Workers assemble toy cars on the production line at a toy factory in Dongguan, China. Global manufacturers struggling with life-or-death pressures to control costs are finding that the legions of low-wage Chinese workers they rely on have limits. (AP Photo/Eugene Hoshiko, File)
Workers assemble toy cars on the production line at a toy factory in Dongguan, China. Global manufacturers struggling with life-or-death pressures to control costs are finding that the legions of low-wage Chinese workers they rely on have limits. (AP Photo/Eugene Hoshiko, File)

A recent paper by Branko Milanovic, Global Income Inequality by the numbers: In History and Now, got me thinking about the remarkable reduction in global poverty over the past two decades or so and the role of trade and international institutions in that process. Milanovic's data points to the first decline in global inequality since the industrial revolution.

The first thing to note is the impact of China on all of this. Not to put too fine a point on it, the market-based reforms that China has introduced over the past 30 years or so have lifted millions out of poverty; the sheer weight of Chinese numbers has led to a marked improvement in global poverty, making the World Bank's goal of eliminating extreme poverty by 2030 not only attainable, but rather modest in ambition. When you begin to think about the transformation that has ocurred over this period, the significance of what has happened seems overwhelming.

But this progress was achieved in the context of an export-led growth strategy. Would this rapid progress have been possible in world of economic and financial autarky? It is hard to imagine. The massive investment in export-oriented industries was made possible by the markets of Europe and North America. In 1979, when it emerged from self-imposed economic autarky, China was too poor to support the production of consumer goods; indeed, it was too poor to make the investments that would allow the economy to take-off. It was caught in a "poverty trap":  too poor to accumulate the savings needed to finance the investment that would allow growth and development.

What it did have was labour — lots and lots of labour. Now, a key result of international trade is that gains from trade arise from the ability to trade goods that are produced the most cheaply. Price differences will reflect factor costs. And, for products in which labour is the biggest cost factor, wage differentials account for the price difference. Moreover, given the huge wage gaps between China and the rich North Atlantic countries, the range of goods in which China was competitive was very wide indeed.

To be sure, foreign firms were willing to make the investment in these industries because of the profit opportunities that low-wage labour offered. But as part of its reform program, China had acceeded to the World Trade Organization (WTO). This gave foreign investors comfort that the authorities were well and truly serious about market-based reforms, on the one hand, and assured them that their production in Chinese plants wouldn't be locked out of markets, on the other hand. This is a good example of the "bonding" role that the international architecture provides and how, to channel Adam Smith, institutions can help "make" markets.

Lest anyone think that trade just benefits capital, however, think about how Chinese wages have risen over the past decade and how much poverty has declined.

This is the factor price equalization theory at work. Wages will obviously be equalized if labour is perfectly mobile: if workers are free to move, labour will migrate to high-wage countries from low-wage countries, as was the case in the great labour movement from Europe to North America in the late 19th century and early 20th century. Labour has generally not been freely mobile since then. But if goods are freely traded, the forces of competitive markets will work so that the factor prices of the inputs used in the production of those goods will be driven together. This has in fact been the case; with wages of unskilled labour in China having risen over the past decade to the point that the huge differentials that existed 10 years ago have narrowed, making manufacturing in Mexico less attractive on the basis of labour costs alone.

Yet, if unskilled wages in China have risen as a result of factor price equalization, wages of unskilled labour in the industrial countries, such as the U.S., have stagnated. At the same time, the returns on capital have increased, as the capital/labour ratio fell with the integration of China into the global economy. These effects account for the winners and losers of globalization. Inequality has declined across countries, as wages have tended to converge, while inequality within countries has increased. In this respect, as Milanovic argues, to preserve the gains that we have achieved against global inequality, efforts must be made to spread the benefits of globalization.

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