A New Model for Managing International Trade and Development , Part II

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In Development…
…only one road leads to Rome, Part 2

By Sid Eschenbach / The Rag Blog / November 13, 2008

History: How did the rich nations get rich?

This is the single most important question that any national leader or policy maker should ask him or herself, because the answer solves their development conundrum: what are the elements of a system which brings economic wellbeing to the greatest number of people? Machiavelli told us that nation states always act in what they perceive to be their own best interests. Unfortunately, those are not as easy to discern as they once were.

In his pre-industrial day, both domestic and international trade consisted almost entirely of the exchange of simple agricultural and mining goods traded between national parties. As such, with the exception of imported rarities like spices, anything one region could produce; another could produce just as well.

As there was no great difference between their production costs… all labor was equivalently cheap, and so the only way to protect ones markets was through tariffs that protected domestic agricultural products. As a result, there were no rich and poor nations… they were all, outside of very few wealthy commercial or dynastic lineages, equivalently poor, agrarian based nations.

What happened, then, between Machiavelli’s day and our own that has produced the enormous differences in wellbeing between nations. How exactly did we get to where we are, a planet populated by some very rich and many very poor nations? The answer, quite simply, is that the rich nations industrialized while the poor nations didn’t. While this answer seems too simple to be true, it is both simple and true, and I will use an early example to flesh out the theoretical economic argument that follows.

History’s first deliberate large-scale industrial policy was based upon an observation that the boy who would become King Henry VII made as a child living with his aunt in Burgundy, France. There he observed great affluence in an area that produced woolen textiles… despite the fact that the area produced neither the wool nor the materials needed to process it. Instead, this affluence was a result of importing both the raw materials, wool and aluminum silicate (Fullers Earth) from England, and manufacturing the finished products in Burgundy.

Later, when he became king (1485) of an impoverished England, he resolved to convert England from a raw materials exporter to a finished goods exporter… and set out to create the policies that would produce that outcome. Among other things, he taxed wool exports while he subsidized small woolen goods manufacturers, encouraging through tax policy the creation of local industry. Simultaneously, he devised a policy that attracted craftsmen and entrepreneurs from abroad, particularly Holland and Italy.

The combined effect of this was to increase English domestic production… and as production rose, so did the export duties, until English producers were able to process all of the wool produced in England. Later, under Elizabeth I, the crown placed a total embargo on the export of raw wool, thereby ensuring the survival and strength of the English textile industry… and as a result of these policies the Elizabethan Tudors are considered by historians to be the originators of the English industrialized state and the founders of English affluence and economic power.

Contrast this policy to what we practice today. By the logic of modern ‘free-trade’ policies, Henry should never have protected his own people, and the more efficient French should have been allowed, through their already established manufacturing base, to export duty free to England. Fortunately for both England and France, this did not happen. Seeing the English success, this policy of protecting and building an industrial base spread to other regions and became national policy for many of the early European states over the following two centuries.

Its use was so dominant that the German economist Friedrich List recognized in 1841 that there was a natural evolution in development: when starting up the economic ladder, the state had to protect its industries and restrict raw material exports. Later, when the domestic industries could service the needs of the nation, the same barriers to trade that had allowed them to prosper behind import/export restrictions began to restrict their potential growth into other nations as their industrial capacity grew stronger.

As an anonymous Italian traveler to Holland put it slightly earlier (1786), “Tariffs are as useful for introducing the arts (manufacturing) in a country, as they are damaging once these are established.”… and it hasn’t been said any better since. Without belaboring the point by going into endless historical example, it nevertheless bears repeating: all industrialized nations, even those poorly run, are relatively richer and have higher standards of living than all non-industrialized nations.

From that reality and from that historical record we can adopt with confidence a fundamental law of development: ‘development and general well-being cannot occur without industrialization’ an economic reality that the current trade/development paradigm completely ignores.

Economists today explain that the theoretical reason this is true is due to phenomena they call increasing returns and diminishing returns. These two concepts describe the economic differences between agricultural, fishing or mining income on the one hand, and industrial or technologically based income on the other hand.

The first is a zero-sum game and a creator of finite wealth, while the second is a non-zero sum creator of infinite wealth. The reason this is true, that one can produce infinite wealth while the other only finite wealth, revolves around the phenomena that are at the heart of the creation of affluence — the potential for worker productivity and innovation available to each sector.

