Global Markets: Evaluating Some Risks the U.S. May Face

Report for Congress
Global Markets:
Evaluating Some Risks
the U.S. May Face
Updated February 5, 2003
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Global Markets:
Evaluating Some Risks the U.S. May Face
The last 30 years have seen a rapid expansion of trade in goods and assets and
a general rise of economic interdependence across the world economy. Globalization
is the popular term given to this ongoing process. To most economists, globalization
is seen as a force that enhances the power of the market and gives greater scope for
realizing the gains from trade. This is an enriching process, with improved economic
well-being growing out of increased specialization of world production and elevated
economic efficiency. To others, however, globalization is seen as a clear threat to
their economic well-being, perceived to be retarding the growth of worker wages,
increasing wage inequality, undermining domestic social relations, and raising the
exposure of the American economy to foreign economic contagion.
The 108th Congress is likely to have to focus attention on trade liberalization
initiatives with Singapore and Chile and, perhaps the Free Trade with the Americas
initiative. Each of these initiatives will likely raise the heat under these simmering
issues with globalization.
The concern that expanding trade erodes the wages of American workers stems
from the observation of two recent trends in U.S. wage behavior. One, there has been
a significant slowdown in the rate of advance of worker real wages. Two, there has
been a marked increase in the inequality of wages between skilled and less-skilled
workers. This report suggests, however, that there is likely little causality running
from a rising level of trade to poor domestic wage performance. Slow average wage
growth is fully and credibly linked to poor productivity growth. A small share of
rising wage inequality can be linked to trade, but most of this trend appears to be
more soundly rooted in a rising demand for skilled workers.
Nevertheless, there are industries and workers adversely affected by expanding
trade. In these circumstances an increasingly urgent concern is that as more trade
occurs with countries that do not play by the same economic and social rules as the
U.S. , there will be a steady undermining of the economic position of workers in the
U.S. and the undermining of important social conventions and institutions that frame
the terms for acceptable economic competition. There is a strong sentiment that there
is a difference between economic gains generated by a comparative advantage based
on factor endowments or consumer preferences and gains generated by a comparative
advantage based on institutional choices in the exporting country that conflict with
the norms of the importing country. Where trade with a country that has different
social standards inflicts economic harm on domestic workers, the case can be made
that trade liberalization cannot be treated as an end in itself, without regard to how
it affects broadly shared values at home. The economic benefits of larger and more
integrated international capital flows are significant. But increased cross-border
capital flows also carry the elevated risks of contagion from negative foreign
economic shocks and financial market instability. The size, orderliness, and
resiliency of U.S. financial markets leave the U.S. well disposed to take full
advantage of the benefits of these asset flows with a minimum of risk.

In troduction ......................................................1
Globalization and U.S. Wages........................................2
Globalization and the Average Level of Wages......................3
Effect of Relative Labor Abundance...........................3
Effect of the Terms of Trade.................................3
Effect of the Trade Deficit...................................4
Evidence from U.S. Multinationals............................4
Effect of Slow Productivity Growth...........................4
Globalization and the Inequality of Wages..........................5
The Effect of Relative Supplies of Labor on Wage Inequality.......5
Reasons for Trade’s Limited Effect on Wage Inequality............6
An Upper Bound for Trade’s Effect on Wage Inequality...........6
What is Causing Wage Inequality?............................7
Trade and Fairness.................................................7
When Trade Conflicts With a Domestic Social Norm..............8
When Trade Does Not Conflict with a Domestic Social Norm.......9
Trade Without Effect on the Distribution of Income...............9
Reconciling Economic Efficiency and Social Fairness................10
Expanding Trade in Assets and the Risk of Instability....................11
Exposure to External Shocks....................................11
Factors That Dampen International Shocks.....................12
Impact of the Asian Economic Crisis on the United States.........12
Weighing Risk and Reward.................................13
Asset Price Volatility and Periodic Misalignments...................13
Has Volatility Been Excessive?.............................13
The Problem of Asset Price Misalignment.....................14
Foreign Finance and Economic Stability.......................15
Conclusion ......................................................15

Global Markets:
Evaluating Some Risks the U.S. May Face
The last 30 years have seen a rapid expansion of trade in goods and assets and
a general rise of economic interdependence across the world economy. Globalization
is the popular term given to this ongoing process. In the United States, the real
volume of trade in goods has grown twice as fast as real output bringing total trade
(exports plus imports) from about 10% of Gross Domestic Product (GDP) in 1970
to 28% in 2001. Trade in assets (e.g. bank accounts, stocks, bonds, and real property)
has grown even faster with cross-border asset transactions, for example, rising by a
multiple of nearly 220 ($5 billion to $1,123 billion) between 1970 and 2001.
The United States has been much involved in this process of globalization, both
as a leader in securing successive rounds of trade liberalization and the establishment
of the World Trade Organization (WTO), as well as an active participant in world
trade. As in the past, many would expect the U.S. to play a pivotal role in any further
opening of the global trading system. Without U.S. leadership many believe that the
prospect of a successful multilateral liberalization would likely be nil. At the same
time, however, U. S. trade policy makers had and will likely continue to face
substantial domestic backlash against further moves toward globalization. Recent
manifestations of this trend have been an eight year hiatus before congress again

