16: The Proximate Sources of Divergence
There is much conjecture as to the reasons for the divergence between rich and poor nations in the wake of the industrial revolution, particularly as the gap between them continues to widen. The various theories, even the less superficial ones, are unsatisfactory in their evidence, and public policy changes that have been based on them has failed to remedy the issue.
The author compares theorists who consider political and social institutions to be the root cause to "physicians of the era who prescribed bloodletting as the cure for ailments they did not understand," and yet who stubbornly continue to prescribe the same treatment in spite of its failure to cure, and in spite of the damage it does, maintaining that "more of the same" is sure to do the trick.
The factors that produce wealth in an economy are well known: land, labor, and capital. The factors that produce wealth for an individual, or any group of individuals, are no different: the land and capital they have, and the efficiency of their efforts to employ them to produce wealth. This chapter demonstrates that the differences in efficiency are the ultimate explanation for the gap between incomes of the rich and poor in modern economies.
In industrialized nations, the income the average person has is about 25% attributed to his capital and 75% to his efforts. In lower classes that have no capital, labor is 100% the source of their income. The effect is cumulative over time: efficient economies amass capital stock over time and inefficient ones diminish their stock over time. This does not mean that capital is transferred from one to another - it is the result of differences in production and consumption in two independent economies.
Even when that is agreed upon, the cause of the difference in efficiency is often mistaken. Access to technology and economies of scale can be factors - but the major source of efficiency differences lies in failure to utilize resources effectively. As a result, the output poor worker remains low in the poorest countries even when resources are equal to, or even greater than, those available to his wealthier counterpart.
Capital and Divergence
The author looks to the returns paid on bonds in different nations as an indicator of the productivity of capital, and finds that there is little difference in the interest rates of bonds offered in different nations. He rather quickly concedes that this is not particularly useful: while the return on capital sets the maximum rate of interest a borrower is capable of paying (the full return on his own investment), borrowers seek the lowest interest rate possible, so the interest rate is a negotiation between buyer and seller that reflects the availability of capital in the market, not necessarily the degree to which borrowers could put it to productive use.
Furthermore, there was a great deal of liquidity in foreign markets, such that even in 1870. It was not at all unusual for investors to fund loans from abroad, and foreign bonds competed on more or less even ground with domestic issues, The fact that most currency was pegged to gold also decreased currency exchange risks, leveling the playing field.
The wealth of rich countries was available to lend to poorer ones in significant amount, and there is historical evidence that it was borrowed quite often: Argentina, Brazil, Egypt, Mexico, and Peru had all attracted $50 in foreign investment per citizen - and given that the average income per person was about $125 at the time, this is a significant capital augmentation. Moreover, the money was lent at reasonable rates. A study of bonds from 1860-1912 shows that the interest rate for investment in domestic firms with domestic operations to have been 5.5%; domestic firms with foreign operations got credit at 6.5%.
These facts considered, the slow adoption of industrialization in poor countries cannot be attributed to lack of capital
Resources and Divergence
Another factor to consider is the availability and cost of resources: while capital may be available to purchase raw materials for industry, the materials may not be available or may be in short supply. However, in examining the cost of cotton for textile manufacture in various markets, it is clear that resources were available. The money cost of such materials is often cheaper in poorer nations, which may be attributed to a poorer economy, but their cost is still proportional when considered in consideration of wages. The author also looks to the cost of a ton of coal, relative to GDP per person, in various economies, and finds only modest differences in the price between richer and poorer economies.
As such, it is considered that geography and access to resources do not explain the divergence of incomes, and given the advances in rail and shipping to bring materials to where they were needed, the period around the industrial revolution is one in which lack of local resources became unimportant as a barrier to industrialization except in a few landlocked or inaccessible countries.
(EN: It may be a stretch, but I wonder if the author is considering the effect of artificial restrictions such as embargoes and tariffs. I have the sense from other sources that these were at times significant obstacles to one nation being able to obtain the raw materials or sell its finished goods to another.)
Efficiency and Divergence
There has always been a strong correlation between the amount of capital per person and the amount of productivity per person across countries, though cause and effect seem to be cross-wired. It is suggested that people produce more when they have more capital to begin with - but more logical that people have more capital as a result of having been more productive.
Stepping back from cause-and-effect to consider mere statistical correlation: the differences in the level of capital per person does explain about a quarter of the income differences across countries in the modern world. This also appears to trend over time: those economies that make efficient use of capital in one year have produced more capital to be used in production the following year, such that efficient use of capital has a compounding effect that explains the reason the gap between more productive and less productive economies is constantly growing.
