REDUCING GLOBAL WAGE INEQUALITY: Rebalancing world trade is key

Large trade surpluses in developing countries lead to higher wage inequality in both poor and rich countries, which suggests that the way to alleviate global wage inequality is to target trade imbalances. These are the central findings of research by Rosario Crinò and Paolo Epifani, published in the May 2014 issue of the Economic Journal.

Their analysis of international trade predicts that an increase in the trade surpluses of developing countries leads to higher skill premia both at home and in developed countries. This is because the rise in developing country exports is shared among a few industries and so most of the increased wages in that country go 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 sets of countries. The researchers find evidence in support of their theory by looking at data on exports and jobs for 113 countries between 1977 and 2007. They conclude:

”Our theory and evidence suggest that a rebalancing of the world economy would reduce inequality in both the South and the North.”

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

A number of alternative explanations have been suggested to account for the observed trends. One strand of research points at foreign direct investment (FDI) and offshoring, rather than international trade, as the main culprits for rising wage inequality. Another blames intra-industry rather inter-industry trade for its distributional effects.

Other explanations look 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 standard trade theory, provided that they are associated with trade imbalances of the type recently experienced by the world economy – namely, growing trade surpluses in 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 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 the 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 in 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 in 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 in 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 previously unnoticed, particularly because trade imbalances are a no less salient feature of the latest wave of globalisation than growing North-South FDI or Southern catching-up.

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 countries (the United States and Japan) and two skill-poor countries (China and Chile). 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, offshoring, technical progress and endowment changes have the expected impact on the structure of countries” exports. Except for technical progress, however, their effect is smaller and less robust than 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.

”Trade Imbalances, Export Structure and Wage Inequality” by Rosario Crinò and Paolo Epifani is published in the Conference issue of the Economic Journal. Rosario Crinò is at CEMFI in Madrid. Paolo Epifani is at Bocconi University in Milan.

Rosario Crinò

CEMFI in Madrid | crino@cemfi.es

Paolo Epifani