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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.

8 comments to Freeing up international trade with poor countries & wage inequality

  • Blissex

    But the first and largest impact of trade is distributional: because even if two countries have roughly the same income level, but different comparative advantages, someone in both countries will be a loser and someone a winner as trade expands. In this trade is not much different from a new technology.

    In the current case, where 1st world countries do not compete among themselves, but with 3rd world countries, there is an additional issue: that the capital/labor ratio is much the same in 1st world countries and 3rd world countries.

    It is this and not low salaries in 3rd world countries (unlike what Krugman says) that creates so many losers in 1st world workforces.

    It is in a sense the scarcity of capital in 3rd world countries that causes a colossal outflow of capital from the 1st world and thus an increasing glut of low paid jobs.

    This has nothing to do with the skills of the workforce — if the R&D labs are moving to China and India it is not because they have higher skills, but *sufficient* ones and much cheaper capital.

    Sure, the USA and other 1st world countries also received immense inflows of capital, but it is short term financial capital seeking a safe heaven, certainly nobody is sending financial capital to the USA for it to be frittered into capital goods investments in the USA.

    Indeed some of that financial capital attracts reduces the cost of funds for USA companies investing in the 3rd world, which is enjoying an immense investment led boom, including inflation, sustained and high wage improvement.

    Beyond a fairly minimal level (let’s say high school) most additional education does not confer skills useful to business; most jobs are not graduate jobs.

    Even most high paying jobs don’t require much in the way of technical skills of the sort that can be taught in universities, but hustle, ruthlessness and connections. Thus the steady stream of Oxford and Cambridge graduates in history and other arts in the UK that go and have very very well paid careers in the City or management in other companies.

    The reasons why Australia imports skilled immigrants instead of unskilled ones (very differently from say Singapore) are that:

    * A whole generation of Australians do not have much in the way of even high school skills.

    * They make for good taxpayers, and because of the previous reasons Australia needs more taxpayers to fund welfare for native citizens.

    For 1st world countries the solution is to make the cost of real capital onshore cheaper than offshore, and this largely means a massive currency readjustment, which however has been prevented by open market intervention by foreign central banks…

    Currency readjustments are the other big missing detail in both your and Krugman’s story, not just the capital/labour relative scarcities.

  • conrad

    1) It seems to me that simply importing skilled migrants is not free, especially at the level we have now. It basically gives everybody an excuse not to fix up the current disaster which we have for a training system, which means Australians essentially become the trash of their own country. It also reduces the wages of professionals, which gives people even more of an incentive not to bother to get trained (there is a good article on this about why US citizens don’t become scientists anymore — part of the reason is that there is huge migration from people in these areas which reduces the wages of those in the areas. I will try and find it).
    THe other real problem with skilled migration is that it isn’t hard to imagine a time when it will either run out due to competition from other countries, or the only groups left are dislikeable enough (quite possibly unfairly so) to the people that live in the countries that they won’t be let in anyway.

    2) This “stealing technology” argument is a weird and hypocrytical argument (the founder of “Suntech” being an Australian example). If you set up a system which only runs well because of people from overseas (many of whom you charge to use it — how can this possibly be stealing?), and some of them happen to go home and make a success of themselves, I hardly see that as stealing technology (I might also point out that in some areas, like engineering, its almost impossible to get Australian born postgraduate students, thus there would be no system without them). Even if it was stealing, its not like countries like the US or Australia are exactly innocent in this respect — quite the opposite — both countries constantly take OS born professionals, often at great cost the countries of origin.

  • hc

    Blissex, The capital/labour ratio is lower in poor countriews and labour is cheaper making the capital that is there more valuable. BTW China cannot absorb the savings it is creating and is a capital exporter.

    Conrad, I think it is undeniable – if regrettable – that migrants and people in developing countries see education as more valuable than Australians do. You see it in private school enrowlments and in foreighn full-fee enrowlments in our universities. Australian kids and their parents have lower aspirations and generally want education on the cheap.

    I think the flow of migrants into research jobs occurred before residents felt a decline in rewards in these areas. I don’t believe expectationsd drove this development. In my area there are few Australiamns doing PhDs – most are foreign students.

    I agree the supply of skilled migrants is a constraint – every country wants them.

    Samuelson’s ‘stealing’ argument suggests that nothing is left for developed countries since the one advantage they have – knowledge – can leak through on-the-job training and education. It is stealing in the sense that the development costs of this knowledge are not paid.

  • conrad


    here is a summary of the initial article which sparked the debate. There were a fair few follow ons.

    I agree with Krugmann, in that its going to be a fun world once China and the like catch up on technology too — and from what I saw working there, that isn’t too long hence. The main area they still lack is decent postgraduate education, which is really hard since you need really good people, whom at present always work in the US.

  • conrad

    Sorry, the hyperlink got killed.

    You can try sticking that together. Sorry for the mess on the blog comments.

  • whyisitso

    I’ve noticed a trend these past ten or fifteen years of the demand that whatever economic reforms are allowed nobody should become economically worse-off – an amazing concept which if adhered to rigidly will stop all human progress in their tracks.

    Much of what has been discussed in this post relates to the USA that has conditions that we in Australia can’t pretend to get our heads around. For example the much larger problems with blacks that appear to be intractable. Also the uncontrolled import of illegal (and cheap labour) immigration workers from Mexico to California.

    What should be done about the disadvantages suffered by GM employees, whose past rent-seeking (and finding) has as much to with GM’s dramatic decline as foreign car imports. In Australia, what are we to do about the loss of income suffered by former Ansett employees, again whose rent-seeking and finding contributed (along with appalling management) to that collapse? Or the large drop in income of wharfies after the Patrick reforms of 1998? Do we increase taxes on capital and higher income earners to “compensate” these worthies as Harry demands? The whole idea horrifies me. Then of course I’m not an economist so what would I know?

  • Anonymous

    Krugman has no evidence that free trade promotes the type of inequality he talks about. Unless he can show the evidence he’s just selling snake oil.

  • Blissex

    «In the current case, where 1st world countries do not compete among themselves, but with 3rd world countries, there is an additional issue: that the capital/labor ratio is much the same in 1st world countries and 3rd world countries»

    OOPS here I meant (as clear from the subsequent paragraphs) that the capital/labour ratio is much the same in 1st world countries and in 3rd world countries, but different between 1st and 3rd world.

    That is the capital/labour ratio is much the same between the USA and Europe (lots of capital per worker), and between India and China (little capital per worker), so trade within the 1st world and within the 3rd world does not cause huge changes in the relative prices of capital and labour.

    So trade between USA and Europe has much smaller distributional impact then that between USA and China or Europe and India.

    Especially if there are free capital flows and relatively abundant 1st world capital can flood the capital scarce 3rd world countries.

    So we have that India and China are not (just) exporting plastic shoes and bamboo baskets, but massive software projects and network routers, thanks to colossal injections of capital from the USA and Europe that have built immense new factories.

    That is the big deal — the advanced sectors of China and India are large (not as large as the whole country), can get capital from abroad far more cheaply than they can raise themselves, and enjoy a vast cost advantage due to being embedded in a much larger and poorer context.

    Never mind that the theory of international trade also relies in currency adjustments, which haven’t happened so far that much thanks to various issues.

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