Paul Krugman: Trade and Wages, Reconsidered
Paul Krugman posted a link to a very preliminary draft of a paper he is writing on the relationship between trade and wages. Here is the introduction and concluding paragraph:
Trade and Wages, Reconsidered, by Paul Krugman, February 2008: This is a very preliminary draft for the spring meeting of the Brookings Panel on Economic Activity. Comments welcome.
There has been a great transformation in the nature of world trade over the past three decades. Prior to the late 70s developing countries overwhelmingly exported primary products rather than manufactured goods; one relic of that era is that we still sometimes refer to wealthy nations as "industrial countries," when the fact is that industry currently accounts for almost twice as high a share of GDP in China as it does in the United States. Since then, however, developing countries have increasingly become major exporters of manufactured goods, and latterly selected services as well.
From the beginning of this transformation it was apparent to international economists that the new pattern of trade might pose problems for low-wage workers in wealthy nations. Standard textbook analysis tells us that to the extent that trade is driven by international differences in factor abundance, the classic analysis of Stolper and Samuelson (1941) – which says that trade can have very strong effects on income distribution – should apply. In particular, if trade with labor-abundant countries leads to a reduction in the relative price of labor-intensive goods, this should, other things equal, reduce the real wages of less-educated workers, both relative to other workers and in absolute terms. And in the 1980s, as the United States began to experience a marked rise in inequality, including a large rise in skill differentials, it was natural to think that growing imports of labor-intensive goods from low-wage countries might be a major culprit.
But is the effect of trade on wages quantitatively important? A number of studies conducted during the 1990s concluded that the effects of North-South trade on inequality were modest. Table 1 summarizes several well-known estimates, together with one crucial aspect of each: the date of the latest data incorporated in the estimate.
For a variety of reasons, possibly including the reduction in concerns about wages during the economic boom of the later 1990s, the focus of discussion in international economics then shifted away from the distributional effects of trade in manufactured goods with developing countries. When concerns about trade began to make headlines again, they tended to focus on the new and novel – in particular, the phenomenon of services outsourcing, which Alan Blinder (2006), in a much-quoted popular article, went so far as to call a second Industrial Revolution. Until recently, however, surprisingly little attention was given to the increasingly out-of-date nature of the data behind the reassuring consensus that trade has only modest effects on income distribution. Yet the problem is obvious, and was in fact noted by Ben Bernanke (2007) last year: "Unfortunately, much of the available empirical research on the influence of trade on earnings inequality dates from the 1980s and 1990s and thus does not address later developments." And there have been a lot of later developments.
Figure 1 shows U.S. imports of manufactured goods as a percentage of GDP since 1989, divided between imports from developing countries and imports from advanced countries.[1] It turns out that developing-country imports have roughly doubled as a share of the economy since the studies that concluded that the effect of trade on income inequality was modest. This seems, at first glance, to suggest that we should scale up our estimates accordingly. Bivens (2007) has done just that with the simple model I offered in 1995, concluding that the distributional effects of trade are now much larger.
And there's another aspect to the change in trade: as we'll see, the developing countries that account for most of the expansion in trade since the early 1990s are substantially lower-wage, relative to advanced countries, than the developing countries that were the main focus of concern in the original literature. China, in particular, is estimated by the Bureau of Labor Statistics (2006) to have hourly compensation in manufacturing that is equal to only 3 percent of the U.S. level. Again, this shift to lower-wage sources of imports seems to suggest that the distributional effects of trade may well be considerably larger now than they were in the early 1990s.
But should we jump to the conclusion that the effects of trade on distribution weren't serious then, but that they are now? It turns out that there's a problem: although the "macro" picture suggests that the distributional effects of trade should have gotten substantially larger, detailed calculations of the factor content of trade – which played a key role in some earlier analyses – do not seem to support the conclusion that the effects of trade on income distribution have grown larger. This result, in turn, rests on what appears, in the data, to be a marked increase in the sophistication of the goods the United States imports from developing countries – in particular, a sharp increase in imports of computers and electronic products compared with traditional labor-intensive goods such as apparel.
