Perhaps the most forceful argument made by critics of free trade is that it confers an unfair competitive advantage on countries with low wages and lax regulations--permitting them to undermine wages and job growth in the U.S. and other industrial nations. How, for example, can U.S. workers compete with Thais or Malaysians making a fraction as much money?

The answer, claims economist Stephen Golub of Swarthmore College in a recent issue of the Federal Reserve Bank of San Francisco's Weekly Letter, is to be found in the dynamic behavior of markets. Low wages in foreign countries usually go hand in hand with low productivity, so that labor costs per unit of output are closer to U.S. levels. And tightening labor markets and productivity gains in developing nations tend to drive up wages and spark currency appreciation.

The chart above tells the tale. Although 1990 factory wages and other compensation in these four developing countries amounted to only 14% to 32% of U.S. pay, unit labor costs were 71% of U.S. levels in South Korea, 86% in Thailand, and actually above U.S. levels in Malaysia and the Philippines. Low productivity in these countries, compared with the U.S., considerably narrowed any competitive advantage conferred by low wages.

Interestingly enough, back in 1970, unit labor costs in these four countries were less than half U.S. levels. In the intervening 20 years, a combination of currency appreciation and increases in real wages fostered by productivity gains closed the gap. Economic theory suggests that this process will continue.

The other part of the story, says Golub, is that productivity gaps between countries also differ from industry to industry. Thus, while Thailand's wages and productivity in overall manufacturing were about 15% of the U.S. level in 1990, its relative productivity is likely to be greater than 15% in simple products such as textiles but less than 15% in sophisticated products such as machinery. So its comparative advantage will lead it to export textiles and import machinery.

Such dynamics and Golub's analysis of recent trends in the Pacific Basin indicate, he says, "that fears about unfair competition from low-wage developing nations are greatly exaggerated."

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