6

Does Foreign Productivity Growth Erode Our Competitive Position?

Two countries: Two goods: Exchange rate: US, Taiwan A, B e = 1 [$/Won]

1990

Taiwan Output per Price worker 1 1 Won 1 Won 1 Won 1

US Output per Price worker 2 2 $2 $1 $1

Good A Good B Wage

US has absolute advantage (higher productivity) in both goods Competitive pricing: Price = [Wage rate] / [Output per worker] Both goods cost $1 in world markets There is no international trade

September 3, 2004 -- 6

1998

Taiwan Output per Price worker 1.1 1.2 Won 0.9 Won 0.8 Won 1

US Output per Price worker 2 2 $2 $1 $1

Good A Good B Wage

10-20% productivity growth in Taiwan, but not in US At e = 1: U.S. is not competitive in either market Excess demand for Won $ depreciates What is the new exchange rate? Dollar depreciates until U.S. becomes competitive in good A pA $1 = e p* A = 1.1$ / Won Won 0.9

Key point: Countries are automatically competitive, if exchange rates are flexible.

September 3, 2004 -- 7

Pattern of Trade
At the new exchange rate, the dollar price of good B is: e p* B = 1.1 0.8 0.9 U.S. cannot compete in good B Pattern of trade: Taiwan produces all B and exports some to US Taiwan may also produce some A US produces only A and exports some to Taiwan Key insight from trade theory: The pattern of trade depends on comparative advantage, not on absolute advantage. The U.S. has a comparative advantage in A, because its productivity advantage for A is greater than that for B:

U .S . productivity in good A Foreign productivity in good A > U .S . productivity in good B Foreign productivity in good B

Here:

2 1.1 > 2 1.2

September 3, 2004 -- 8

Who Gains From Taiwanese Productivity Growth?

US nominal wages have not changed (still $1) But US real wages have risen because the price of good B has dropped from $1 to $0.9 Foreign productivity growth has cost jobs in sector B, but an equal number of jobs were gained in A
Key insight: Trade with low wage countries neither creates nor destroys jobs

September 3, 2004 -- 9

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What if Taiwan Pegs Against the Dollar?

Now Taiwan offers goods in world markets for: e p* e p* A = 1 0.9 = $0.90 B = 1 0.8 = $0.80 The US must lower wages to compete:
1998

Taiwan Output per Price worker

1.1 1.2

US Output per Price worker 2 2

$1.80

Good A Good B Wage

Won 0.90 Won 0.80 Won 1

$0.90 $0.90

The trade pattern and real wages are the same as under flexible exchange rates.
Key insight: Flexible wages ensure that a country remains competitive, even if the exchange rate is fixed

September 3, 2004 -- 10

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Lessons from the Example

1. Low wages do not provide a competitive edge. Domestic wages reflect domestic labor productivity. U.S. wages are not set in Beijing 2. We benefit from foreign productivity growth through lower prices for imported goods. There is no loss of jobs or output. 3. The exchange rate takes care of productivity differences 4. Therefore: Countries are always competitive. Competitiveness is only a problem, if a country fixes the exchange rate and nominal wages.

September 3, 2004 -- 11

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Why the Opposition to Free Trade?

Loss of high value added jobs Our standard of living can only rise if capital and labor increasingly flow to industries with high value-added per worker. -- Magaziner and Reich But: It is traditional industries (oil, steel) that have the highest value-added per worker (not high tech industries; why not?) Trade leads to redistribution of income There are losses of employment and capital income in import competing sectors E.g.: Protecting the local farmer. Voluntary import restrictions in the car industry. Nafta. What about dumping? Trade policy as a lever for human rights or environmental concerns E.g.: WTO/Seattle. MFN for China.

September 3, 2004 -- 12