Does Trade and Financial Globalization Cause Income Inequality?

The integration of the world economy through the progressive globalization of trade and finance has reached unprecedented levels, surpassing the previous peak prior to World War I. This new wave of globalization is having far-reaching implications for the economic well-being of citizens in all regions and among all income groups, and is the subject of active public debate. This article provides an overview of the latest research about the effects of trade and financial globalization on income inequality.

The global economy has changed dramatically over the past two decades. World trade has grown fivefold since 1980, and its share of world output has risen from 36 to 55 percent. Trade integration accelerated in the 1990s as the former Eastern bloc countries entered the global trading system and developing countries in Asia progressively dismantled trade barriers. The globalization of financial flows has also been rapid. Total cross-border financial assets more than doubled as a share of output between 1990 and 2004, from 58 percent to 131 percent of global GDP. The advanced economies continue to lead the trend in financial integration, but other regions are beginning to catch up. How have these developments affected people's incomes and the gap between the rich and the poor within countries?

The debate on the distributional effects of globalization is often polarized between two points of view. One school of thought argues that globalization leads to a rising tide of income that raises all boats. Hence, even low-income groups come out as winners from globalization in absolute terms. The opposing school argues that while globalization may improve overall incomes, the benefits are not shared equally among the citizens of a country, with clear losers in relative and possibly even absolute terms.¹ Moreover, widening income disparities may not just raise welfare and social issues, but may also limit the drivers of growth, as the opportunities created by the process of globalization may not be fully exploited (Birdsall, 2006; World Bank, 2006).

While there is by now a well developed and extensive body of work investigating the effects of globalization on growth and volatility,² there has been less attention to the potential effect of globalization on income inequality. Jau-motte, Lall, and Papageorgiou (2008) aim to fll this gap by examining the impact of both trade and financial globalization, whereas the existing literature has focused only on trade, with little attention paid to financial globalization (exceptions are Behrman, Birdsall and Székely, 2003; Claessens and Perotti, 2007). The cross-country analysis employs a new dataset on income inequality—based on Chen and Ravallion (2004, 2007) and Luxemburg Income Studies datasets—that produces greater methodological consistency in survey-based inequality measurements across countries and over time.

The analysis of the available data by Jaumotte, Lall, and Papageorgiou (2008) yields two main conclusions. First, the main factor driving the recent increase in inequality across countries has been technological progress. Technological progress alone explains most of the increase in the Gini coefficient from the early 1980s, supporting the view that new technology, in both advanced and developing countries, increases the premium on skills and substitutes relatively low-skill inputs. Interestingly, among developing countries, the effect of technological progress is stronger in Asia than in Latin America, possibly reflecting the greater share of technology-intensive manufacturing in Asia.

Second, globalization has had a much smaller effect relative to technological change, reflecting the opposing influences of trade and financial globalization on inequality. On the one hand, trade globalization has actually contributed to reducing inequality. The positive effect of trade on reducing income inequality is particularly noticeable for agricultural exports, especially in developing countries where agriculture still employs a large share of the workforce. The net impact of tariff reduction is also found to be positive in reducing income inequalities. For advanced economies, rising imports from developing countries are associated with declining income inequality, presumably through the substitution of lower-paying, low-end manufacturing jobs in advanced economies with higher-paying service sector jobs such as retailing and consumer finance. On the other hand, foreign direct investment (FDI) has had a disequalizing impact on the distribution of income, as higher FDI inflows have increased the demand for skilled labor, while outward FDI in advanced economies has reduced the demand for relatively lower-skilled workers in these countries.

What do these findings imply for policymakers as countries become increasingly integrated through trade and financial flows? Overall, technological progress and FDI are associated with higher growth, and their disequalizing effect reflects an increase in the returns from acquiring higher skills. The appropriate policy response is therefore not to suppress FDI or technological change, but to make increased access to education an important priority. This would allow less-skilled and lower-income groups to capitalize on the opportunities from both technological progress and the ongoing process of globalization. Similarly, broadening access to finance, such as by improving institutions that promote pro-poor lending, could help improve the overall distribution of income even as financial development broadly continues to support overall growth.

