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.

Conclusion:

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. 

20 Replies to “Krugman on Trade and Inequality”

  1. I’ve read this general theme, with varying amounts of schadenfreude, several times today, and while I don’t like this plan, isn’t there a real problem here because once they’re under-water homeowners only have two choices: keep paying or hand the house over the bank by one mechanism or another. All the normal options of redeeming the loan by some other mechanism, barring a huge cash windfall, are absent.
    Lots of people had, and some still have, mortgages that are only intended to be held for short periods of time. At the most innocuous end of the spectrum, these are 3, 5 and 7 year hybrid ARMs which won’t actually cause any pain until rates go back up. At the less innocuous end, there are loans that were intended to exploit growing equity to allow refinance into other products – most sub-prime loans were of this class. People with these mortgages could in many (not all) cases have continued to afford their homes (and still could, given current rates) had they not lost their equity just as lending standards tightened to require more equity. Other than schadenfreude, I don’t see how anyone benefits by leaving these people in that position.
    Similarly, many people need to move house for one reason or another, and in many places rents do not cover the cost of mortgage interest, insurance and property tax, let alone principal payments or maintenance. The option of renting out their old house and renting or buying elsewhere may not be practical, so they’re stuck – its foreclosure or staying where you are.
    There are other scenarios, including family problems, life changes, etc. that may mean the house becomes unaffordable. I know many people in these situations, and none of them were irresponsible speculators. They just expected the housing and mortgage markets to continue to operate in a normal way.
    Why should we care? Three reasons, besides ordinary compassion – Firstly, the health of the economy requires that people trust banks and the normal operation of markets. The longer they feel they can’t, the deeper the crisis gets. Secondly, because labour and capital mobility benefit the economy as a whole and leaving people stuck with houses they don’t want won’t help with that. And thirdly, because its in everyone’s interest that the grossly overvalued housing markets are allowed to clear quickly. Helping sellers will help them to accept lower prices, and until they do, buyers are going to be reluctant to buy.
    Simon

    1. It’s not schadenfreude, it’s supply and demand. As the supply of houses increase, prices drop.
      As a responsible renter, this is good for me and those like me as we will then be able to afford homes that now are over-priced.
      Supply and demand is very simple…even most democrats can understand it.

      1. I can’t speak for you, but I see a lot of schadenfreude in people’s responses to this. Everyone who bought a house during the peak was an irresponsible speculator who bought what they couldn’t afford and deserves to suffer, so we can delight in their misfortunes. Sorry, but it isn’t true – this has caught those who were responsible along with those who were not.
        As a fellow responsible renter, I agree with everything else you say. Prices have to fall and I have no interest in putting a floor under them. What I am interested in is measure to help the market clear (ie prices to fall) as fast as possible, and with the miniumum in collateral damage to people who didn’t do anything wrong. This plan makes some moves in that direction, and some others that are bad. Rather than making some kind of sensible analysis, Will just quoted someone elses glib, thoughtless response.

    2. Sounds great Simon.
      How much of your money would be better spent subsidizing troubled mortgages than anything else you can think of doing with it?
      For me, it’s $0.
      If it’s more than that for you, then maybe you should write a check.
      There are lots of projects that have some value, and it’s tempting to spend other people’s money (along with a little of your own) on them. But, I think it’s almost always better (practically and morally) to have a policy of not doing that.

      1. That would be wonderful were we not in a giant, largely government-created mess. Unfortunately governments can create messes to which there is no private sector solution, and this would appear to be one.

  2. Don’t forget inflation. I assume it will help with this problem. There is a general appreciation in housing over time, but the change in the value of the dollar could be of immense help. Inflation has all sorts of nasty consequences but in this case a high rate of inflation may be preferable to alternatives.

