Trade and Inequality

REBALANCING WORLD TRADE IS KEY TO REDUCING WAGE INEQUALITY

Large trade surpluses in developing countries lead to higher wage inequality in both poor and rich countries, suggesting that the way to alleviate global wage inequality is to target trade imbalances. That is the central finding of research by Rosario Crinò and Paolo Epifani, presented at the Royal Economic Society’s 2013 annual conference.

One of the most controversial issues in international trade is the recent worldwide increase in wage inequality, particularly so in the developing countries, which have undergone drastic trade liberalisation.

The study presents an analysis of international trade that predicts that an increase in developing countries’ trade surplus leads to higher skill premia in both the developing countries and developed countries. This is because the rise in developing country exports is shared among a few industries and so most of the increase in wages in that country goes to a relatively small part of the population. At the same time, the developed countries ‘deindustrialise’, leading to lost wages, particularly for unskilled workers. These two factors lead to rising inequality in both countries.

The research finds evidence in support of this theory by looking at data on exports and jobs for 113 countries between 1977 and 2007. The authors conclude:

‘Our theory suggests that a rebalancing of the world economy would reduce inequality in both the South and the North.’

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One of the most important and controversial issues in international trade is the recent worldwide increase in wage inequality, particularly so in the developing countries, which have experienced a drastic and successful trade liberalisation. This fact has called into question the validity of the traditional trade theory, and in particular the Stolper-Samuelson theorem, according to which trade liberalisation, by reducing skill premia, should help alleviate wage inequality in the skill-poor countries.

A number of alternative explanations have been put forth in the trade literature to account for the observed trends. One strand of the literature points at foreign direct investment (FDI) and offshoring, rather than international trade, as the main culprits for rising wage inequality.

Another one instead blames intra-industry rather inter-industry trade for its distributional effects. Other explanations look instead at the distributional implications of international trade in the presence of firm heterogeneity and selection into export markets; and or at the interplay between trade and imperfections in the labour market.

This study formulates and tests a new trade explanation for the recent worldwide increase in wage inequality. The researchers argue that a concomitant increase in inter-industry trade flows and worldwide wage inequality are consistent with the standard trade theory, provided that they are associated with trade imbalances of the type recently experienced by the world economy, namely, growing trade surpluses by Southern countries. The theory also suggests that a rebalancing of the world economy would reduce inequality in both the South and the North.

The study uses some standard tools of the trade theory to formulate a simple model that clarifies the main insight on the link between trade imbalances and wage inequality. The model predicts that an increase in the Southern trade surplus leads to higher skill premia in both the North and the South, whereas an increase in the Northern trade surplus reduces wage inequality in both regions.

The intuition behind our result is essentially the same as the intuition for why North-South FDI flows are skill-biased or Southern catch-up is skill-biased. The basic idea is that a trade surplus by the South is associated with Southern countries expanding into ‘comparative disadvantage’ industries, which are more skill intensive than the average.

Conversely, the North partly deindustrialises by losing a range of industries that are less skill intensive than the average. Consequently, a trade surplus by the South is associated with an increase in the average skill intensity of exports in both regions. The opposite results would instead hold in the case of a trade surplus by the North, as in this case the North would expand into relatively less skill-intensive industries, whereas the South would lose some of its most skill-intensive industries.

The theory builds on a well-understood mechanism and is perhaps not too surprising. But it is surprising that the explanation has been unnoticed so far. In particular because the North-South trade imbalances experienced by the world economy in the recent past are an order of magnitude larger than net FDI flows, which suggests that the empirical relevance of the explanation may be overwhelming relative to that of alternative explanations building on a similar mechanism.

The researchers test the core mechanism of their theory, according to which, depending on whether a country is skill abundant or skill poor, a trade surplus will reduce or increase the average skill intensity of exported goods.

Figure 1 illustrates some suggestive evidence in line with the theory. It reports the co-evolution of trade surpluses/deficits as a share of GDP and a measure of average skill intensity of exports in two skill-rich (the US and Japan) and skill-poor (China and Chile) countries. The figure suggests that the trade surplus and the skill intensity of exports are strongly negatively correlated in rich countries and strongly positively correlated in the developing countries.


The study also provides systematic evidence on the impact of trade imbalances on the skill composition of exports using a panel of 113 countries observed between 1977 and 2007. The results suggest that, independent of estimation method and specification details, changes in the trade surplus are strongly positively (negatively) correlated with changes in the average skill-intensity of exports in skill-poor (skill-rich) countries.

Moreover, they suggest that trade liberalisation, endowment changes, foreign direct investment and productivity catching up have the expected impact on the skill composition of countries' exports. But in this data, the impact of each of these variables is small relative to that of trade imbalances, thereby suggesting that the theory points out a potentially relevant and so far neglected trade-induced mechanism leading to (hopefully temporarily) higher worldwide inequality.

ENDS


Contact:

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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