granted presidential “fast-track” authority1 and a major political initiative to seek
new protection for the steel industry.
Trade initiatives with Chile and Singapore and, perhaps, the Free Trade for the
Americas initiative will likely come before the 108th Congress. These moves towards
freer trade can be expected to raise the heat under a number of simmering concerns
over the effect of expanding trade and trade policy responses on the U.S. economy.
What are the burdens of a rising tide of imports on the American worker? What
standing should concerns about labor and environmental standards have in trade
liberalization initiatives? What are the risks to economic stability of the near
explosive growth of cross-border asset flows? Questions such as these are likely to
be central to upcoming policy debates over the United States’ role in an ever more
globalized economy.
To most economists globalization is seen as a force that enhances the power of
the market and gives greater scope for realizing the gains from trade. This is an
enriching process, with improved economic well-being growing out of increased
specialization of world production and elevated economic efficiency. To others,
however, globalization is seen as a clear threat to their economic well-being,
perceived to be retarding the growth of worker wages, increasing wage inequality,
undermining domestic social relations, and raising the exposure of the American
economy to foreign economic contagion.
There can be no doubt that market forces in the process of raising the economic
well-being of the nation may worsen the plight of many sub-groups. The free market,
as the economist Joseph Schumpeter noted, is a force for “creative destruction.”
Markets create wealth by continually reallocating resources to more efficient uses
that increase total well-being. But that process of reallocation must also destroy
inefficient uses of resources, deteriorating the economic circumstances of those
whose job or business is eliminated or downgraded. A critical dimension of a
successful market economy is how well it manages the achievement of higher
efficiency and the adjustment of those hurt by these dynamic wealth-creating forces.
Much popular and political debate about globalization, however, is heavily shaded
with the image of rising international trade, particularly with low-wage developing
economies that do not compete “fairly”, as a threat to the U.S. workers’ economic
well-being. In addition, greater asset market integration raises the specter of
economic and financial instability abroad quickly spreading harm to the United
States. For many, it would seem globalization is felt to be more “destructive” than
“creat i v e.”
This report will examine three prominent concerns about globalization and U.S.
economic performance: one, the effect of trade on worker wages, particularly those

1 Fast-track refers to procedures, initiated under the Enactment of Trade Act of 1974, to
implement trade agreements negotiated by the President. Those procedures established
mandatory deadlines, limited debate, and a no amendment requirement on congressional
deliberation of trade agreements. This authority expired in 1994 and was not renewed until

2002. See: C RS Report RS20039, Fast-Track Implementation of Trade Agreements: Issuesth

for the 107 Congress, by Lenore Sek.

of less-skilled workers; two, the question of trade and fairness, namely trade with
countries that have much lower worker and environmental standards; and three, the
expanding cross-border trade in assets and the risk of financial and economic
Globalization and U.S. Wages
The concern that expanding trade erodes the wages of American workers stems
from the observation of two recent trends in U.S. wage behavior, coincident with
rising globalization. One, there has been a significant slowdown in the rate of
advance of worker real wages. For example, between 1980 and 2001 real hourly
compensation in the business sector had a relatively slow cumulative increase of
24.3%. Two, there has been a marked increase in the inequality of the distribution
of wages between skilled and less-skilled workers as measured by education levels.
For example, the difference between the earnings of the college educated and those
with a high school education rose about 20% between 1970 and 2000.2
Trade can have strong effects, good and bad, on worker wages. The plight of
the worker adversely affected by imports comes quickly to mind. On the other hand,
workers in industries that export benefit from expanding trade. What is, perhaps, less
well understood is that, because all workers are also consumers, they will benefit
from the expanded market choices and lower product prices that trade provides.
There is no necessary reason to assume that the overall effect of trade on workers is
bad, but sound economic analysis also suggests that trade, even as it raises overall
well-being, can also sharply alter the distribution of income among the several factors
of production, including labor. This section of the report first evaluates critically
whether an increasing level of trade and interdependence has played a role in the
slow growth of the average level of real wages of American workers and then
examines whether rising globalization has made the distribution of worker wages
more unequal.
Globalization and the Average Level of Wages
Effect of Relative Labor Abundance. We consider first whether an
expanding level of trade is responsible for slow average real wage growth. Economic
theory suggests that increased trade, while making the overall economy better off, can
have strong effects on the distribution of income among factors of production. That
theory points to the possibility that, if labor is relatively more abundant in the rest
of the world than at home, an expansion of trade with the rest of the world could
increase the “effective supply” of workers to the U.S. economy and reduce worker
wages relative to rewards paid to other factors of production, most importantly
capital. Since trade has clearly raised the living standard of the country, a general
decline in the real wage of U.S. workers would have to mean that labor’s share of the
economic pie has shrunk. This has not occurred, however. Labor’s share of national

2 For further discussion of these trends see: Murphy, Kevin M. “Changes in Wage Structure
in the 1980s: How Can We Explain Them?” Memo. University of Chicago, 1992. And also:
CRS Report 97-142E, Earnings Inequality in the 1980's and 1990's, by Gail McCallion.

