How does trade affect inequality?
Published 13 July 2022
Gregory Mankiw’s (1997) popular introductory textbook lists the principle that “trade can make everyone better off” as one of the fundamental tenets of the discipline. But does it? In reality, changes in trade policy – whether they raise or lower trade barriers (or, as is sometimes the case, both) – create both winners and losers. One definition of an inclusive trade policy is one that would allow countries like the UK to reap the benefits from greater openness to trade (through for example access to more and cheaper varieties of goods and services) without significantly increasing social inequalities, or at the very least without seeing large numbers of vulnerable individuals losing out in absolute terms.
It is increasingly recognised that this is no easy task. However, it wasn’t so long ago that the prevailing view among economists was that openness to trade, even rapid growth in trade, could promote growth with only moderate impacts on inequality.
During the 1990s and 2000s, the ratio of global merchandise trade to world GDP nearly doubled, with a growing share of goods originating from low-income countries, allowing economists to put theories of trade’s impact on inequality to the test. While a number of factors lay behind this increase, including rapid improvements in communication technology, the spread of regional trade agreements, declines in tariff rates and lower transportation costs, the transition of communist countries towards market-oriented economic systems was undoubtedly a big part of the story. China, now the leading exporter of manufactured goods, was the largest contributor to growing world trade during the 1990s and 2000s.
During this period, most empirical studies by economists did not find that trade made an important contribution to growing wage inequality in the US or Western Europe. The eventual Nobel Laureate Paul Krugman summarised the consensus view in 1995, noting that “a preponderance of research to date suggests that the impact of third world exports on first world labour markets has been small” (Krugman, 1995), and towards the end of the wave of globalisation thirteen years later that there remained a “consensus that trade has only modest effects on inequality” (Krugman, 2008).
However, as the growth in imports levelled off in the 2010s, research started to show that trade’s labour market impacts had been much more disruptive than previously thought (see Dorn and Levell, 2021, for a review). For example, the rapid growth in Chinese manufacturing imports in the 1990s and 2000s reduced the long-term earnings of US and UK workers who were initially employed in import-competing industries, compared to similar workers in less-exposed industries (Autor, Dorn and Hansen 2013). Low-wage workers were hit hardest. Moreover, the geographic locations where import-competing firms clustered experienced not only declines in earnings and employment levels, but also changes in social outcomes and attitudes. Studies have linked greater local exposure to import competition to a deterioration in the local provision of public goods, adverse health outcomes and greater mortality, a dissolution of traditional family structures, and greater support for extreme political parties and politicians, especially on the far right.
Findings such as these led economists to reappraise their views of trade’s impact on inequality in rich countries. In 2021, Paul Krugman noted that “economists, myself included, have tended to underplay the disruptive effects of rapid change. (…) Many of us feel that we missed something important about the downsides of globalization” (Krugman, 2021). What had economists missed? Textbook models of trade assume that workers smoothly transition from declining industries and regions to growing ones. A trade shock to specific industries would then rapidly dissipate in the broader labour market, affecting workers only via modest changes in national wage levels. In reality, workers exposed to adverse shocks take a long time to find new work, or to move to new locations (Autor, Dorn and Hansen 2021). This meant that trade’s impacts may have been relatively small on average but nonetheless sharply concentrated in labour markets where import-competing industries were clustered.
The experience of the recent globalisation wave contains important lessons for how to make trade policy inclusive in the future. We now know that sudden shifts in trade patterns can have damaging and persistent impacts on certain workers and geographic regions. This applies to both trade integration but equally to cases of trade disintegration (such as Brexit), whose effects may be no less damaging and concentrated.
Raising trade barriers can in principle avert or mitigate the effects of import competition, but they should only be used as a last resort. Such policies prevent consumers and businesses from reaping gains from reduced prices, while causing disruptions of their own for workers in industries that purchase their inputs from abroad. Moreover, they can provoke retaliatory measures from other countries. The short-term impacts of the 2018-2019 US-China ‘trade war’, which raised prices while failing to protect US employment, provides an important cautionary tale (Flaaen and Pierce 2020, Amiti, Redding and Weinstein 2019, Fajgelbaum, Goldberg, Kennedy and Khandelwal 2020).
More helpfully, both active labour market policies to support workers and ‘place-based’ policies to support distressed regions can help to smooth the dislocations from trade shocks, even if such policies can also create important trade-offs between equality and efficiency. Potentially exposed workers and local areas should ideally be identified before big changes in trade patterns, giving policymakers, businesses and workers time to prepare for changing economic circumstances.
Overall, an inclusive trade policy needs to anticipate future challenges, react quickly to adverse events and be considered jointly with training, employment and social policies that help workers and places get back on their feet after negative shocks. The difficulties of doing this well should not be underestimated, but neither should the potential benefits.
Autor, D., Dorn, D., and Hanson G. (2013), ‘The China Syndrome: Local Labor Market Effects of Import Competition in the United States’, American Economic Review, 103(6), 2121–68, https://doi.org/10.1257/aer.103.6.2121.
Autor, D., Dorn, D., and Hanson, G. (2021), ‘On the Persistence of the China Shock’, Harvard University, Working Paper.
Amiti, M., Redding, S., and Weinstein, D. (2019), ‘The Impact of the 2018 Tariffs on Prices and Welfare’, Journal of Economic Perspectives, 33(4), 187–210, https://doi.org/10.1257/jep.33.4.187.
Borusyak, K., and Jaravel, X. (2018), ‘The Distributional Effects of Trade: Theory and Evidence from the United States’, Society for Economic Dynamics, Meeting Paper 284.
Dorn, D. and Levell, P. (2021), ‘Trade and inequality in Europe and the US’, IFS Deaton Review of Inequalities, https://ifs.org.uk/inequality/trade-and-inequality-in-europe-and-the-us/.
Fajgelbaum, P., Goldberg, P., Kennedy, P., and Khandelwal, A. (2020), ‘The Return to Protectionism’, Quarterly Journal of Economics, 135(1), 1–55, https://doi.org/10.1093/qje/qjz036.
Flaaen A., and Pierce, J. (2020), ‘Disentangling the Effects of the 2018-2019 Tariffs on a Globally Connected U.S. Manufacturing Sector’, unpublished manuscript, https://economics.yale.edu/sites/default/files/pierce_fp_draft_55_10-26-2020.pdf.
Krugman, P. (1995), ‘Growing World Trade: Causes and Consequences’, Brookings Papers on Economic Activity, 1995(1), 327–77, https://doi.org/10.2307/2534577.
Krugman, P. (2008), ‘Trade and Wages, Reconsidered’, Brookings Papers on Economic Activity, 2008(1), 103–54, https://doi.org/10.1353/eca.0.0006.
Krugman (2021) “Krugman Wonks Out: The China Shock and the Climate Shock”, New York Times, https://www.nytimes.com/2021/04/23/opinion/climate-coal-china-us.html.
Mankiw, G. (1997), Principles of Economics, South-Western Cengage Learning, Mason.