Department of Economic History Julius Probst

Spring term 2016 900515-6857

julius.probst@ekh.lu.se

Foundations of Economic History

PART 2: The industrialization process

Martin Andersson
Industrialization and the process of modern economic growth:

1. Introduction
Rapid economic growth as such is a rather recent phenomenon that only started with the
so-called Industrial Revolution. Indeed, any reasonable estimate shows that per capita
income was not significantly larger in 17th century Britain than in Ancient Rome, implying
that living standards were relatively stagnant for many decades or even centuries. This, of
course, is in very stark contrast with the phenomenon of exponential economic growth,
which Western economies have experienced since the onset of the Industrial Revolution
around 1800. Indeed, yearly British growth rates in per capita income averaged about 1
percent during the 19th and almost 2 percent per during the 20th century, a large multiple
from the abysmal average growth rates one could observe in earlier periods, such as the
Middle Ages (Maddison, 1991). Hence, the relatively recent period of rapid growth may
very well been seen as an anomaly within the whole period of economic history.
The following essay will address the question why rapid economic development started to
materialize during the Industrial Revolution as well as explain the driving forces of long-
term economic growth. Here I will make a distinction between ultimate and proximate
causes. I will also discuss the relative advantage of backwardness and how structural
change might be instigated, a question that should be of high priority for policy-makers
nowadays. Finally, I will address the relevance of these perspectives for economic
development on a subnational level.

2. The source of long-run economic growth

Schumpeter laid out his theory of economic growth in the early 1930s and his ideas remain
highly relevant for today. According to Schumpeter (1934), the protagonist in the process
of economic development is the entrepreneur. He is the instigator of economic growth
because he invents and develops new methods of production and/or new products. More
importantly, he also makes them economically viable, thus turning the invention into an
innovation. Schumpeter (1934) stresses that innovations, the application of a new idea to
an economic activity, are of first-order importance for the development process.
Entrepreneurial activity is instigated by the allure of potentially large profits that arise if
research and development is carried out successfully. In the long-run, of course, profits
that arise from an innovation are eventually competed away as new market participants
erode what was previously a monopoly position. Schumpeter (1934) stresses that it is the
carrying out of new innovative activities, technological progress in modern parlance, which
is the only source of long-run economic development. He also points out that
entrepreneurs tend to interact with each other and that many entrepreneurial activities
might be complementary. As such, one innovation can bring about secondary and even
higher-order rounds of new innovative activity. Because of such externalities, Schumpeter
(1934) asserts that innovations tend to appear in swarms and that it is this clustering of
innovative activities over time which is causing long-term wave-like movements in
economic growth, essentially creating the ups and downs of the business cycle.
Modern growth theorists mainly accept the Schumpeterian idea that technological
progress is the main source of long-run economic development albeit with a few caveats
(Gerschenkron, 1968). Indeed, there are several other types of economic growth that can
play an important role in the short-run. Those are related to the accumulation of one or
more factors of production, the exploitation of economies of scale and market size, and an
increasing division of labor. Economists usually distinguish between four different factors
of production: Physical capital, human capital, raw labor, and energy. An increase in any of
those factors can lead to short-term economic gains. One should note, however, that any
factor accumulation eventually faces rapidly diminishing returns.
Raw labor is restricted by population growth rates as well as the constraint on working
hours per laborer per year, energy is ultimately constrained by the access to natural
resources, and the accumulation of both physical and human capital eventually faces
increasingly high opportunity costs. Alternatively, an increase in the market size or an
increasing division of labor can lead to a more efficient allocation of resources within the
economy and might thus instigate short-term economic growth (Maddison, 1991). North
and Thomas (1973) assert that some of the income gains that Western Europe
occasionally enjoyed during the Middle Ages can be attributed to the expansion of markets
and a better division of labor. Ultimately, all these effects, however, can only be temporary
in nature. Just as factor accumulation faces diminishing returns, efficiency gains from
market expansion and increasing specialization will eventually be exhausted.
Technological progress, on the other hand, does not face the characteristic of diminishing
returns and it is thus the only source that can potentially contribute to long-term economic
development without running out of steam.
Maddisons (1991) analysis of 16 advanced economies over a period of almost 200 years
forcefully backs up this conclusion. In the spirit of modern growth accounting, changes in
GDP are explained by changes in various factor inputs, technological change, and some
other factors like the scale effect mentioned above. Maddison (1991) demonstrates that
factor accumulation did play a role in explaining economic growth. Its contribution,
however, varied widely by country and decade. Furthermore, especially in the leading
nation at the technological frontier, long-run changes in per capita income are almost fully
explained by productivity growth (changes in output per man-hour) over the last two
centuries. Maddison (1991) also objects to Schumpeters (1934) claim that economic
growth occurs in regular wave-like movements, which Schumpeter never backed up with
empirical data. Instead, technological progress occurs continuously and the economy
develops in line with the continuous stream of innovations that pushes out the
technological frontier. In contrast to the very early growth models like the one put forward
by Solow (1956), Maddison (1991) also asserts that the stream of innovations is not
constant over time. There have been various accelerations and decelerations in
productivity growth since the onset of the Industrial Revolution. The modern era is
characterized by several distinct phases of capitalist development since 1800, which differ
greatly in amplitude as well as variance of economic development as measured by per
capita income growth (Maddison, 1991).

