questions about the productivity of a nation’s capital stock.

"Capital" actually has two interrelated meanings: physical capital (machinery and buildings) and financial capital (stocks and bonds), which lays claim on physical capital and the income it generates. Capital productivity is the measure of how well physical capital is used in providing goods and services. Productive use of physical capital and labor are the two most important sources of a nation’s material standard of living.

In addition, how well a nation uses its physical capital affects the return that people get on the money they save. The higher the returns, the less they need to save for the future, and the more they can consume today. This is especially critical because most developed countries have a rapidly growing proportion of retirees. Very small differences in rates of return create large differences in future retirement income.

To measure how productively major economies use capital and to understand the causes for differences in performance, the McKinsey Global Institute has studied capital productivity in Germany, Japan, and the US.¹ We analyzed economywide performance and also conducted case studies in five industries: auto, food processing, retail, telecommunications, and electric utilities.

Our principal findings are:

• Significant differences exist in capital productivity across nations: productivity in Germany and Japan is about two-thirds US levels.
• Managers in Japan and Germany could close most of the gap without a single change in regulation but do not because of lack of incentives and lack of market pressure.
• Combining this work with the previous work of MGI on labor productivity, we find that the US achieves leading economic performance by having higher productivity in both labor and capital. Japan’s low productivity is due to sub-par performance in both factors, while Germany’s lower overall productivity stems primarily from less productive use of a very high level of capital (Exhibit 1).
  
• Higher capital productivity in the US has led to higher financial returns, which have more than compensated for lower savings and investment rates by generating more capital income (Exhibit 2). As a result, the US has maintained greater financial wealth and consumed more at the same time.
  

The following sections summarize our findings about differences in capital productivity and how those differences affect economic and financial performance.

Standards of living—two paradoxes

The differing overall economic performance of the three countries poses two important paradoxes:

• Why is Japan’s GDP per capita not higher than that of the US when Japan has saved so much more and worked so hard?
• Why has German labor productivity not exceeded US levels when Germany has invested so much more capital per worker?

The resolution of the Japanese paradox is straightforward. GDP per capita is simply a product of labor and capital, and how productively they are used (Exhibit 1). Although Japan invests more capital and uses more labor than either the US or Germany, extremely low productivity in both capital and labor drags down their GDP. Japan has a market sector GDP per capita similar to that of Germany, and only 77 percent of US levels. Simply put, the Japanese invest a lot of money and a lot of time and energy and get comparatively little back in return.

Germany’s situation is different. As Exhibit 1 shows, Germany uses far more capital than the US but works significantly less. As a result, there is about 40 percent more plant and equipment for each worker hour than there is in the US. We would expect, therefore, that German labor would be more productive. It is not, however, because capital has not been used efficiently and effectively. This explains the German labor productivity paradox and shows up as capital productivity that is only two-thirds of the US level.

The combination of much lower capital productivity and slightly lower labor productivity results in an overall productivity level in the German market sector that is 20 percent below the US level. As shown in Exhibit 1, this lower overall productivity is the primary reason why Germany’s market sector GDP per capita is 26 percent below US levels. The other, less important, reason is lower labor inputs. In this sense, capital productivity is the most important factor in understanding Germany’s lower GDP per capita.

Analysis of individual industries supports our overall results (Exhibit 3). For both Germany and Japan, in four out of our five case studies, capital productivity was significantly below US levels.

Managers’ choice

Detailed industry analysis also permits us to understand why capital productivity really differs. Exhibit 4 summarizes the hierarchy of factors that caused productivity differences. Surprisingly, we found that managers in Japan and Germany could achieve performance close to US levels if they ran their companies differently, which they appear to be free to do. Formal external constraints, such as labor laws and rules, do not fundamentally restrict improvement opportunities.

Capital productivity shows up in two ways: the amount of assets used to create a given level of capacity, and the extent to which that capacity is utilized. Different levels of capacity utilization explain 70 percent of the productivity gap between Germany and the US, while Japan’s lower productivity is almost equally accounted for by each of the two factors. We found that managers’ actions, especially their marketing decisions and the effectiveness of their operational processes, directly affect performance on both variables (Exhibit 5).

