September 5, 2016

Trade Deficits and Income Inequality in OECD Countries

The previous blog post in this series [1] demonstrated that trade deficits are clearly an important source of income inequality in the United States. However, since we cannot run an experiment to see what today’s income distribution pattern would have been if America had maintained balanced trade over the past 30-40 years, we need to look at cross-country data to see if other developed countries with higher trade deficits also tend to have higher income inequality.

This blog post, which is based on data on OECD countries since 1980, clearly shows that trade deficits and income inequality are highly related. This evidence supports the hypothesis that America’s virtually constant trade deficits since the 1970s have contributed significantly to the high degree of income inequality in America today.

Cross-Country Data

Figure 1 charts IMF current account balance data as a share of GDP against OECD data on income inequality over the past thirty-five years for twenty-eight OECD countries.[2]

Figure 1

The experience of the OECD countries shown in this chart generally supports the hypothesis that greater income inequality is associated with larger external deficits.

The significant correlation between trade deficits and income inequality across EU countries happens despite the many important exogenous factors that drive external trade balance outliers such as:
1. Resource Endowments, most notably oil and gas for Norway and, to a lesser extent, the Netherlands. 
2. Relatively Large Financial Sectors, which can be beneficial or toxic depending on the circumstances. Compare, for example, the external deficits of Iceland, Ireland and the UK with those of Switzerland and Luxembourg. 
3. Under- and Over-Valuation of the Exchange Rate. Compare Switzerland and Japan on the undervalued side, with Australia and New Zealand on the other.  
4. Presence of a Monetary Union. Through the Eurozone, many of the European OECD countries are locked into an exchange rate over which they have no control. A combination of excess foreign capital inflows and consequent price inflation was thus a major cause of the current account deficits and banking crises experience during the Euro Crisis by Spain, Portugal, and Greece, for example.[3]
Once these country-specific differences have been taken into consideration, it is very clear that external deficits and income inequality are closely related. In fact, we can see the picture more clearly by removing the noise generated by country-specific conditions and charting Gini coefficients against the least squares trend average of current account balances for the countries ranked by size of their Gini coefficient (Figure 2).

Figure 2

Implications for Free Trade Agreements Like the TPP

The biggest take-away from these charts for U.S. trade policy is the low ranking of the United States – deep income inequality and deep average external deficits. Regarding income inequality, the U.S. is close to Turkey and only modestly better off than Mexico and Chile, the worst of the OECD countries in terms of income distribution. At the same time, America’s external deficits over the past 35 years place it well down in the group of fifteen deficit OECD countries, clustering the U.S. with countries like Chile, Turkey, the UK, Spain, Portugal and Iceland.

The undeniable benefits of specialization and lower costs that freer international trade can bring are likely to be relatively small and biased towards the rich, making it is impossible to assume that the winners will compensate the losers. Yes, trade will expand exports along with imports, but past experience indicates that imports will expand faster than exports, making America’s already serious trade deficits and income inequality even worse.

Unless trade is already reasonably well balanced and exchange rate adjustment mechanisms are in place to maintain this balance, implementing free trade agreements like the Trans-Pacific Partnership (TPP) are likely to impose heavy costs on the lower income classes, thereby exacerbating America’s already high inequality, risking further polarization of the body politic.

The winners, who are likely to be the same well-off international corporations that helped design the TPP, will have little incentive to share enough of the benefits of the expanded trade to compensate the lower-income losers for the retraining costs, loss of earning while unemployed, cost of job search, moving, lower wages until the always-promised “better jobs” arrive, and the other costs that are an inevitable part of any significant expansion of free trade.

America’s woefully outdated international monetary policies plus the absence of any meaningful mechanism in the TPP to restore balanced trade for the U.S. through necessary exchange rate adjustments make it impossible to meet the classical requirement for successful free trade agreements – that winners compensate losers, assuring that no group is worse off because of the expanded trade.


While strong arguments can be made that implementing the TPP would generate scale, specialization and efficiency benefits (primarily for other countries, not the United States), [4] the TPP should not be implemented until a mechanism is in place to bring America’s international trade into balance and keep it there.

Many mechanisms have been suggested over the years to do this, and some such as the anti-currency manipulation rules in the Omnibus Trade Act of 1988 are already in place – as are parallel rules by the IMF.

