The United States of Inequality

Trade Didn't Create Inequality, and Then It Did
What's causing America's growing income inequality?
Sept. 14 2010 7:02 AM

The United States of Inequality

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Cargo boats on the Changjiang (Yangtze River) in Wuhan
Cargo boats on the Changjiang (Yangtze River) in Wuhan

I typed this article on a laptop that was made in China. Just about everything I own was made in China. Just about everything you own was made in China, too. In 1979, when the Great Divergence began, you and I didn't own anything made in China. With Mao only three years in the grave, China still had a sluggish centrally planned economy. In that year, Mao's successor, Deng Xiaoping, decided enough was enough and inaugurated various market reforms. "Black cat, white cat," the Communist leader famously said. "What does it matter what color the cat is as long as it catches mice?"

Since 1979, China has caught a stunning quantity of mice, raising the annual value of its exports one-hundredfold. In 2007, China displaced the United States as the world's second-biggest exporter, and in 2009 it displaced Germany as the world's biggest exporter. That year, China's per capita gross national income was $6,710—compared to $47,240 in the United States—and the U.S. trade deficit with China stood at $227 billion. Given China's aggressively mercantilist trade policy and its preposterously huge pool of cheap labor, it's logical to wonder whether the common timeline of China's manufacturing boom and the United States' inequality boom is more than mere coincidence.   Did China—and growing trade competition from other low-wage nations—cause the Great Divergence?

Two decades ago, Adrian Wood, a British economist, started arguing that trade with low-wage countries lowered wages for unskilled workers in developed countries. "There is a clear inverse association," Wood wrote in a 1995 paper. "Countries with larger increases in import penetration experienced larger falls in manufacturing employment." But in the United States, Wood had to concede, imports of manufactured goods from low-wage countries still totaled less than 3 percent of gross domestic product. By itself, that wasn't enough to displace many workers. Wood answered by arguing the effects were subtle and indirect. For example, he wrote that imports from low-wage countries required more labor than other goods, and therefore displaced more U.S. workers than imports from high-wage countries.

Most leading economists in the United States didn't buy it. Paul Krugman (then at MIT, now at Princeton) and Robert Z. Lawrence (then at the Brookings Institution, now at Harvard), argued that international trade had played a much smaller role in U.S. manufacturing's decline than had domestic considerations. Among these, ironically, was the U.S. manufacturing sector's own efficiency, which had lowered prices on consumer products and therefore on the proportion of U.S. spending on goods (TVs, refrigerators, groceries) as opposed to services (CT scans, legal advice, college tuition). From 1970 to 1990, the prices of U.S. goods relative to services had fallen by nearly one-quarter. "Although the effect of foreign competition is measurable," Krugman and Lawrence concluded, "it can by no means account for the stagnation of U.S. earnings."  

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A decade later, Krugman decided his earlier analysis no longer held up. "My argument was always yes, in principle" imports from low-wage countries could affect income inequality, Krugman told me. But in the 1990s there simply weren't enough of them. That changed  in the aughts. In a December 2007 New York Times column and a 2008 paper for the Brookings Institution, Krugman observed that the United States had in 2006 crossed "an important watershed: we now import more manufactured goods from the third world than from other advanced economies."  (See Figure One.) Imports of manufactured goods that came from less-developed nations had more than doubled as a percentage of gross domestic product, from 2.5 percent in 1990 to 6 percent in 2006. Moreover, the wage levels in the countries ramping up U.S. trade the fastest—Mexico and China—were considerably lower than the wage levels in the countries whose increased U.S. trade had created worry in the 1990s—South Korea, Taiwan, Hong Kong, Singapore. The Southeast Asian nations had, in 1990, paid workers about 25 percent of what U.S. workers received. By 1995 they paid 39 percent—demonstrating, reassuringly, that low-wage developing countries that undergo rapid economic growth don't stay low-wage for long. But as of 2005, Mexico and China paid 11 percent and 3 percent, respectively. "It's likely," Krugman concluded, "that the rapid growth of trade since the early 1990s has had significant distributional effects."

Lawrence, looking at the same new data, continued to believe that trade did not affect U.S. income inequality to any great extent. Lawrence focused on the fact that China was increasingly exporting computers and other sophisticated electronics. To depress the wages of lower-skilled workers in the United States, Lawrence reasoned, China would have to compete with American firms that employed lower-skilled workers. But the U.S. tech sector doesn't, for the most part, employ lower-skilled workers. It employs higher-skilled workers. If trade with China were throwing anybody out of work, Lawrence concluded, "it is likely to be … workers with relatively high wages." And in fact, Lawrence wrote, during the first decade of the 21st century there was very little measured increase in income inequality "by skill, education, unionization or occupation." Income inequality did increase through the aughts, but that was because incomes soared at the tippy top of the income-distribution scale. It didn't increase because less-skilled workers got squeezed—or rather, it didn't increase because less-skilled workers got squeezed any more than they did during the previous two decades. At the very bottom, incomes actually edged up slightly.

Krugman wasn't convinced by his former collaborator's argument. "There is good reason to believe that the apparent sophistication of developing country exports is, in reality, largely a statistical illusion," he answered in his Brookings paper. Unskilled laborers paid a pittance in China weren't really doing high-tech work, Krugman wrote. They were grabbing sophisticated components manufactured in more advanced and higher-paid economies like Japan, Ireland, and—yes—the United States, and they were slapping them together on an assembly line. That couldn't be good news for less-skilled workers in the United States, though Krugman said he couldn't quantify the effect without "a much better understanding of the increasingly fine-grained nature of international specialization and trade."

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Where does that leave us? Trade does not appear to have contributed much to the Great Divergence through the mid-1990s. Since then, it may have contributed to it more significantly, though we don't yet have the data to quantify it. With trade more than with most topics, the economics profession is struggling to interpret a reality that may not fit the familiar models.

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