Why is marketing so important? Good decisions on pricing and product lines can influence demand to increase capacity utilization, which in turn means higher productivity. For example, in electric utilities, time-of-use pricing reduces peak loads and raises average utilization of power plants. Marketing can also increase the value to the consumer of each unit produced, as it does in retail through effective merchandising and new format development.

Excellent "shopfloor" operational practices are also crucial. For instance, Toyota’s production system illustrates the many ways that effectiveness in operations can raise capital productivity. Interestingly, the same operational practices that improve labor productivity boost capital productivity as well. Thus, we find that high capital productivity is not achieved by throwing in more labor, nor vice versa.

We also found that for many German firms ineffective investment planning lowered capacity utilization, and "goldplating" and overengineering were common. For example, the phone cables of Deutsche Telekom must be able to withstand being run over by a tank. We found other examples of goldplating in the auto industry.

These results further explain the two paradoxes above. Goldplated or underutilized equipment in Germany does not improve labor productivity. In addition, the US achieves higher overall productivity, especially relative to Japan, through better marketing and operational practices that improve both labor and capital productivity at the same time. Amassing more resources, without changing managerial practices, does not improve productivity.

Although not impacting physical productivity, global sourcing of equipment is another way to improve financial return on capital. German and Japanese managers tend to buy their equipment locally. Yet they could vastly reduce equipment prices by buying more on the global market. The potential savings range from 10 percent in the food industry to as much as 60 percent in telecom.

Motivating managers

We do not believe that managers in one country are any more skilled, or have acted any more rationally, than in another. Rather, they have responded to the pressures and incentives placed upon them by their environments. Productivity differences across countries arise because economic systems create different dynamics of innovation, improvement, and creative destruction.

A competitive product market is critical in creating a positive dynamic. Low entry barriers, intense competition on price/value trade-offs, and frequent start-ups and exits spur managers to improve productivity. In all of our "non-monopoly" case studies—food, auto, retail—the more intense the product market competition, the higher the productivity. Regulations, from zoning to trade protection, were often the basic cause of differences in the nature of competition, because they raised entry barriers and constrained managerial actions.

Interestingly, in the regulated monopoly industries—telecom and electric utilities—performance differences across countries were significant. We found that higher performance levels in the US were attributable to the fact that firms were owned by private investors, not the government, and that regulators focused on maintaining low prices. Both of these factors combined put more pressure on US managers to use their resources well.

The capital market is also important in stimulating higher productivity. More so in the US than elsewhere, the capital market boosts productivity because it gives managers a clear primary objective—financial performance—that generally guides them to use their resources productively. Furthermore, the US capital market complements the competitive pressures of the product market by cutting off funds to failing firms. Consequently, the high levels of productivity attained in most US industries do not square with the "conventional wisdom" that the US capital market undermines economic performance by forcing firms to be too focused on short-term results.

Capital productivity and wealth

Capital also has the role as the storage device for saving some of current income for future consumption. The accumulation of these savings represents the wealth of a nation. The connection between savings and wealth raises another paradox: how could the US, which has saved relatively little, have created more new wealth than the other two countries (Exhibit 6)? As the exhibit shows, a large part of US wealth existing in 1970 was eroded by underlying physical depreciation. This depreciation was offset by the creation of more new wealth than in Germany and Japan.

The explanation of higher US wealth and the resolution of the paradox lies in combining the right savings numbers with the differences in capital productivity. First, US savings invested in the business sector have not actually been as dramatically low relative to Germany and Japan as popular wisdom suggests, once they are measured on a per capita basis and equalized for purchasing power. Commonly published net domestic savings rates feature the well-known, very large differences among Germany, Japan, and the US. Germany’s net domestic savings rate has been more than 60 percent higher than that of the US, and Japan’s has been more than double.

This picture is misleading, however, when we want to explain per capita levels of new wealth creation because it is based on net rather than gross and on rates rather than levels. We care about new wealth creation because it, not net wealth creation, reflects the total, real performance of an economy. New wealth is generated from all new (gross) investment, including investment that replaces old capital. Net wealth takes into account the wearing out of old capital assets (depreciation). However, depreciation is a "fact of life" that depends on the level of initial wealth. Replacing depreciated assets is as much a part of the real performance of an economy as the addition of net wealth. To analyze new wealth created on a per capita basis thus requires starting with gross investment on a per capita basis. These numbers paint a very different picture from net savings rates (Exhibit 7). Between 1974 and 1993, gross business investment levels have been only about 20 percent higher in Germany and Japan than in the US.