income shows no significant trend, up or down, over the past four decades, typically
falling between 68% and 72%, depending on the year examined3.
Effect of the Terms of Trade. Real living standards depend not only on
workers’ share of domestic production, but also on their ability to exchange that
output for foreign output (i.e., to realize gains from trade ). That gain can be eroded
if import prices rise faster than home prices, causing a fall in the real purchasing
power of any given level (or share) of national income. The ratio of U.S. export
prices to import prices — the terms of trade — is a measure of changes in the home
economy’s share of the gains from trade. It is plausible that expanding trade in a
world economy, increasingly populated with technologically capable foreign
producers, could have put downward pressure on U.S. export prices, reduced the
terms of trade, and lowered the real wages of workers. The data do not support that
scenario, however. The terms of trade did fall in the 1970s, but the cumulative effect
on real income was relatively small (less than a 2% decline over the decade).
Through the 1980s and the 1990s, the U.S. terms of trade have slowly risen tending4
to increase worker real wages rather than erode them.
Effect of the Trade Deficit. What about our persistent, large trade deficits
over the last 18 years? Have they dampened worker wage growth? First, trade
deficits are not a symptom of globalization and a rising level of trade. Rather, they
are mainly a consequence of domestic macroeconomic behavior, such as a high rate
of domestic investment relative to domestic saving, that has pushed domestic
spending beyond domestic production requiring a net inflow of goods — a trade
deficit — to sustain the excess domestic spending. As such these trade deficits do not
represent a reduction in domestic output, nor a reduction in the demand for labor.
Second, even if the trade deficits had reduced domestic output, the size of those trade
deficits and the potential scale of the effect on domestic labor markets is far too small
to explain the slow growth of American real wages5.
Evidence from U.S. Multinationals. The recent behavior of U.S.
multinational manufacturing companies gives some added confirmation that there has
not been any sharp swing in the demand for labor away from domestic sources and
toward foreign sources. It is estimated that U.S. multinational firms account for about
half of all domestic manufacturing employment, making them good barometers of
trends in the tradeable goods sector, particularly if those trends are reflective of
changing economic attractiveness of different countries as locations for production.
If low-wage countries provide a significant cost advantage, then we would expect
to see a shift of employment from the domestic parent to these foreign affiliates. The
data reveal, however, that multinational manufacturing employment has fallen both
at home and abroad. Between 1977 and 1993, domestic employment in these firms

3 The White House. Economic Report of the President, February 2001, p. 306
4 See: U.S. Department of Commerce. Bureau of Economic Analysis. Survey of Current
Business, various issues. Table 1.11.
5 See: Lawrence, Robert, and Matthew Slaughter. International Trade and American Wages
in the 1980's: Giant Sucking Sound or Small Hiccup? Brookings Papers on Economic
Activity, vol. 2. Washington, Brookings Institution, 1993.

fell about 21% (or about 2.6 million jobs), while employment in their plants in the
rest of the world fell 17% (or about 830,000 jobs). If we look at manufacturing
affiliates in only developing countries, employment did increase about 5% (or about
85,000 jobs). But, these gains amount to less than 4% of the reduction of domestic
manufacturing employment. This implies that the multinational’s U.S. workers have
maintained their relative productivity. Consequently, there is no great outrush of U.S.
multinational firms to increase employment in their low-wage affiliates at the
expense of their domestic counterparts.6
Effect of Slow Productivity Growth. If a rising level of trade is not the
culprit behind slight real wage growth, what is? We know that wages are basically
a function of how productive workers are. High levels of productivity (output per
worker) are associated with high wages, and rapid productivity growth is associated
with rapid wage growth. Therefore, it is highly credible that the sharp slowdown in
average productivity growth since the early 1970s in the United States is the cause
of slow wage growth over the same period. Measures of U.S. worker compensation,
appropriately deflated using a price index for the goods workers produce, gives a
measure of inflation adjusted or real compensation that moves in step with the trend
path for productivity over the last 25 years. In other words, workers’ share of the
economic pie is not getting smaller, the pie is just not growing as fast as it once did.
Underscoring the importance of productivity growth for wage growth, more rapid
productivity advance evident since 1997 has been associated with more rapid growth7
of real compensation.
Globalization and the Inequality of Wages
The Effect of Relative Supplies of Labor on Wage Inequality. Even
if expanding international trade has not adversely affected the average level of wages,
it can still have a distorting effect on the distribution of wages among workers.
Labor is not a homogeneous resource, and market forces, including trade, can help
one class of worker while hurting another. In recent years, wages have been steadily
skewed in favor of high-skilled workers relative to low-skilled workers. It is
conceptually possible that expanding trade, particularly with countries that have a
relative abundance of low-skilled workers, will tend to increase the “effective
supply” of low-skilled workers available to the U.S. economy, and thereby put
downward pressure on the wages of low-skilled workers in America. Other forces,
unrelated to trade, could give the same outcome, however. For example, a strong
general increase in the demand for skilled workers presumably growing out of the
evolving pattern of final demand (increased demand for skill-intensive products) and
the nature of technological change requires higher and higher inputs of “skill.” What
does the evidence show? This remains an area of some contention. Yet, the weight
of evidence from most careful studies suggests that trade has been a minor factor

6 For these data and a discussion of this phenomenon see: Lawrence, Robert Z.
Globalization and Trilateral Labor Markets. The Trilateral Commission, No. 49. P. 32.
7 See: Lawrence, Robert and Matthew Slaughter op. cit; and Lawrence, Robert Z. and
Robert E. Litan Globaphobia: The Wrong Debate Over Trade Policy. The Brookings
Institution. Washington, 1998.

