As a music arranger of a military band, try giving the melody line to the third clarinets and assign the harmony lines to the rest of the band. I can guarantee that no one will ever hear the melody despite its presence. Alternatively, give the melody to the trumpet section doubled by the piccolos. In this case I can offer the same guarantee that a deaf man seated in the last row of the fourth balcony will be tapping his foot and humming the melody.
This principle also finds application in our world of economics. Although important realities of our economy are constantly present in economic data, our ability to spot them often eludes us until something big happens.
For example, the link between spending and employment was always present in 19th and early 20th century economic data. But not until the Great Depression were economists able to understand the nature of the relationships – the real melody, if you will.
Theoretically, economists understood the link between money and inflation. But the link was empirically verified through the hyperinflation of post-WWI Germany. Conversely, economists believed that high interest rates could reduce inflation. But until Paul Volcker raised the U.S. fed funds rate to 20 percent in 1981, we could not decipher from the available data the extent to which this relationship worked in practice, as opposed to in the classroom.
In sum, big economic events are the chief means by which theory is tested and verified, since it is at these times that the melody line goes to the loudest musicians. Economists like theory, but they also feel better when theory can be verified or rejected empirically.
International-trade theorists have received just such an event during the first 15 years of the new millennium. To unravel what has happened, let us look into the anatomy of economic understanding.
In the early part of the 19th century, economist David Ricardo demonstrated that free trade between nations would, in theory, improve welfare in both countries through a mechanism of comparative advantage. When countries concentrate on producing the products for which they are most suited, and then trade with other countries for the goods the others produce relatively more effectively, both are made richer.
In 1933 a pair of Swedish economists, Eli Heckscher and Bertil Ohlin, developed and published a model which added to the understanding of international trade. Their theory, known as the Heckscher-Ohlin theorem, demonstrated that countries will produce and export goods which require a factor of production (i.e., production ingredient) which is relatively abundant in that country.
The classic example of this concerns the so-called 2-2-2 model: two countries (the U.S. and Denmark), two goods produced (wheat and cheese), and two factors of production (land and labor). In this model, we assume that wheat takes more land than labor, and cheese requires more labor than land for their productions.
Since the U.S. has relatively more land and Denmark has relatively more labor, when free trade is opened, Denmark will supply cheese and the U.S. will supply wheat. Within the mathematics of their model, those results do, in fact, appear. But, as economists are known to caution, the map is not the territory, and the model is not the actual economy.
In 1951, economist Wassily Leontief, published a research paper which indicated that the Heckscher-Ohlin theorem did not fit the U.S. trade data. Leontief noted that the U.S. was a country with a high degree of plants and equipment known as “capital” by economists. Other nations had an abundance of workers, i.e., labor. Yet, contrary to the prediction of the Heckscher-Ohlin theorem, the U.S. actually imported capital-intensive goods and exported labor-intensive products.
The Heckscher-Ohlin theorem still appears in every international-trade textbook today. Why? It was later shown that if we examine low-skilled labor versus high-skilled labor, then the trade patterns follow the Heckscher-Ohlin theorem. The U.S. has a relatively highly skilled labor force. China, for one, has a lower-skilled labor force. As such, the U.S. tends to import goods which require lower-skilled labor and export products which require high skill. The Heckscher-Ohlin theorem has been exonerated.
Nearly a decade after the publication of the Heckscher-Ohlin theorem, economists Wolfgang Stolper and Paul Samuelson produced a corresponding theorem now taught as the Stolper-Samuelson theorem. According to their mathematics, when international trade takes place along the lines hypothesized by the Heckscher-Ohlin theorem, the owners of the abundant factor will be made richer and the owners of the less abundant factor will be made poorer.
In our 2-2-2 model, the U.S. wheat producers and Danish cheese producers will get a bonus from trade, while the U.S. cheese producers and Danish wheat producers will see a drop in income. In other words, according to the Stolper-Samuelson theorem, opening up international trade redistributes income.
How has this theory worked out in practice? Has international trade redistributed income around the U.S. as the Stolper-Samuelson theorem would predict? Until recently, economists would have said that we have no real evidence of this.
To be sure, economists noted that as trade opened up in the 1980s and 1990s, the gap in wages between low-skilled workers and highly skilled labor increased quite dramatically. Many hypothesized that this was the Stolper-Samuelson theorem at work. After all, the U.S. was exporting products made by highly skilled laborers while importing low-skilled goods. But the Stolper-Samuelson theorem melody could not be discerned from the data. Too many other things appeared in the available numbers which offered more robust explanations for the rising income inequality. The melody was masked by the other players.
And then came a big economic event: China. The Chinese manufacturing and export machine cranked up to full force. Through liberalized trade, the U.S. gave a huge amount of its manufacturing capacity over to the Chinese. Any longtime resident of Maine remembers well the shoe mills, paper mills, and clothing mills of yesteryear. Nearly all have shifted to China.
We now have some serious and robust data to explore which allows us to more clearly hear the real melody. And how does it sound? It sounds a whole lot like the Heckscher-Ohlin theorem and the Stolper-Samuelson theorem. We import low-skilled and labor intensive goods. We export products made by highly skilled workers. And the U.S. wages for low-skilled jobs have fallen while the wage rates for highly skilled workers have risen. Trade has redistributed income.
Earlier this year, economists David H. Autor, David Dorn, and Gordon H. Hanson produced a paper for the National Bureau of Economic Research in Cambridge, Mass. titled, “The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade.” Their findings are interesting and insightful, and offer interesting policy prescriptions.
We will examine their observations next week.
(Marcus Hutchins, MA, M. Phil, Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at email@example.com.)