Thus, our approach starts by measuring the levels of new capital invested in business and calculates new income generated, accounting for the consumption of capital in the production process as a reduction in the return generated. We analyzed only wealth generated by businesses, because other forms of wealth (real estate, government infrastructure) cannot be managed through an active production process to create income to capital.

Second, higher capital productivity in the US means that savings worked harder and generated higher capital income, despite the somewhat lower savings.

Our measures of financial performance demonstrate that the US has earned higher returns to capital than the other two countries. By incorporating into our measure of physical capital productivity the prices of outputs and capital inputs, as well as how much of the income generated goes to capital, we can calculate the financial return that investors get in a one-year period. This static measure, which we call the production return to capital, shows that over 1990 to 1993, capital in Germany and Japan earned roughly three-quarters of what it did in the US (Exhibit 8).

We have also calculated a dynamic measure of financial return, the real internal rate of return. This measure is dynamic because it relates current income to past investments and is market based because it includes the appreciation in the value of financial assets. This appreciation is linked to expectations of future earnings, as reflected in increases in stock market prices. Again, we see marked differences in performance over the period 1974 to 1993, with Germany and Japan earning roughly 80 percent of US levels (Exhibit 9). German performance is consistently lower than the US, while for Japan, our results are sensitive to the time period measured because of high income share to capital in the early 1970s and the stock market "bubble" in the late 1980s.

These two measures of return, taken together, offer several striking conclusions. Both show marked differences in performance between countries. While each measure has its limitations and irreducible sensitivity to assumptions persists, the similarity of results from both static and dynamic measures strengthens the findings.

Differences in physical capital productivity explain the higher returns to capital. Because the income share to capital is roughly the same in the three economies, the higher financial performance in the US is attributable to "a larger pie being created" and not to capital’s "taking a larger share of the pie." Moreover, this correlation between productivity and return supports our observation in the case studies that a clear managerial goal of high financial performance is generally consistent with high levels of productivity.

Finally, these different rates of return compound to significant differences in wealth creation, and help explain the US "savings/wealth" paradox. Higher returns create more capital income, allowing the US to create more new wealth while saving less and thus consuming more today (see Exhibit 2). Moreover, this higher wealth has been achieved while maintaining the highest labor productivity.

Because we have studied GDP per capita levels and not growth rates, our results have no implications for the relationship between savings rates and GDP growth.

Implications

These results offer clear implications for policymakers, corporations, and investors in all three countries.

Policymakers should recognize the importance of capital productivity to overall standards of living and to financial returns to investors. As economies all over the world increasingly have to rely on funded pension systems, higher financial returns to investors will become a critical requirement for securing adequate retirement benefits. Policymakers can help investors exert performance pressure on managers of public corporations by improving the quality and clarity of information that investors receive in public filings.

To improve national productivity performance, governments should foster product market competition by eliminating regulations that raise barriers to entry and protect existing corporations. In the case of regulated monopolies, policymakers can increase the performance pressure on managers through the use of price cap (price reduction) regulation or prudence reviews. Finally, remaining government-owned firms should be privatized to create investor pressure on managers, which in turn should increase productivity.

Corporations should establish explicit performance goals that include both financial and operational measures of capital and asset productivity. What gets measured gets done. A growing body of research suggests that capital productivity measures such as return on invested capital are key drivers of returns to investors. Adoption of these measures would go a long way to getting managers to use capital better.

Particularly in Germany and Japan, the bias to procure locally, resulting in significant cost penalties for capital goods relative to global sourcing, should be addressed. In addition, more closely linking investment decisions to customer requirements should help avoid unwarranted goldplating. Finally, a relentless focus on asset and capacity utilization, both through better marketing and adopting global best practice in shopfloor operations, should have significant impact on asset and capital productivity. In this regard, pursuit of global opportunities will provide both a window on global best practice as well as additional markets to reap the benefits of improved productivity performance.

Investors, particularly institutional investors that manage pension funds, should recognize the high cost of lower financial returns. They should demand to be better informed, seeking better financial as well as operational information on capital and asset productivity. They should also become insistent advocates of good investment performance, as they represent all of us who are dependent on investment performance for a secure retirement.