Evan Soltas
Jul 25, 2012

The Great Factor-Price Equalization

Noah Smith's recent post, "Something Big Happened in the Early 70s," discussed how growth in productivity and in compensation appear to dramatically decouple at that time. Short version: Until the 1970s, real wages and compensation had increased roughly one-for-one with productivity; since then, productivity has soared with comparatively no change in real earnings.

Noah put forth two possible "stories" of causation: (1) the oil shock of 1973 and (2) the end of the Bretton Woods in 1971.

I shared some short-form thoughts in Noah's comment section on the second possibility, and here is my more thorough "something big" story.

The end of Bretton Woods began the process of globalization, and more specifically, the emergence of global markets for goods, services, and inputs where factor-price equalization operates powerfully. (Arnold Kling of "EconLog," in fact," refers to this as "The Great Factor-Price Equalization.") The basic idea here is that the maintenance of Bretton Woods' fixed exchange rates required a system of financial controls which so severely limited capital flows, global investment and trade that economies were effectively closed. When Bretton Woods ended in 1971, currencies floated, capital controls began to come down, global trade and investment increased -- and nations developed open economies.

The United States' compensation-productivity ratio was forced lower and lower as American companies faced strenuous competition in their domestic market against exporters. This competition came primarily from the East Asian tiger economies, as their low labor costs -- considered as W/MPL, wages divided by the marginal productivity of labor -- gave them a comparative advantage in the production of nondurable, low-skill, labor-intensive goods.

One such sector was apparel, which was perhaps the first sector for which this story unfolded. New York City, notably, saw the implosion of its garment manufacturing industry during this period. In Edward Glaeser's book, Triumph of the City, he notes that at its height garment manufacturing occupied a larger part of the New York City workforce than auto manufacturing for Detroit. Then came the "something big" of 1970 -- a flood of vigorous foreign competition -- and the city's manufacturing employment base was halved in two decades.

The signature item of evidence, however, is the collapse of the real (or relative) price of apparel in the United States, as measured by the apparel component of the Consumer Price Index against the overall CPI. Indexing the January 1970 value to 100, the real price of apparel fell by a third within the end of the decade. It remains approximately one third of its 1970 real price today.The high-labor-cost American nondurable manufacturing sector had a snowball's chance in such an environment. Although (unfortunately) the Bureau for Labor Statistics' detailed data on nondurable manufacturing employment goes back only to 1990, that is enough to bear witness to the power of factor-price equalization.

The apparel production industry had nearly a million Americans on its payrolls in 1990. It employs less than 150,000 today.Related sectors saw similar hollowings-out. In 1990, half a million Americans worked in textile mills of the sort which produces cloth and other intermediate goods; in 2012, 120,000 did. In 1990, 240,000 worked in final-good textile mills; in 2012, less than 120,000 did. In 1990, 130,000 worked in leather and allied industries; in 2012, 30,000 did.

We can see this story unfolding at the macro level as well in the United States' trade-to-GDP ratio, which went parabolic starting in the 1970s. It had risen slightly in the 1950s and 1960s as global trade networks recovered from the one-two punch of the Great Depression and World War II -- keep in mind Europe's reintegration into the global economy under the Marshall Plan. Yet it took the "something big" in the early 70s to shift the United States from a closed economy with trade less than a tenth of GDP to an open -- or at least opening -- economy with trade roughly a third of GDP.The "something big" shows up again in data from Hong Kong, Taiwan, Japan, and South Korea, looking at the real value of goods exports.In 1960, Japan exported goods worth $1.8 billion in 2005 constant dollars; by 1980, it was $22.7 billion. That's a twelve-fold increase. Over the same two-decade period, real Taiwanese goods exports rose 47-fold, from $74 million to $3.4 billion. South Korea's real goods exports rose 250-fold from $13.1 million in 1962 -- the earliest year for which IMF data is available for this country -- to $3.1 billion in 1982. Also consider the nominal changes in Hong Kong's exports from 1960 to 1980, measured in Hong Kong dollars, which rose 25-fold from HK$3.9 billion to HK$98.2 billion.

If factor-price equalization was the actual story, we should expect to find increases in wages in these countries as W/MPL converged around the globe. Well, ta-da.Manufacturing labor costs in Japan as measured in US dollars were flat from 1950 until 1970, at which point the trend abruptly breaks, turning into a rip-roaring increase of the sort we are seeing in China today. By 1990, when the factor-price equalization process seems to finish, manufacturing compensation has increased fivefold. The same appears to happen in Taiwan and South Korea.