3. The Industrial Revolution and its consequences

It is a rather undisputed fact among economic historians that economic growth rates
accelerated sharply with the onset of the Industrial Revolution. This phenomenon started
in Great Britain around the turn of the 18th century, but only tentatively spread to other
countries at first, as the diffusion of technological progress back then was still relatively
slow-paced. The beginning of the Industrial Revolution in continental Europe and North
America is thus usually dated up to a few decades after its initiation in Great Britain, the
leading nation at that time (Maddison, 1991).
Nevertheless, during the 19th century mankind witnessed for the first time in history a rapid
acceleration in economic growth that was global in nature. Consequently, Kuznets (1966)
names the era since the onset of the Industrial Revolution the era of modern economic
growth, as it clearly differs from earlier time periods in a number of important
characteristics. First, while living standards only improved very modestly in protocapitalist
economies, an acceleration to an average per capita income growth of 1.2 percent like the
UK experienced it in the phase from 1820 to 1870 implied that real incomes would more
than double every 60 years. Individuals thus saw for the first time considerable increases
in real incomes and living standards over their lifespan, as economic progress unfolded
before their eyes. Second, the unprecedented growth rates were necessarily accompanied
by enormous structural shifts in the economy as new products and goods were invented.
The Schumpeterian logic of creative destruction implies that structural shifts in the
economy are positively related to the growth rate of the economy and Kuznets (1966)
analysis seems to back up this hypothesis. As such, he finds a positive correlation
between per capita income and changes in the labor share of industries, an indicator of
structural change.
But the Industrial Revolution did not only affect the composition of output of different
industries within one sector. More importantly, it also affected the composition of output of
different sectors as a share of total national product. As such, the agricultural sector in
Great Britain was still about 30 percent of national product in 1800 and even higher in
other Western economies (Kuznets, 1966). However, the first stage of the era of modern
economic growth led to a rapid relative decline of the agricultural sector in favor of
industries. Interestingly enough, agricultural productivity outpaced the productivity of other
sectors for many decades, meaning that a large part of the labor force initially employed in
agricultural activities was freed up and reallocated to industries and, to a lesser extent,
also services (Kuznets, 1966). The birth of the modern factory system, the very rapid
reallocation of labor from agriculture towards industries, with a growing importance of
manufacturing in particular, and the growing share of industrial output in national product
are some of the key characteristics of the Industrial Revolution.
The emergence of unprecedented economic growth rates that came along with the
Industrial Revolution occurred because the diffusion of technology and, more importantly,
the pace of technological change accelerated to a level not seen before in the history of
mankind. It is especially the invention of some key technologies that would play a crucial
role in the subsequent development process of advanced economies. Kuznets (1966)
emphasizes, among others, the role of steel, railroads, communication technologies like
the telegraph, and the adoption of electricity. Steel was used in the construction of large
cargo ships, for example, providing the basis for a global boom in commodity trade among
advanced countries during the latter half of the 19th century (Maddison, 1991). The
construction of railroads greatly facilitated and accelerated the transport of goods and
people, leading to higher market integration both within as well as across national
boundaries. The adoption of electricity had even more profound implications for economic
growth, as this technology spread to every single sector of the economy and greatly
transformed everyday life. Kuznets (1966) points out that these technologies had a
particular big impact on the structure of the economy because of their network effects.
Modern growth economists now label these inventions General Purpose Technologies, a
technology that affects most if not all sectors of the economy, thus having macroeconomic
consequences that can be felt for years or even decades (Jovanovic and Rousseau,
2005).