A barber or a house painter, once they learn their trades, can only paint so many houses or cut so many heads of hair in one day… and that’s it. There is no way to significantly increase their productivity.

Likewise, an acre of ground can only produce so much wheat or corn. Yes, yields increase as the painter gets faster, but the limits to both are quickly reached. Indeed, after the production limits have been reached, these become examples of businesses of diminishing returns because any dollar invested in them after they reach their peaks yields proportionally less income rather than more.

One of the defining features of industry, however, is that of increasing returns. As any car manufacturer, computer screen producer or a production-line worker knows, once the system is in place to manufacture any widget, the savings generated through scale, repetition and mechanization create an endless vehicle for increased productivity, and every additional widget produced costs less than the one before it.

While the barber is stuck at one head every half hour, the production line worker goes from one car per day to 100 cars per day. It is this increasing return and increased productivity that creates rising standards of living within the labor force … and this is exactly how rich nations got rich; they industrialized. Through that process of increasing returns and increasing productivity they created the wealthy societies that they enjoy today.

As a result, and again not coincidentally, there is not now nor has there ever been an industrialized nation that is not wealthy. There are industrialized nations that are richer than other industrialized nations, and there are a few nations that are not industrialized that are wealthy, but those are limited to the anomalous economic realities of the oil producing nations… and indeed that is only due to the industrialization of their production base, allowing them to enjoy increasing returns like any other industrial enterprise.

The Role of Labor in National Development

And industrialized labor… how does that fit in? Again, it is interesting and instructive to turn to the historical record, and then to the economic theory… but as a preface, a restatement of the obvious. The engine of development, manufacturing, requires two things: inside the factory, quality labor, and outside the factory, buyers. But where do they come from?

To put it another way, if the economic gains generated by the increasing returns of manufacturing are not shared broadly, the poverty of the region, like the tariffs for developed manufacturing areas (above), becomes a brake to growth, not an aid to it. Production requires education and consumption, so if workers are not sharing in the economic gains generated by their labor in the manufacturing sector, there will be no growth because there will be no increased capability nor demand.

A historic fact not widely known is that prior to the massive industrialization brought on by the Second World War, the United States, like all other nations, did not have a large middle class, a fact which raised the question of how the U.S. got from the Gilded Age, the period characterized by a small middle class and great inequalities in income, the period that ended with the Great Depression (again, a non-coincidental event), to the post WWII middle class society of today.

The answer to that question lies in the phenomena of something that economists now call ‘Fordism’, named after Henry Ford. Among the many myths surrounding Ford, perhaps the greatest is that he paid his workers a substantial premium above the minimum wage ($5.00 vs. $2.34 p/day) in the belief that those who worked in his factories should be able to afford his products.

The real reason he gave them a raise is because he recognized that he could make far more cars and money if his workers were efficient and highly productive. Worker turnover being a major problem for his business, he reasoned that if he paid his workers more than others, he would attract the best workers and keep them longer.

This wasn’t an altruistic policy, but a strictly selfish one. It was to manufacturing what Adam Smiths famous line about why the barber cuts your hair was to cottage labor: barbers cut hair not because they want to keep you well-shorn and neat, but because they need the income. Ford, likewise, paid his workers more because it was in his best interests. That it was also in the best interests of the workers was essentially a highly beneficial byproduct of Fords search for higher and higher productivity.

Economists now define ‘Fordism’ in slightly broader terms; as a system where wages increase in step with the productivity increases of the leading industrial sector. There are various theories as to why it Fordism works… which take us to unions, higher labor costs and the role they play within national developmental policy.

The concept that Henry Ford put into practice in his factories, paying higher wages and getting higher productivity, is known in labor economic theory as the ‘efficiency wage hypothesis’. Unfortunately, while recognizing the empirical validity of the phenomena, economists are not clear on why exactly it works… that is, why does paying workers more always result in higher productivity? The reason for this confusion, in my opinion, is that they are looking under the wrong rock to find the answer.

It lies not under the ‘how workers might respond to higher wages’ rock, but rather the ‘how management does respond to higher costs’ rock. The traditional analysis advances the following principal worker response factors as probable reasons for the existence of the phenomena:

  • higher pay yields lower shirking (the worker values the job more with higher pay, and works harder to minimize the chance of losing it);
  • minimized turnover yields a better trained and thus more productive workforce;
  • higher pay yields higher morale which makes for more productive workers, and in extreme cases,
  • higher pay yields a better fed worker who is able to work harder and thus be more productive.

