What if Paul Krugman were right about trade and wages?

For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net.

That is Paul Krugman, here is more.  I have yet to see the evidence that trade has a significant negative impact on middle class wages, but for sake of argument assume it is true.  However benevolent it may sound, strengthening the social safety net would not be my policy recommendation number one.  After all, if Samuelson-Stolper factor price equalization is the main mechanism at work, wages would have a long way to fall downwards and if anyone in the middle class is to keep working, the safety net must eventually be cut, not increased.  You might think we can fund all these trade-losers by taxing capital but of course the incidence of taxes on capital sometimes falls on labor, not to mention that at some point the Laffer Curve kicks in. 

Is not the appropriate policy recommendation to create a budget surplus, create a U.S.A. Sovereign Wealth Fund, and invest the resulting capital in the corporate winners from this entire process?  In other words, we would be giving the trade-losers a more direct share in capital.  Since output is rising and wages are falling, the return to capital must be rising; let’s make money off of that.

You might not trust the government with such investments but it is awkward for Krugman to push that argument too hard.  Alternatively, you might think that share prices already have capitalized these gains, but that is hard to square with the view that Krugman is reporting a new result about trade.  Share prices are driven by liquidity to some extent, and if you know something about the returns to labor and capital that the rest of the world does not, there ought to be a way to make money.  Why spend more on consumption (a stronger safety net today) if the rate of return on investment is rising so high and we are going to need even more of a safety net in the future?

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After all, if Samuelson-Stolper factor price equalization is the main mechanism at work, wages would have a long way to fall downwards

In an integrated economy, wages are set at the margin of production. For this to be true, one must assume that foreign workers are going to crowd into labor-intensive sectors so that each individual worker will earn very low wages. This can definitely occur in the short run, but it's unlikely to be a lasting effect. So far, we've seen a sudden doubling of the low-wage workforce with wages soaring in poorer countries and a modest stagnation in the developed world.

and if anyone in the middle class is to keep working, the safety net must eventually be cut, not increased.

This is not an issue if the social safety net is properly designed. For instance, EITC subsidies do not have this problem.

Since output is rising and wages are falling, the return to capital must be rising; let's make money off of that.

If the return to capital is rising, why isn't this being reflected in real interest rates? When real interest rates rise, the recommendation to create a budget surplus becomes obvious.

It seems like workers have done well since NAFTA went into effect, for example. Most of you probably know this but here are the numbers

Using Bureau of Labor Statistics data, hourly wages from 1994-2006 rose 47.8 percent while the Consumer Price Index went up 36 percent.

In the 12 years before NAFTA wages rose 44 percent while prices roses 54 percent.

The unemployment rate was 6.9 percent in 1993 and 6.1 percent in 1994. It fell steadily until reaching 4 percent in the year 2000. Even in 2003, two years after we had a recession, the rate was 6 percent, lower than the year NAFTA began. Now it's 4.7 percent. From 1981 to 1993, it averaged 7.1 percent a year. From 1994-2006, 5.1 percent. The percentage of the population employed is higher today than before NAFTA went into effect.

Krugman also mentions in his book "Pop Internationalism" that if cheap imports cost jobs, the Fed can lower interest rates to offset this (page 159). On page 123 he emphasizes that the level of employment is a macro issue as well, determined by AD and AS. It seems to me that if falling demand for US workers (causing either unemployment or lower wages) results from cheap imports, that demand can be increased by some type of macro policy. For some reason Krugman is not considering this anymore. Maybe it is a specific class of workers whose wages are falling and other wages are rising enough to more than enough to offset this. But wouldn't their wages increase with the appropriate macro policy?

I would much prefer that if economists are going to talk about "compensating" the losers from free trade that they talk not of justice or fairness but merely of buying out the political opposition to freer trade. I do not think that a case can be made that if some wages fall this is unfair or unjust or any such fancy sounding things. It is simply that some of these people who are earning less will try to forestall what is best for the most people and virtually everyone in the long run.

In other news, California's workers wages have increased much faster than
those of Alabama.

Sloc wrote in response to rustbell:

high-priced union labor and legacy costs (deriving from even more high-priced union labor, now retired, from decades past) have made the 'Big 3' uncompetitive with the lower-priced non-union 'foreign' labor located in ... Kentucky, Tennessee, South Carolina, Alabama, etc. NAFTA had nothing to do with it.

Rustbell did not mention NAFTA in his post.
Sloc is being dishonest here.
Do you have a real answer to the rust, Sloc?

"if Samuelson-Stolper factor price equalization is the main mechanism at work"

Not being economist, have no idea what that S-S factor is.
But you said if, what if that factor is NOT the main mechanism?

Do you have the prove that S-S factor must be the main mechanism?
If you do, you certainly did not mention it.

Cyril Morong confused me.
First he sez this:
"hourly wages from 1994-2006 rose 47.8 percent while the Consumer Price Index went up 36 percent.

In the 12 years before NAFTA wages rose 44 percent while prices roses 54 percent."

So nominal wages in the period in question - period includes dotcom bubble, went up by 3.5% a year and real wages by about 1% a year.

Why would anyone complain? Look like terrific performance to me.
There is no problem, right?

But then CM sez:
"if falling demand for US workers (causing either unemployment or lower wages) results from cheap imports, that demand can be increased by some type of macro policy. "

But you just proved, with some data backing, that wages growing very nicely, why would demand for US workers fall?