4. Ultimate vs. proximate causes of economic development

It is clear that the sudden acceleration of technological change combined with the
invention of some key technologies is the proximate cause of the Industrial Revolution and
the sudden economic development that started in Great Britain and other advanced
economies in the early half of the 18th century. It is, however, much less straightforward to
pinpoint to the ultimate causes. More specifically, economic historians disagree on the set
of factors that have sparked the sudden technology boom. North and Thomas (1973) focus
on the development of modern institutions, such as the emergence of deposit banking,
joint stock companies, insurance markets, and the patent system, as the most important
contributors to modern economic growth by allowing markets to function more smoothly,
thus leading to a more efficient allocation of resources. While it is true that such institutions
were highly conducive to growth, Maddison (1991) points out that those already existed by
large in the Netherlands of the 17th century. Nevertheless, the Industrial Revolution did not
occur there, thus pointing to alternative explanations. Instead, Maddison (1991) highlights
three other factors that were crucial, two of them being specific to Great Britain and the
third one being of European nature. The period of enlightenment led to a fundamental
change in the belief system in European societies. Medieval superstitions and
metaphysical religious beliefs were replaced by a more scientific view of the world. Rising
education levels and the foundation of universities and academic societies led to the
diffusion of scientific knowledge within the overall population. An unguided trial and error
approach to problem-solving was increasingly cast aside and entrepreneurs started to
approach all sorts of economic problems in a more rigorous and scientific manner. Mokyr
(1990) emphasizes that it is the invention of the invention, the spread of the scientific
method within society, which can explain the rapid acceleration of technological change
during the Industrial Revolution.
While a general Scientific Revolution was widespread in Western Europe, two other
factors specific to Great Britain greatly contributed to the countrys spectacular ascent
during the first half of the 18th century. Maddison (1991) argues that mercantilist policies
played an important role. The Netherlands were the economic leader during the 17th
century precisely because the country established itself as the most important trading hub
for European merchandise coming from Asia and other parts of the world. The Dutch East
India Company had a monopoly position in the extremely important spice trade and
enjoyed significant profits for more than a century. However, the Netherlands status as
important trading nation eventually eroded over the course of the 18th century with the rise
of the British military navy and merchant fleet. Great Britain pursued extremely aggressive
mercantilist and expansionist policies and the Dutch monopoly on spice trade was broken
and replaced by the British East India Company. The British also monopolized a large part
of the increasingly important North Atlantic trade with the colonies in the New World.
Maddison (1991) argues that the benefits that Great Britain enjoyed from being the worlds
leading trading nation played an important role in the Industrial Revolution, as the country
strongly relied on its colonies as a source for a large variety of commodities.
The second great advantage that Great Britain enjoyed vis--vis other countries was the
close proximity of its coal fields to its urban centers combined with the fact that this
resource was more easily accessible than in many other parts of the world. Kuznets (1966)
emphasizes the special role that coal played in the industrialization process. Alternative
energy sources like timber or even peat, which was used primarily in the Netherlands,
were simply not energy-intensive enough to allow for production processes to occur on a
sufficiently large scale. The General Purpose Technologies of the 19th century, the
railroad, steel, and the invention of the modern manufacturing system, all hinged on the
fact that the country had access to an extremely energy-intensive and sufficiently cheap
energy source. Wrigley (2010) points out that Great Britain already had an absolute
advantage in coal mining during the 17th century. Indeed, it was the first country where the
heating of residential housing units shifted away from the use of timber to an increasing
reliance on coal. A century later, the coal industry would become the fundamental building
block of the British Industrial Revolution, as all major industries, ranging from
manufacturing to transportation, would be strongly dependent on it.
The early development of the coal industry within the country and its establishment as the
worlds dominant colonial power were two factors specific to Great Britain that can help us
understand the onset of the Industrial Revolution. Resource exploitation in its colonial
nations but also normal commercial trade with overseas provided a massive boost to
Great Britains national income, thus increasing the demand for new products and
technology. On the supply side, the development of modern industrial structures rested
heavily on the successful exploitation of coal, which was a necessary input for most of the
major innovations that would ultimately unlock the enormous growth potential of the
modern era (Wrigley, 2010). It is extremely likely that these two developments are among
the most important ultimate factors that were causing the Industrial Revolution, as they can
explain both the timing as well as the location, namely Great Britain at the turn of the 18th
century.

