realitybase - Journal

This New Yorker article contains a fascinating account of the evolution of Paul Krugman's economic and political beliefs. He went from Council of Economic Advisors staffer in the Reagan Administration (1982-83), economic consultant to Enron (1999), and strong supporter of monetarism, deregulated markets, and other views of Milton Friedman in the 1990s to author of The Great Unraveling: Losing Our Way in the New Century (2003), The Conscience of a Liberal (2007) and a liberal column and blog in The New York Times. Along the way he has gone, for example, from belief in the "platonic beauty" of traditional Ricardian (comparative advantage) trade theory to showing that it has been displaced in practice by trade based on economies of scale and "economic geography" (first mover advantages), both of which are subject to manipulation by governments' "industrial policies."

Since I've only been reading Krugman for the last decade, I was unaware that there was an earlier, economically conservative Krugman. The whole article is worth reading for its insights into what motivated Krugman's general transformation into a self-described liberal. (Spoiler alert: The George W. Bush Administration was a big factor.) But since, I have a special interest in globalization, I'll focus on that here. The New Yorker piece summarizes Paul Krugman ver. 1.0 this way:

He was driven mad by Lester Thurow and Robert Reich in particular, both of whom had written books touting a theory that he believed to be nonsense: that America was competing in a global marketplace with other countries in much the same way that corporations competed with one another. In fact, Krugman argued, in a series of contemptuous articles in Foreign Affairs and elsewhere, countries were not at all like corporations. While another country's success might injure our pride, it would not likely injure our wallets. Quite the opposite: it would be more likely to provide us with a bigger market for our products and send our consumers cheaper, better-made goods to buy. A trade surplus might be a sign of weakness, a trade deficit a sign of strength. And, anyway, a nation's standard of living was determined almost entirely by its productivity—trade was just not that important.

. . . . Until the late nineties, when he became absorbed by what was going wrong with Japan, he believed that monetary policy, rather than government spending, was all that was needed to avoid recessions: he agreed with Milton Friedman that if only the Fed had done its job better the Great Depression would never have happened. He thought that people who wanted to boycott Nike and other companies that ran sweatshops abroad were sentimental and stupid. Yes, of course, those foreign workers weren't earning American wages and didn't have American protections, but working in a sweatshop was still much better than their alternatives—that's why they chose to work there. Moreover, sweatshops really weren't the threat to American workers that the left claimed they were. "A back-of-the-envelope calculation . . . suggests that capital flows to the Third World since 1990 . . . have reduced real wages in the advanced world by about 0.15%," he wrote in 1994. That was not nothing, but it certainly wasn't anything to get paranoid about. The world needed more sweatshops, not fewer. Free trade was good for everyone. He felt that there was a market hatred on the left that was as dogmatic and irrational as government hatred on the right.

. . . .

Krugman wrote his thesis on exchange rates, but another class, on international trade, inspired him. "There was this kind of platonic beauty to the whole thing," he says. "I remember going through the two-by-two-by-two model—two goods, two countries, two factors of production. The way all these pieces fitted together into a Swiss-watch-like mechanism was beautiful. I loved it." The traditional theory of international trade, first formulated by the British economist David Ricardo, two hundred years ago, explained trade by comparative advantage: a country exported the goods that it could produce most cheaply, owing to whatever advantages it possessed—cheap labor, climate, technological expertise, and so on. It followed from this theory that countries that were the most dissimilar should do the most trade—countries in the Third World dispatching labor-intensive goods to the First World, the First World selling technology- or capital-intensive goods in return.

Krugman's earliest departure from economic orthodoxy was in trade theory, which led eventually to his Nobel prize in 2008.

In the years following the Second World War, however, economists had noticed that much international trade didn't follow this pattern at all. There was a large amount of trade between countries whose economies were extremely similar, and these countries traded goods that were virtually identical: Germany sold BMWs to Sweden and Sweden sold Volvos to Germany. People had speculated about why this should be so, but nobody had come up with a model that explained it in a rigorous manner.

