Alworth Institute

While the standard trade theory tells us that free trade would leave low-skilled workers worse off, most economists believe - at least, they did until recently - that trade would have only a negligible impact on the earnings of the workers. But, just last week, Princeton economist and New York Times columnist Paul Krugman stated: “It’s no longer safe to assert that trade’s impact on the income distribution in wealthy countries is fairly minor. There’s a good case that it is big, and getting bigger.�

Krugman’s fear is due to two reasons: (1) given the fact that China has a vast pool of untapped (mainly low-skilled) labor force, it is unlikely that she will lose her comparative advantage in the production of labor intensive goods for a very long time to come - to quote Krugman again, “in 1990...the original four Asian Newly Industrialized Economies (NIEs) had hourly compensation costs that were 25% of the US level. Now ...China’s labour costs are only 3% of US levels�; and (2) the growing fragmentation of production: even in high-tech industries, such as microprocessor manufacturing, the low-value-added activities, like assembly and testing, are carried out today in low-wage countries.

Coming as it did from an avid advocate of free trade, Krugman’s worries about the harmful effects of free trade have already set off a heated debate, especially in the blogosphere. However, there are reasons to believe that Krugman could have got it wrong - at least until we have more evidence. Here is why.

First, comparing hourly compensation in the NIEs in 1990 and that in China today is misleading. A more relevant comparison would have been between the hourly compensation in the NIEs in the mid-seventies or early eighties (when these economies began to emerge as the leading net-exporters of labor intensive goods) with that in China today; by the 1990s the NIEs had almost become net importers of labor-intensive goods and China had replaced both Japan and the NIEs as the major net-exporter of these types of goods. Such a comparison would not likely yield dramatically different wage rate differentials between the NIEs and the US on the one hand and China and the US on the other. It is also conceivable that the fast-growing money wages in China will bring about greater balance in US-China trade in the near future (the money wage growth in China today is comparable to that in Japan during the 1950s and 1960s, when Japan was at a similar stage of development as China is today).

Finally, what is the nature of income inequality in the US today? As Thomas Piketty and Emmanuel Saez demonstrate in their 2006 NBER working paper, “most of the overall increase in the inequality of income has been driven by the very top of the income distribution …For example, the top 0.01% of earners paid over 70% of their income in federal taxes in 1960, while they paid only about 35% of their income in 2005�. They further point out that “the surge in top incomes [that is, of the top 0.1% of earners] since the 1970s has been driven in large part by a steep increase in the labor income component [(capital income was the major component of the total income received by the top 0.1% in the 1960s)], due in large part to the explosion of executive compensation�. Indeed the growth in executive pay over the last three decades has been staggering. As the “Executive Excess 2006� report by the Institute of Policy Studies, Washington D.C., reveals, CEO-worker pay gap has grown from 42-to-1 in 1980 to 107-to-1 in 1990 to 411-to-1 in 2005. The report also notes that “if the minimum wage had risen at the same pace as CEO pay since 1990, it would be worth $22.61 today, rather than the actual $5.15.�

In sum, many forces are at work here. And, mere China-bashing won’t help. Two issues worth consideration are the following: (1) making the federal tax system more progressive, especially at the level of the top 0.1% of earners, and (2) strengthening the trade union movement, and thereby improving the bargaining power of the workers.