Is Globalization the Force Behind Recent Poor U.S. Wage Performance?: An Analysis

Is Globalization the Force Behind Recent Poor U.S. Wage Performance?: An Analysis

Order Code 98-441 E
Updated January 12, 2001
CRS Report for Congress
Received through the CRS Web
Is Globalization the Force Behind Recent Poor U.S.
Wage Performance?: An Analysis
Craig K. Elwell
Specialist in Econometrics
Government and Finance Division
Summary
The last 25 years have seen a rapid expansion of trade in goods and assets and a
general rise of economic interdependence across the world economy. Globalization is
the popular term given to this ongoing process. Concurrent with this rising level of trade
has been a significant slowdown in the pace of U.S. real wage growth and a substantial
increase in wage inequality between skilled and less-skilled workers. Are the trade and
wage trends linked? This report suggests that there is likely little causality running from
a rising level of trade to poor domestic wage performance. Slow average wage growth
is fully and credibly linked to poor productivity growth. A small share of rising wage
inequality can be linked to trade, but the great bulk of this trend is probably more soundly
rooted in a rising relative demand for skill, growing out of a changed pattern of
technological change. This report will not be updated.
Introduction
The world economy in the postwar era has become increasingly “globalized,” with
a vast expansion of trade in goods and assets and increased interdependence among
trading nations. The pace of this process has clearly accelerated in the last twenty-five
years. In the United States, the real volume of trade has grown twice as fast as real output
bringing total trade (exports plus imports) from about 10% to over 27% of GDP in 1999.
The United States has been much involved in this process of globalization, both as a leader
securing successive rounds of trade liberalization and as an active participant in world
trade.
As Adam Smith first made clear in 1776 and as reiterated by successive generations
of economists since then, expansion of the level of trade and increased interdependence
is an enriching process whereby an enlarged scope for realizing gains from trade raises
economic efficiency and elevates the living standard of the average citizen. However, the
free market, as the economist Joseph Schumpeter noted, is a force for “creative
destruction.” Markets create wealth by continually reallocating resources to more efficient
Congressional Research Service ˜ The Library of Congress

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uses that increase total well-being. But, that process of reallocation must also destroy
inefficient uses of resources, deteriorating the economic circumstances of those whose job
or business is eliminated or downgraded. A critical dimension of a successful market
economy is how well it manages the achievement of higher efficiency and the adjustment
of those hurt by these dynamic wealth-creating forces. Much popular and political debate
about globalization, however, is heavily shaded with the image of rising international
trade, particularly with low-wage developing economies, as a threat to the U.S. worker’s
economic well-being, a threat that such expansion may be more “destructive” than
“creative.”
There is a concern that expanding trade erodes the wages of American workers. Two
recent trends in U.S. wage behavior, coincident with rising globalization, reinforce this
suspicion. One, there has been a significant slowdown in the rate of advance of worker
real wages. For example, between 1979 and 1999 real hourly compensation in the
business sector had a relatively slow commutative increase of 18.3%. Two, there has
been a marked increase in the inequality of the distribution of wages between skilled and
less-skilled workers as measured by education levels. For example, the difference between
the earnings of the college educated and those with a high school education was estimated
in 1995 to have risen 18% between 1973 and 1994.1
Trade can have strong effects, good and bad, on worker wages. The plight of the
worker adversely affected by imports comes quickly to mind. On the other hand, workers
in industries that export benefit from expanding trade. What is, perhaps, less well
understood is that, because all workers are also consumers, they will benefit from the
expanded market choices and lower product prices that trade provides. There is no
necessary reason to assume that the overall effect of trade on workers is bad, but sound
economic analysis also suggests that trade, even as it raises overall well-being, can also
sharply alter the distribution of income among the several factors of production, including
labor. The rest of this report attempts to evaluate critically whether an increasing level of
trade and interdependence has played a role in the slow growth of the real wages of
American workers and whether that process of globalization has made the distribution of
worker wages more unequal.
Globalization and Average U.S. Wages
Effect of Relative Labor Abundance. We consider first whether an expanding level
of trade is responsible for slow average real wage growth. Economic theory suggests that
increased trade, while making the overall economy better off, can have strong effects on
the distribution of income among factors of production. That theory points to the
possibility that, if labor is relatively more abundant in the rest of the world than at home,
an expansion of trade with the rest of the world could increase the “effective supply” of
workers to the U.S. economy and reduce worker wages relative to rewards paid to other
factors of production, most importantly capital. Since trade has clearly raised the real
living standard of the overall economy, a general decline in the real wage of U.S. workers
1 For further discussion of these trends see: Murphy, Kevin M. Changes in Wage Structure in the
1980s: How Can We Explain Them? Memo. University of Chicago, 1992. And also: U.S. Library
of Congress. Congressional Research Service. Earnings Inequality in the 1980's and 1990's. CRS
Report 97-142E by Gail McCallion.

