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A Brief History of Cheap Labor

How was cheap labor key to turning Britain, Germany and the United States into industrial powers?

September 13, 2011

How was cheap labor key to turning Britain, Germany and the United States into industrial powers?

The Industrial Revolution began in Britain at the end of the 18th century, and for much of the 19th century it was the dominant industrial power in the world. By the 1880s, however, it was bypassed by the United States — and then by Germany at the turn of the century. In both cases, the newcomers benefited greatly from absorbing and deploying British technology such as the steam engine and the Bessemer process for steel making.

The newcomers initially grew by leapfrogging technologies and ramping up production capacities on an unprecedented scale. Sound familiar?

Consider what happened to the railways. In 1830, the United States had barely 40 miles of railroads — but the network had jumped to 28,920 miles by 1860 and further to a staggering 163,562 miles by 1890. This was more than the rest of the world put together, according to the U.S. Census Bureau.

Before the end of the 19th century, the United States was itself at the cutting edge of technology. The U.S. Patent Office issued Patent No. 174465 to Alexander Graham Bell on March 7, 1876. Within four years there were 60,000 telephones in America — and 20 years later there were six million.

In the next half-century, the United States would invent technologies ranging from the airplane to the radio, and then press them into mass production. Germany would do the same with products such as automobiles and chemicals.

Technological invention was very important for turning Britain, Germany and the United States into industrial powers, but the key factor that allowed mass production was the deployment of cheap labor.

The share of the population that was urbanized in England and Wales jumped from 20% in 1800 to 62% in 1890 as people from the countryside migrated into the industrial cities.

The United States saw wave upon wave of migrants who pushed up its population from a mere ten million in 1820 to 152 million in 1950, according to data compiled in 2001 by the OECD.

In the popular imagination, these migrants headed west to settle in remote farms or participate in the Gold Rush. In reality, the migrants were usually absorbed by the booming industrial sector. At the turn of the century, around 80% of New York’s population of five million was either foreign-born or children of migrants.

Many of them were squeezed into the slums of the Lower East Side, with as many as 25 people sharing a single windowless room and sleeping in shifts. Most indicators suggest that living conditions were significantly worse than in the slums of present-day Mumbai.

Even as the West was industrializing, the experience was very different for China and India. These two giants had been home to large artisan-based manufacturing sectors in the pre-modern age and had been exporting manufactured products like textiles and porcelain for millennia. However, both of them found it difficult to adapt to the changing world.

As the Mughal Empire in India crumbled in the early 18th century, it appeared for a while that the Marathas would replace it. When the Maratha bid for power stumbled, India dissolved into chaos, with many indigenous and foreign groups vying for power. The uncertain political conditions severely affected the investment climate and caused many parts of India to de-industrialize. The re-establishment of order under British colonial rule, however, did not help.

The Industrial Revolution had taken off, and cheap goods produced by British factories flooded India beginning in the early 19th century, further damaging the old artisan-based sector. Note that this happened even though Indian labor was much cheaper than that in England. Even in 1820, Indian per capita incomes were less than a third of British levels, but the largely illiterate workforce was not capable of absorbing new technology.

The building of new infrastructure like the railways also did not help. In fact, it worsened matters by allowing imported goods to penetrate further inland. Therefore, the de-industrialization of India is a good illustration that neither cheap labor nor improved infrastructure is useful unless the overall investment eco-system is in place.

It is important to remember that the productive deployment of cheap labor depends on many factors, ranging from property rights and general governance to the prevalence of basic literacy.

Japan was the first Asian country to experience industrialization and, beginning in the 1890s, output rose very rapidly. Despite the devastation of World War II, Japan had built up a competitive industrial sector by the 1950s.

Yet again, the deployment of cheap labor was a key component of this success. As recently as 1980, when Japan was already considered a developed country, the unit labor cost in nominal U.S. dollar terms was barely half of today’s levels. The sharp increase in Japan of the cost of labor input in the last three decades has been due mainly to the exchange rate.

The currency appreciated from 250-240 yen per U.S. dollar in 1985 to just over 120 per dollar by the end of 1987 and then further to 84 per dollar in 1995. The yen would drift weaker to the 100-150 per dollar range for the next decade and a half before appreciating back to the current range of 80-85 per dollar.

This currency movement undid the 0.5% per year decline in unit labor cost in local currency terms that Japanese manufacturing has sustained over the last three decades. This goes to illustrate how the exchange rate is an important factor that needs to be considered when dealing with the international competitiveness of labor. It is possible, of course, to compete on design and quality, but a strong currency does make matters difficult.

The exchange rate was an important factor in the re-emergence of both China and India on the world stage. The yuan depreciated significantly between 1990 and 1993 before the currency regime was unified on January 1, 1994, and the exchange rate was depreciated by 50% from 5.8 yuan per dollar to 8.7 yuan per dollar.

There is a great deal of academic debate about the exact impact of this move, but it would be hard to deny that Chinese wages, already low by international standards, became even more competitive. According to official data, the average annual wage in China was $637 in 1995.

The Indian rupee too experienced sharp devaluations after the external crisis of 1990-91. The exchange rate depreciated in a number of steps from around 18 rupees per U.S. dollar before the crisis to 31.4 per dollar in 1993. It is no coincidence that the world came to recognize the competitiveness of Indian white collar workers in subsequent years.

In 1994, a fresh MBA graduate from one of India’s top business schools was offered a starting monthly salary of 35,000 rupees by an international consulting firm. This was equivalent to less than $13,375 per year at the prevailing exchange rate, but it was considered so high that it made the front page of a number of newspapers. It was more than a senior civil servant made after decades on the job. At that time, a graduate from a good engineering college could be hired for less than 4,000 rupees per month (less than $1,500 per year).

Note that in India’s and China’s cases, the cost effectiveness of labor was only relevant because reforms had created conditions where the workforce could be deployed in the global supply chain. Moreover, the workforce was educated enough to absorb modern technology.

By 1990-91, China had a literacy rate of 78%. The literacy rate in India was still low at 52% because of inadequate focus on primary education, but investments in elite schools had created an educated but under-employed middle-class.

The difference in their initial labor endowments partly explains China’s subsequent success in mass manufacturing compared to India’s preference for exporting white-collar services.

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How was cheap labor key to turning Britain, Germany and the US into industrial powers?