contributing to rising wage inequality, causing perhaps 5% to 15% of the observed
rise in wage inequality.8
For international trade economists looking at this issue, a critical bit of evidence
regarding trade’s effect on the distribution of wages is the behavior of the prices at
which goods trade. Foreign workers do not compete with home workers directly, but
indirectly through the price of the goods they produce. If foreign low-wage workers
provide an efficiency advantage over domestic workers, then that advantage must,
through trade, manifest itself as a lower price of the foreign goods in the home
market. Reduced profitability of the domestic industry that competes with the low-
price import induces a reallocation of resources toward more profitable skill-
intensive applications, and a general decrease in the demand for and wage of
domestic low-skilled workers. In this chain of causation, the critical factor is not the
volume of trade, but rather traded goods prices. This leaves us with the empirical
question: Have the prices of import competing goods that use low-skilled workers
intensively fallen relative to the price of goods that use high-skilled workers
intensively? With appropriate deference to data problems, relative prices have not
moved in a pattern consistent with the conjecture that trade has adversely affected
low-skilled domestic workers.9 (In some cases there is evidence that this critical price
ratio has moved in the opposite direction, in a direction consistent with trade helping
low-skilled workers relative to high-skilled workers.)
Reasons for Trade’s Limited Effect on Wage Inequality. That
globalization has, so far, had a relatively minor effect on the level and distribution
of U.S. worker wages is, perhaps, less surprising if one considers that, despite the
sizable growth of trade with low-wage developing countries, such trade still remains
a relatively minor component of total U.S. trade and is particularly small when
compared to the total size of the U.S. economy. Imports from countries where wages
are less than half of U.S. wages was equal to 2.6% of GDP in 1990, up only slightly
from 1.8% in 1960.10 By and large, for the United States, the great bulk of trade in
manufactures is with other high-wage economies. It has been estimated that, in 1990,
the trade-weighted average hourly manufacturing wage of U.S. trade partners was
88% of that in the United States, not a large enough difference to cause the observed
change in wage inequality.11 Thus, trade’s impact on the domestic labor market can
also be expected to be small. This is reinforced by the data on U.S. multinationals’
employment changes in recent years. That is, those data are also consistent with the

8 See: Cline, William R. Trade and Wage Inequality . Institute For International Economics,
Washington , DC, 1997;; and Borjas, George, and Richard B. Freeman; Lawrence F. Katz.
How Much Do Immigration and Trade Affect Labor Market Outcomes? Brookings Papers
on Economic Activity p. 1-90; Susan Collins, Trade and the American Worker, Brookings
Institution, Washington, D.C., 1997; and Lawrence and Litan, op. cit.
9 See: Lawrence, Robert and Matthew Slaughter. Op.cit. P. 161-226; and Sachs, Jeffery and
Howard Shatz. Trade and Jobs in U.S. Manufacturing. Brookings Papers on Economic
Activity, vol. 1. Washington D.C. 1994. P. 1-84.
10 See: Lawrence and Litan, op. cit.
11 See: Economic Report of the President. February 1998, p. 243.

notion that there has been no differential shift of employment toward low-skilled
foreign workers and away from low-skilled domestic workers.
An Upper Bound for Trade’s Effect on Wage Inequality. Of course,
as trade with developing countries grows, so might its contribution to wage
inequality. Economic analysis suggests, however, that there may be an upper bound
to this potential effect and that it could be reached fairly quickly as the cost
differences between home and foreign production widen. It is credible that a
condition of complete specialization might be reached after only a relatively small
price disadvantage appears. That is, the United States would find it most efficient to
stop producing the import competing goods as increased specialization leads to trade
in noncompeting sectors. If there is no domestic industry that uses low-skilled labor
intensively in the production of tradeable goods, there can be no downward pressure
on U.S. wages caused by trade with developing countries.12 It is also important to be
mindful that trade can also set in motion other forces that can have a favorable effect
on all domestic workers. For example, economies of scale can be more fully realized
through expanding trade. Further, trade may heighten competition and raise
efficiency. Such forces may be strong enough to allow all factors of production to
see their real return rise.
What is Causing Wage Inequality? Many economists argue that “biased”
technological change likely is the primary cause of rising U.S. wage inequality.
Modern production techniques have generally raised the demand for skill in the labor
market. In effect, “skill” is suspected of becoming more complementary to capital
and “less-skill” more of a substitute for capital. Thus, the process of capital
accumulation and technological change will tend to raise the wage of skilled labor
and to lower the wage of low-skilled labor.13 Other minor causes might be
immigration, deunionization, and falling real minimum wage. So far the evidence
does not give a full picture of the nature and extent of this process.
Trade and Fairness
Even though the evidence is that trade has had little overall effect on wages in
the United States, there are industries and workers adversely affected by trade
expansion. Their plight gives rise to the concern that trade with countries that do not
play by the same economic and social rules as the United States can undermine the
economic position of U.S. workers. Worse, it can undermine important social
conventions and institutions that frame the terms for acceptable economic
competition. Most importantly this includes labor standards that set rules for
minimum age, maximum hours, health and safety norms, as well as collective
bargaining rights; and environmental standards that regulate industries’ use of land,
air, and water. Employers in many developing countries, it is observed, do not meet
labor standards common in advanced countries, nor are they subject to the same

12 See: Krugman, Paul. Growing World Trade: Causes and Consequences. Brookings Papers
on Economic Activity, No. 1, 1995.
13 See: Grilliches, Zvi. Capital-Skill Complementarity. Review of Economics and Statistics,
no.465, 1967, P.51.

