The Financial Express

Trade and income inequality

| Updated: October 21, 2017 16:01:12

Trade and income inequality

It has been widely recognised that over the last three decades and a half, income inequality has risen quite significantly not only in developed countries but also increasingly happening in developing countries like Bangladesh. Many survey results indicate that income inequality is a common concern for public around the world. Many blame rising income inequality on the growing importance of liberalised international trade.
Income inequality sits at the top of the political agenda in democratic countries. Even Pope Francis weighed into the debate giving it also a moral dimension. In authoritarian countries where because of rulers' lack of political legitimacy, they quite often try to legitimise their illegitimate hold on state power through gaining economic legitimacy by advocating the necessity of authoritarian rule to achieve economic growth which will provide better economic life. In this advocacy there is a hint of better income outcome for all citizens of the country.
Income inequality, while an economic issue, can dangerously become a very hot political issue as reflected in the rise to prominence of populist politicians in many developed countries in recent times preaching xenophobia. Some in developed countries not only are even advocating literally erecting walls to stem the flow of immigrants (labour) but also, with equal vigour, are calling for erecting barriers to the flows of goods and services. Their political mantra gives a very simple message; once those barriers are erected nirvana will be in hand in no time.
It is indeed a very tricky business to design a well-crafted response to rising income inequality. Arthur Okun (Yale University) in 1975 argued that societies cannot have both perfect equality and perfect efficiency, a trade-off between the two ought to be worked out. Figuring out the precise relationship between growth and income inequality is also a challenge.
But there can be a political cost if the issue is not addressed as Dani Rodrik (Harvard University) pointed out that it could threaten public confidence in growth boosting policies like free trade. In effect there is a serious crisis of confidence in free trade now and it has been brewing for a considerable period of time; in particular since the Global Financial Crisis (GFC) of 2007-08. Public demonstrations against trade in front of venues where and when the World Trade Organisation (WTO) convenes its conferences lend support to this view.
It is now becoming very clear that the shared gains from liberalised trade flows being put at risk as countries around the world are fighting to safeguard the interests of very narrow interest groups. These groups are largely comprised of the people who represent industries that do not have comparative advantage to compete in the global market. But the global financial crisis of 2007-08 has, without any doubt, worked as a catalyst for trade protection.
As the world economy deteriorates, some countries now try to boost growth by erecting trade barriers. Furthermore, there is a great risk that popular concerns about the distribution of benefits arising from trade (a major contributor to growth) can lead to developing strong protectionist sentiment and ultimately lead to influencing trade policies and trade flows. According to the World Bank, 17 out of 20 members of the Group of Twenty (G20) have adopted measures restricting trade despite the pledge it made to avoid protectionism.
Economists are always unanimous in emphasising the positive role of trade in enhancing economic efficiency and promoting economic growth. If we accept the premise that liberalised trade results in faster economic growth, then the question now is: how does liberalised trade affect income distribution? The simple answer is the distributional effect of trade is only conditional upon factor mobility and factor market distortions. 
Furthermore, while trade is beneficial, that does not automatically confer equitable benefits to all; indeed there may be losers. It has been well recognised for a long time and vigorously argued that initiatives would be required to compensate those who do not benefit from trade. For this end, a set of well articulated policy options have been developed by economists, but at the end of the day it is the government that will have to implement them.
More importantly, a large number of industries are involved in the non-tradeable sector. Trade does not play any direct role affecting income inequality there. Regulatory restrictions (technical barriers to trade) are quite common in advanced economies to protect very highly paid professionals like doctors, dentists, lawyers, and accountants etc., from international competition enabling them to earn significantly more causing significant welfare loss to consumers. Intellectual property rights are state-sanctioned monopolies, now also covered by WTO rules relating to intellectual property, and they are closely related to technological advances thereby conferring very high levels of financial rewards to people with high education and skills. 
However; countries, now struggling with very slow growth to no growth with the spectre of economic stagnation hanging over, are looking for short-term solutions in the form of putting restrictions on trade flows. This is done by erecting trade barriers such as tariffs, subsidies and other similar practices. They do affect the mix of trade flows but definitely do not alter the trade balance which is driven by total national spending and its production. Now, does protectionism remedy income inequality? 
There is no empirical evidence available to support that. Rather, there are sufficient arguments that can be put forward that it (protectionism) in fact contributes to worsening income inequality. Protected industries are able to earn economic rent and a part of which employers in many instances may share with their employees, thus achieving an overall better distributional outcome for themselves. But at the same time this imposes a cost to export-oriented industries thus worsening the distributional outcome for employees in those industries; consumers are as well made to pay higher price, causing their real income to decline and leading to income inequality to further deteriorate. 
There are a number of factors that lie behind rising income inequality. Most of them have very little direct or indirect link to liberalised trade. Technological changes have caused job polarisation which can cause and expand income inequality among different skill groups. Other factors such as changes in family structures and transfer payments also play an important role. Financial innovations have contributed to unearned income to grow very strongly over last three decades and half in the upper bracket of income distribution. 
At the same time increased financialisation of the economy also contributed to increased income inequality because its returns have gone to very wealthy people. Structural changes have caused wage stagnation and in many instances wage depression in the manufacturing and services sectors, quite often aided by changes in labour laws. There has also been an increasing trend in the casualisation of jobs, in particular in the services sectors causing a decline in real wages. 
The rapid growth of finance diverted income from labour to capital. Income inequality has also risen in countries where progressive taxation policies such as high marginal rates have been significantly weakened. Raghuram Rajan, then Governor of the Reserve Bank of India (RBI), argued that governments often respond to income inequality by easing the flow of credit to poorer households. This rise in household debt, in effect, leads to further worsening of the situation in a period of stagnant to falling real wages.
The 1929 Smoot-Hawley Tariff Act of the USA with its astronomical tariff hikes led to a trade war which turned a recession into a great depression. Now in a period of very slow growth, protectionism can only cause further worsening of income inequality resulting from further slowing-down of economic activity. The fear of economic stagnation is very alive and real and stemming the flows of trade may even lead a prolonged recession if we do not heed to the lessons of history.
The writer is an independent economic and political analyst.
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