The World Economy (2007) doi: 10.1111/j.1467-9701.2007.01039.x © 2007 The Author Journal compilation © 2007 Blackwell Publishing Ltd, 9600 Garsington Road, 962 Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA Blackwell Publishing Ltd Oxford, UK TWEC World Economy 0378-5920 © 2007 The Author Journal compilation © Blackwell Publishers Ltd. 2006 > XXX Original Articles EX ANTEEFFICIENCY RATIONALE FOR WAGE INSURANCE KIM KAIVANTO Trade-related Job Loss, Wage Insurance and Externalities: An Ex Ante Efficiency Rationale for Wage Insurance Kim Kaivanto Lancaster University Management School The extension of adjustment assistance to those who have suffered trade-related job displacement is widely supported on both sides of the economics of globalisation debate. The form that such assistance should take, namely wage insurance, is also the subject of wide agreement. Nevertheless, the formal economic rationales offered for such a policy are varied, including political economy arguments, equity arguments, and market failure / ex post efficiency arguments. This note proposes an ex ante efficiency-based rationale for the provision of adjustment assistance in the specific form of wage insurance. Job displacement imposes pecuniary externalities on displaced workers, which, in a complete markets setting, induces only shifts along the ex ante Pareto efficient frontier. However, when markets are incomplete, pecuniary externalities become welfare-relevant. Without the possibility of diversifying or hedging the risk of pecuniary external diseconomies of job displacement using contingent claims, welfare is reduced ex ante. Wage insurance – whether publicly underwritten, privately underwritten (as in Shiller’s (2003) ‘livelihood insurance’), or supplied on a mixed public/private basis – completes the market for contingent claims, allowing workers to diversify or hedge the risk of trade-related pecuniary external diseconomies. By facilitating risk sharing, wage insurance removes an impediment to ex ante Pareto efficiency. Moreover, wage insurance affects not only post-displacement behaviour by increasing the incentive to reacquire employment quickly, but it also affects pre-displacement consumption and investment behaviour, in particular, lowering the threshold at which workers will be willing to undertake irreversible investment in industry-specific skills. 1. INTRODUCTION T HE provision of adjustment assistance to those whose jobs have been displaced by international outsourcing currently receives support from both sides of the economics of globalisation debate. 1 Both camps also share a common view of what form such adjustment assistance should take, namely ‘wage insurance’ or one of its variants (see Kletzer, 2004). In the United States, support for wage insurance also extends across the entire political spectrum. Such assistance has been framed in ways ranging from ‘compensating the losers’ to simply ‘buying off labour’. As proposed by Kletzer and Litan (2001), for instance, wage insurance is seen to be instrumental to reducing worker anxiety and thereby ‘should reduce worker opposition to trade liberalization and globalization more broadly’. Relatedly, adjustment assistance could be said to redeem on the promise that free trade makes us all better off. The author thanks Baloo Balasubramanyam for support, encouragement and feedback, and Kwok Tong Soo for his 2005 LUMS Economics Society talk on outsourcing, which initially caused the author to think more deeply about adjustment assistance and wage insurance. This paper benefited greatly from detailed comments and helpful suggestions by an anonymous referee, as well as from conversations with Steve Bradley and Colin Green. Any remaining errors are the author’s own. 1 Paul Samuelson suggests that we ‘need more temporary protection for the losers’ (quoted in Lohr, 2004). In turn Jagdish Bhagwati observes that ‘[i]f trade liberalization is to occur and be sustained, one or more of these special programs and policies have to be considered, and working with adjustment assistance rather than protection is the better way to go, since the latter is more expensive’ (Bhagwati, 2004, p. 234).