Many observers have expressed concern not just about wages lost because of a shrinking manufacturing sector but also about a broader erosion of U.S. real income caused by inability to compete effectively in world markets. But they often fail to make the distinction between the adverse consequences of having slow productivity growth – which would be bad even for an economy that did not have any international trade -- and additional adverse effects that might result from productivity growth that lags behind that of other countries.

To see why that distinction is important, consider a world in which productivity (output per worker-hour) increases by the same amount in every nation around the world -- say, 3 percent a year. Under these conditions, all other things remaining equal, workers’ real earnings in all countries would tend to rise by 3 percent annually as well. Similarly, if productivity grew at 1 percent a year, so would earnings. (The relation between productivity growth and earnings growth holds regardless of the absolute level of productivity in each nation; only the rate of increase is significant.)

Concerns about international competitiveness, as opposed to low productivity
growth, correspond to a situation in which productivity growth in the U.S. falls to 1 percent annually while elsewhere it continues to grow at 3 percent. If real earnings in the U.S. then grow at 1 percent a year, the U.S. does not have anything we could reasonably call a competitive problem, even though it would lag other nations. The rate of earnings growth is exactly the same as it would be if other countries were doing as badly as we are.

The fact that other countries are doing better may hurt U.S. pride, but it does not by itself affect domestic standards. It makes sense to talk of a competitive problem only to the extent that earnings growth falls by more than the decline in productivity growth.

Foreign competition can reduce domestic income by a well-understood mechanism called the terms of trade effect. In export markets, foreign competition can force a decline in the prices of U.S. products relative to those of other nations. That decline typically occurs through a devaluation of the dollar, thereby boosting the price of imports. The net result is a reduction in real earnings because the U.S. must sell its goods more cheaply and pay more for what it buys.

During the past 20 years, the U.S. has indeed experienced a deterioration in its terms of trade. The ratio of U.S. export prices to import prices fell more than 20 percent between 1970 and 1990; in other words, the U.S. had to export 20 percent more to pay for a given quantity of imports in 1990 than it did in 1970. Because the U.S. imported goods whose value was 11.3 percent of its GDP in 1990, these worsened terms of trade reduced national income by about 2 percent.

Real earnings grew by about 6 percent during the 1970s and 1980s. Our calculation suggests that avoiding the decline in the terms of trade would have increased that growth to only about 8 percent. Although the effect of foreign competition is measurable, it can by no means account for the stagnation of U.S. earnings.

A more direct way of calculating the impact of the terms of trade on real income is to use a measure known as command GNP ( gross national product). Real GNP, the conventional standard of economic performance, measures what the output of the economy would be if all prices remained constant. Command GNP is a similar measure in which the value of exports is deflated by the import price index. It measures the quantity of goods and services that the U.S. economy can afford to buy in the world market, as opposed to the volume of goods and services it produces. If the prices of imports rise faster than export prices (as will happen, for example, if the dollar falls precipitously), growth in command GNP will fall behind that of real GNP.

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