On the Future of Capitalism: Trade and Income Inequality

Free trade is one of the cornerstones of modern capitalism. There appears to be general agreement that trade produces wealth. Therefore, it is assumed that maximizing trade should be the goal of governmental policy. An issue arises if the growth in aggregate wealth is distributed in such a manner as to be biased towards the already wealthy. Data presented here indicates that over the past several decades, during the era of increased globalization, there has been a general trend towards increased income inequality within countries. The subject here is whether or not international trade inevitably leads to growing income inequality for a country like the US. A system that promotes ever increasing inequality is inherently unstable and will not survive.

The real world is complicated, but aspects of trade can be analyzed in quite simple terms. When two countries agree to allow the mutual selling and purchasing of goods across their borders they are agreeing that they will allow their local industries to compete with those of the other country. If import duties on goods are small then the agreement can be referred to as free trade—the situation most economists assume is ideal. The most efficient industries in terms of quality and price will see a boost in sales as they gain market share in the other country. The least efficient in terms of price and quality will see a decrease in domestic market share if the trading partner has companies that can provide a more competitive product. Ideally, the flow of goods and money across the borders will be large and balanced, and the increased competition will create greater efficiency and lower prices for consumers. The increased economic activity is assumed to create more jobs and put displaced workers from the inefficient industries back to work.

But what actually happens?

In this simple picture, the most efficient companies are generally the ones with the highest capitalization. In general, they have gained their competitiveness by trading labor for automation. Manufacturing in the US has been gaining steadily in output for decades, while at the same time requiring ever lower numbers of workers to produce a given level of output. These companies will enjoy greater profitability through trade. A significant fraction of that profitability will go to the providers of capital who tend to be on the wealthy end of the spectrum. A fraction will be invested in trying to attain even greater efficiencies because every worker they are forced to hire diminishes their profit. A fraction of the profit from trade will be devoted to providing increased output and will produce additional employment opportunities. These efficient companies tend to have fewer workers, but they are better-educated and better-paid workers.

The inefficient companies will see greater competition from trade and many will experience decreased income or will even be forced out of business entirely. Often these industries are deemed inefficient because they rely on a work force that is not required to be highly trained or highly educated. This class of worker can be easily displaced by better-capitalized industries in another country, or by industries that have access to cheaper labor. Unemployment will increase in the class of workers employed in these industries.

The net result is that more money flows to the wealthy and jobs are created at the higher end of the spectrum, while financial and employment losses are incurred in areas with lesser-skilled workers. Historically, in developed countries like the US, the number of jobs lost exceeds the number gained in this process. The resulting surplus of lower-skilled workers will tend to drive wages down for this class of worker. Economists like to entertain models in which the displaced workers move into the new, often higher paying, positions that have been created. There are enlightened countries where this process actually occurs, but the US is not one of them. Richard Katz has an article in Foreign Affairs discussing these issues. He claims the data indicates that that is a false assumption.

"U.S. workers who lose their jobs due to globalization have to take a 20 percent pay cut, on average, to get their next job, the worst decline of any country in the Organization for Economic Cooperation and Development (OECD)."

As for the notion that the economic pain at the lower wage levels is balanced by the benefit from lower costs on imported goods, consider a graph that was incorporated in an article discussing Walmart and its employment and trade practices: Wal-Mart: The damage It Has Done to Society. It is of interest here because just about everything importable and of interest to consumers will be available at Walmart. This data was provided by the Economic Policy Institute.

The data indicates that there has been a long term trend—that started long before globalization became an issue—for non-tradable goods and services to dominate expenditures for consumers. If one takes expenditures on Walmart-available goods as an indication of the fraction of a consumer’s income that can be devoted to tradable goods, then taking a 20% income loss after being displaced by trade-generated activity can only be balanced by providing him all tradable goods at no cost.

This simple analysis indicates that for a developed country like the US international trade will lead to growing income inequality unless there is some specific societal response. What do economists and their models have to say on the issue?

There is an IMF-generated study that was published in 2008: Rising Income Inequality: Technology, or Trade and financial Globalization? by Florence Jaumotte, Subir Lall, and Chris Papageorgiou. This study tries to include the effects of trade, foreign direct investment, and financial openness in a study of globalization and its relationship to the Gini coefficient that typically is used to assess income inequality. The higher the Gini number, the greater is the inequality. A Gini of 1.0 indicates that one person earns all the money; a Gini of 0.0 indicates that everyone has equal incomes. The authors here use a scale of 0-100. The authors also attempt to assess technological changes as a factor in determining the Gini coefficient. The Gini value is then calculated for a given country or class of countries by determining parameters that will fit into a single equation. While this sort of model has an aura of robustness about it, it is really a series of approximations concatenated together. Nevertheless, let us consider the conclusions.

The conclusion is that globalization is the greatest single factor contributing to increased income inequality in developed countries, although technology change is also an important contributor. The situation is quite different when considering developing countries.

In this case the effect of globalization was found to be beneficial, while technology change was the main culprit in generating inequality.

The authors provide the conclusion that, in general, trade contributes to income equality while financial globalization, particularly foreign direct investment, contributes to inequality. Unfortunately, they do not refine that statement by how it applies to the individual classes of countries. As their results show, developing and developed countries are affected in different ways. I see nothing in this study that convinces me that the simple analysis provided above is in error for a country like the US..

The following graph is also provided by the authors.

The rise in inequality in advanced countries is not inevitable. Each country makes a different decision about how to respond to the disruptions of globalization. Inequality in France has actually decreased since 1980. One can argue that France is going broke providing its social safety net, but consider that Germany, a country that is considered to possess one of the most robust economies in the world, has also made social decisions that have held its inequality essentially constant over the same period.

Katz emphasizes this issue in his article. He claims the fault lies not in globalization, but in the nation’s response to it.

"....look at the Scandinavian countries, which suffered a deep recession and structural problems similar to those of Japan during the 1990s, from banking crises to inefficient domestic sectors. Scandinavia has since recovered, partly by becoming even more globalized. Sweden and Denmark increased their trade-to-GDP ratios by almost 40 percentage points between 1990 and 2008. Just before the most recent global recession, Danish workers enjoyed the highest real wages in Europe, the second-lowest unemployment rate in the OECD, and the highest income equality in the OECD. The Swedes, who came in second in income equality, enjoyed one of the highest rates of real wage growth in the decade prior to the global slump and saw their country’s unemployment rate drop from 10.2 percent to 6.2 percent during that time. To combat the negative effects of globalization, the United States should expand trade and then use part of the resulting addition to GDP to aid those who have been harmed by open trade."

The form of capitalism practiced in the US is leading to ever increasing income inequality. If this trend is unchecked, history tells us the system will come to a bad end. It is inevitable that government must play a greater and, hopefully, wiser role in the economy, and in devising an appropriate system of social support.