A complementary approach to the cross-country analysis of the impact of globalization on inequality is based on country studies (Goldberg and Pavcnik, 2007). The advantage of intra-country studies is that they focus on more detailed measures of inequality (i.e., wage inequality), and at a finer level of disaggregation geographically or by sector. In addition, they also utilize more detailed data on other variables such as tariffs and social policies. As a result, such studies tend to have a country-specific focus and provide a useful complementary perspective to that gained from cross-country work. Recent studies on Mexico, China, and India illustrate the usefulness as well as the limitations of country studies.

Mexico undertook radical reforms between 1985 and 1994 to open its economy to trade and capital flows. Over the same time period, the earnings gap between high- and low-skilled workers began to widen, generating a substantial literature examining whether this was caused by the process of opening up. Hanson and Harrison (1999) find that 1984 industry tariffs are negatively correlated with the 1984 industry ratio of white-collar to blue-collar employment. However, the 1984–90 change in industry tariffs is positively correlated with this employment ratio, implying that trade protection was initially higher in less skill-intensive sectors, and was reduced by more in these sectors during reform. If these tariff changes were passed through to changes in the prices of goods, then this would imply that the relative wage of skilled labor would have risen. Robertson (2004) finds evidence in support of this conclusion, with the relative price of skill-intensive goods in Mexico rising during 1987–94 and raising the relative wage for white-collar labor. Other studies with a slightly different focus find that, while globalization may have contributed to widening earnings inequality in Mexico, low-skill workers are better off in absolute terms as a result of the policy changes (Nicita, 2004; Hanson, 2007).

The dramatic increase in trade openness in China has been accompanied by striking increases in income inequality, with the Gini coefficient rising sharply from 0.28 in 1981 to 0.42 in 2004. However, a closer look at the data reveals that such aggregate numbers may present a slightly distorted view of underlying changes. Wei and Wu (2007) examine the effect of trade globalization on Chinese income inequality using new methods and two unique datasets on Chinese regions. The analysis reveals that an increase in openness reduces urban-rural income inequality, leads to a modest increase in intra-urban inequality, and decreases intra-rural inequality. Summing up the three components of inequality, the authors estimate the effect of openness to modestly reduce overall inequality. This finding is in contrast with the popular perception that trade openness has contributed to the rise in income inequality in China.

India intensified reforms aimed at opening up the economy in the early 1990s through the reduction in tariffs and nontariff barriers, barriers to FDI and restrictive domestic regulations. Topalova (2007) examines the variation in the preliberalization industrial composition across districts in India and the degree of liberalization to foreign trade and FDI across industries. Results from this work indicate that trade liberalization led to an increase in inequality, especially in urban districts, where the incomes of the richest and those with higher education rose substantially faster relative to households in the bottom of the income distribution. Moreover, there does not appear to be any relationship between FDI and inequality within a district in either the rural or urban samples. An important qualification of this exercise is that it does not study the country-wide effect of globalization on inequality. While liberalization may have had an overall effect of increasing or lowering inequality, the difference-in-difference methodology tests whether this effect was unequal, and whether certain districts benefited more from globalization than others. Other studies on the effects of tariff changes on wages in Indian districts find mixed results (Dutta, 2004; and Kumar and Mishra, 2008).

In summary, intra-country analyses of globalization and inequality reveal an intricate picture of their interrelationship that cannot be captured in cross-country studies. The evidence suggests that the mechanisms through which globalization affects inequality are country-, case-, and time-specific, reflecting the vast heterogeneity of countries and the nature and timing of their trade reforms. Such analyses also demonstrate that intra-country studies address questions somewhat different from those in cross-country studies.