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would have to mean that labor’s share of the economic pie has shrunk. This has not
occurred, however. Labor’s share of national income shows no significant trend, up or
down, in the post-war era. The share of worker compensation in national income was
71.2% in 1973 and 71.1% in 1999.
Effect of the Terms of Trade. Real living standards depend not only on worker’s
share of domestic production, but also on their ability to exchange that output for foreign
output (i.e., to realize gains from trade ). That gain can be eroded if import prices rise
faster than home prices, causing a fall in the real purchasing power of any given level (or
share) of national income. The ratio of U.S. export prices to import prices — the terms
of trade — is a measure of changes in the home economy’s share of the gains from trade.
It is plausible that expanding trade in a world economy, increasingly populated with
technologically capable foreign producers, could have put downward pressure on U.S.
export prices, reduced the terms of trade, and lowered the real wages of workers. The
data do not support that scenario, however. The terms of trade did fall in the 1970s, but
the commutative effect on real income was relatively small (less than a 2% decline over
the decade). Through the 1980s and the 1990s, the U.S. terms of trade have slowly risen
tending to increase worker real wages rather than erode them.2
Effect of the Trade Deficit. What about our persistent, large trade deficits over the
last 16 years? Have they dampened worker wage growth? First, trade deficits are not a
symptom of globalization and a rising level of trade. Rather, they are mainly a consequence
of domestic macroeconomic behavior, such as a high rate of domestic investment relative
to domestic saving, that have pushed domestic spending beyond domestic production
requiring a net inflow of goods — a trade deficit — to sustain the excess domestic
spending. As such these trade deficits do not represent a reduction in domestic output, nor
a reduction in the demand for labor. Second, even if the trade deficits had reduced
domestic output the size of those trade deficits and the potential scale of the effect on
domestic labor markets is far too small to explain the deterioration of American real
wages3.
Evidence from U.S. Multinationals. The recent behavior of U.S. multinational
manufacturing companies gives some added confirmation that there has not been any sharp
swing in the demand for labor away from domestic sources and toward foreign sources.
It is estimated that U.S. multinational firms account for about half of all domestic
manufacturing employment, making them good barometers of trends in the tradable goods
sector, particularly if those trends are reflective of changing economic attractiveness of
different countries as locations for production. If low-wage countries provide a significant
cost advantage then we would expect to see a shift of employment from the domestic
parent to these foreign affiliates. The data reveal, however, that multinational
manufacturing employment has fallen both at home and abroad. Between 1977 and 1993,
domestic employment in these firms fell about 21% (or about 2.6 million jobs), while
employment in their plants in the rest of the world fell 17% (or about 830,000 jobs). If we
2 See: U.S. Department of Commerce. Bureau of Economic Analysis. Survey of Current Business,
various issues.
3 See: Lawrence, Robert, and Matthew Slaughter. International Trade and American Wages in the
1980's: Giant Sucking Sound or Small Hiccup? Brookings Papers on Economic Activity, vol. 2.
Washington, Brookings Institution, 1993.

