Does Globalization Cause Income Inequality?

Yesterday, in TCS Daily, Tim Worstall argued that income inequality (if it exists, he wasn’t quite willing to concede that) should in fact be caused by globalization. (Note that this post was featured on Harvard economics professor Greg Mankiw’s blog, which is where we came across it). It goes on to say, “Further, I’ll argue that this is a very good idea indeed, one that we should fully support.”

Now this argument is increasingly made by the free market absolutists. We all know that free trade is a good thing, since it makes all parties wealthier (well, at least in the two-country, two-goods model we all learned in school, and presumably in models with more countries and more factors). But if this good policy happens to have some side effects, as in it leaves some individuals worse off, that doens’t necessarily obviate the overall merits of more open trade.

When framed this way, the argument is about efficiency versus fairness, and people can legitimately differ as to how to balance them when they are in conflict. But the free market fundamentalists generally oppose the idea that there are any circumstances when it makes sense to meddle in “free” markets (as we note in an earlier post, the platonic ideal of efficient markets seldom exists in practice).

But making income inequality the result of free trade (an indisputably good thing, as we are told) has the effect of putting it outside the reach of debate. But that line of reasoning is dubious.

The causes of income inequality appear to be many, including the declining power of unions, less progressive taxes and income redistribution, and the rise of technology (both in reducing the number of lower-skill jobs and in increasing the incomes of higher skill ones). While globalization may play a part, given that only 1% of American jobs have been outsourced, its role appears to be secondary.

But if you accept the line of argument that globalization is a major contributor to income disparity, it isn’t because globalization is operating as theory would predict. What we have is a system of managed trade, not free trade, and as William Greider discussed in a New York Times op-ed article “America’s Truth Deficit, we appear to be playing the game less astutely than our counterparties:

The United States’…weakening position in the global trading system is obvious and ominous, yet leaders in politics, business, finance and the news media are not willing to discuss candidly what is happening and why. Instead, they recycle the usual bromides about the benefits of free trade and assurances that everything will work out for the best.

Much like Soviet leaders, the American establishment is enthralled by utopian convictions — the market orthodoxy of free trade globalization….

Reporters and editors typically take cues from the same influential sources and learned experts in business, finance and government. If the news media decided to cast these facts as the story of the world’s only superpower losing ground in global competition and becoming financially dependent on strategic rivals like China, the public would take greater notice. But governing elites would regard such clarity as inflammatory. America’s awesome trade problem is instead portrayed as something else — an esoteric technical dispute about currency values, the dollar versus the Chinese yuan. The context is guaranteed to baffle and benumb citizens.

The possibility that the United States can no longer afford globalization, at least not as it now functions, is what opinion leaders do not wish to discuss….

An authentic debate might start by asking heretical questions: Why is the United States one of the few advanced economies that suffers from perennial trade deficits? Why do new trade agreements, despite official promises, always leave the United States with a deeper deficit hole, with another wave of jobs moving overseas? How do the authorities explain the 30-year stagnation of working-class wages that is peculiar to America? Are we supposed to believe that everyone else is simply more competitive or slyly breaking the rules? In the last three decades, American policymakers have succeeded in closing the trade gap with only one event — a recession….

American political debate is enveloped by the ideology of free trade, but ”free trade” does not actually describe the global economic system. A more accurate description would be ”managed trade” — a dense web of bargaining and deal-making among governments and multinational corporations, all with self-interested objectives that the marketplace doesn’t determine or deliver. Every sovereign nation, the United States included, uses its vast arsenal of policies to pursue its national interest.

But on the crucial question of how policy makers define ”national interest,” Washington stands alone. Western Europe, whatever its problems, manages economic policy to maintain modest trade surpluses. Japan manages to insure far larger surpluses in recessions (its export income subsidizes inefficient domestic employers). China strives to acquire a larger, more advanced industrial base at the expense of worker incomes and bank profits. Germany and Japan, despite vast differences, both manage to keep advanced manufacturing sectors anchored at home and to defend domestic wage levels and social guarantees. When they do disperse production and jobs overseas, as they must, they do so strategically.