Do you believe in your own proof?

I'm also confused about the Samuelson-Stolper factor price equalization theory. What is this?

However, I'm somewhat disturbed by this Sovereign Wealth Fund idea...if you just want Americans to share on the returns to capital, why not just give them the capital? Does it sound too...socialist?

Interesting idea... But I think the factor that is benefiting in Krugman's story is not capital, but human capital. That is, the two factors in the model are skilled and unskilled labor, where the wages of skilled labor are really returns to human capital. At the moment, there's no way to buy equity in that, but maybe one of our newly-unemployed "financial innovators" could set up a market where people could finance higher education by selling shares rather than taking out loans.

Aren't you and Krugman both saying that what is needed is to tax the haves and transfer to the have-nots?

Nobody is owed a certain standard of living and nobody has the moral right to tell me who I can and cannot associate with (which includes buying from and selling to). Those people who have their wages threatened by allowing me what is a fundamental human right shouldn't be asking for a "safety-net". Rather, they should be glad they aren't required to refund the money they've been able to extort through restricting who we're allowed to buy from over the years. Excuse me if I don't shed a tear for the poor bully who for years forced you to buy from him when we're finally "allowed" to choose for ourselves.

I'm usually happy to see Krugman attacked, but I don't think Tyler is being fair here.

In the simplest, Ricardian model of trade, there are no loosers: the wine-makers simply become cheese-makers, or assembly-line workers become IT consultants, and everyone is better off. In more complex models with non-transferable assets, the owners of the such assets can be loosers: vinyard owners, or owners of assembly-line skills but no IT skills, are worse off. The loosers in such models are permanent -- the vinyards and assembly-line skills are forever useless -- so a long-term stake in a rising industry is indeed a better compensation than a temporary social safety net. If this were Krugman's model, Tyler's critique would be a good one.

But I don't think this is Krugman's model. The more realistic model of loosers from trade involves temporary losses as the economy shifts: vinyards do become dairies and assembly-line workers do become IT consultants, but it takes time for capital to shift and workers to learn new skills. There are few economic models of this phenomenon, because economists' models are almost invariably quasi-equilibrium models, not true dynamic models derived from micro-behavior which could predict how re-equilibration unfolds in time. Still, Tyler and most economists would probably agree that a near-term depression of income below the societal average evolving in the long-term back toward the societal average is a better fit to the real experiences of trade loosers than either no depression or a permanent depression. Given the usual income-utility relationships, a social safety net to cushion the impact of the temporarily depressed income could indeed offer more utility than a stake in the new industries, which will only pay off in the long term.

Such a utilitarian argument is of course irrelevent if you simply take free trade and no income redistribution as ethical axioms. But that is the not perspective from which either Krugman or Cowen were arguing.

"...government can bear risk far more effectively than a private investor"

In what sense is this true? Not in the Miller-Modigliani sense or in modern portfolio theory. Unless you are indifferent to the risks borne by the residual claimants of government investment (i.e., the hapless taxpayer). Even if gov't could bear risk AS effectively as a private investor, the agency costs of government investment would surely swamp all possible benefits. And that's before the public choice issues raised by such a scheme.

"I haven't shopped at wal-Mart in a while, so I guess I don't benefit from trade."

TDM - Unless you're being facetious, you should know that if you were shopping at any Wal-Mart competitor, you are benefiting from trade (in this sense, at least).

"Hello, Paul? It's MIT on the phone. They say that they want their PhD back."

Rustbell did not mention NAFTA in his post.
Sloc is being dishonest here.
Do you have a real answer to the rust, Sloc?

He did not mention NAFTA specifically, but claimed that free trade generally was responsible for Michigan's and Ohio's problems. My answer was (and remains) that's simply not true -- unless you consider free trade with southern, right-to-work-states as a problem that needs to be addressed with trade restrictions.

"Actually a sovereign fund investing in equity makes a lot of sense economically, because government can bear risk far more effectively than a private investor; and it's well known that the risk premium on equities is abnormally high."

If it's well known that the ERP is abnormally high, that creates the preconditions for the ERP to end up abnormally low, markets being what they are. A widespread belief ('real estate never falls on a national basis') tends to engender its own negation.

"Is not the appropriate policy recommendation to create a budget surplus, create a U.S.A. Sovereign Wealth Fund, and invest the resulting capital in the corporate winners from this entire process? In other words, we would be giving the trade-losers a more direct share in capital. Since output is rising and wages are falling, the return to capital must be rising; let's make money off of that."

That is how the old tax code worked. The government taxed enough to raise a surplus. Then it invested in infrastructure, education, enforcement, research and so on. Then, when people and companies used that investment to make money, the government taxed them. That went for corporate profits, CEO wages, and investor gains. Cutting taxes and eliminating the surplus broke the cycle, but it's still a good idea. I'm surprised, however, to see you suggest it.

Kaleberg: What are the olden days of the tax code to which you refer? The government's take of the GDP has been essentially constant since the 1950s (20% to the feds, 10% to state and local). What has changed is not the tax burdon, but the spending mix, which has shifted massively away from the sort of investment you praise (infrastructure, education, research, etc.) and toward straight-up transfer payments (social security, medicaid, medicare, etc.). If you want to return to the good old days, the key isn't higher taxes, it's lower entitlement spending.

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