This research finds that "that trade with low-income countries has had a profound impact on US relative prices," leading to a reduction in producer price inflation of more than two percent per year:
The impact of low-income economies on US inflation, by Raphael Auer and Andreas Fischer, Vox EU: Have cheap imports from low-wage nations held down inflation in rich economies? Contrary to what customers at Wal-Mart, Toys"R"Us, or Best Buy observe every day, the academic literature has found surprisingly little evidence that trade with China and other poor, yet rapidly industrializing nations have had a large impact on prices in the rest of the world.
Is China exporting deflation?
In an influential study, Stephen Kamin, Mario Marazzi, and John Schindler (2006) ask whether China is "exporting deflation" to the United States, a question answered with a definitive no. Imports from China, they find, have a much smaller effect on US import prices than expected and no detectable impact on US producer prices. Related studies for Austria, Norway, Japan, the United Kingdom, and other countries report similar findings.
Identifying the effect of import competition on prices is difficult, however, due to the problem of distinguishing supply and demand shocks. For example, winter jackets in US got cheaper when quotas on imports from China and India were removed. Nevertheless, if demand was simultaneously increased by a cold winter, the equilibrium price would not necessarily decrease. Yet it is exactly the supply side that we must identify if we want to know how much dearer jackets would have been without the cheap imports. Because current studies cannot identify the supply and demand shocks that cause changes in trade flows, they cannot establish the true effect of import competition on prices and inflation.
The empirical literature of international trade is well aware of the simultaneity of supply and demand and, therefore, utilizes one-time tariff reductions to identify the causal effect of trade; see for example Daniel Trefler's (2004) work on the effect of NAFTA on Canadian industry. Unfortunately, large tariff reductions are rare and the literature has yet to find a suitable event that led to a substantial increase of imports from low-cost producers.
In a recent study, we develop a new methodology to establish the causal effect of imports from nine low-income countries on US inflation (Auer and Fischer 2008). The nine countries we examine are China, Brazil, Indonesia, India, Malaysia, Mexico, Philippines, Thailand, and Vietnam. In 2006, these nine low-income countries accounted for imports worth more than 600 billion dollars, equivalent to one third of all US imports or 5.5% of US GDP (see Figure 1).
Identifying the Effect of Import Competition
At the heart of our argument lies the simple observation that when labour abundant nations grow, their exports tend to increase most in sectors that intensively use labour as a factor of production. US imports originating from low-income countries are highly concentrated in labour intensive sectors such as textiles or toys (see Figure 2). In our study, we document that this relation also holds in terms of changes. If a low-income country's output capacity grows, its exports increase most in labour intensive sectors.
This observation gives us an empirical lever on supply-side changes that does not depend upon the price. With this lever, we can separate out the supply and demand effects (i.e. it gives us an instrumental variable).
Building on the fact that the change in imports at the sector level is related to the sector's labour intensity, we then estimate the effect of import competition from low-wage countries on US producer prices in a framework that controls for both sector-specific trends and aggregate shocks. When the nine low-income countries grow above trend, US imports in labour intensive sectors increase relative to US imports in capital intensive sectors. This difference in the reaction of sectoral import volume to low-income country growth is utilized to establish the effect of import volume on US prices.
In a panel covering 325 manufacturing industries from 1997 to 2006, we find that trade with low-income countries has had a profound impact on US relative prices. For example, we find that if the US market share of low-income countries increases by 1%, prices in the sector decrease by between 2% and 3%. We next decompose this price-dampening effect of imports into the contributions stemming from productivity growth, mark-up reductions, and cost changes.
Cheap imports’ impact on productivity
By and large, the dominant channel through which imports have affected US industry is via inducing sectoral productivity growth. In our estimations, a one percentage point increase in the US market share of low-income economies is associated with an increase in productivity by around two percentage points. Decreasing mark-ups can explain the remainder of the drop in prices. Surprisingly, we do not find any evidence that imports affect the cost of intermediate goods used in production or reduce the wages of unskilled workers.
From Changes in Relative Prices to Inflation
The conclusion of our study is that globalization has had a more profound impact on US relative prices and productivity than is commonly assumed. Our results, however, have to be interpreted with care when making statements on the effect of low-income countries on aggregate US inflation and productivity. Due to the difference-in-difference type identification, our methodology abstracts from factors such as the increase in global raw material prices that growth in emerging economies has brought about. Given these limitations, a rough estimate is that from 1997 to 2006, imports from low-income countries reduced the US PPI inflation rate in the manufacturing sector by about two percentage points (each year). China accounts for over half of the total effect.
While manufacturing prices make up only a fraction of the PPI inflation index and producer price inflation is passed through only imperfectly to consumer prices, the effect of imports from emerging economies should not be neglected and needs to be addressed in monetary policy decisions.
What Lies Ahead
The overall effect of relative price shocks on aggregate inflation ultimately depends on the response of the central bank (see for example Mishkin 2007 or Trichet 2008). Imports from low-income countries had a dampening effect on inflation in the booming US economy of the last decade, thus allowing - among other factors - monetary policy to be relatively loose. At this juncture, core inflation has finally caught up and may stay elevated for a prolonged period: monetary tightening will crowd out cheap imports from low income countries and, consequently, have a smaller effect on inflation than would be the case in the absence of trade.
Auer, Raphael and Andreas M. Fischer, 2008, The Effect of Trade with Low-Income Countries on US Industry, CEPR Discussion Paper 6819.
Kamin, Stephen B., Mario Marazzi, and John W. Schindler, 2006, The Impact of Chinese Exports on Global Import Prices, Review of International Economics, vol. 14(2), pp. 179-201.
Mishkin, Frederic S., 2007, Globalization, Macroeconomic Performance, and Monetary Policy, Held at the Domestic Prices in an Integrated World Economy Conference, Board of Governors of the Federal Reserve System, Washington, D.C.
Trefler, Daniel, 2004, The Long and Short of the Canada-US Free Trade Agreement, American Economic Review, vol. 94(4), pp. 870-895.
Trichet, Jean-Claude, 2008, Globalization, Inflation and ECB Monetary Policy, Speech held at the Barcelona Graduate School of Economics, Barcelona, 14 February 2008.
1 Although the accession of Mexico to NAFTA had a sizeable effect on Mexico, it did not affect the much larger United States to an extent measurable in nationwide data. Similarly, China's accession to the WTO in 2001 reduced average tariffs by less than two percentage points and did not result in a significant effect on the US economy.
2 In Figure 2, labour intensity is defined as average total expenditures for labour during 1997-2006 divided by average total expenditures for capital and labour during the same period. Low-income country market share is defined as imports from the nine economies in a given sector divided by total US sales in the respective sector.