Employment and wage prospects for low-skill workers have deteriorated sharply over the last two decades in many developed economies. At the same time, developed country trade with the East Asian economies has accelerated spectacularly. But most studies, predominantly by US economists, reject a causal link between trade and unskilled wages, arguing instead that technological change has favoured skilled over unskilled workers, independent of trade. Patrick Minford, Jonathan Riley and Eric Nowell challenge this view.

To do so, they use a complex general equilibrium model of the world economy which, for the first time, they contend, allows trade and technology transfer to play their proper role in the growth process. The model comprises two linked open economies, ‘North’ and ‘South’, and is based on the Heckscher-Ohlin-Samuelson (H-O-S) theory of international trade – there are constant returns to scale and factors of production are either mobile or immobile, with only immobile factors determining comparative advantage.

The Minford et al model is distinct because it emphasizes differences in the relative technology of a country’s traded sector and in the accumulation of savings and skills, as key reasons why some countries do better than others. It also stresses the importance of property rights, communications and transport technology in determining foreign investment and technology transmission.

The authors describe these extra, endogenous ingredients in the growth process as the ‘elixir’ of open economy capitalism. Free trade, property rights and investment in skills and communications can, in combination, suddenly turn previously torpid or declining economies into growth miracles.

Minford and his colleagues model the impact of trade and technology transfer from North to South, establishing that it is not a zero-sum game. Their simulations suggest that the transfer of technology to ‘emerging markets’ enhances world welfare, improving the terms of trade of the North, while raising productivity and Southern living standards.

But the process dramatically reduces the living standards of unskilled workers in the North. In these simulations, Northern unskilled wages fall sharply, by 2% a year in real terms, while the supply of unskilled labour contracts.

The plight of unskilled Northern workers follows from the H-O-S assumption. Trade and technology transfer increase Southern manufacturing productivity, boost Southern incomes and raise the relative world prices of services and agriculture compared to manufacturing.

The overall effect of this is good for Northern workers since their economies are more intensive in services. But the beneficiaries are skilled not unskilled workers: the fall in manufacturing’s relative price drives down the real wages of the unskilled labour in which manufacturing is intensive.

The finding that unskilled wages in the North fall sharply in response to the growth of Southern manufacturing is a sharp rebuttal to the conventional wisdom that it is skill-biased technological change, not trade, that hurts unskilled workers.

Katz and Murphy, for example, have argued that the shift in relative wages in favour of skilled workers has not occurred because the importance of manufactured traded goods has declined, but instead has occurred both in non-traded sectors and within industries. And Lawrence and Slaughter have produced evidence to show that, contrary to H-O-S, the rise in the relative price of skilled labour has not driven down its factor share. The fact that both the relative wages and employment shares of skilled US workers have risen suggests that there must be a pro-skill bias in technology.

But Minford and his colleagues argue that the Katz and Murphy study, and others like it, are methodologically flawed. Their main criticism is that partial equilibrium analysis of the labour market treats shifts in labour supply as exogenous. This is contrary to the Minford et al<D> assumption that such shifts are endogenously determined with changes in world prices and relative wages themselves affecting factor supplies.

Lawrence and Slaughter, by contrast, do adopt what the authors call the ‘correct’ general equilibrium approach. But they are criticized for using the ratio of non-production workers in order to rank US industries by their skill intensity, despite the fact that many US manufacturing production activities are increasingly highly skilled.

Moreover, the relationship between changes in relative wages and factor intensities is very sensitive to the level of aggregation employed, suggesting that the apparent increase in skill content may merely be due to the process of outsourcing, whereby the US abandons production of low-skill items. Lastly, Lawrence and Slaughter’s terms of trade calculation, which severely contradicts the international data, may be biased by a shifting definition of goods – for example, ‘shoes’ would seem to rise in price as Gucci shoes replace sneakers.

The trade versus technology debate will continue. If Minford, Riley and Nowell are right, and the dramatic fall in the absolute living standards of the unskilled, which they predict, does take place, then the inequality generated would pose severe challenges, for both social policy and the maintenance of popular allegiance to free trade. And if they are wrong, and it is technology rather than trade which continues to drive a wedge between the skilled and unskilled, the dangers are no less great.