By contrast, Washington defines ”national interest” primarily in terms of advancing the global reach of our multinational enterprises. Elites are persuaded by the reigning orthodoxy that subsidiary domestic interests will ultimately benefit too. The distinctive power of America’s globalized companies is reflected in trade patterns. Nearly half of American exports and imports are not traded in open markets — the price auction idealized by neoclassical economics — but within the companies themselves, moving materials and components back and forth among their far-flung factories. A trade deficit does not show on the company’s balance sheet, only on the nation’s. In recent years, much of the trade deficit has reflected the value-added production and jobs that companies moved elsewhere.

The United States is thus especially vulnerable to the downward pressures on working-class wages that exist on both ends of the global system. American producers are generally free — and even encouraged by Washington — to shift production to low-wage locations. Companies regularly use this cost-cutting technique as a competitive weapon without regard to the domestic consequences. The practice works for companies and investors, but not so well for a nation.

Indeed, the cumulative effects of retarding labor incomes worldwide repeatedly threatens stagnation or worse for the entire system. Workers, to put it crudely, cannot buy what the world can make. Too much capital leads to the speculative ”bubbles” that bounce around the world, visiting financial crisis on rich and poor alike.

At a different moment in history, American leadership might have stepped up to these disorders and led the way to solutions. If globalization is to continue without encountering more crisis and random destruction, governments must together shift the balance of power so labor incomes can rise in step with rising productivity and profits. If the United States is to avert its own reckoning, it must take decisive action to draw firm limits on its exposure to trade deficits, that is, resign its position as the open-armed buyer of last resort. In effect, Washington would also reform its own national interest imperatives so that they more closely resemble what other nations already embrace. Ultimately, American remedial action may protect the global system from its own crisis — the moment when trading partners discover they have just lost their best customer.

Similarly, the blog Angry Bear in its post, “Tim Worstall on Stopler-Samuelson: Meet the Leontiff Paradox,”takes a more rigorous economic look at the Worstall argument and finds it wanting:

Tim Worstall suggests that free trade will naturally lead to rising income inequality in the U.S., but we really should see this as a good thing:

The theory is the Stolper-Samuelson Theorem. Stripped to its essentials this says that we would expect the process of globalization to have the following effect: it will lower wages in the US and raise corporate profits (more precisely, returns to capital). In the poor countries that the US is trading with it will have the opposite effect

In other words, workers in the U.S. make more than workers in places like China and Mexico because the U.S. has a higher capital to labor ratio. Free trade will tend to equalize wages internationally, which means Mexican and Chinese wages will rise as U.S. wages will fall. It’s called the Factor Price Equalization theorem:

The fourth major theorem that arises out of the Heckscher-Ohlin model is called the factor-price equalization theorem. Simply stated the theorem says that when the prices of the output goods are equalized between countries as they move to free trade, then the prices of the factors (capital and labor) will also be equalized between countries. This implies that free trade will equalize the wages of workers and the rents earned on capital throughout the world. The theorem derives from the assumptions of the model, the most critical of which is the assumption that the two countries share the same production technology and that markets are perfectly competitive.

Worstall is relying on a very simple two-good, two-factor of production theorem where all workers are homogenous. He is seemingly unaware of the Leontiff Paradox.

Leontief reached a paradoxical conclusion that the US – the most capital abundant country in the world by any criterion – exported labor-intensive commodities and imported capital- intensive commodities. This result has come to be known as the Leontief Paradox. Leontief took the profession by surprise and stimulated an enormous amount of empirical and theoretical research on the subject.

Greg Mankiw seemed to enjoy Worstall’s post. While I also found it interesting, I would hope that the economics students at Harvard go well beyond the Heckscher-Ohlin model when they take international economics. Especially when Worstall and Mankiw use an oversimplified model of international trade to talk about morality. I’m sorry fellows, but I’d rather listen to my preacher when it comes to questions of morality.