EconTech

Trade and inequality, revisited — Rooftops edition

Another way of investigating the relationship between inequality and trade with poor countries implies that China may actually help the poor, suggests new work from University of Chicago economists Christian Broda and John Romalis.

Instead of focusing purely on what’s produced outside of the country, Broda and Romalis turn their attention to an interesting but obvious relationship between imports and consumption within our border: The goods exported by poorer countries are typically consumed by lower-income Americans. Our typical methods of quantifying inequality, however, don’t take this into account.

At the same time, inflation in the price of these goods has fallen behind inflation in services, which make up a greater portion of what wealthier people buy. Taken together, these trends imply that official measures may be overstating the rise in inequality.

Looking at trade data between 1994 and 2005, Broda and Romalis construct inflation rates for different income groups and find that rates for the richest outpaced rates for the poorest by about 4 percent over the period. Since income inequality between the top and bottom 10 percent of earners grew by about 6 percent, the different inflation rates among income groups wipes out about two-thirds of the rise in inequality.

The emphasis in that last sentence is mine. It continues:

China’s role in this new way of analyzing inequality is large, accounting for about 50 percent of the total reduction.

And scream this part from the rooftops too [how do you scream a parenthesis?]:

(A very interesting aside. Broda and Romalis also find that the poor are more likely than the rich to buy newer goods. Because of the lag in how quickly the CPI tracks new products, the researchers argue that once this “new goods bias” which serves to keep official inflation rates higher than they actually are since newer goods are typically cheaper, is factored out, inequality between the rich and the poor between 1994 and 2005 may not have changed at all.)

Here is the link. Again, here is the Broda and Romalis paper. If this holds up it is big, big news and we must revise many claims that have been made about inequality, trade, and China.

First note that the paper referred to says quite specifically in big bold letters at the top “Preliminary and Incomplete. Please do not circulate.” Oops. I do apologize for furthering the circulation of this paper, but I hope if anyone bothers reading this, some improvements in the framing of the results can be improved.

I’ve read similar papers and other data on how variable inflation rates among different socioeconomic groups but I haven’t read this one in detail. Taking Tyler’s description as representative of the paper, I think pushing this line of reasoning misrepresents why we care about inequality (or at least, why I care about inequality). First off, though, this research is important. Understanding these movements in prices among various groups is helpful to understand for various reasons, if not making the Fed’s life considerably more difficult. If inflation is moving in different directions for different groups, how do they formulate sensible policy to deal with that and maintain stable prices, that is, stable prices for who?!

But getting back to the point on inequality. Why do we care about inflation? Because it helps us keep track of purchasing power, right? Of course, there are other macroeconomic implications of various levels of inflation, but at its core, we use it to adjust nominal money to real money. In terms of measuring utility or welfare from spending, what do we learn from knowing that inflation levels vary among socioeconomic groups?

Happiness and income: Justin Wolfers has a series of posts showing a relationship, seemingly strong and positive, between the two, both within and across nations, over on the Freakonomics blog. (I’ll leave my views on happiness research for another time). You can also take this from a utility/welfare perspective: we know that pricier goods are preferred to cheaper goods (otherwise, they wouldn’t fetch a higher price!). However you slice it, being poor seems to generate less happiness/utility/welfare than being rich.

So, apparently, there is something that the more wealthy are able to purchase that the less wealthy aren’t that makes them happier. Given that there does not seem to be a positive relationship between leisure and income, I suspect this may be something else, even if it is just what some other more wealthy people have. In a way, then, we get a sense of the welfare of the less wealthy by their purchasing power capabilities in terms of the goods of the wealthy.

My impression, however, is that this is not what the paper is measuring. For the high and low quality goods, H, L, respectively ; wages of the rich and poor, , respectively; and inflation rates of the high and low quality goods, , the paper seems to be saying that, the purchasing power of the rich of high quality goods and the purchasing power of the poor of low quality goods[1]:

are moving in a relatively stable manner:

They attribute much of this to the fact that Chinese and other imports have kept low quality good prices from rising much. That is all fine and well, but it’s not what we care about! What we care about is the purchasing power of the poor of high quality goods . We don’t expect this to be equal to , but in talking about inequality, if we have to choose a ratio, that we are interested in it is:

As this represents more of what we were talking about above about increasing income implying increasing happiness/utility/welfare. What has been typically measured is the purchasing power of a representative of both groups, which leaves out quite a bit of information. And we know that that is diverging and therefore I is increasing.

Ultimately, I think a lot of my problems with how inequality is framed in Cowen’s post and the paper goes back to my problems with the consumption versus income measures of inequality. By focusing on what they end up getting, not enough attention is paid to the choices they had and the quality of what they got, thus knowing income streams and overall wealth over time is important for knowing how people are doing in their economic lives.

I hope the criticism of this paper doesn’t come off too strong (or long winded!). I like it. As I’ve said before, knowing how prices are moving for various groups is important (though as one of the above links points out, the Chicago Fed has been doing something like this for some time). These results seem different from what I remember about the Fed’s.

Further, we get a sense of how important trade is for maintaining the stability of the poor’s purchasing power of their typical set of goods. While maybe not ideal, it is important to know that cheaper goods from imports have helped to prevent a collapse in the purchasing power of the poor. This is something that was more or less intuitively suspected by most economists, I believe, but the quantification provided is interesting. However, as an analysis of inequality per se this is not a particularly insightful paper.

Edit: I forgot to mention that the situation of food prices may be changing this game.

Footnotes:

1. [W]e document that the prices of the basket of non-durable goods consumed by the poor have fallen relative to the basket consumed by the rich. The prices of the lower quality non-durable products consumed by the poor have fallen by 5 percentage points relative to the price index of the rich over this period. [pg. 2] [↩]