5. The advantage of backwardness

Growth economists have emphasized for decades that there is a certain inverse
relationship between the level of per capita income and economic growth rates.
Accordingly, Abramovitz (1986) points out that there is a certain advantage of
backwardness, namely that countries with low income levels have the potential for rapid
growth rates to catch up to the leader at the global technological frontier. An analysis of
advanced economies does indeed reveal convergence in the very long-run, meaning a
period of up to several decades. In the short to medium-run, however, country specific
shocks can lead to a widening divergence instead. Furthermore, Abramovitz (1986) also
anticipates the critique of DeLong (1988) who argues that convergence is all but
guaranteed if one focuses exclusively on a set of advanced nations that have roughly
similar income levels nowadays. Expanding the sample size by including developing
countries would lead to strikingly different results as many of those nations have failed to
escape the low-income trap. Abramovitz (1986) thus argues that convergence is
conditional on a number of factors.
The advantage of backwardness obviously arises because backward countries have the
possibility to leapfrog an entire set of intermediate technologies and instead adopt the
best-practice technology immediately. One should note, however, that technological
backwardness is usually not a mere coincidence. The institutional context is of first-order
importance. Countries that have failed so far to participate in the catch-up process might
simply not possess various social capabilities that would allow them to produce the
technological leap necessary to close down the gap to the leading nation (Abramovitz,
1986). The capability to absorb new technologies is highly dependent on a set of
institutional factors as well as technical competence. The quality and effectiveness of the
government, the quality of infrastructure, the level of education, the development of
financial markets and many other factors will interact with each other and determine to
what extent a backward country can unlock and exploit its potential for catch-up growth
(Abramovitz, 1986).
While Kuznets (1966) and Abramovitz (1986) both stress the importance of potential
catch-up growth and the inverse relationship between per capita income and growth rates
that arises, they mostly emphasize that the process of economic growth displays many
similarities among different countries. Especially Kuznets (1966) analysis of advanced
economies reveals that both the rate at which economic growth proceeds as well as the
structure of economic development displays a large set of common characteristics. This,
however, might simply be an inherent feature of the particular sample of high-income
countries he restricts his attention to.
Gerschenkron (1962), on the other hand, points out that the industrialization process within
Europe actually did play out very differently from country to country and that European
nations actually took several distinctive paths to economic development. The common
feature of industrialization is that it must commence on a large-scale because of
complementarities between different industries. Especially the financing of the
development process, however, was to some extent country-specific and thus differed on
a case by case basis. More specifically, the degree of backwardness would also determine
the structure of the subsequent industrialization process, an argument that is in stark
contrast with Kuznets (1966) claim that modern economic development proceeded more
or less in similar ways across nations. Gerschenkron (1962) puts a particular emphasis on
the investment side of economic development. There is no doubt that the process of
industrialization requires nationwide large-scale investment projects, mainly in
infrastructure and modern industries. Thus the question arises how the investment
activities are to be financed. It turns out that European nations took very different routes
when it comes to the source of funds and how savings were channeled into investments.
Gerschenkron (1962) argues that the initial degree of backwardness at the onset of the
industrialization process has played a crucial role in the shaping of the subsequent
economic development by determining the source of funds required for investment
activities. The British banking system was fully developed before the Industrial Revolution.
It was a classic system of deposit banking where banks simply engage in maturity
transformation, transforming short-term deposits into long-term credits. The banking
systems main purpose is that of the classic financial intermediary, which usually does not
have any skin in the game in specific industries or companies.
This is in stark contrast to the financial system that developed in countries like France,
