Freeing up international trade with poor countries & wage inequality

Paul Krugman in today’s NYT summarises a widely-held assessment of the impact of trade with low wage countries on US growth and inequality. There is nothing radical about his claim - free trade with poor countries increases growth but increases wage inequality by driving down unskilled wages.

The same general message applies to effects on Australian labour markets of promoting freer trade here with poor countries.

The US now imports more manufactured goods from poor than from other advanced economies so most industrial trade is with countries that pay their workers much lower wages. This reduces the real wages of many and he claims ‘perhaps most' workers in the US. Krugman's claim: Trade between countries at very different levels of economic development tends to create large classes of losers as well as winners.

Workers with less formal education either see their jobs shipped overseas or find their wages driven down 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 of goods that these unskilled workers purchase are not, in themselves, sufficient compensation.

Textbook economics says that free trade normally makes a country richer – growth prospects are in aggregate improved - but it doesn’t say that it’s normally good for everyone. Still, when the effects of third-world exports on U.S. wages first became an issue in the 1990s, a number of economists looked at the data and concluded that any negative effects on US wages were modest. These effects may no longer be as modest as they were, because imports of manufactured goods from the third world have grown dramatically — from 2.5% of G.D.P. in 1990 to 6% in 2006.

And the biggest growth in imports has come from countries with very low wages. The original “newly industrializing economies” exporting manufactured goods — South Korea, Taiwan, Hong Kong and Singapore — paid wages that were 25% of US levels in 1990. Since then, the sources of imports have shifted to Mexico, where wages are only 11% of the U.S. level, and China, where they’re only 3-4%.

There are some qualifications. Many made-in-China goods contain components made in Japan and other high-wage economies. Still, there’s little doubt that the pressure of globalization on American wages has increased.

Krugman sums up:

‘So am I arguing for protectionism? No. Those who think that globalization is always and everywhere a bad thing are wrong. On the contrary, keeping world markets relatively open is crucial to the hopes of billions of people.

But I am arguing for an end to the finger-wagging, the accusation either of not understanding economics or of kowtowing to special interests that tends to be the editorial response to politicians who express scepticism about the benefits of free-trade agreements.

It’s often claimed that limits on trade benefit only a small number of Americans, while hurting the vast majority. That’s still true of things like the import quota on sugar. But when it comes to manufactured goods, it’s at least arguable that the reverse is true. The highly educated workers who clearly benefit from growing trade with third-world economies are a minority, greatly outnumbered by those who probably lose.

As I said, I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect’. (my bold)

Greg Mankiw points out that Krugman’s argument is totally a priori and begs for empirical evidence – the bolded passages need to be demonstrated though Krugman’s overall claims seems intuitive. To this point empirical evidence supports the direction of the effects suggested by Krugman but not their extent. Moreover, Krugman’s claim is supported by evidence of low US wage growth. But this evidence is also consistent with the high immigration policies of low-skilled labour that the US has pursued. Some econometrics is called for here to back up the claims. (My own preference for Australia is to do as it did under the Howard Government and emphasise high-skilled migration which does not harm the less skilled but creates better job opportunities for these low-paid workers).

It is also clear that theory predicts that returns to inputs other than unskilled labour (namely skilled labour and capital) must be increased more than the losses to unskilled labour. Thus incomes overall do rise with freer trade it is just that low income earners lose out. Overall the US economy must enjoy uncompensated gains from improved opportunities to trade with countries such as China provided that China pays for all of its inputs*.

There are two types of policies I believe can ensure free trade benefits all:

1. One policy approach is to effect transfers which bring about the requisite compensations. Taxes on capital and on high income skilled labour need to be increased not cut, if all sections of the community are to benefit from freer trade with the developed world. It is a lesson Australia needs to remember. This is a variant of Krugman's policy to 'strengthen the social safety net'.

2.. Another approach is to try to provide an increasingly skilled workforce. This is a more positive policy which recognises that having people doing unskilled, unpleasant work in poorer countries creates opportunities for people in wealthier countries to do more skilled, creative work and to enjoy their lives even more. This can only occur however if private individuals are motivated to invest more in their own skills and human capital. On the demand side this does not seem to be the pattern at present – kids in Asia (and Asian migrants to developed countries) seem to have a much higher motivation to acquire skills than residents. On the supply side Australians seem to want a cheap education system heavily dependent on full-fee income Asian students and that is what they are getting. This needs to change.

Adopting these sorts of policies will enable countries to fully enjoy the benefits of free trade while limiting the distributional damages. Not addressing distributional concerns will ultimatetely undermine the case for free trade.

*Paul Samuelson in the link points out that if China 'steals' technology by importing educational services at less than the value of such services that the US can be immiserised by trade – its per capita income can fall. But even in this case Samuelson still supports free trade on the grounds that the losses from restricting trade will be more than the losses from the theft-induced immiserisation.