Do Trade Deficits Cause Income Inequality in America?

International trade has long been a non-issue for most Americans voters. Today, however, the American public is so concerned about trade that the presidential candidates seem to be competing for the Anti-Trade Crown – especially when it comes to talking about the Trans-Pacific Partnership (TPP).

Why such virulent feelings against free trade? Why are so many Americans willing to throw the baby out with the bathwater – to forgo the benefits of increased efficiency and lower prices that free trade can yield?

The best explanation is almost certainly the justified belief that trade worsens income distribution by killing jobs when trade is not balanced – when Americans cannot earn as much producing exports as they spend on imports.

This note summarizes the key reasons why expanding trade will almost certainly have a negative impact on income distribution if the U.S. is already running trade deficits and no mechanism is being put into place to return the dollar to its trade balancing equilibrium exchange rate and keep it there.

The next blog post in this series will examine the experience over the past thirty-five years in developed countries that are members of the Organization for Economic Cooperation and Development (OECD) to see if the negative impact on income distribution of trade deficits that we see in the United States is found there as well.

Links Between Import Competition and Worsening Income Distribution Equality in the United States

The voters most worried today about the negative impact of international trade on jobs are workers in the following categories:

1. Skills. Workers who do not have the skills to seek jobs with equal or better pay if they lose their current jobs are worried. Education is a particularly serious problem given that manufacturing now requires increasingly high levels of technical skill, but only about one-third of U.S. workers have a college-level education.[1]

2. Geography. Workers who live in areas heavily dependent on the manufacture of products such as furniture, textiles, and footwear, products that are likely to be imported from low-wage areas like China are particularly at risk, as are those who live in areas where alternative employment is hard to find – except at sharply lower wages 

3. Excessive Financial and Social Costs. Workers who do not want or cannot afford to leave the communities where they and their families may have lived for generations may find the cost of relocation unbearable, forcing them to take lower-paying jobs or to depend on the generosity of families, friends, and local organizations. 

4. Older Workers. It is much harder for older workers to bear the cost of retraining, job search, and transition than for younger workers with a lifetime of earnings ahead.

Research at the Economic Policy Institute by experts including Mishel, Bivens, and Scott indicate that, on average, workers who lose their manufacturing jobs will earn about $1,800 less per year in their new jobs [2] – if in fact they find another job.

Data from the Bureau of Labor Statistics show that the length of time required to find any alternative employment rose from 15 weeks before 2008 to 40 weeks between 2006 and 2009. Longer periods of unemployment hurt workers’ incomes in at least two ways.

First, the total loss of income grows over time.  

Second, workers find it harder to re-enter the labor force because job skills become rusty and workers’ reputations become “tarnished” as future employers wonder why they have been so long out of work. 

Research by Autor, Dorn, Hanson, and Song at MIT provide valuable confirmation that the costs of adjustment to foreign competition is very unevenly spread across the workforce, with a particularly heavy impact on the relatively poor in the above categories – the people who are least able to bear the costs.[3] The abstract from one of their recent papers is most informative:

Individuals who in 1991 worked in manufacturing industries that experienced high subsequent import growth garner lower cumulative earnings, face elevated risk of obtaining public disability benefits, and spend less time working for their initial employers, less time in their initial two-digit manufacturing industries, and more time working elsewhere in manufacturing and outside of manufacturing. 

Earnings losses are larger for individuals with low initial wages, low initial tenure, and low attachment to the labor force. Low-wage workers churn primarily among manufacturing sectors, where they are repeatedly exposed to subsequent trade shocks. High-wage workers are better able to move across employers with minimal earnings losses and are more likely to move out of manufacturing conditional on separation. These findings reveal that import shocks impose substantial labor adjustment costs that are highly unevenly distributed across workers according to their skill levels and conditions of employment in the pre-shock period.  (emphasis added).

This and related studies leave no doubt that import competition is far more likely to hurt the those in lower rather than higher income groups.

Trade Deficits Reduce Income Levels in General

Trade deficits indicate that, because of the overvalued U.S. dollar, both domestic and foreign demand for made-in-America goods is lower than it would be if trade were balanced. The lack of demand means that America’s production capacity and thus its GDP growth has been reduced.

For example, manufacturing capacity utilization dropped from nearly eighty percent before the Great Recession to about sixty-three percent by the depth of the recession – an event triggered in large measure by the collapse of the irrational exuberance associated with foreign-financed trade deficits and large speculative foreign capital inflows.

Furthermore, workers become under- or un-employed when domestic and foreign demand for American goods falls. This was seen during the early 1980s when trade deficits were associated with headline unemployment rates exceeding ten percent, and again at the time of the Great Recession when unemployment rates generally stayed over nine percent for nearly three years.