costly environmental standards of the advanced nations. The cost advantages
afforded by these lower production standards, it is argued, will steadily put
competing American industries and, most often, low-skilled American workers at a
major disadvantage as well as erode established domestic social relations.
From the standpoint of economic gain or loss does such “unfair competition”
matter? A cheaper product, regardless of how it was made cheaper, is an overall gain
to the importing economy. It is certainly possible for those who gain to compensate
those who lose and still be better off. Adequate compensation, in practice , is most
often problematic, however. Of course, the loss to the displaced worker in the import
competing industry is the same whether caused by “unfair” foreign practices or
“state of the art” technological prowess. Yet, the former is often seen to be far less
accept abl e. 14
Under what circumstances does “fair-trade” represent a valid argument against
free trade? There are three possible situations. While the economic case argues
against restriction in all three cases, the degree to which other “social requirements”
are met varies.
When Trade Conflicts With a Domestic Social Norm. For many people
the acceptance of the gains from trade will hinge on whether those gains emerge from
a process where all trading parties adhere to social norms of “fair play.” For
example, different child labor rules can afford a basis for trade. The United States,
with long held restrictions on child labor in its domestic practices, can find it
economically beneficial to trade with a country that has a low level or no restriction
against child labor. Lower child labor standards could give a production cost
advantage to the foreign producer. If the exports of the low labor standards country
compete directly with U.S. industries, the price advantage of those lower standards
will encourage a higher level of imports to the United States. These imports will
come at the expense of domestic production. U.S. workers in the affected industry
will lose jobs. With time these workers may find new jobs but most likely at a lower
wage. In the aggregate, both nations are economically better off through this
exchange, but the distribution of income has been changed in the United States as the
income of the import competing workers falls.
Is this an acceptable outcome, or should trade policy(tariffs, quotas, etc) be used
to protect the affected domestic workers from this outcome? The hard core economic
response would be that this is an acceptable outcome and that the use of trade policy
to alter it would be inefficient, reducing the gains from trade, hurting domestic
consumers, and hurting workers in the foreign export industry. It may be concluded
that the harmed American workers can be more efficiently helped with income
transfers and adjustment assistance. The gains from trade are large enough to
compensate the displaced workers and still leave everyone better off.
While this is certainly an efficient outcome, it is, however, an outcome that
likely violates a prevailing social norm ( i.e. domestic adult workers should not have

14 The discussion in this section draws extensively on: Rodrik, Dani. Has Globalization
Gone too Far. Institute for International Economics. Washington D.C. , 1997.

to compete against child labor), and will be seen as unacceptable to many. If it is
unacceptable to have child labor in a purely domestic context, why would it be
acceptable to have domestic workers living standard reduced by competing indirectly
through trade with countries with more lax child labor laws? The overriding
sentiment in this circumstance is that there is a difference between gains from trade
generated by a comparative advantage based on factor endowments or consumer
preferences and trade generated by a comparative advantage based on institutional
choices in the exporting country that conflict with the norms of the importing
In this circumstance, where trade with a country with different social standards
inflicts economic harm on domestic workers, the case can be made that trade
liberalization can not be treated as an end in itself, without regard to how it affects
broadly shared values at home. Economic activity occurs in a social and moral
context which tells us that there are unacceptable ways of imposing a burden on
fellow citizens. In concept, a trade restriction can be justified in this case to protect
the strongly held social norm. In practice, however, under the rules of the World
Trade Organization (WTO) it would be improper to use trade policy to curtail
imports from countries using child labor because WTO rules, while prohibiting trade
in products made by prisoners, generally do not allow discrimination on the basis of
the mode of production. Of course, WTO rules do have the so called “escape clause”
mechanism that allows seeking relief from damage caused by certain types of import
surges. We can imagine an elaboration of the “escape clause” mechanism that could
be used for providing relief from damage done by unacceptable modes of foreign
production. In its current form, however, WTO rules governing the use of that
mechanism provide a very limited scope for using trade restrictions and has been
little used by member nations.
When Trade Does Not Conflict with a Domestic Social Norm. When
trading partners have essentially the same economic and social framework, there
may be another commonly cited “unfair” trade practice –- foreign dumping of
exports. Dumping is the selling of a good for a price that is less than the cost of
production. Economic analysis clearly demonstrates that the lower price of the
‘dumped’ import raises overall economic well-being in the importing country. But
particular workers and firms that compete with the imported product will likely be
hurt. Is this, like the child-labor case above, a situation where an alleged unfair
practice is violating a domestic social norm and therefore an appropriate target for
restrictive trade policy?
Price cutting is not generally seen as violating a strongly held domestic social
norm. Rather, price cutting is most often a basic element of competition in the market
place that serves efficiency and overall well-being, and is widely practiced in the15
domestic economy. WTO rules make provision for nations using trade restrictions
as part of an anti-dumping policy. Because it is relatively easy to invoke, an anti-

15 A possible exception would be instances of dumping that are “predatory” and part of a
plan to establish monopoly power. Such predatory practices reduce economic welfare in the
long-run and preventing them is in our economic interest. However, predatory pricing
appears to be rare.

