By Thomas Palley
Special to PAI

WASHINGTON (PAI) - There is a famous theorem in international economics - the Stolper-Samuelson theorem - that says when a rich, capital-abundant country, such as the U.S., trades with a poor, labor-abundant country, such as China, wages in the rich country fall and profits go up.

The theorem's economic logic is simple.

Free trade is tantamount to a massive increase in the rich country's labor supply since the products made by poor country workers can now be imported.

Additionally, demand for workers in the rich country falls as its firms abandon labor-intensive production to the poor country. The net result is an effective increase in labor supply and a decrease in labor demand in the rich country, and wages fall.

The relevance of the Stolper-Samuelson theorem is clear. For the last two decades, U.S. policy makers, from both major political parties, have worked assiduously to create a global market place in which goods and capital are free to move. Over the same period, 2.5 billion people in China, India, Eastern Europe and the former Soviet Union discarded economic isolationism and joined the global economy.

Now, these tectonic shifts come together as a "super-sized" Stolper-Samuelson effect, and they stand to have depressing consequences for American workers.

Much attention has been devoted to the adverse impacts of the U.S. trade deficit, particularly with China. And the U.S. government is rightly criticized for failing to apply adequate pressure to get China to remedy its unfair and illegal trading practices. But no one in Washington is talking about the deeper question of what happens to wages when two billion people from low-wage countries join the global labor market.

Such an event is unprecedented in history. In the past, countries joined the international economy through a slow evolutionary process. Initially, they would export a few goods in which they specialized and had natural competitive advantage. Thereafter, they would gradually deepen involvement in international trade. The process was one of gradual integration, and production was largely immobile across countries.

Globalization changed this by accelerating the process of international integration. It also made capital, technology, and methods of production mobile, marking a watershed with the past. The new order is exemplified by China's recent experiences.

In less than two decades, China has become a global manufacturing powerhouse through massive foreign direct investment and technology transfer. The impact of this transformation on the U.S. economy is seen in the trade deficit, the loss of manufacturing jobs, and downward pressure on wages.

Whereas classical free trade connected goods markets across countries, globalization creates a global labor market and moves jobs. Previously trade equalized the prices of goods, now it also equalizes wages through job shifting.

With the emergence of China, India and Eastern Europe, the dam of socialism
that held back two billion workers has been removed. If two swimming pools are joined, the water level will eventually equalize. That is what is happening with globalization.

Manufacturing was already placed in competition across countries, with dire consequences for its workers. The Internet promises to do the same for previously untradable services. Higher-paid knowledge workers will start feeling similar effects.

Not since the Industrial Revolution has there been a transformation of this magnitude, and that took 150 years to complete. By comparison, the new revolution is a mere 25 years old. These developments have a significance far beyond the currency manipulation and WTO rules violations that have been the focus of trade deficit policy discussions.

There is no reason to think the end is in sight, and American workers can look forward to the international economy exerting downward pressure on wages and work conditions for the next several decades.

As is so often the case, workers understood the new reality long before economists and policymakers. Workers realize trade is no longer a matter of exchanging exotic commodities for manufactured products, and the new system involves trading their jobs and equalizing wages, often downwards.

Especially bitter is that large American multinational corporations that American workers helped build are driving the process of globalization. And U.S. policymakers have abandoned American workers by promoting free trade pacts that de facto created a global labor market that threatens workers' livelihoods and economic security.

Globalization demands we begin anew the task of establishing fair and just rules that make the economy work for all. This is the same challenge U.S. workers faced at the beginning of the 20th century. Unions, minimum wages, and fair labor practices were essential to meeting that challenge, and are essential again. But such tools are no longer sufficient when applied nationally. They must be applied globally.

That means China, India and other industrializing developing countries must agree to, and enforce, core labor standards and worker rights. Trade cannot be free without worker freedom and the right to share in the wealth created.

Successive administrations pushed free trade without worker protections
and gave the green light to a global system without core labor standards. Through poor diplomacy and lax enforcement we give away access to U.S. markets and valuable negotiating leverage without getting commitments on labor standards in recent free trade agreements.

The consequences of these trade policies and the reality of the new global system must be exposed so that our approach can be changed. This is a task that will not be easy given Washington's captive economic policy elite and big business' interest in concealing the new reality.

Thomas Palley is former chief economist of the AFL-CIO and former chief economist of the U.S.-China Commission, a congressionally created panel that monitors U.S.-China trade and economic relations. This other economic analyses can be found on www.thomaspalley.com