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look at manufacturing affiliates in only developing countries, employment did increase
about 5% (or about 85,000 jobs). But, if Mexico is excluded from this group,
employment in affiliates in developing countries declined about 8% (or about 100,000
jobs). This implies that the multinational’s U.S. workers have maintained their relative
productivity. Consequently, there is no great out rush of U.S. multinational firms to
increase employment in their low-wage affiliates at the expense of their domestic
counterparts.4
Slow Productivity Growth. If a rising level of trade is not the culprit behind slight
real wage growth, what is? We know that wages are basically a function of how
productive workers are. High levels of productivity (output per worker) are associated
with high wages, and rapid productivity growth is associated with rapid wage growth.
Therefore, it is highly credible that the sharp slowdown in average productivity growth
since the early 1970s in the United States is the cause of slow wage growth over the same
period. Measures of U.S. worker compensation, appropriately deflated using a price index
for the goods workers produce, gives a measure of real compensation that moves in step
with the trend path for productivity over the last 25 years. In other words, workers share
of the economic pie is not getting smaller, the pie is just not growing as fast as it once did.
Underscoring the importance of productivity growth for wage growth, more rapid
productivity advance evident since 1997 has been associated with more rapid growth of
real compensation.5
Globalization and Wage Inequality
The Effect of Relative Supplies of Labor on Wage Inequality. Even if expanding
international trade has not adversely affected the average level of wages, it can still have
a distorting effect on the distribution of wages among workers. Labor is not a
homogeneous resource, and market forces, including trade, can help one class of worker
while hurting another. In recent years, wages have been steadily skewed in favor of high-
skilled workers relative to low-skilled workers. It is conceptually possible that expanding
trade, particularly with countries that have a relative abundance of low-skilled workers,
will tend to increase the “effective supply” of low-skilled workers available to the U.S.
economy, working to put downward pressure on the wages of low-skilled workers in
America. Other forces, unrelated to trade could give the same outcome, however. For
example, a strong general increase in the demand for skilled workers presumably growing
out of the evolving pattern of final demand (increased demand for skill -intensive products)
and the nature of technological change (the productive process) requires higher and higher
inputs of “skill.” What does the evidence show? This remains an area of some contention.
Yet, the weight of evidence from most careful studies suggests that trade has been a
minor factor contributing to rising wage inequality, causing perhaps 5% to 15% of the
observed rise in wage inequality.6
4 For these data and a discussion of this phenomenon see: Lawrence,Robert, Z. Globalization and
Trilateral Labor Markets. The Trilateral Commission, No. 49. P. 32.
5 See: Krugman and Lawrence, op. cit; and Lawrence, Robert Z. and Robert E. Litan Globaphobia:
The Wrong Debate Over Trade Policy. The Brookings Institution. Washington, 1998.
6 See: Cline, William R. Trade and Wage Inequality . Institute For International Economics,
(continued...)