Germany, and Austria. Continental Europe saw the emergence of large development
banks during the 19th century. These type of financial institutions were created as
promoters of industrial development. As such, they commonly ended up being extremely
large stakeholders in companies, conglomerates or even entire industries (Gerschenkron,
1962). The financial sector in Germany and Austria, for example, developed very close ties
with the industrial sector. A large consolidation movement in both banking and industries in
the late 19th century led to a situation where banks ended up owning competing
companies, so that they pushed for further cartelization. Gerschenkron (1962) argues that
these large-scale companies and conglomerates thusly created actually gave Germany an
advantage over Britain as industrialization proceeded. Large German companies in the
steel-making and chemical industry had an edge over British competitors, which were
smaller in scale. Size certainly matters in capital- and research-intensive industries
because of economies of scale. Potentially cheaper funding, a result of size and the
interconnectedness with the financial industry, might also have played a role. The
emergence of development banks and large industrial conglomerates was mainly specific
to Austria and Germany. It represented a very different type of economic development
from the British experience and proved to be advantageous in the later stage of the
industrialization process at the turn of the 19th century. As such, German banks were
especially involved in heavy industries where the country would become a front-runner
during the so-called second Industrial Revolution (Gerschenkron, 1962).
Industrialization in Eastern Europe yet took on another shape. It is worth remembering that
the Industrial Revolution started in Great Britain around 1800 and spread to the continent a
couple of decades later. Economic development in Eastern Europe, however, lagged
behind for almost a century where the industrialization process only took hold at the very
end of the 19th century. The Eastern part of the Austrian-Hungarian Empire was still
severely underdeveloped at that time. Incomes compared to other advanced economies
were extremely low and the largest part of the population was still employed in the
agricultural sector. The same can be said for Russia where a major part of the peasants
still lived in a system of serfdom until the middle of the 19th century (Gerschenkron, 1962).
While industrialization in Bohemia and Austria itself was successfully promoted via
development banks, the Eastern part of this empire had to take a very different route to
economic development. The main problem was simply the severity of economic
backwardness in Eastern Europe. A widespread functional banking system was never
developed. Moreover, high levels of corruption, fraudulent bankruptcies, bad business
practices in general, and a severe deficiency in infrastructure made private long-term
investment quite infeasible. Private investors would have to bear extreme levels of risk
were they to engage in any form of private enterprise where capital is locked up for longer
periods of time (Gerschenkron, 1962). The scarcity of private capital meant that the state
had to assume the pivotal role in economic development. The first push towards
industrialization in Russia came through the construction of an extensive network or
railroads. In a subsequent step, the state mobilized capital and pushed for investments in
heavy industries. It is thus the budget policies by the state that was the binding constraint
in Russia whereas in Western European nations credit creation by the banking system
played a more fundamental role.
While Gerschenkrons (1962) analysis is more qualitative in nature, it is not without merit.
As Kuznets (1966) restricts himself to a select sample of Western societies with a
particular focus on the 20th century, he finds a number of similarities and common trends in
the economic development of those nations. Gerschenkrons (1962) detailed historical
account of the development process during the 19th century, on the other hand, reveals a
number of important dissimilarities on a case-by-case basis. As mentioned above, different
nations have pursued very distinct development strategies and, more importantly, the
degree of backwardness played an important role in how the industrialization process was
pursued. Extremely underdeveloped nations like Russia followed a strategy of big push
where the state became the most important instigator of industrialization simply out of
necessity, especially due to severely underdeveloped capital markets. This development
strategy forced from above by the state might still be relevant for today, as many low-
income countries face problems very similar to those of economically backward Eastern
Europe around 1900.