Lawrence (2008), in a study that shares the same motivation as this paper, essentially concludes from the evidence on factor content and apparent rising sophistication that the rapid growth of imports from developing countries has not, in fact, been a source of rising inequality. But this conclusion is, in my view, too quick to dismiss what seems like an important paradox. On one side, the United States and other advanced countries have seen a surge in imports from countries that are substantially poorer and more labor-abundant than the third-world exporters that created so much anxiety a dozen years ago. On the other side, we seem to be importing goods that are more skill-intensive and less labor-intensive than before. As we'll see, the most important source of this paradox lies in the information technology sector: for the most part there is a clear tendency for developing countries to export labor-intensive products, but large third-world exports of computers and electronics stand out as a clear anomaly.
One possible resolution of this seeming paradox is that the data on which factor-content estimates are based suffer from severe aggregation problems – that developing countries are specializing in labor-intensive niches within otherwise skill-intensive sectors, especially in computers and electronics. I'll make that case later in the paper, while admitting that the evidence is fragmentary. If this is the correct interpretation, however, the effect of rapid trade growth on wage inequality may indeed have been significant.
The remainder of this paper is in four parts. The first part offers an overview of changing U.S. trade with developing countries, in a way that sets the stage for the later puzzle. The second part describes the theoretical basis for analyzing the distributional effects of trade, then shows how macro-level calculations and factor content analysis yield divergent conclusions. The third part turns to the case for aggregation problems and the implications of vertical specialization within industries. A final part considers the implications both for further research and for policy. ...
Implications of the analysis
The starting point of this paper was the observation that the consensus that trade has only modest effects on inequality rests on relatively old data – that there has been a dramatic increase in manufactured imports from developing countries since the early 1990s. And it is probably true that this increase has been a force for greater inequality in the United States and other advanced countries.
What really comes through from the analysis here, however, is the extent to which the changing nature of world trade has outpaced our ability to engage in secure quantitative analysis—even though this paper sets to one side the growth in service outsourcing, which has created so much anxiety in recent years. Plain old trade in physical goods has become remarkably exotic.
In particular, the surge in developing-country exports of manufactures involves a peculiar concentration on apparently sophisticated products, which seems at first to put worries about distributional effects to rest. Yet there is good reason to believe that the apparent sophistication of developing country exports is, in reality, largely a statistical illusion, created by the phenomenon of vertical specialization in a world of low trade costs.
How can we quantify the actual effect of rising trade on wages? The answer, given the current state of the data, is that we can't. As I've said, it's likely that the rapid growth of trade since the early 1990s has had significant distributional effects. To put numbers to these effects, however, we need a much better understanding of the increasingly fine-grained nature of international specialization and trade.
Hillary Clinton and NAFTA
Did Hillary Clinton oppose moving forward on NAFTA in 1993? Robert Reich tells what he remembers:
Hillary and Barack, Afta Nafta, by Robert Reich: Was Hillary Clinton really against NAFTA in 1993? I was in the administration then, and I remember her position quite precisely. And I'll get to that in a moment. But before I do, I want to say something: It's a shame the Democratic candidates for president feel they have to make trade – specifically NAFTA – the enemy of blue-collar workers and the putative cause of their difficulties. NAFTA is not to blame. ... What happened? The economy ... crashed in late 2000, and the manufacturing jobs lost in that last recession never came back. They didn't come back for two reasons: In some cases, employers automated the jobs out of existence... In other cases, employers shipped the jobs abroad, mostly to China – not to Mexico.
NAFTA has become a symbol for the mounting insecurities felt by blue-collar Americans. While the ... winners from trade ... far exceed the losers, there's a big problem: The costs fall disproportionately on the losers -- mostly blue-collar workers who get dumped because their jobs can be done more cheaply by someone abroad...
Even though the winners from free trade could theoretically compensate the losers and still come out ahead, they don't. America doesn't have a system for helping job losers find new jobs that pay about the same as the ones they've lost... There's no national retraining system. Unemployment insurance reaches fewer than 40 percent of people who lose their jobs... We have no national health care system to cover job losers and their families. There's no wage insurance. Nothing. And unless or until America finds a way to help the losers, the backlash against trade is only going to grow.
