Economic theory says inequality will rise as international trade grows

Ever since Thomas Picketty published his magnum opus on inequality there has been a great deal of hand-wringing, dismay, alarm and call for action. Broadly, there is a universal refrain “we must do something.”

But no one really knows what exactly to do because Robin Hoodism — robbing the rich to pay the poor — isn’t consistent with either democratic ideals or trust in government. It is easy to call for expropriation by confiscation or taxation but there is no real evidence that this actually works.

There is a very good reason why the highly laudable objective, of greater economic equality, cannot be achieved and it can be found in some old economics, specifically the Stolper-Samuelson theorem of 1941 and the factor price equalisation theorem of 1948.

These theorems have a lot of restrictive assumptions such as constant returns to scale, perfect competition, etc.

But in reality these conditions do obtain in varying degrees of fulfilment, usually closer to complete fulfilment than incomplete fulfilment. In that sense they are not all that restrictive.

According to the Stolper-Samuelson theorem, if some factor of production is very intensively used for producing something, the real return to it increases — and, most importantly, the return to the factor that is not used intensively decreases.

As international trade increases, unskilled workers producing traded goods become worse off because, relative to the world market in the goods they produce, an unskilled worker in a developed country is a less abundant factor of production than capital. This is what makes the difference.

As to the little remembered factor price equalization theorem, it says that the returns to identical factors of production will equalise across countries as a result of international trade in commodities.

Trade as the real reason for rising inequality?

This being so, here is a completely heretical thought, namely, that growing inequality within countries is because of the hugely increased international trade since 1975. Yes, growth happens but it also increases inequality.

The enthusiasts of the Washington Consensus of the early 1990s completely ignored this contradiction because it suited the US then. It no longer suits it.

That’s partly why academic research in the US and think-tank analysis are both trying hard now to draw the old Marxian distinction between wages and profits, and saying that the share of the former in GDP has declined and, of the latter, increased.

Truth be told, this is a political statement. It has no economic content at all because as Wolfgang Stolper and Paul Samuelson showed, open borders would eventually have this effect.

But no one, least of all the bureaucrat-economists of the World Bank paid any heed. They were marching to a different tune.

And the WTO, of course, was committed to ever-increasing trade. It could not be bothered with the implications for income distribution. It’s remit was economic growth.

Even UNCTAD, which had a left-of-centre orientation, was more concerned with the problems of ‘equal-unequal’ trade rather than with trade itself.

Enter China

All this would have been sort of fine if China, with its slave labour economy, had not been allowed into the tent. But once it was given a free pass by the US, the denouement was inevitable.

Both the Stolper-Samuelson theorem and the factor-price equalisation theorem have come true— without there being full mobility of labour. If the US exports its inflation, China exports its low wages.

I can see the data wallahs —whose knowledge of economic theory is as scant as mine is of data crunching — dismissing what I have said above. I am used to that.

But then if they have a better explanation for increasing inequality they should come out with it.