Tuesday, June 10, 2008

Trade and inequality debates

It has long been argued that international trade is a Pareto improvement and benefits both partners. The Ricardian theory of comparative advantage states that the most efficient and mutually beneficial arrangement for each country is to produce those goods in which they have a comparative advantage and then trade in those with other countries. While it may indeed be true that trade benefits both partners in the long-run and as a whole, it may have adverse distributional effects within any country.

There is an intense debate raging on in the United States over the sharply widening inequality and the role of trade in promoting this. It has been argued that trade has intensified wage inequality in the US. One of the foremost trade theorists, Paul Krugman, suddenly changed track from his long-held position that trade has very limited influence on inequality, and now claims that trade may be a much larger influence on inequality in developed countries. He based this claim on two factors - the rise of China, and the growing fragmentation of production.

The steep rise in share of imports from China led developing world, 6% of GDP for US, where wages are only a fraction of the developed world, 3% of US wages in China, has put sharp downward pressure on American wages. This has been exacerbated by the proliferation of a new category of labour-intensive industries through the fragmentation of production process and outsourcing of services, facilitated and encouraged by globalization, advances in communications technology and the increasing trade between nations.

Paul Krugman also feels that, "it's hard to avoid the conclusion that growing U.S. trade with third world countries (that pay their workers low wages) reduces the real wages of many and perhaps most workers in this country".

He argues that unlike trade between high-income countries, which produces broadly shared gains in productivity and wages, "trade between countries at very different levels of economic development tends to create large classes of losers as well as winners". He writes, "Workers with less formal education either see their jobs shipped overseas or find their wages driven down by the ripple effect as other workers with similar qualifications crowd into their industries and look for employment to replace the jobs they lost to foreign competition. And lower prices at Wal-Mart aren’t sufficient compensation."

James Surowiecki waded into this debate by suggesting that the "benefits of free trade with China, at least when it comes to shopping, are concentrated overwhelmingly among average Americans". While conceding that job losses and wage declines have affected middle and low income Americans badly, he argued that the same category, as consumers, were the biggest beneficiaries of the cheap Chinese import of manufactured goods.

Given that these imports consist mainly of products commonly consumed by lower and middle-income Americans and make up a large share of their consumption budgets, trade with China benefits them disproportionately more than the richer consumers. He quotes a study by University of Chicago economists Christian Broda and John Romalis which indicates that between 1999 and 2005, the inflation rate for lower-income Americans was almost seven points lower than it was for the wealthiest Americans, due mainly to trade with China.

Mark Thoma however takes a different view and feels that given the stagnant wages, rise in inequality, loss of health care and retirement benefits, and decreased job security, low and middle-income Americans may not feel that the benefits of globalization has not been proportionately shared.

He writes, "We need to find a way to distribute the gains (and the pains) of globalization so they are shared more equally, to increase opportunity so that everyone has the chance to reach their full potential, and we need to reverse the declines in economic security, retirement benefits, and health care coverage that have occurred for middle and lower income households over recent decades."

Some others have cited the Stolper-Samuelson theorem to explain the rising wage inequality in the US and other developed countries. This theorem states that "a rise in the relative price of a good will lead to a rise in the return to that factor which is used most intensively in the production of the good, and conversely, to a fall in the return to the other factor". Alternatively, trade lowers the real wage of the scarce factor of production, while protection from trade raises it.

Therefore, an increase in the relative price of American exports to cheaper Asian imports, will lead to higher returns for capital (which is more intensively deployed in US exports) and lower returns for the other factor, labour. To quote Wikipedia, "Unskilled workers producing traded goods in a high-skill country will be worse off as international trade increases, because, relative to the world market in the good they produce, an unskilled first world production-line worker is a less abundant factor of production than capital."

It is therefore claimed that if the removal of barriers to trade causes the price of exported goods to increase (relative to imports), and if the exported goods use skilled labor intensively, then the price of skilled labor (the wage) will go up, and that of unskilled labor will go down.

But this may only be part of the story, since the other side of Stolper-Samuelson theorem reveals that in the Asian economies, the opposite effect dominates when export prices rise. Since their exports are more labour intensive, the returns to labour rises while the returns for capital falls.

The whole debate ultimately boils down to identifying which of the two effects - work migration and downward wage pressure on American workers, and cheaper produce for American consumers - pre-dominate. While Surowiecki argues in favor of the later, Mark Thoma and Krugman feels that the former pre-dominates.

As Tim Worstall points out, the importance of trade lies in the undeniable fact that while relative poverty is increasing in the rich countries, it is at the same time abolishing absolute poverty in the poor ones.

There are also convincing studies to indicate that changing economic environment and technology may play critical roles in determining wage inequality. Dani Rodrik calls attention to the work of Robert Feenstra and Gordon Hanson, who show that global "production sharing" has the same effect as skill-based technological change in shifting demand away from low-skilled activities, while raising the relative demand and wages of the higher skilled. Lawrence Katz and Claudia Godin have made out a brilliant case that the rising inequality in the US can be accounted for by rising educational wage differential.

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