dumping safeguard mechanism has been a widely and often used device for seeking
relief from surging imports that are harming particular workers and firms in the home
economy. Many economists argue that the anti-dumping safeguard mechanism is
being greatly overused. Rodrik, for example, believes there has been excessive use
of the anti-dumping procedure which “subverts the trade regime, gives safeguards
a bad name, and crowds out an effective outlet for legitimate concerns.”16 Industries
harmed by dumping, however, believe such measures are necessary to preserve a
“level playing field.”
Trade Without Effect on the Distribution of Income. The fairness issue
takes a somewhat different form if imports from a country with lower social
standards do not compete with any domestic industry. In this circumstance there is
no effect on the distribution of income in the U.S., nor are there any harmed domestic
workers. Objections to trade with these nations must arise out of humanitarian
concerns for foreign workers and citizens. If so, then the standard economic argument
against the use of restrictive trade policy to attempt to force more humanitarian
outcomes abroad may have more resonance. Restrictive trade policies in this case
do not protect any domestic practice nor remove any economic burden. They will,
however, lower economic welfare at home and abroad. Foreign workers in the
exporting country would most likely be harmed, as reduced demand for the products
they produce pushes them out of a job or, at best, into some inferior alternative.
Those who acknowledge such values, but oppose using trade restrictions may argue
that other mechanisms would be a more efficient response. Direct technical or
financial assistance, for examples, might better serve raising labor and environmental
standards than would restrictive trade policy. Others holding these values, who
believe access to the U.S. market is a potent incentive for moderating other countries
behavior, often advocate trade restraints.
Reconciling Economic Efficiency and Social Fairness
Resolving questions of “fairness” is likely to be central to any continuation of
the process of trade liberalization among nations. Negotiations aimed at increasing
global market integration will likely be concerned with issues that extend well
beyond differences at the border to include domestic social and political
arrangements. In such cases, policy responses based only on an economic basis are
very likely to be insufficient. Yet, the current WTO rules governing international
trade do not provide an efficient mechanism for reconciling often divergent
economic and social goals. The failure of the WTO meetings in Seattle in December
of 1999 has meant that there is no clear vision of how and when future multilateral
trade negotiations would proceed. Overcoming this state of drift in the world trading
system may require the U.S. to take a pivotal leadership role in shaping a vision for
the world economy.
In contemplating that future form several points drawn from the discipline of
economics and the insights of political economy might be useful. First, economics
makes clear that the very existence of “gains from trade” arises from some
economically exploitable difference. If all nations were alike in resource endowments

16 See: Rodrik, op.cit. p 82.

and social institutions there would be little reason to trade. A crucial question
underlying the efficacy of trade and continued market integration is what differences,
particularly in social norms, are an acceptable basis for mutually beneficial trade.
Second, the power of the market to bring steady economic improvement does
not grow out of good intentions; rather, it is the quite unintended consequence of
entrepreneurs pursuing their own self interest and seeking profit from what small
advantages might exist in a developing economy. In many poor nations the
acceptability of having children work long hours and of denying labor the right to
collective bargaining may be the only way they perceive to produce a tradeable good
today and improve economic well-being in the future.
Third, the United States and other advanced nations have an interest in
improving economic conditions in poor nations. Rising prosperity helps to undergird
political and social stability, but it also likely enhances the willingness and ability of
these nations to adopt higher labor and environmental standards.
Finally, to some degree concerns about “unfair” trade might be allayed if
harmed workers in the U.S. were more confident of receiving equitable compensation
and other adjustment assistance. Insurance against adverse labor market outcomes
has been part of a social bargain in the U.S. and other advanced countries that has
enabled these nations to make fuller use of the wealth creating potential of the market
economy, including trade liberalization. If further global market integration is to
occur it may be necessary to reevaluate the sufficiency of our social insurance
Expanding Trade in Assets and the Risk of
Capital markets have achieved a higher degree of globalization than has goods
trade and carry a somewhat distinct set of potential problems and policy concerns.
The extent of capital market integration is evident in the huge increases in cross-
border flows in most financial realms over the last 22 years. These include bank
deposits, securities (stocks and bonds) and foreign exchange. Beyond their size, asset
transactions are far more fluid than goods transactions, able to move quickly and
change direction just as quickly.
The economic benefits of international capital flows are significant. The
presence of well functioning international asset markets can extend the benefit of
international trade well beyond the gains associated with the exchange of goods and
services. International capital markets can facilitate a more efficient allocation of
saving and investment across nations, allowing an optimal spreading of consumption
spending over time. International trade in assets can also enable greater
diversification of investment portfolios, leading to reduced investor risk. In
conjunction with flexible exchange rates, high capital mobility also enhances the
power of monetary policy, and alters how monetary forces are transmitted and
distributed through the economy.

