October 24, 2011

Free Trade Isn't Free

The trade agreements with South Korea, Panama, and Colombia that were signed into law on October 21 are being touted by proponents as a way to spur US job growth. But are they really?

Rebecca McReynolds
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The free trade agreements with South Korea, Colombia, and Panama signed into law October 21 were touted by proponents as a way to spur US job growth. But two papers by Donald R. Davis, a Chazen Senior Scholar, show that liberalizing international trade, while typically a net positive for a country as a whole, may actually eliminate many higher paying jobs or cut wages.

According to Davis, free trade advocates lean heavily on earlier studies that show across-the-board gains in jobs and wages when tariffs are dropped and borders are opened to foreign competition. Those studies, though, were based on two false assumptions, he says: That all businesses equally participate in the global market, and that the countries studied enjoyed full employment. Davis says his research quantifies for the first time how globalization is widening the gap between winners and losers in the international marketplace.

The Export Advantage

In his paper “Firms, Trade, and Wages: Theory and Evidence,” written with Mary Amiti, a research officer with the Federal Reserve Bank of New York, Davis tracked the impact of lower tariffs on individual companies in Indonesia. “The results of our study are striking,” he says. For example, when tariffs dropped on finished products, such as toys, imported toys became less expensive in the local market. As a result, toy makers that predominantly focused on domestic consumers saw their businesses shrink and wages fall. On the other hand, because trade pacts lower tariffs for both countries involved, companies that exported most or all of their production saw a jump in business as their products became more affordable in the new market. Employee wages also increased.

A similar trend appeared when Davis and Amiti looked at tariffs on the intermediate goods used in production. Decreasing tariffs by 10 percentage points on manufacturing materials, or inputs, had only a minimal impact on firms that don’t import parts and supplies, but that same drop increased wages by up to 12 percent at firms that do import production materials.

These swings are even more pronounced when you look at specific industries, Davis says. For example, during their study period Indonesia cut tariffs on finished products 45 percent for the motor vehicle industry. Companies that bought parts locally and sold their final products exclusively in the domestic market saw wages drop 15 percent. In the same industry, though, firms that exported most of their output and imported their materials saw wages increase an average 4 percent.

The Cost in Jobs

The second study, “Good Jobs, Bad Jobs, and Trade Liberalization,” written with James Harrigan, an economics professor at the University of Virginia, looked beyond wages and measured the impact of lower tariffs on jobs themselves. Again, previous studies looked only at the total number of jobs created by trade liberalization without considering the types of jobs available, Davis says. But this new paper shows that as many as one-fourth of “good jobs” (those with above-average wages) may be destroyed in a free-trade economy. “This is true even as the model shows minimal impact on aggregate unemployment and quite substantial aggregate gains from trade,” he says.

These results illustrate what Davis calls the “creative destruction” inherent in any major market shift. Firms caught in the undertow of trade liberalization will need to rethink their business strategies to remain competitive, Davis says. “The rising tide will not lift all boats,” he says.

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