Some of you may remember an article I wrote a few weeks past that discussed the theory of the “great stagnation” proposed by economist Tyler Cowen. In essence, his theory is that the United States, and other developed nations, have depleted the easy technological innovations in their economies which has put a crimp on worker productivity and slowed growth. It seems that these days, people can’t get enough of talking about income inequality, each presenting his own theory on why over the past 30 years, the income inequality has increased in the wealthy economies. The Economist just today posted up a graphic on income inequality in some rich countries. You see a similar type of argument brought up about tax policy, with pundits claiming that we need to return to pre-Reagan taxes in order to redistribute the income gains that used to be directed to the average worker during the boom time of the 1950′s and 1960′s.
In my article I proposed an alternative mechanism for why the income inequality has increased over the past few decades. First let’s consider the fact that the 1950′s and 1960′s were a complete historical anomaly, with the developed nations riding the reconstruction boost of the the post-war era while simultaneously enjoying (some might say exploiting) terms of trade reminiscent of the colonial era. Rich nations produced almost all of the world’s capital and exported it to the third world, who sent back cheap primary products. Since all wage growth is essentially linked to capital production, the West was the world’s “engine of growth” so-to-speak and thus controlled the terms of trade with the developing world. So while the West enjoyed great growth in total GDP and per capita income, with gains going to the average middle-class worker, the developing world suffered low growth, stagnating wages, civil conflict, famine, and foreign invasion and intervention (Vietnam (1950′s, 1960′s, 1970′s), Korea (1950), Afghanistan (1980′s), East Germany (1940′s, 1950′s), China (1940′s), Hungary (1956), Guatemala (1954), Czechoslovakia (1968), Dominican Republic (1966), the list goes on). The fact that some Americans are prone to harken back to these times as good times flies in the face of the pure historical fact that these were times of brutal foreign policy by the Soviets and the West and that much of the growth in Western incomes occurred while wages elsewhere remained for the most part constant.
The utility of the foreign policy is not in question here, all I am trying to illustrate for you all is the simple fact that the 1950′s and 1960′s were also an era of massive income inequality, but on a global rather than national scale so it is somewhat inappropriate to label think of them otherwise.
This fact leads me to my second reason for doubting theories similar to Tyler Cowen’s, which is that while there has been pressure on the middle class in the West since the late 1970′s and early 1980′s, the actual size of the middle class world-wide has exploded over the past 30 years in no small part due to the contributions of China as it has grown by double digits per annum for just about that whole period. What we’re seeing can almost be considered a reversal of the increase in income disparity between the developed world and the developing world during the early post-war era, as most of the income growth is now centered in developing nations finally catching up with the West. We can find some theoretical basis for why this is the case by using a little trade theory.
Consider two countries, not trading with each other (much like China and America in 1960), one with a large workforce and very little capital and one with lots of capital and a relatively smaller workforce (pretty much everyone’s workforce is small compared to China’s). Under no trade (autarky), each country will produce both of two aggregate goods, X being labor intensive and Y being capital intensive. Of course if you examine prices in these two economies you will find that wages are higher in America than in China. This is because America has much more capital relative to its labor supply and as I’ve mentioned, this determines worker productivity and ultimately wages. It then follows that the price of the labor intensive good is more expensive in America because the wages are so high. Likewise it is very expensive to produce the Y-good in China because it has so little capital and is not very productive per unit of labor. Now let’s say these countries start trading (1980?) and allow capital mobility (1990′s) between the two countries (capital mobility just means that Nike or Apple can set up a factory in China, and the profits of this factory come back to America).
What will happen?
Even without much economics, I’m sure just common sense will tell you that first production of the labor intensive good shifts to China and production of the capital intensive good shifts to America. This is analogous to many cheaper manufacturing jobs leaving America and moving to China (t-shirts, shoes, and lower end assembly). Assuming that America does not experience a large increase in unemployment, which was essentially true up until the financial crisis, the wages of American workers must fall relative to Chinese workers’ wages. Why does this happen? Because now Americans can buy X from the Chinese for cheaper than before and the Chinese can sell X for more expensive than before (in America). Thus if Americans want to produce X, they must work for a lower wage. So this sort of trade raises wages in China and lowers them in America.
This is not the only effect, remember I said that capital can be moved from America to China. Since capital is the basis of higher wages, as capital leaves America, wages should fall with productivity and Chinese wages should rise as well (this compounds on top of the other effect in the last paragraph). But because China has so little capital, the marginal productivity of capital (the amount of production per one more unit of capital) is much there than it is in capital-rich America. Assume for now that profit is correlated with the marginal product of capital (it is). This means that American capitalists can make more money by shifting capital over to China. This increases their profit.
Now one distinction that I think is safe to make between the middle class and the rich is that the rich invest a lot more than does the middle class. Keep in mind that investing is the same as “owning” capital since you own shares of a company and they use this money to get capital. If profits go up, so do stock price and the like. This means that as capital is shifted from America to China, those with the most investments will benefit more than those that don’t.
So what are we left with? As labor intensive production moves from capital rich to capital poor countries, the developed country’s wages will decline while the developing country’s wages rise. Meanwhile, the rich in the developed see their effective incomes increase because the profitability of their investments has also gone up. Isn’t this exactly what we’ve seen over the past 30? Income gains being focused to the rich while the middle class suffers stagnating wages?
Of course, this is a simple model that doesn’t capture everything going on, but right here we have a way of explaining why the West is struggling with stagnating wages while its wealthiest members benefit. We don’t need to invent some idea of depletion of technical innovation, which has never been witnessed in human history, to explain the fall in productivity, we can simply show that productivity gains are happening elsewhere! This is something to think about next time someone brings up income inequality.