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.
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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.