The slow decline of US terms of trade

Worsening terms of trade imply that trade has started to be a drag on US real wages

A nation’s terms of trade — the ratio of its export prices to its import prices — help determine whether trade is hurting or benefiting its workers. In 1994, Paul Krugman dismissed concerns that trade was lowering average US wages, because US terms of trade had been improving. That is, US imports were becoming cheaper while we were getting higher prices for our exports.

He wrote (my emphasis):

“[T]his potential adverse effect should show up in a readily measured economic statistic: the terms of trade, or the ratio of export to import prices. For example, if U.S. companies are forced to sell goods more cheaply on world markets because of foreign competition or are forced to pay more for imports because of competition for raw materials or a devalued dollar, real income in the United States will fall. Because exports and imports are about 10% of GNP, each 10% decline in the U.S. terms of trade reduces U.S. real income by about 1%. The potential damage to advanced economies from Third World growth rests on the possibility of a decline in advanced-country terms of trade. But that hasn’t happened. Between 1982 and 1992, the terms of trade of the developed market economies actually improved by 12%, largely as a result of falling real oil prices.”

More recently, though, US terms of trade have gotten somewhat worse. According to BLS figures they fell about 3% from 2000 to 2010. They have fallen a bit more since. Overall, they are down about 10% since their 1998 peak, though up since their 2008 nadir.

This is not a large decrease. But since trade now amounts to about one-quarter of US GDP, the effect of a 10% decline in the terms of trade now translates to  two-and-a-half times as much reduction in real wages as in Krugman’s 1994 model.

The decline in our terms of trade appears to result from increased competition for resources as China and India develop. In particular, a 2009 paper by Marshall Reinsdorf of the BEA says that the decline in terms of trade results entirely from increased real oil prices.

I would draw several lessons from this. First, the effects of trade are still a small part of the US economy. So it’s still true that whatever caused US wages to stagnate before 2000 and start to decline since is probably mostly not trade related. However, as trade becomes a larger share of US GDP it has become more significant, and evidence is growing that this effect is negative overall.

Second, as trade becomes more important we can no longer complacently ignore the terms of trade. The terms of trade argument for tariffs becomes more important, at least as something to be aware of. Tariffs are one means that nations use to improve their terms of trade.

Third, competition for scarce natural resources could make trade and development a zero-sum game from the perspective of the non-capitalists (wage-earners) in the developed world. Oil is a scarce resource, and so is clean air. An intelligent energy conservation policy would help avoid this unpleasant outcome. I’m not holding my breath, yet.