  3. There is a (in my opinion) pernicious deception being bruted by the socalled MSM and the politerati, that this crisis is a mortgate, or toxic mortgage issue. It’s not. It’s a gainful employment issue. JOBS!!! Real, sustainable, secure, living wage jobs are the key to restoring credibility and stability in the markets. If you are unemployed, no matter how toxic your mortgate or how much that individual may desire to own something, anything, – there are simply no options. Unemployment, and underemployment are the real root cause of this global economic crisis. Government can print endless amounts of paper and call it curreny, or bail out FAILE institutions, and FAILED management bruting FAILED models, or lower interest rates to zero, or concoct any strategy for shielding predator class cronies and oligarchs from radical haircuts, or outright insolvency – but until people get back to work is relatively well paying secure jobs, with real bargaining power, {(NOT) 35 hour a week, benefitless, $8 dollar an hour slave wages} – there is no hope of recovery. The old ways, the old models, the old leaders, the old system is dead and rotting in a putrid swamp. New ways, new models, new leaders and a new more equitable, fair, legal, and fiercely regulated economic system must be erected replacing the old and catastrophically FAILED system. All the old message-force multipliers and the old system FAILED. It’s over. There is no righting this horrorshow wrong, and no way to remedy the criminal and FAILED economic system of the past. It must be intelligently dismantled and replace with a new more equitable, lawful, transparent, and moral system.
    If not – then high ho high ho it’s off to the Mayan calender end of the world as we know it we go.
    Tony Foresta

  4. It’s very simple. You have an incentive to walk whenever you can pay less in rent than you
    do in mortgage payments. How attractive that incentive is depends on how badly you need the difference. If your need for that difference is pressing, you walk.

    1. Very simple. And wrong.
      You don’t just pay rent. You pay in lost future credit, and perhaps job, opportunities. You pay in lost reputation among your peers. You pay in self-respect. On the other hand, you do gain mobility.
      It’s true that it’s a trade-off calculation. But, it’s not just the prices of mortgage vs. rent.

      1. In Canada, a bank that forecloses on a mortgage thereby forgives the debt (the “personal covenant”). I’m not familiar with American law, and I assume it may vary state-by-state. But if that’s the case, there is no reason why a person walking away from a house that was underwater would jeopardize thier credit rating.

      2. I’m no expert, but I know I’ve read that it haunts your credit for seven years.
        I also know that there are services that claim to be able to have such items removed.
        Maybe somebody else knows how cheaply, easily and reliably this can be done.
        In any case, there’s a cost worth weighing in the calculation.

      3. You can’t remove a foreclosure from your credit report once it happens. If you really need to get out from under a mortgage that is for more than the home’s value, by far the best option is to reach a deal with the bank to either do a short sale, or surrender the deed in lieu of foreclosure. Such a deal usually includes provisions to improve the borrower’s chances of getting credit later.

  5. “But I really don’t understand why it’s such an unbearable crisis for responsible homeowners themselves.”
    It’s not an unbearable crisis for homeowners. It’s an unbearable crisis for politicians and bureaucrats. For government to expand they need to create new classes of dependent people. Otherwise they will not be able to cultivate votes, demand large budget increases, and funnel huge new contracts to their friends. Also in order to save the banksters from paying the consequences of their own greed and fraud, it is necessary to push larger and larger amounts of credit through the banking system. Cleaning up balance sheets and liquidating toxic assets would be a real crisis (for the banksters).
    It may seem like a sensible, pragmatic solution to you, if they would only leave the markets alone and let people sort out their housing and financial problems for themselves, peacefully and without any drama. But that would be a disaster for the people who are running things. Not because they can’t survive in a free market, but because they don’t want to.

  6. This is an excellent post. For an example of the mentality that is debasing contemporary dialogue see this racist tirade by Julian Elson. Lovers of liberty and freedom need to stand about against people like Julian Elson. Julian Elson is the cancer that is killing the internets.

  7. While I can’t say what ALL Republicans have said, the consistent comment I’ve heard is that we may be subsidizing that bad bets of homeowners who over-extended while ignoring those who didn’t buy more than they could afford. Of course those folks have their own reward (isn’t doing the “right thing” its own reward)
    Now the counter argument has been that letting the “bad bet” homeowners default further reduces property values and puts more of the responsible homeowners at risk.

  8. In order to save the banksters from paying the consequences of their own greed and fraud, it is necessary to push larger and larger amounts of credit through the banking system.

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