Why Were Poor Countries Inefficient?
The inefficiencies of production in poorer countries was not in their inability to access labor-saving technologies, but in their inability to effectively use them.
The author considers cotton textiles, which catapulted Britain to the lead of the industrial revolution. Individually, cotton mills are small enough to scale - in larger nations, there were more mills in operation, and in smaller nations, fewer could be used, such that it cannot be argued that a nation would be "too small" to take full advantage of the technology.
It is also evident that technology was readily available internationally and at modest prices, and many British firms changed from being manufacturers to sellers of manufacturing equipment after the ban on exporting such equipment was lifted.
Neither can it be argued that skilled workers were required to operate this equipment. Even in England, manufacturing work was done by uneducated workers with a modicum of training and supervision. If anything, the availability of unskilled labor in poorer countries is cheaper. An account is given of a textile firm in India, in which the observer mentions that the Indian laborer was fully as capable of manufacturing tasks as his British counterpart. With this in mind, it seems that poorer countries, with greater proximity to raw materials and a significantly lower labor cost, should have taken over the cotton textile industry and driven the British out of the market.
The author provides an examination of the costs and profits of producing cotton cloth in various countries - given wages, cotton, and coal - to find that poorer countries should have been able to produce cloth at a higher profit margin: 22% in China, 19% in India, and 14% in Italy and Japan. Spain, Mexico, and Russia should each have been able to earn a 10% profit on cotton textiles. Meanwhile England produced textiles at an 8% profit and the US would have produced it at a 1% loss (much higher labor and fuel costs at the time).
There is also some discussion of the problems plaguing English manufacturers at the time, namely social reformers and labor unions that prevented efficient use of the facilities. In England, mills operated for only 2,775 hours per year, the lowest of any nation, as opposed to most nations that ran between 3500-4000 hours, and the extreme example of Mexico, where workers in shifts around-the-clock ran their mills 6,750 hours per year.
Even with these disadvantages, England remained the low-cost and high-volume producer of yarn and cloth: it paid more for materials, more for labor, and worked laborers fewer hours - but was highly efficient in the use of its labor ,as were most of the richer nations.
A comparison was done in 1913 between US and Chinese workers in the textile industry that demonstrates this stark contrast: American spinning operations produced 900 spools of yarn per worker per day, whereas Chinese produced 170. In an American weaving facility, one worker would manage eight machines at a time, whereas a Chinese facility each employee managed only two. Even accounting for the differences in wages (which as a percentage of revenue were actually not that different), the American workers produced more and cheaper products per worker, generally by a margin of 6:1.
One explanation is offered in terms of the speed of work: because industrial machines could be run at an arbitrary speed, it is suggested that the Chinese ran the machines faster but needed more employees because the bobbins would run out more frequently and threads would break more often - but given the difference in output (900 spools to 170), it should have been plain to see this was not resulting in better output.
From textiles, the author turns to the railroad industries - but the discussion is a bit convoluted, and involves a great deal of variation in the "standards" to which the railways were operated. Ultimately, however, the comparison boils down to the same ratio of efficiency between rich and poor countries - about 6:1 - when the number of employees is compared to the number of miles per locomotive per year.
Japan is an interesting case, given that it was transformed from an underdeveloped nation to an economic superpower in the mid twentieth century - but even early in the same century, it can be seen that efficiency improvements helped to improve the economy. During the 1920s and 1930s, the textile industry increased output per worker by 80%
Skip ahead further to the present day: the technology in textiles and garment making is relatively standard in the present day, with workers in countries around the world using largely identical machines. Still, labor is the driving cost in textiles - even in low-wage economies such as China, Mexico, and Nicaragua, the cost of labor accounts or about 75% of the cost of making garments (including shipping to the US markets).
While there has been an exodus of the textile industry in the last quarter of the twentieth century, there is still significant domestic production: 42% of all apparel purchased in the US is manufactured domestically. It's also noted that the remaining 58% did not flow to the cheapest providers: Mexico and Costa Rica are major suppliers to the US market, but their wages are still six times those of the Indian subcontinent.
It's clear once again that the cost of wages paid to workers is less significant than the cost of labor relative to productivity - that is, nations that have the most efficient workers, not necessarily the cheapest, have competitive advantage in the market for industrial production.