Trade and Wages, Reconsidered

Here I mentioned the papers for the Brookings Papers on Economic Activity: Spring 2008 Conference including the paper "Trade and Wages, Reconsidered" by Paul Krugman. (A draft version is available.) Now The Economist magazine has commented on the Krugman paper. Krugman's conundrum they call it.

The Economist explains that Krugman thinks "It's no longer safe to assert that trade's impact on the income distribution in wealthy countries is fairly minor. There's a good case that it is big and getting bigger." Krugman offers two reasons why this could be so. First, more of America's trade is with poor countries, such as China. Second, the growing fragmentation of production means more tasks have become tradable, increasing the universe of labour-intensive jobs in which Chinese workers compete with Americans. His Brooking's paper set out to substantiate these assertions. But as the Economist points out "That proved hard." The Economist writes

Certainly, America's trade patterns have changed. Poor countries' share of commerce in manufactured goods has doubled. In contrast to the 1980s, the average wage of America's top-ten trading partners has fallen since 1990. All of which, you might think, would increase the impact of trade on wage inequality.

But by how much? If you simply update the approach used in Mr Krugman's 1995 paper to take into account today's trade patterns, you find that the effect on wages has increased. Josh Bivens, of the Economic Policy Institute, a Washington, DC, think-tank, did just that and found that trade widened wage inequality between skilled and unskilled workers by 6.9% in 2006 and 4.8% in 1995. But even with that increase, trade is still far from being the main cause of wage inequality. Lawrence Katz, a Harvard economist who discussed Mr Krugman's paper at Brookings, estimates that, using Mr Bivens's approach, trade with poor countries can account for about 15% of the growth in the wage gap between skilled and unskilled workers since 1979.

Even this is almost certainly an overstatement. Many imports from China have moved up-market from easy-to-produce products, such as footwear, to more sophisticated goods, such as computers and electronics. As a result, to use economists' jargon, the “factor content” of American imports—in effect, the amount of skilled labour they contain—has not shifted downwards. Mr Katz says factor-based models suggest trade with poor countries explains only 5% of rising income inequality.

Mr Krugman argues that the effect is bigger, but that import statistics are too coarse to capture it. Thanks to the fragmentation of production, Chinese workers are doing the low-skill parts of producing computers. Just because computers from China are classified as skill-intensive in America's imports does not prevent them from hurting less-skilled American workers. Mr Krugman may be right but, as he admits, it is hard to prove.

The Economist notes that Harvard economist Robert Lawrence argues that

... the contours of American inequality sit ill with the idea that trade with poor countries is to blame. Once you measure income properly, the gap between white- and blue-collar workers has not risen that much since the late 1990s when China's global integration accelerated. The wages of the least skilled have improved relative to those in the middle. Some types of inequality have increased, notably the share of income going to the very richest. But there is little sign that wage inequality has behaved as traditional trade theory might suggest.

Two reasons can be offered as to why,

One possibility is that America no longer makes some of the low-skilled, labour-intensive goods that it imports. In those goods there are no domestic workers to lose out to foreign competition. Second, even when America does produce something that is imported from China, it may make it in a different way, with more machinery and only a few high-skilled workers. If imports from China and other poor countries compete with more-skilled American workers, they may displace workers but will not widen wage inequality.

The Economist end their article by saying that while it is possible that globalisation is becoming a bigger cause of wage inequality in the US, given the lack of fine-grained statistics none of the studies available settles the debate. The evidence is just too inconclusive.

(HT: Greg Mankiw)