Get me? The Dems shouldn't be redebating NAFTA. They should be debating how to help Americans adapt to a new economy in which no job is safe. Okay, so back to my initial question. The answer is HRC didn't want the Administration to move forward with NAFTA, but not because she was opposed to NAFTA as a policy. She opposed NAFTA because of its timing. She wanted her health-care plan to be voted on first. She feared that the fight over NAFTA would use up so much of the White House's political capital that there wouldn't be enough left when it came to pushing for health care. In retrospect, she was probably right.
Mortgaging the Nest Egg
This is not a good sign. A lot of people are borrowing from their retirement accounts to pay off debt:
Borrowing from the Nest Egg, by Lane Kenworthy: This news is discouraging, but hardly unexpected. According to a "Marketplace" report, a survey by the Transamerica Center for Retirement Studies (pdf here) finds that the share of workers borrowing from their 401(k) retirement funds increased from 11% in 2006 to 18% in 2007. Nearly half of those taking out such loans in 2007 cited the need to pay off debt, compared to a quarter in 2006.
Stagnant wages and salaries, most spouses already employed, rising health care and college tuition costs, higher mortgage debt loads, and falling home values mean lots of American households — including many middle-income ones — are pinched financially. The late 1990s economic boom lessened the strain for a while. Then home equity loans helped. More recently, credit card usage has jumped. Borrowing against retirement savings is the logical next step.
This is why I wonder about the long-term participation rate in "opt out" retirement accounts that are being promoted as a way to deal with the retirement security problem. How many people will opt out of these accounts when economic conditions for the household deteriorate temporarily for some reason? And once they opt out, will they opt back in? People who are motivated enough to borrow against their retirement accounts - almost one fifth in 2007 - would also be motivated enough to opt out of an automatic savings plan. Many of the studies, at least the ones I have seen, do not track people over long periods of time where this type of deterioration would be present, and they do not follow people through a recession when the pressure to opt out would be greatest. I'm not saying we shouldn't have these programs, they do help some people save, and even if some people opt out at least they have a source of funds to use when times get tough. The point, though, is that the people most likely to opt out are the very ones we would like to see participate in savings programs so that they have more than just Social Security available during their retirement years. Because of that, we should be careful not to place too much emphasis on opt-out types of mechanisms for solving the retirement security problem. These accounts may not provide as much of a boost as we hope to key segments of the population.
Update: Megan McArdle follows up with comments on forced saving as a solution to this problem.
Why Bubbles Occur
In 1998, Paul Krugman explained why housing and stock bubbles occur. The answer? "Me want mammoth meat!":
The Ice Age Commeth, by Paul Krugman: The more I look at the amazing rise of the U.S. stock market, the more I become convinced that we are looking at a mammoth psychological problem. I don't mean mammoth as in "huge" (though maybe that too), but as in "elephant". Let me explain.
If you follow trends in psychology, you know that Freud is out and Darwin is in. The basic idea of "evolutionary psych" is that our brains are exquisitely designed to help us cope with our environment - but unfortunately, the environment they are designed for is the one we evolved and lived in for the past two million years, not the alleged civilization we created just a couple of centuries ago. We are, all of us, hunter-gatherers lost in the big city. And therein, say the theorists, lie the roots of many of our bad habits. Our craving for sweets evolved in a world without ice-cream; our interest in gossip evolved in a world without tabloids; our emotional response to music evolved in a world without Celine Dion. And we have investment instincts designed for hunting mammoths, not capital gains.
Imagine the situation back in what ev-psych types call the Ancestral Adaptive Environment. Suppose that two tribes - the Clan of the Cave Bear and its neighbor, the Clan of the Cave Bull - live in close proximity, but traditionally follow different hunting strategies. The Cave Bears tend to hunt rabbits - a safe strategy, since you can pretty sure of finding a rabbit every day, but one with a limited upside, since a rabbit is only a rabbit. The Cave Bulls, on the other hand, go after mammoths - risky, since you never know when or if you'll find one, but potentially very rewarding, since mammoths are, well, mammoth.
Now suppose that it turns out that for the past year or two the Cave Bulls have been doing very well - making a killing practically every week. After this has gone on for a while, the natural instinct of the Cave Bears is to feel jealous, and to try to share in the good fortune by starting to act like Cave Bulls themselves. The reason this is a natural instinct, of course, is that in the ancestral environment it was entirely appropriate. The kinds of events that would produce a good run of mammoths - favorable weather producing a good crop of grass, migration patterns bringing large numbers of beasts into the district - tended to be persistent, so it was a good idea to emulate whatever strategy had worked in the recent past.
