Don't Blame China for Rise in Inequality

In his recent Brookings paper, Princeton economist and NYT columnist Paul Krugman tried to find out how low-wage workers were affected by rising trade with cheap-labor countries like China. His working assumption was that this type of trade should reduce the wages of less-educated workers and increase inequality.

Research done in the 1990's, however, indicated that this effect was relatively small, somewhere between 1 and 7 percent. But, as an anonymous Economist columnist points out in his/her/its review of Krugman's paper, there's a growing sense of doubt in America about the benefits of globalization, so it's worth taking a look at the question anew.

Unfortunately, Krugman throws up his his hands in the end and complains that the data we have doesn't give a good picture of the real trade patterns that could affect inequality: Current figures show emerging economies have been exporting greater quantities of sophisticated manufactured goods. This move up the value chain means that, theoretically, most economic classes in the U.S. should be getting hurt by roughly the same amount. In other words, trade shouldn't have had an impact on inequality.

But Krugman argues that the data aren't detailed enough to capture what's really going on: The Chinese segment of many manufacturing chains are the most labor-intensive and the least knowledge-intensive parts. For example, the iPod is assembled in China, but components like the screen and hard drive parts are made elsewhere. So, what on paper looks like a sophisticated Chinese import masks a more complicated process which leaves low-wage Americans who might otherwise do this work at risk to competition from China and other low-cost countries.

Still, using the data that we do have, the, Harvard economist Lawrence Katz found that "trade with poor countries can account for about 15% of the growth in the wage gap between skilled and unskilled workers since 1979." That's a sizable amount, but far from being a major driver of inequality.

But all of this worry could be misplaced. Another way of investigating the relationship between inequality and trade with poor countries implies that China may actually help the poor, suggests new work from University of Chicago economists Christian Broda and John Romalis.

Instead of focusing purely on what's produced outside of the country, Broda and Romalis turn their attention to an interesting but obvious relationship between imports and consumption within our border: The goods exported by poorer countries are typically consumed by lower-income Americans. Our typical methods of quantifying inequality, however, don't take this into account.

At the same time, inflation in the price of these goods has fallen behind inflation in services, which make up a greater portion of what wealthier people buy. Taken together, these trends imply that official measures may be overstating the rise in inequality.

Looking at trade data between 1994 and 2005, Broda and Romalis construct inflation rates for different income groups and find that rates for the richest outpaced rates for the poorest by about 4 percent over the period. Since income inequality between the top and bottom 10 percent of earners grew by about 6 percent, the different inflation rates among income groups wipes out about two-thirds of the rise in inequality.

China's role in this new way of analyzing inequality is large, accounting for about 50 percent of the total reduction.

(A very interesting aside. Broda and Romalis also find that the poor are more likely than the rich to buy newer goods. Because of the lag in how quickly the CPI tracks new products, the researchers argue that once this "new goods bias" which serves to keep official inflation rates higher than they actually are since newer goods are typically cheaper, is factored out, inequality between the rich and the poor between 1994 and 2005 may not have changed at all.)

If Broda and Romalis's results stand up to closer scrutiny, it could go a long way towards refocusing concerns on other, more substantive, causes of income inequality in America.