Cleveland Fed paper finds trade liberalization reduces wage inequality

A working paper from the Federal Reserve Bank of Cleveland investigates the causal effect of international trade on the full wage distribution, focusing on Spain's 1993 entry into the European Single Market (ESM).

The study finds that increased trade openness significantly reduced wage inequality, leading to wage compression.

This compression manifested as earnings gains for workers at the bottom of the distribution and wage losses for those at the top.

This finding contrasts sharply with established literature, which often suggests that import competition harms low-skill workers and exporting benefits high-skill workers, thereby exacerbating inequality.

The paper traces this outcome to asymmetric effects: import competition disproportionately harmed high earners, while export opportunities benefited low earners.

The key mechanism identified is an import-driven 'skill-downgrading,' where high earners were pushed into lower-skill roles due to import competition, while demand for low-skill labor increased.

To establish causality across the full wage distribution, the researchers developed a novel shift-share instrumental variable (IV) strategy, integrated into an unconditional quantile regression framework.

This approach leverages later European Single Market entrants to instrument for Spain's trade experience.

A key insight is that trade's distributional effects depend critically on the skill intensity of a country's tradable sector.

Spain's tradable sector was relatively low-skill intensive during its ESM integration, contrasting with many settings.

This structural difference provides a unified theoretical foundation for the observed skill downgrading and wage compression.