Trade and labour income risk in the US: Evidence from longitudinal data

Pravin Krishna, Mine Zeynap Senses, 19 December 2009

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The severe recession has intensified the political pressure on governments to safeguard jobs at home. As has been argued on this site before, protectionism is the wrong response because import protection stifles access to a greater variety of goods, raises prices and hinders the efficient allocation of resources. Moreover, if the major trading nations were to engage in retaliatory protection against each other, the impact on world growth would be devastating.

Despite these facts, heightened public concerns regarding globalisation remain – and not without justification since greater trade may induce reallocation of workers across sectors and firms and in the process expose workers to the possibility of income losses and unemployment. Further, as argued by Rodrik (1997), an increase in foreign competition increases the elasticity of demand for domestic goods and thereby raises the elasticity of derived labour demand. This, in turn implies that shocks to labour demand could lead to large variations in wages and employment with significant economic consequences.

New research

The impact of trade on wages has been the subject of a rich body of research. Up to now the focus has mostly been on the average effect of trade on wages of different categories of workers (see the discussion of this issue on this site by Krugman, 2007). In recent research (Krishna and Senses 2009), we have studied a different dimension of the labour market experience and focused on the effect of increased trade on the risk to income (the variance of unpredictable changes to income) experienced by workers in the US.

These unpredictable changes to worker incomes may be transitory or permanent. For example, during the adjustment process following trade liberalisation, workers may experience temporary job loss resulting in a temporary loss of income. Alternately, individuals moving across sectors may see permanent income losses since their work experience may not be valued and, thus not be rewarded, in their new sector.

When faced with transitory income shocks workers can borrow or use their own savings to smooth consumption. However, this is clearly not feasible when income shocks are permanent. As a result, highly persistent income shocks will have a far more significant effect on the well-being of workers compared to transitory shocks.

Focusing therefore on permanent income shocks, we ask two questions:

  • What is the magnitude of income risk faced by workers?
  • To what extent is the risk faced by workers associated with the sector's exposure to international trade?

To answer these questions, we use longitudinal data on individuals from the 1993–1995, 1996–1999 and 2001–2003 panels of the Survey of Income and Program Participation. Each panel of the survey is designed to be a representative sample of the US population and surveys thousands of workers. Interviews are conducted at four-month intervals over a period of up to four years, collecting data on earnings and labour force activity for each of the preceding months.

Table I presents estimates of permanent income risk (variance of permanent income shocks) averaged across industries in the manufacturing sector for each panel. We find that income risk is rising over time. Our estimates suggest that the annualised standard deviation of shocks to permanent income (which, roughly speaking, measures the spread in income growth rates across individuals) rises from 13% in 1993-1995 to 17% in 1996-1998 to 19% in 2001-2003.

Table 1. Individual labour income risk estimates

Reported means and medians are calculated across point estimates for 18 2-digit SIC industries.

Higher import penetration is associated with increased income risk

Figure 1 plots the changes in the estimated permanent income risk against changes in import penetration for each industry. The relationship is strongly positive. An increase in import penetration by 10% of its initial (1993) level raises the standard deviation of shocks to income by around 23%. Formal statistical analysis confirms this positive association between trade and income risk, while also allowing us to control for the influence of other factors such as exports, skill-biased technological change, offshoring, unionisation, and productivity that might otherwise bias the results (See Krishna and Senses, 2009, for details).

Figure 1. Changes in permanent income risk and changes in import penetration

Welfare Impact

Next we analyse the link between income risk and welfare using a simple dynamic model of consumption and savings in the face of risky income (based on Krebs 2004). Our goal here is not to provide a complete assessment of the effects of international trade on welfare, taking into account all possible channels, but rather to obtain suggestive estimates of the effect of trade on welfare due to the income risk channel. Under standard parameter values of the inter-temporal discount rate and the coefficient of relative risk aversion, we find that the increase in permanent income risk associated with a 10% increase in import penetration is equivalent to a reduction in lifetime consumption of between 4 and 11%. These effects are economically significant and suggest that a sizeable social safety net would be necessary to insure workers against this risk.

Conclusion

Our results suggest that increased import penetration has a statistically and economically significant effect on labour income risk in the US manufacturing sector. We emphasise that our analysis has focused exclusively on the links between trade exposure and income risk. Our finding of economically significant negative effects through the income risk channel does not suggest that the gains from trade are negative overall. Therefore, this research should not be viewed as a call for protection, or support for anti-globalisation arguments. Instead, our results indicate that the income risk channel should be considered seriously when evaluating the costs and benefits of trade and trade policy reform. One implication from our findings is to emphasise to policymakers the need for a social safety net to insure workers against the risks of increased exposure to trade.

References

Rodrik, D., 1997, Has Globalisation Gone Too Far? Institute for International Economics, Washington, DC.

Krishna, P and Senses, M. Z., 2009, International Trade and Labour Income Risk in the US, NBER, Working Paper, Number 14992, NBER, Cambridge MA.

Krebs, T., 2004, “Testable implications of Consumption-Based Asset Pricing Models with Incomplete Markets," Journal of Mathematical Economics 40: 191-206.

Krugman, P., 2007, Trade and inequality, revisited, VoxEU.org, 15 June

Topics: International trade, Labour markets
Tags: protectionism, trade and unemployment, US trade policy

Pravin Krishna
Chung Ju Yung Professor of International Economics and Business at Johns Hopkins University
Assistant professor of international economics in the School of Advanced International Studies at Johns Hopkins University