Globalization Alone Does Not Produce Losers!

by Gunther Schnabl*

The Brexit and the election of U.S. President Donald Trump were unexpected and were followed by a search for explanations. Subsequently, the common view spread that globalization is at the root of the frustrations of more and more people who are susceptible to strong nationalist statements from populists. This is surprising because for a long time, the reduction of trade barriers was acknowledged to be a basis for global prosperity. Why should the accepted view suddenly be so different?

The theory of comparative advantage (first described by David Ricardo in 1817) explains the benefits of free trade. In this historical model, Portugal and England may produce both cloth and wine without trade. Portugal produces more of both cloth and wine than England with the same input of labor. Thus for both goods, the productivity (i.e. quantity produced per worker) is higher in Portugal. Allowing for free trade, Portugal specializes in wine because the productivity advantage over England is greater than in cloth. All Portuguese get to work in the vineyards, whereas cloth production is left to foggy England. Specialization and trade mean that more cloth and more wine are produced with the same amount of work. Thus, prosperity in both countries grows.

In the Ricardian model, there are no losers because the workers who lose their jobs through free trade simply move on to other sectors of the economy. With ideal free trade, all Portuguese work in the vineyards and all English work in cloth production. However, it is widely acknowledged that in the real world, this structural change is problematic. Different qualifications needed for different jobs may cause unemployment. Since the early 1980s, the employment in some U.S. industry sectors has indeed declined strongly as trade with East Asia intensified. But this has not caused any mass unemployment. In contrast, the unemployment rate in the U.S. has fallen from 7.2% in 1980 to 4.8% today. Many of those unemployed from free trade must have found new jobs in other sectors as the Ricardian model predicts.

However, the wage level for the employed often seems lower. This cannot be explained with the Ricardo model as in his theory, the real wage level is determined by productivity. The productivity is increasing in the model in both countries because all the workers are moving to the more productive sectors, respectively. In a model with more than two sectors, it is also theoretically inconceivable that the wage movements between individual sectors completely diverged. In the past, productivity gains in industry have resulted in higher wages in other sectors as well (for example, in the service sector).

The wage descent in considerable parts of the U.S. middle class must therefore have additional reasons. One is likely to be found in the Federal Reserve’s monetary policy that has created losers. Since the mid-1980s, the continual interest rate cuts by the U.S. central bank have caused immense capital outflows from the U.S., in particular to East Asia. The U.S. capital exports have contributed to the built-up of large overcapacities in China’s industry, which were cheaply unloaded in trade with the U.S. with the help of subsidized credit. In short: the Fed’s money policy is one major cause of destroyed jobs in U.S. industry.

In addition, until recently, the ever more expansive monetary policy has inflated the financial sector, where speculative investments have made a few very rich. Think about the exorbitant bonuses for investment bankers! When some market bubbles burst, monetary policy rescue operations ensured that even more fresh money flowed into the financial sector. Since 1980, the average hourly wage in the U.S. financial sector has actually increased by 60%.

On the other hand, the financial crises curbed wages in industries to prevent unemployment from growing. Even more in the long term, the Fed’s low-cost liquidity provision has reduced the productivity gains because it systematically curbed financing costs. Efforts to increase efficiency therefore became more and more subdued. With the decline in productivity growth, the basis for real wage increases in the U.S. industry has been lost. Hourly wages across the U.S. industries have fallen slightly since 1980.

President Donald Trump argues that globalization is the cause of much evil and is now turning to an anti-globalization program: trade barriers against China, fiscal easing for industry and a wall against Mexico should help the alleged victims of globalization. But this “de-globalization policy” will destroy even more prosperity because the barriers to competition will lead to new declines in productivity growth.

A better option would be a tighter monetary policy, forcing enterprises to generate higher productivity gains to create room for higher wages. Janet Yellen at the Fed is therefore currently doing the right thing. However, this policy is unlikely to continue with the planned massive investment program by Trump, because sooner or later the Fed will have to finance the additional expenditures. The combination of trade barriers and expansionary monetary policy can be expected to make many U.S. citizens even more frustrated in the future.

 

Reference

Hoffmann, Andreas / Schnabl, Gunther (2016): The Adverse Effects of Unconventional Monetary Policy. Cato Journal 36 (2016), 3, 449-484. For working paper version click here.

 

*Gunther Schnabl is Full Professor of Economics and Director of the Institute for Economic Policy at Leipzig University.

 

 

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