Krugman realized that trade took place not only because countries were different but also because there were advantages to specialization. If one country was the first to begin manufacturing airplanes, say, it might accumulate an advantage in economies of scale so large that it would be difficult for another country to break into the industry later on, even though there might not be anything about the first country that made it particularly well suited to airplane-making. But why would countries trade goods that were almost the same? Because consumers like to have a choice, and, as Avinash Dixit and Joseph Stiglitz had pointed out a few years earlier, the same logic of increasing returns to scale that Krugman had identified as an essential dynamic in trade could apply to a single brand as well as to a whole industry. . . .

. . . .

Later on, Krugman became interested in economic geography, in the related question of why there were regional specialties—why, in the United States, for instance, were cars produced in Detroit, carpets in Dalton, Georgia, jewelry in Providence, and chips in Silicon Valley? Again, the answer turned out to be history and accident. Once an industry started up in one place, for whatever reason (the carpet industry in Dalton appears to have its origin in a local teen-ager who in 1895 made a tufted bedspread as a wedding present), local workers became trained in its methods, skilled workers from elsewhere moved there, and related businesses sprang up close by. Then, as more skilled labor became available, the industry could grow and benefit from economies of scale. Soon, as long as it didn't cost too much to transport the industry's products, the advantages of the place would be such that it would be impractical for someone to open up a similar business anywhere else. Many economists found the idea that economic geography could be so arbitrary "deeply disturbing and troubling," Krugman wrote, but he found it exciting.

Again, as in his trade theory, it was not so much his idea that was significant as the translation of the idea into mathematical language.

This work provided important theoretical support to left-wing economists in their opposition to trade liberalization in the Ricardian model, but in those days Krugman remained a free trader.

One implication of Krugman's theory was that, contrary to economic orthodoxy, industrial policy might have its benefits. If the location of a new industry was essentially arbitrary, then a government, by subsidizing and protecting its emergence, could enable it to gain such a lasting advantage that other countries would find it difficult to catch up. But Krugman tried to discourage industrial strategists who cited him. For, while in principle industrial policy could be helpful, in practice, he believed, it was so difficult to determine which industry should receive government help, at the expense of all the others—so difficult to predict an industry's future, and so difficult to determine merit when powerful interests would be trying to influence that determination—that in the end industrial policy would be likely to benefit mostly the owners of a few businesses and hurt everybody else.

However, by June 2007 Krugman was waiving red flags about harmful effects of trade on US wage levels based on more current data.

What all this comes down to is that it’s no longer safe to assert, as we could a dozen years ago, that the effects of trade on income distribution in wealthy countries are fairly minor. There’s now a good case that they are quite big, and getting bigger.

This doesn’t mean that I’m endorsing protectionism. It does mean that free-traders need better answers to the anxieties of those who are likely to end up on the losing side from globalisation.

In December 2007, Krugman cautioned the NYT editorial board that its assertion that imports do not hold down US wages might be wrong, and in recent months Krugman has been saying other things about international trade that are anything but orthodox. In his One-Minute Trade Policy Theorist at page 10 he uses an example to show that although there are positive effects from trade, the impact is rather small. He summarizes with these "two big lessons:"

1. Major growth effects from trade policy, if they exist, must come from unconventional channels. Conventional trade theory DOES NOT justify claims of huge positive payoffs from free trade.

2. In the politics of trade policy, distributional effects can easily swamp concerns about efficiency.

(Emphasis in original.) Further, Krugman calculated in this December 2009 column that China’s defense of non-market currency exchange rates has cost the US about 1.4 million jobs and countered the arguments that the US should not take action to fix this problem:

[China’s] trade surplus drains much-needed demand away from a depressed world economy. My back-of-the-envelope calculations suggest that for the next couple of years Chinese mercantilism may end up reducing U.S. employment by around 1.4 million jobs.

. . . .

Second, there’s the claim that protectionism is always a bad thing... If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high..., the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson...: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

Krugman is careful to assert that his views about trade are being driven by the data and that since the explosion of trade with China the data are showing negative effects on the US that theorizing did not anticipate.