6. Implications for economic growth on a sub-national level

It has always been clear that national boundaries represent an invisible barrier to the
movement of labor and capital as well as to the flow of goods and services. Historically,
many governments have adopted policies that restrict the movement of factors of
production, labor in particular, across national borders. The existence of capital controls
and tariffs impede international trade and foreign direct investment. Consequently,
economic integration within the borders of a given country is much higher, as most of the
restrictions mentioned above do not apply. Kuznets (1966) emphasizes the particular
importance of internal migration for modern economic development. The agricultural sector
increasingly declined in importance and its share of national product decreased, on
average, from over 50 percent in 1800 to barely 10 percent in 1950 in his sample of
advanced economies, with relatively large variations on a country by country case. As
already mentioned, agriculture also experienced the highest growth rates in productivity,
meaning that the sector freed up a large amount of labor. The reallocation of labor from
agriculture into services and industries was accompanied by an unprecedented level of
internal migration from rural areas to the cities. According to Kuznets (1966), rapid
urbanization was both a cause of modern economic growth as well as a consequence
thereof since a large pool of labor represented a necessary input for industrial
development. Even though modern economic growth was characterized by the rapid
invention of many successive labor-saving techniques, industrial development and the
emergence of large-scale production led to the employment of millions of workers in the
manufacturing sector and heavy industries. However, rapid productivity growth in the
agricultural sector was a necessity, as it allowed the reallocation of agricultural labor into
modern sectors of the economy to occur in the first place. Large internal migration and the
rapid urbanization that followed as a logical consequence of industrialization led to a
complete restructuring of the entire economic system. Home production became less and
less common. The massive expansion of urban areas meant that transportation systems
and infrastructure became more important since workers increasingly faced longer
commutes. Moreover, a growing amount of produce had to be imported from the
countryside to the expanding cities. The development of infrastructure, transportation
networks and logistics thus became crucial as the production of goods and services
became spatially more concentrated (Kuznets, 1966).
A higher level of economic integration on a regional level was thus a central aspect of
modern economic development, as it brought along a large range of efficiency gains and
benefits that were associated with the scale economies of modern industrial production.
Increased internal migration led to a better allocation of resources. Thicker labor markets
are just one of the many positive externalities that arise with increasing urbanization and
more concentrated economic activity.
The gains from more integrated markets are thus potentially large, but can only be
exploited on a subnational level most of the time because national boundaries still
represent formidable obstacles. However, it seems to be clear that countries can
somewhat overcome this barrier by the creation of regional customs unions or potentially
even the formation of a single market similar to the European Union. This avenue should
be pursued vehemently by developing countries so that they can exploit the various
benefits from higher economic integration mentioned above also on a supranational level.

7. Conclusion
The Industrial Revolution was a time of very dramatic change. Individuals in industrializing
countries saw for the first time in human history substantial increases in real wages and
living standards during their life span. The most important feature of modern economic
development was the rapid pace of technological progress that suddenly allowed for
continuous and substantial progress. Kuznets (1966) emphasizes that the rate and
structure of modern economic development show many similarities in a set of advanced
economies during the 20th century. These countries are thus assumed to have followed the
same road to prosperity. While this might be true, it is to large extent driven by sample
selection. Gerschenkron (1962) points out that there have been several distinct paths to
industrialization. Furthermore, the degree of economic backwardness as well as the
institutional context matters a lot. The quality of infrastructure and education, the
development of financial markets, political constraints, and many other factors interact with
each other and determine to what extent any given industrialization policy can be
successful. The very different historical experiences of Great Britain, Germany and Russia
reveal that there is no one-size-fits-all policy to economic development. Governments of
advanced economies and, more importantly, international institutions like the IMF and the
World Bank should keep that in mind when formulating policy prescriptions to low-income
nations today.
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