Krugman on Trade and Inequality

Paul Krugman has published an interesting article on trade and inequality at VoxEu that nicely illustrates the morally puzzling nationalist assumptions of standard welfare economics.

After economists looked hard at the numbers, however, the consensus was that the effect of trade on inequality was probably modest. Recently, Ben Bernanke cited these results – but he recognised a problem: “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. Whether studies of the more recent period will reveal effects of trade on the distribution of earnings that differ from those observed earlier is to some degree an open question.”

But the question isn’t really that open. It’s clear that applying the same models to current data that, for example, led William Cline of the Peterson Institute to conclude in 1997 that trade was responsible for a 6% widening in the college-high school gap would lead to a much larger estimate today. Furthermore, some of the considerations that once seemed to set limits on the possible inequality-promoting effects of trade now seem much less constraining.

There are really two key points here: the rise of

China, and the growing fragmentation of production.


What all this comes down to is that it’s no longer safe to assert, as we could a dozen years ago, that the effects of trade on income distribution in wealthy countries are fairly minor. There’s now a good case that they are quite big, and getting bigger.

This doesn’t mean that I’m endorsing protectionism. It does mean that free-traders need better answers to the anxieties of those who are likely to end up on the losing side from globalisation.

I’m just going to assume that Krugman is right about everything. Maybe he is. If a large part of Krugman’s argument is that we increasingly buy stuff from China (and other such countries), since they can produce it more cheaply, then it is a large part of Krugman’s argument that “the economy” in which Americans participate is increasingly one in which parties to complex forms of exchange work and reside in different nation-states. Krugman, as far as I can tell, thinks the increasingly globalized network of exchange creates a larger overall surplus than would exist in a more highly protectionist world, and Americans on average are better off for it. But, the argument seems to be, the share of that larger surplus going specifically to low-skilled American workers is smaller than it would be in a more heavily protected economy. These folks are on “the losing side.” The policy upshot, I’m sure, is that “winners” might need to compensate “losers.”

I think there are lots of conceptual problems here that flow from knee-jerk economic nationalism. Let’s imagine just U.S. – Chinese trade, to make things simpler.

First, it is not clear why the scenario of a continued, less-globalized status quo ante, in which low-skilled American workers earn higher wages, counts as the relevant baseline. That is a world in which, I guess, we are supposed to imagine that the Chinese economy has not been liberalized, and so there is less competition from Chinese workers. Implicit in this idea is that unreformed Chinese communism — which keeps its workers off the world labor market — is a subsidy to low-skilled American workers. But now the subsidy has been withdrawn, making low-skilled workers “losers.” There is clearly a kind of perspective relativity going on here. We could just as well say that the prior generation of low-skilled workers were winners, receiving a bonus from Chinese economic illiberalism. I think the normative baseline should be competitive world labor markets — a world in which individuals’ passports have no effect on their freedom to trade with one another. And so the opening of Chinese labor markets is a reversion toward the baseline, and a withdrawal (from other low-skilled workers) of a positive externality of injustice.

Second, it seems to me that American low-skilled workers are suffering from a classic pecuniary externality (that is, the withdrawal of a positive pecuniary externality). If you and I are both in the hot dog biz, and I sell my hot dogs for a lower price, a reduction in your profits may be (to you) a negative external effect of my offering a lower price. But this is not the kind of thing you can claim as a “harm” or a basis for compensation. Pecuniary externalities are essential to competitive markets: we want them. Nobody is doing anything to low-skilled domestic laborers. It is simply that their segment of the labor market has become more competitive, bidding down wages. It’s just as if you had to cut the price of your hot dogs to stay in business, resulting in lower profits. Now imagine that our friend Larry is now buying hot dogs from me rather than you, since my hot dogs are cheaper. There are gains from our trade, which he and I divide. Larry comes to me not you, because he gets a relatively bigger bit of the surplus than he did with you. At the end of the year, Larry has more cash in his pocket than he would have had if he had been trading with you. And you have less in your pocket than you would have had if he had been trading with you. So the inequality between you and Larry has increased, all because I’ve been offering a cheaper hot dog. But I had next to nothing before I was selling cheap hot dogs. So the inequality between me and Larry has decreased.       

That’s what it’s like, isn’t it? Many Americans get a boost in real wages from the relative decline in prices due to cheaper stuff made in China. But that boost isn’t enough to fully compensate workers who would have been doing the work the Chinese are doing (if the ChiComs hadn’t opened their markets.) Meanwhile, hundreds of millions of Chinese edge ever slightly closer to American wages. Which change in inequality matters morally? It simply isn’t obvious that it’s the gap among fellow Americans.    

  Unites States and China GDP per capita 1975-2004

Now, it may be the case that if the class of citizens who suffer a pecuniary externality is large enough, they may drum up effective political demand for restrictions on trade (for reinstating their previous subsidy, by other means), which would make most other citizens worse off in the short term, and everyone worse off in the long term. So we might want to enact direct wage subsidies, or an increase in the EITC, retraining programs, or whatever, to get those on the “losing side” of globalization from trying to use the political process to make themselves “winners” again. But, if that’s the real argument, we should be clear that the point of this is not to ameliorate the injustice of increasing national income inequality caused by global trade, because there is probably no such injustice. Increasing national inequality may be a side-effect of a straightforward improvement in justice globally.

It may also be that Krugman is not right about everything.