But these efforts have all failed to balance U.S. trade. They have failed to make it possible for Americans to earn as much producing exports as they spend on imports.  Currency manipulation today is a non-issue, [5] but our trade deficits keep growing. What can America do?

Better tools such as currency-adjusted countervailing duties should be implemented to prevent or compensate for the export of artificially cheap steel and other goods to the United States. Bills to this effect were presented in 2015 but have not been approved (e.g. the Currency Reform for Fair Trade Act, and the Currency Undervaluation Investigation Act).

The Countervailing Currency Intervention (CCI) mechanism proposed by Fred Bergsten and his colleagues at the Peterson Institute for International Economics should be enacted into law, even though currency manipulation is not a significant issue today. The presence of such legislation would discourage countries from resuming the practice and would allow the U.S. to respond effectively to any new currency manipulation. [6]

However, a Market Access Charge (MAC) is the only proposal designed to fix the fundamental overvaluation of the U.S. dollar that lies at the root of all U.S. trade deficits today. If the TPP is to benefit all Americans equitably,  a mechanism like the MAC is needed to return the dollar to its trade balancing equilibrium exchange rate and keep it there. Balanced trade is an essential first step towards assuring that the TPP will neither impose heavy costs on those least able to afford them nor grant most of the benefits to multinational corporations that are already wealthy. To pave the way for a TPP, the Market Access Charge needs to be implemented as quickly as possible – and definitely before the TPP is approved.

This is not the place to go into the details of the MAC, which is spelled out in detail here. [7]  In brief, however, the Market Access Charge would bring the dollar back to its equilibrium exchange rate by moderating the inflow of capital from abroad, the main source of the dollar’s overvaluation. The Market Access Charge, which would act like a peak-load pricing mechanism, would go into effect whenever foreign investors and speculators are bringing so much foreign capital into the U.S. financial markets that the dollar’s exchange rate is being driven to undesirable levels as indicated by trade deficits exceeding one percent of GDP.

Once policy tools such as currency-adjusted countervailing duties, countervailing currency intervention (CCI) and a market access charge (MAC) are in place, America can confidently move forward with state-of-the-art free trade agreements, knowing that expanded trade will no longer mean expanded trade deficits and growing income inequality.

1. John Hansen, 2016.09.05, Do Trade Deficits Cause Income Inequality in America? 

2. Data from OECD.Stat database: Social Protection / Income Distribution and Poverty by Country – Inequality (current definition; total population; Gini based on disposable income post taxes and transfers). 

Data on former Soviet Union and ComEcon bloc countries that are now OECD members are excluded because comparable time series are not available. Also, these countries developed as closed planned economies, so their experience is not directly comparable to the other OECD countries, which developed as open market economies. Given the focus of this note, it would have been desirable to have data on trade deficits rather than on current account deficits. However, for present purposes, current account balances are sufficient.

3. As the value of the euro is set for all Eurozone countries, individual countries cannot change its value directly. However, measures such as tight monetary and fiscal policies together with efforts to hold down wages and prices and to stimulate capital outflows have allowed Germany to create a Euro that is undervalued for Germany. This accounts for a major share of Germany’s extreme international competitiveness and current account surpluses. On the other hand, by borrowing extensively from Germany and elsewhere, countries like Italy, Greece, Spain and Portugal injected exceptional volumes of high-powered money into their economies – a direct cause of their inflation that in turn drove their current account deficits. 

4. See Peter A. Petri and Michael G. Plummer, 2012.06, The Trans-Pacific Partnership and Asia-Pacific Integration: Policy Implications, Washington:  Peterson Institute, Policy Brief Number PB12-16

5. C. Fred Bergsten and Jeffrey J. Schott, 2016.08,” TPP and Exchange Rates,” Chapter 20 in Trans-Pacific Partnership: An Assessment, Washington: Peterson Institute

6. C. Fred Bergsten and Joseph E. Gagnon (2012.12), Currency Manipulation, the US Economy, and the Global Economic Order, Policy Brief Number PB12-25. Washington, DC: Peterson Institute.

7. John Hansen. 2016.05.25. How the MAC Would Help Restore American Manufacturing

America Needs a Competitive Dollar - Now!

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