October 27, 2016

Part 2. Trade Openness, Income Distribution,
and Income Levels

 “Trade is killing our jobs! We must build a wall! We must abandon international trade agreements!”

Protectionists who want to build walls against imports of foreign goods and services commonly believe that international trade is bad per se, and that more trade is even worse. In reality, however, increased openness to trade, as measured by the ratio of trade to GDP, tends to be associated with higher levels of income and with more equal patterns of income distribution.

Trade Openness, Income Levels, and Income Distribution

Trade Openness and Income Levels

The main benefit of expanding foreign trade relative to GDP is that this breaks down isolation and encourages competition, thereby increasing productivity and efficiency. As the American automobile industry discovered during the 1950s and 1960s, isolation from foreign trade reduces the competition that stimulates innovation and increased productivity.

The increased efficiency and income levels that trade openness should produce can be seen by looking at the experience of the OECD countries. A scatter plot of country rankings by openness and levels of per capita income shows a strong positive relationship (Figure 1). Countries like Turkey, Chile and Greece are relatively closed economies where international trade is small relative to total GDP, and these countries are among the poorest of the OECD nations. At the other end of the spectrum, countries like Luxembourg, Ireland and Switzerland, which have very open economies, have the highest per capita incomes.

Figure 1

The United States and Australia are the obvious outliers in this plot, but they do not invalidate the conclusion that more open economies tend to have higher levels of per capita income. These are both large continental countries endowed with abundant natural and human resources, and both are advanced industrialized countries, capable of producing domestically, with relatively good efficiency, a major share of what they need.

We can therefore conclude that more trade is better trade from the perspective of total average income per person. But as noted in the first post in this series, it is critically important that the trade be relatively balanced. Otherwise, high levels of income inequality are likely.

Trade Openness and Income Distribution

Like more balanced trade, trade openness also tends to improve income distribution.

The reasons for this are clear. Provided that trade is reasonably balanced, trade openness is associated with higher levels of income.  The higher income levels are generated primarily by expanding the production of manufactured goods. A major share of the people engaged in manufacturing are lower middle income workers. Consequently, when trade expands, manufacturing output and employment expand, producing more jobs and income for precisely the people who are most at risk.

Another reason for the positive relationship between trade openness and income distribution is that, as trade and GDP expand, the demand for workers will expand. This has two effects. First, as the competition for workers increases, the labor market will become tighter, and this will drive up wages. Second, as the demand for manufacturing workers increases, people will be drawn into the manufacturing labor force from other lower-paid jobs, especially those in the services sector. Also, currently unemployed people will rejoin the labor force. In each case, workers from lower income groups are the most likely to benefit. Hence the positive correlation of trade openness and income distribution.

The correlation between trade openness and income equality can be seen by ranking OECD countries by trade openness and by income equality. In Figure 2, countries are sorted by openness (the solid blue line), then plotted against income equality as measured by the Gini coefficient (the dashed red line),   As the most open country in the group, Luxembourg is in first place, and the United States, the least open country in the group, places last.

Near the top of the openness scale, we see the relatively high income equality of countries like Belgium, Ireland and Luxembourg where total trade averaged between 175 percent and 365 percent of GDP from 2005 to 2015. At the other end of the openness scale, the United States has one of the highest levels of income inequality.

Figure 2

Although the correlation is by no means one to one, the dashed red line that shows the rank of countries by income equality clearly declines along with declines in trade openness.

In addition to trade that is balanced and open, government programs such as job-oriented vocational skills, relocation assistance, and transitional income support to help people move from unemployment to a new job are needed to help assure that disposable income is more equitably distributed.

The next and final post in this series will examine what America needs to do to reduce trade deficits, thereby creating an environment where the benefits of trade are shared more equitably. Once people have confidence that more trade will benefit them personally, it will be easier to implement policies that reduce trade barriers and facilitate the expansion of good foreign trade.

America Needs a Competitive Dollar - Now!

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