Increased capital market integration also carries risks. One risk is that with
more points of economic and financial contact there is also a raised probability for
the inward transmission of negative economic shocks, sometimes called “contagion”
effects. Another risk is seen arising from the great size and fluidity of asset markets
themselves, which give them the potential to be destabilizing and able to generate
periodic economic crises. The unsettling prospect in this regard is that in the current
international financial system with large volumes of highly mobile international
capital, an economy is open to assault by currency speculators who may incite excess
volatility of exchange rates and other assets, and impose economic instability and
hardship on the U.S. economy.
Exposure to External Shocks
Increased interdependence increases the points of contact among the economies
of the world. Most often these enhanced linkages are a positive construct that help
raise economic efficiency, but from time to time they can play a negative role as
conduits for economic “contagion.” With increased globalization, economic maladies
on the other side of the world will spread more quickly, perhaps bringing undeserved
economic misfortune to U.S. citizens.
Expanding trade in goods and assets and the associated increase of global
market integration will increase the risk of economic shocks carrying from one
economy to another. In practice, however, such shocks are seldom carried from the
initiating country to others on the same scale. This attenuation of the transmitted
shock is largely due to differences in economic size and to differences in the degree
of integration. The U.S. is far larger then any single trading partner. Further, trade
for the U.S. is a small share of total economic activity. Taken together, these two
factors most often assure that a foreign economic calamity has small ripple effects
on the United States. Of course, these factors can be expected to exert less and less
of an attenuating effect as trade, interdependence, and the relative size of our trading
partners grows, but there are other forces that will likely work to attenuate the impact
of foreign economic shocks.
Factors That Dampen International Shocks. First, well functioning
markets will provide automatic offsets to external shocks through movement of
exchange rates, interest rates, and prices. Second, quickly responding and prudently
applying economic policy, most often monetary policy, can help to mitigate the
effects of external shocks. A third factor attenuating the impact of external shocks is
that increased global integration also allows shocks to be absorbed by a far larger
global market, thereby arguably reducing the effect on any individual economy.
Fourth, to the extent they provide more rapid and more comprehensive flow of
market information about risk and profitability of investment prospects around the
globe, integrated asset markets help facilitate a quicker adjustment to disruption and
a more efficient allocation of the world’s limited saving in both the short-run and the

17 For further discussion see: International Capital Markets :Developments, Prospects, and
Key Policy Issues. IMF, September 1998.

For the United States in particular, financial markets have a breath and depth
that affords a high degree of resiliency to financial and economic storms. Recent
troubles in Asia highlight the problems that large flows of financial capital can pose
for systems that have relied too heavily on the “banking system” for financial
intermediation and have not adequately regulated and supervised that system. In
contrast, the U.S. financial system employs an array of well developed financial
intermediaries (stock markets, bond markets, and banks) that achieve a higher
proficiency at risk management, and subjects those institutions to a high level of
regulation and supervision.
Impact of the Asian Economic Crisis on the United States. In recent
years the American economy has prospered despite substantial economic ills in
Japan, Europe, and Mexico. Nor have troubles in several Asian countries had a
sizable effect on the United States. During these crises the U.S. has maintained
vigorous economic growth, achieved record low levels of unemployment, and
avoided any re-acceleration of inflation.
The Asian crisis did have an impact, however, in that it contributed to a
substantial widening of the U.S. trade deficit. Sizable inflows of Asian capital,
seeking high and more certain U.S. asset yields, pushed up the dollar exchange rate,
weakening exports and encouraging imports. Several tradeable goods sectors of the
economy were hurt by these changes. On the export side, agriculture and commercial
aircraft experienced damped export sales. On the import side the steel industry and
the textile and apparel industries came under considerable pressure from low price
competition from the crises-affected countries.
On the other hand, there have been economic benefits derived from that crisis.
Lower import prices have elevated real income in the United States and dissipated
inflation pressures. In addition, large capital inflows have kept domestic interest rates
lower than they otherwise would be, a boon to U.S. borrowers and interest sensitive
sectors such as housing and consumer durables.
Weighing Risk and Reward. Increased global integration probably does
raise the exposure of the U.S. economy to external shocks. But, such integration also
boosts the rewards to the economy through improved efficiency. So far there is no
conclusive evidence that the added risk exceeds the added reward. While individual
sectors were hurt, the overall U.S. economy weathered recent international financial
storms with little difficulty and some benefit. Moreover, we have seen that the
prudent application of domestic macroeconomic policy can do much to assure that
on balance the rewards from this ongoing process continue to exceed the economic
Asset Price Volatility and Periodic Misalignments
Beyond their potential for transmitting economic shocks, integrated financial
markets themselves can be the source of problems. Specifically, those markets may
produce excess “volatility” of asset prices, most importantly exchange rates, causing
economic disruption and costly adjustment. Because exchange rates communicate
important economic signals to those involved in international trade and investment,
the argument can be made that any tendency for foreign exchange markets to

“overreact” to events will transmit confusing and error-filled data to international
traders and investors, causing a misallocation of global resources.
Has Volatility Been Excessive? It is difficult to determine what
constitutes “excessive” volatility. Where one person perceives volatility and
disruption, another sees global asset markets working quickly and usefully in
response to changes in economic fundamentals that affect risk and profitability.
Whether international asset markets overreact and whether such overreaction carries
more costs than their efficiency benefits warrant is an open question. While exchange
rates have in recent years appeared to be rather volatile, evidence does not point to
significant increases in the variability of other asset prices. And even the increase in
exchange rate volatility has not been conclusively shown to be excessive in the sense18
that it has gone beyond what could be attributable to an efficient market function.
The currency crisis of several Asian countries in the late 1990s highlights these
issues. The international capital market clearly induced sharp and painful
depreciations of the foreign exchange value of those countries’ currencies. Yet, what
is also increasingly evident is that these countries were pursuing “questionable”
macroeconomic policies, had “suspect” banking and financial practices, and
promoted “imprudent” exchange rate management regimes. International asset
markets serve economic efficiency by reacting quickly and strongly when evidence
of “bad” fundamentals emerges.19 Thus, globalization and rapid capital flows, in this
view, have a positive role in limiting the ability of countries to pursue incompatible
and unsound economic and financial policies.
On the other hand, to the extent that there is a degree of overreaction by
currency and other asset traders, it is possible that economies will be forced through
a measure of “unnecessary” adjustment. In such cases, there are international
adjustment mechanisms for assistance. An economic role of the International
Monetary Fund (IMF), for example, is to provide adjustment aid to help weather
international financial crises. But we might keep in mind that the economic purpose
of IMF assistance in such circumstances is not to bail-out enterprises generally,
rather it is to offset the unnecessary adjustments forced by the currency markets
over-reaction. It is possible that the global markets in conjunction with well targeted
economic assistance may be a workable and efficient mix, enhancing the operation
of the world economy, and providing indirect benefit to the U.S. as it improves the
wealth and stability of our economic “neighborhood.”
The Problem of Asset Price Misalignment. A more critical issue for the
United States and other industrial economies in an international environment of large
and rapid capital flows is the prospect of asset prices becoming misaligned, that is,
straying, and remaining for a time, well beyond a level that is consistent with
underlying economic fundamentals. This was likely true for the dollar in the 1984-
85 period, for the U.S. stock market just prior to the crash in 1987, and for the
Japanese Yen in 1995. Such misalignments often impose disproportionate burdens