While any and all of these reasons could certainly impact the worker in the manners suggested, the far more probable reason that higher labor costs always produces higher productivity is because of the management. The simple reason is that the fundamental role of management is to increase profit, and it can do that in two ways: increase sales, or lower costs.

When labor becomes a higher percentage of production costs, management will of necessity focus all their talents on the creation of ‘labor saving’ devices in order to reduce those costs. In manufacturing, lowering labor costs while maintaining production levels means lower unit costs … which is the very definition of increased productivity.

Put simply, Henry Ford’s higher wages may have indeed motivated the workers to work harder, shirk less, etc. However, as both the modern production line and Ford’s memoirs attest, his number one goal was to constantly work on creating systems that cut the labor cost of manufacturing … due to its high cost!

In manufacturing, then, the result of higher labor costs (although obviously not infinitely) can be nothing other than higher productivity… and that’s why unions are important. Contrary to the conclusion that common sense might produce, low wages do not create high productivity… but low productivity.

Unfortunately, as most managers are not as hard working as was Henry Ford, they would prefer to pay their workers less and not work as hard on finding labor saving devices as he did. However, as I hope I have shown, without increased productivity there can be no upwards spiral, and under a high wage scenario capitalist management itself will guarantee that that will happen.

Unions and organized labor simply remove the ‘lazy management/surplus labor’ option from management, thereby creating within the industrialized state the essential wage/productivity spiral that leads to the creation of a middle class. It is a historical fact that the periods of fastest growth in real wages have been periods of what J.K. Galbraith called periods of the “balance of countervailing powers”, that is, when industrial power and labor power were generally equal, and the result was highly efficient ‘Fordist’ wage regimes, periods characterized by rising wages, rising productivity and thus a broad and rising stand of living.

Fordism provides us with a blueprint of how to create prosperity: first, pay your workers enough that you create a middle class whose consumption would sustain the industry; and second, pay your workers enough to make them want the job and to push management into creating a more productive workforce. It is doing the impossible, lifting oneself up by ones own bootstraps. Without providing the industrial and labor conditions for ‘increasing returns’, no economy really advances at a rate any greater than its own population growth.

The Evolution of Well-being: a Review

As I mentioned earlier, none of this is new, as Friedrich List theorized essentially what I have summarized below almost 200 years ago. However, in the event that what I’m trying to explain still isn’t clear, let me condense the previous pages into their salient few points without their respective accompanying arguments:

  1. For a nation to enjoy broadly shared well-being, it must be industrialized.
    1. Therefore, for an undeveloped nation to prosper, a developed industrial sector must be created.
    2. In order for that industry to grow, it must be protected when small and inefficient from larger, more efficient producers.
    3. If it is not protected, it will not survive the competition from those who have come before it somewhere else, and as a result…
    4. Industry will not develop, and broad national well-being will NEVER be achieved.

  2. In exchange for the protection of national tax or tariff policies, the protected industry must allow workers to organize and bargain collectively. This will…
    1. insure that the industry, as it develops, will be as productive as possible;
    2. start the essential wage/productivity spiral that will broaden prosperity;
    3. prepare for the day when the industry is big and productive enough to survive without national protection.

If the above is true, is there anything about modern free-market capitalism that would lead one to believe that a by-product of its use would be broad, global development and well-being? Is there anything inherent in the functioning of ‘free trade’ that would create the conditions necessary to build broad-based prosperity, remembering that there is only one road to Rome?

The answers to those questions, of course, are no. Be they the older examples of England, Germany, Italy, and France, the newer examples of the United States and Russia, to the recent rise of the ‘Asian Tigers’, China and India… all nations have used this route to development: protect, industrialize, export… because there is no other.

How then, if it’s so obvious, did the currently dominant development model take control of the development narrative? Simply because the goals of the global multi-nationals are not congruent with those of the nations states.

As noted earlier, nations and businesses act in their own best interests, and it is not in the interests of international business to create a series of local and national producers of the products that they themselves make elsewhere. The fact that without this industrialization the country will develop much more slowly if at all is not their problem. This doesn’t make them evil or malicious, but rather just one more entity acting as it would be expected to act… in their own best interests.

Sidney Eschenbach, 60, lives and works in Guatemala, Central America. His thoughts regarding developmental economics and trade are based on decades of development work in Latin America at various levels, community and corporate.

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