When freer trade means bigger deficits, it is impossible to imagine that economic efficiency and incomes will improve.

Negative Inter-Generational Impact of Trade Deficits on Income Distribution

Trade deficits also impose an inter-generational worsening of income equality. When we run trade deficits, we force the next generation to pay the difference between what we import and what we pay for with exports.

Furthermore, trade deficits impose an inter-generational worsening of income equality. When we run trade deficits, we force the next generation to pay the difference between what we import and what we pay for with exports.

In 1990-91, for example, Americans paid for over 90 percent of their imports with exports. But by the height of the mid-2000s financial and economic bubbles, Americans paid for less than 65 percent of imports with made-in-America exports. The rest of the import costs were financed by debt.

No wonder imports have become so cheap – for us – but not for future generations who will have to deal with paying off this debt or rolling it over.

Though less immediately obvious, negative impact of trade deficits on America’s economic efficiency, international competitiveness and income distribution may be even more serious in the longer-term than the simple inter-generational theft just described – the stealing from our children so that we can live beyond our means.

When American enterprises face abundant excess capacity and low profitability from domestic production, they have little incentive to invest in new equipment, new production technologies, and new labor skill training. As a result, America falls farther and farther behind the rest of the world, leaving future generations worse off rather than better off, not only in terms of accumulated debt, but also in terms of the ability to compete internationally.[4]

Trade Deficits and the Wealthy

At the other end of the income spectrum, trade deficits tend to increase the income and wealth of those at the high end of the income spectrum for at least two reasons:

First, wealthier individuals are far more likely to spend more on foreign travel, imported cars, and other luxury goods from abroad than the poor. The overvalued dollar that leads to trade deficits makes such imports artificially cheap, giving the rich an artificial boost in their real effective incomes. [5]

Second, wealthier individuals are far more likely than the poor to hold assets in financial markets. The excess inflows of foreign capital that drive the dollar’s overvaluation and U.S. trade deficits tend to inflate asset prices in financial markets, providing a wealth boost to the relatively wealthy.

Conclusions

We can safely conclude that expanding free trade with an agreement like the TPP when trade is already unbalanced and no mechanism is in place to balance trade will worsen domestic income inequality the following reasons:

1. Most of the costs of adjusting to freer trade are borne by the poor in the form of lost jobs, reduced income, and the costs of job search, retraining and relocation. 

2. Most of the benefits of freer trade go to the non-poor. 

3. The U.S. has no adequate mechanisms to assure that the beneficiaries of free trade such as large multinational corporations will compensate the poor in a manner assuring that, at a minimum, no group in society will be worse off with the trade agreement in place, and that, ideally, all groups will be better off. 

No wonder trade agreements like the TPP have been generating so much negative feeling in the current presidential campaign, a feeling that could well cost America and the world dearly in terms of increasing productive efficiency through freer trade that is also balanced trade.

Is a similar correlation between trade, trade deficits, and income inequality found in other developed countries? That will be the topic of the next blog posting.

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1 Robert E. Scott, 2016.01.13, Trans-Pacific Partnership Agreement - Currency Manipulation, Trade, Wages, and Job Loss. Washington: EPI.

[ http://www.epi.org/publication/trans-pacific-partnership-agreement-currency-manipulation-trade-wages-and-job-loss/ ]

2 Josh Bivens, 2013.03.22, "Using Standard Models to Benchmark the Costs of Globalization for American Workers Without a College Degree." Washington: Economic Policy Institute [ http://www.epi.org/files/2013/standard-models-benchmark-costs-globalization.pdf ]

3 David H. Autor, David Dorn, Gordon H. Hanson, and Jae Song, 2014.09.24, Trade Adjustment: Worker-Level Evidence, QJE, pp. 1799-1860.

4 Warren Buffett starkly highlights this problem of immiseration in his 2003 parable of Thriftville and Squanderville where the latter ended up losing its assets to the former through continuously unbalanced trade. (Warren E. Buffett and Carol J. Loomis, 2003.11.10, “America's Growing Trade Deficit Is Selling the Nation Out from Under Us,” Fortune Magazine).

5 Some argue that the overvalued dollar is good for the poor because it allows them to buy cheap clothes and other household items at Wal-Mart, which is true but misleading. About ninety percent of the consumption basket of those in the lowest income quintile goes to basically non-traded goods and services such as food, medicine and medical services, housing rental, and transport. Consequently, imports represent a small part of the poor’s annual expenditures.
Furthermore, being able to pay somewhat less for a lunchbox at Wal-Mart becomes very unimportant if you have no job to go to, or no food to take to school.
This analysis, which is based on a 2014 paper from the Cleveland FRB entitled Income Inequality and Income-Class Consumption Patterns, will be explored in more detail in a forthcoming blog post.

America Needs a Competitive Dollar - Now!