But now transplant our tribes into the world of modern finance, and - at least according to finance theory - those instincts aren't appropriate at all. Efficient markets theory tells us that all the available information about a company is supposed to be already built into its current price, so that any future movement is inherently unpredictable - a random walk. In particular, the fact that people have made big capital gains in the past gives you absolutely no reason to think they will in the future. Rational investors, according to the theory, should treat bygones as bygones: if last year your neighbor made a lot of money in stocks while you unfortunately stayed in cash, that's no reason to get into stocks now. But suppose that, for whatever reason, the market goes up month after month; your MBA-honed intellect may say "Gosh, those P/Es look pretty unreasonable", but your prehistoric programming is shrieking "Me want mammoth meat!" - and those instincts are hard to deny.
And those instincts can be self-reinforcing, at least for a while. After all, whereas an increase in the number of people acting like Cave Bulls tended to mean fewer mammoths per hunter, an increase in the number of modern bulls tends to produce even bigger capital gains - as long as the run lasts. Any broker can tell you that in the last few months the market has been rising, despite mediocre earnings news, because of fresh purchases by ever more people distraught about having missed out on previous gains and desperate to get in on the action. Sooner or later the supply of such people will run out; then what?
OK, OK, I know that this isn't supposed to happen. Sophisticated investors are supposed to take the long view, and arbitrage away these boom-bust cycles. And maybe, just maybe, the market is where it is because wise and far-seeing people have understood that the New Economy can produce growing profits forever, and that the rise of mutual funds has eliminated the need for old-fashioned risk premia. But my sense is that people who try to take a long view have been driven to the edge of extinction by the sheer scale of recent gains, and that the supposed explanations you now hear of why current prices make sense are rationalizations rather than serious theories.
The whole situation gives me the chills. It could be that I just don't get it, that I'm a Neanderthal too thick-skulled to understand the new era. But if you ask me, I'd say that there's an Ice Age just over the horizon.
Free to Choose: A Debate between Milton Friedman, Jamie Galbraith, and David Brooks
Jamie Galbraith debates Milton Friedman and David Brooks. Arnold Schwarzenegger also makes an appearance at the beginning. The debate begins about halfway through the video (from 1990):
Multilateralising Regionalism: The WTO's Next Challenge
Richard Baldwin says it's time for the WTO to "adjust to the new realities of regionalism" (more on regionalsim):
Multilateralising regionalism: The WTO's next challenge, by Richard Baldwin, Vox EU: The world's most important trade talks – the Doha Round – appear to be slipping into a coma while key nations play a waiting game. What are they waiting for? Some are waiting to see if Europe commits to unilaterally dismantling the EU's massively distortionary agricultural policies during its 2008/2009 review. Others are waiting to see if the next US president is more protectionist or more accommodating. And the major developing nations see their exports growing at double-digit rates despite the stalemate, so what's the rush?
But trade liberalisation is not standing still. Nations around the global are falling over themselves to liberalise trade regionally, bilaterally and unilaterally. The world trade system is labouring under a massive proliferation of regional trade agreements and the problem gets worse month by month. The resulting tangle of trade deals conspires to inject both inefficiency and discrimination against poor countries into the multilateral system.
Most amazingly, the WTO has had next to no involvement in this important development. The WTO – and this means the WTO membership since the institution only does what its members want – has adopted the role of "innocent bystander". Key figures in world trade – negotiators, ministers, the WTO secretariat, academics, civil society and the media – need to look beyond the Doha Round. Doha or not, countries will continue to strike bilateral and regional deals. Doha will do little or nothing to 'tame the tangle'. What is needed is a WTO Action Plan on Regionalism.
Regionalism is here to stay
The argument for action is simple. It is based on four facts:
Fact #1. The world trade system is marked by a motley assortment of discriminatory trade agreements known as the 'spaghetti bowl' for reasons that the diagram of trade relations in the Western Hemisphere makes clear.
Figure 1. 'Spaghetti bowl' RTAs in the Western Hemisphere
Fact #2. Regionalism is here to stay. Even if the Doha Round finishes tomorrow, free trade agreements will continue to proliferate and the motley assortment will continue to get 'motley-er'.