18 See: Bank for International Settlements. Financial Market Volatility : Measurement,
Causes, and Consequences, BIS Conference Papers, March 1998.
19 See CRS Report 97-1021, The Asian Financial Crisis, by Dick K. Nanto.

on sectors of the economy (e.g., exchange rate impacts on tradeable goods sectors)
and their correction is potentially disruptive to the wider economy (e.g., inducing
financial market instability).
Misalignments are difficult to identify at the time they are occurring because
there is usually a substantial margin of uncertainty about whether a given level of
asset prices is inconsistent with macroeconomic fundamentals. Those fundamentals
will most often be consistent with asset prices moving in the direction they are
moving. The problem is deciding if they have moved too far.
Once identified, misalignments can be hard to correct because of the huge
volumes of private capital flows that may need to be offset. The corrective actions
of the central bank of one nation may be unable, in some circumstances, to counter
the tide of private capital supporting the misalignment. In these cases coordinated
intervention by several governments may be more effective at correcting the
misalignment. Such coordinated strategy did help to correct the soaring dollar in
1985 and the “overvalued” yen in 1995. Such actions are also thought to carry an
important “signaling” function in the sense that their effectiveness does not stem so
much from the quantity of their financial market actions but from their role as an
indicator of the participating governments’ commitment to more sustainable
economic policies. In general, the governments of the industrial economies may not
have shown a capacity to always avoid the periodic policy missteps that induce asset
market misalignments. To an extent, however, they have revealed a capability to
deal effectively with the misalignments in a way that is not overly disruptive to
economic activity.
Foreign Finance and Economic Stability. A related concern with
globalized asset markets is that countries with open capital markets will from time
to time be recipients of large net inflows of financial capital, which will just as
quickly leave. These rapidly shifting funds can be a destabilizing force, creating
inflationary pressure and pushing up the real exchange rate. On the other hand,
capital inflows can be a useful and efficient source of financial capital. The
desirability and undesirability of such inflows will hinge critically on the factor or
factors that caused them. If the capital inflow is the consequence of flawed or
misguided macroeconomic policies, then, such capital flows may quickly desert the
economy, and perhaps precipitate a crisis. If, on the other hand, those inflows are
caused by sound economic policy and good long-term investment prospects, then
such inflows can be enduring and beneficial.
There is little doubt that the process of trade liberalization and the development
of ever more integrated global markets has been on balance an enriching endeavor
for the United States and the world economy. Nevertheless, it has of late become a
particularly contentious process, with a very vocal opposition. At the moment there
is mixed interest for undertaking a new round of multilateral liberalization of trade
in goods and services. For the advanced nations like the United States, the moderate
and widely dispersed benefits of more open trade are countered by localized and
sharply felt costs. For many poorer trading nations it is often the case that the

benefits of expanded trade will be reduced or not realized if they are compelled to
operate their industries subject to the costly social and economic “rules” that the
advanced nations maintain.
Breaking this impasse will require leadership and the United States has played
a central leadership role in past trade liberalization initiatives. For the United States
to assume that role now, it may have to assuage the heightened concerns of its
citizens about the costs and risks accompanying the process of globalization. While
the data indicate that the costs of trade to the United States are less than commonly
perceived, concerns do exist. It may be the case that an adequate response to these
concerns will require reform and expansion of the U.S. system of social insurance for
workers. But, it may also require an expanded scope and use of the WTO “escape
clause” mechanism to more readily allow trade policy remedies in cases where trade
is undermining strongly held social norms. But an enhanced “escape clause” can
only emerge from new multilateral negotiations.
Expanding trade in assets proceeds with greater speed and with less
encumbrance then does trade in goods. It seems clear that, short of a dramatic shift
in the form of the world trading system, large and often rapidly shifting flows of
international capital are a fact of life, irresistible and irreversible. The size,
orderliness, and resiliency of U.S. financial markets leaves the United States well
disposed to take full advantage of the benefits of these asset flows with a minimum
of risk. However, the importance of global stability points to the United States
having an interest in helping to develop and support an international financial
architecture that will extend the benefits of international capital to the world’s
smaller economies, that often fare less well with global capital markets.