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For international trade economists looking at this issue, a critical bit of evidence
regarding trade’s effect on the distribution of wages is the behavior of the prices at which
goods trade. Foreign workers do not compete with home workers directly, but indirectly
through the price of the goods they produce. If foreign low-wage workers provide an
efficiency advantage over domestic workers, then that advantage must, through trade,
manifest itself as a lower price of the foreign goods in the home market. Reduced
profitability of the domestic industry that competes with the low- price import induces a
reallocation of resources toward more profitable skill-intensive applications, and a general
decrease in the demand for and wage of domestic low-skilled workers. In this chain of
causation, the critical factor is not the volume of trade, but rather traded goods prices.
This leaves us with the empirical question: Have the prices of import competing goods that
use low-skilled workers intensively fallen relative to the price of goods that use high-
skilled workers intensively? With appropriate deference to data problems, relative prices
have not moved in a pattern consistent with the conjecture that trade has adversely
affected low-skilled domestic workers.7 (In some cases there is evidence that this critical
price ratio has moved in the opposite direction, in a direction consistent with trade helping
low-skilled workers relative to high-skilled workers.)
Reasons for Trade’s Limited Effect on Wage Inequality. That globalization has,
so far, had a relatively minor effect on the level and distribution of U.S. worker wages is,
perhaps, less surprising if one considers that, despite the sizable growth of trade with low-
wage developing countries, such trade still remains a relatively minor component of total
U.S. trade and particularly small when compared to the total size of the U.S. economy.
Imports from countries where wages are less than 50% of U.S. wages was equal to 2.6%
of GDP in 1990, up only slightly from 1.8% in 1960.8 By and large, for the United States,
the great bulk of trade in manufactures is with other high-wage economies. It has been
estimated that, in 1990, the trade-weighted average hourly manufacturing wage of U.S.
trade partners was 88% of that in the United States, not a large enough difference to cause
the observed change in wage inequality.9 Thus, trade’s impact on the domestic labor
market can also be expected to be small. (We should also note that the data on U.S.
multinationals’ employment changes in recent years, discussed in the previous section, are
also consistent with the notion that there has been no differential shift of employment
toward low-skilled foreign workers and away from low-skilled domestic workers).
An Upper Bound for Trade’s Effect on Wage Inequality. Of course, as trade
with developing countries grows, so might its contribution to wage inequality. Economic
analysis suggests, however, that there may be an upper bound to this potential effect and
6 (...continued)
Washington , DC, 1997;; and Borjas, George, and Richard B. Freeman; Lawrence F. Katz. How
Much Do Immigration and Trade Affect Labor Market Outcomes? Brookings Papers on Economic
Activity p. 1-90; Susan Collins, Trade and the American Worker, Brookings Institution,
Washington, D.C., 1997; and Lawrence and Litan, op. cit.
7 See: Lawrence, Robert and Matthew Slaughter. Op.cit. P. 161-226; and Sachs, Jeffery and
Howard Shatz. Trade and Jobs in U.S. Manufacturing. Brookings Papers on Economic Activity,
vol. 1. Washington D.C. 1994. P. 1-84.
8 See: Lawrence and Litan, op. cit.
9 See: Economic Report of the President. February 1998, p. 243.

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that it could be reached fairly quickly as the cost differences between home and foreign
production widen. It is credible that a condition of complete specialization might be
reached after only a relatively small price disadvantage appears. That is, the United States
would find it most efficient to stop producing the import competing goods as increased
specialization leads to trade in noncompeting sectors. If there is no domestic industry that
uses low-skilled labor intensively in the production of tradeable goods, there can be no
downward pressure on U.S. wages caused by trade with developing countries.10 It is also
important to be mindful that trade can also set in motion other forces that can have a
favorable effect on all domestic workers. For example, economies of scale can be more
fully realized through expanding trade. Further, trade may heighten competition and raise
efficiency. Such forces may be strong enough to allow all factors of production to see
their real return rise.
What is Causing Wage Inequality? Many economists argue that “biased”
technological change likely is the primary cause of rising U.S. wage inequality. Modern
production techniques have generally raised the demand for skill in the labor market. In
effect, “skill” is suspected of becoming more complementary to capital and “less-skill”
more of a substitute for capital. Thus, the process of capital accumulation and
technological change will tend to lower the wage of low-skilled labor.11 Other minor
causes might be immigration, deunionization, and falling real minimum wage. So far the
evidence does not give a full picture of the nature and extent of this process.
Conclusion and Policy Implications
The analysis and evidence presented in this report suggest that globalization is
unlikely to have played a substantial role in causing recent slow real wage growth and
increased wage inequality in the U.S. economy. The implication for the congressional
policymaker is that these negative wage trends might now be seen as less of an
encumbrance to the pursuit of trade liberalization measures that offer significant economic
benefit to the American and world economies. The argument made here is not that some
domestic workers have not or will not be hurt by globalization. The complete story is that
expanding trade creates and destroys jobs just as other market forces do (i.e.,
technological change, shifting consumer tastes). Trade will tend to create jobs in industries
that are relatively more efficient and destroy jobs in industries that are relatively less
efficient. This analysis suggests that the policy challenge, as with other disruptive market
forces, is facilitating the quick and equitable adjustment of workers hurt by trade, such as
compensation for lost earnings and incentives for retraining and relocation. The total gains
are large enough to make everyone better off.
10 See: Krugman, Paul. Growing World Trade: Causes and Consequences. Brookings Papers on
Economic Activity, No. 1, 1995.
11 See:Grilliches, Zvi. Capital-Skill Complementarity. Review of Economics and Statistics, no.465,
1967, P.51.