Fact #3. This tangle of trade deals is a bad way to organise world trade. The discrimination inherent in regionalism is already economically inefficient but its costs are rising rapidly as manufacturing becomes ever more internationalised. Stages of manufacturing that used to be performed in a single nation are now often geographically unbundled in an effort to boost efficiency. Supply chains spread across many borders. Unbundling, which accelerated since the 1990s, is the most important new element in the regionalism debate. It is the reason why business is pushing so many nations to 'tame the tangle.'
Fact #4. While the spaghetti bowl is a problem for firms in big nations, it is much more so for firms in poor nations. Rich nations have the resources and negotiating leverage to navigate the tangle's worse effects. The governments of small and poor nations do not. The spaghetti bowl falls much harder on the heads of the world's small and poor nations.
Implication. Since the spaghetti bowl's inefficiencies are increasingly magnified by unbundling and the rich/poor asymmetry, the world must find a solution. Since regionalism is here to stay, the solution must work with existing regionalism, not against it. The solution must multilateralise regionalism.
The WTO must choose innocence or engagement
The WTO faces a choice. What that means is that the WTO membership faces a choice. Should the WTO remain as an innocent bystander, or should it engage constructively and creatively in making regionalism as multilateral-friendly as possible? Innocence or engagement is the choice. The problem will not go away on its own.
The innocence option poses many difficulties and pitfalls. Regionalism is so pervasive that some political leaders view it as an alternative to multilateralism – Plan B for the world trading system. Starting from this situation, the continued and uncoordinated proliferation of regionalism might kill the proverbial gold-laying goose – the multilateral trade system that brought post-war prosperity to today's rich nations and helped lift billions out of subsistence agriculture.
Engagement is also difficult. WTO members have shown little appetite for cooperating on regionalism. Recent progress on the Transparency Mechanism shows that they recognise the problem, but negotiating a WTO Action Plan on Regionalism would be difficult.
In a new book published this week, a co-author and I argue that engagement is the right option. Developing a WTO Action Plan on Regionalism is both necessary and feasible. The book discusses more than a dozen ideas for the Action Plan. Some ideas require WTO sponsorship, negotiations and actions while others would mainly engage the parties to RTAs with the WTO playing more of a coordinating and fair broker role.
Most of the proposals turn on critical details and intricacies that can give headaches to even the most dedicated trade specialist – not the sort of thing that works well in an essay. The one proposal that is easy to understand concerns help for the developing nations. To make regionalism more development friendly and help poor nations with their free trade agreements, we should establish a WTO advisory services and/or a Centre on RTAs for poor nations – something along the lines of the Advisory Centre on WTO Law that helps them with WTO legal issues.
This advisory centre would provide subsidised economic, legal and negotiation services and training to developing nations. The proposed Centre's role and practical details could take inspiration from the Advisory Centre on WTO Law. To avoid waste, it should link up with the efforts of regional banks (Inter-American Development Bank, Asian Development Bank, etc.).
Action is needed
The ideas in the book – which stem from a three day conference of the world's leading trade experts held at the WTO in September 2007 – need more work. They may not be the right answer as to what the WTO should do, but "Do nothing" is surely the wrong answer. If the WTO does not adjust to the new realities of regionalism, it risks an erosion of its relevance.
The GATT/WTO survived and flourished during its half-century's existence by adapting to new realities. When the colonies became countries, the GATT expanded from a cosy club of two dozen members to a global organisation. When the distinct trade needs of developing nations were recognised, the GATT responded with the Enabling Clause. When non-tariff barriers began to replace tariff barriers, the GATT expanded its negotiating agenda. And when the need for greater institutional stability became clear, the GATT was embedded in the WTO.
Today's new reality is regionalism. If the WTO is to survive and flourish, it must adapt because regionalism is here to stay. Embarking on a WTO Action Plan on Regionalism would be a strong step towards adapting to the new reality.
References
Baldwin, Richard and Philip Thornton (2008). Multilateralising Regionalism.
links for 2008-02-29
- Chairman Greenspan's Legacy - NY Review of Books - Benjamin Friedman
- Fear and False Claims - FactCheck.org
