Dec 10, 2008

World - Krugman and the vices of economists

Erik S. Reinert

Contacts between Europe and the American continent soon made it clear that pre-Columbian American cultures had not known the wheel. A 1940s discovery of wheeled pre-Columbian toys in Mexico therefore produced great interest among archaeologists. The big question was of course why the ancient Mexicans, having invented the wheel, failed to make any practical use of it.

Coming across this story in an old issue of American Antiquity years ago, I immediately thought of Paul Krugman, who deservedly received the Nobel Memorial Prize from the Swedish Central Bank. Professor Krugman and the ancient Mexicans have something in common. Both made epochal discoveries, only to keep them as toy models instead of putting them to practical use. In my book How Rich Countries Got Rich…and Why Poor Countries Stay Poor, I refer to two important vices of the economics profession: what Schumpeter calls the Ricardian Vice, that is, the habit of piling a heavy load of strong policy recommendations upon very shaky assumptions; and what I have dubbed the Krugmanian Vice, the production of theoretical models that explain the real world better than Ricardo did – but not applying them to actual economic policy. In the third world the two vices combine to create serious obstacles to development.

Professor Krugman receives the Nobel Memorial Prize for having formalised what has been a main argument for industrialisation since the early 17th century: increasing returns or economies of scale found in industrial production, and their consequences in international trade theory and economic geography. His New Trade Theory did not go back in history, but to Lenin’s Imperialism, the Highest Stage of Capitalism and to an important 1923 article by Princeton economist Frank Graham. A Krugman article from the early 1980s supports Lenin, radical economists Baran, Frank, and Wallerstein, and classical development economists like Myrdal and Lewis. He mentions them all.

In 1980, when Krugman’s New Trade Theory appeared, I had just finished my Ph.D. thesis that picked up and elaborated on Frank Graham’s 1923 simple taxonomy of nations either a) exporting from the increasing returns sector and achieving lower costs, imperfect competition, and wealth as specialisation deepens, or b) exporting raw materials produced under diminishing returns, and seeing their production costs increasing, and poverty remaining, as they specialise under perfect competition. I had found Graham’s model actually corresponding to Latin America’s historical experience, and was strongly encouraged when Professor Krugman also focused on increasing returns and their absence as a key to explaining uneven economic development. Finally, mainstream seemed to be catching up.

I was soon discouraged. Professor Krugman, not yet 30 years old, may have been intimidated by the wide-ranging implications of his models. He largely succumbed to the assumption that economic activities are qualitatively alike, and leaving out that some activities are subject to diminishing returns — an argument that had been crucial in explaining poverty from Malthus via John Stuart Mill to Frank Graham — increasing returns turned into another argument for free trade.

Following Krugman’s models, theoretical discussions took place around the heading of strategic trade policy. Meanwhile the real world of trade policy experienced a violent movement in exactly the opposite direction, away from what Professor Krugman’s early writings had suggested. During the 1980s and 1990s an increasing number of small countries from Mongolia via Eastern Europe and Africa to Latin America were subjected to a shock therapy that forcefully opened up poor countries with weak industrial sectors to instant free trade. This happened so fast that large parts of the industrial sector – the increasing returns sector of the economy that Krugman had shown us was so important – died out in these countries, causing real wages to precipitate.

At the 1996 conference marking the repeal of the Corn Laws, Professor Krugman thundered against everyone disagreeing with Ricardo’s trade theory (which leaves out the increasing/diminishing returns dilemma), which he called “utterly true, immensely sophisticated — and extremely relevant to the modern world.” In practical policy, Ricardo was to rule uncontested.

I particularly recall the rage of a Brazilian colleague over Professor Krugman’s models that potentially explained world poverty, but were not to be prescribed in the real world. Powerful cures do not help patients if doctors lack the courage to prescribe them. This has been the Krugmanian vice, and it means that in trade policy — as Alan Greenspan explained to us about financial policy — ideology got the upper hand over experience and theory.

Professor Krugman receives the prize for having formalised theories that were once in the mainstream of German economics: industrialisation (increasing returns) and economic geography. He certainly deserves the price for his courage in venturing outside what he appropriately calls the profession’s “path of least mathematical resistance.” We can only hope that post-financial-crisis economics will make his early insights politically correct. Another reason this may come true is that early Krugman coincides with Keynes’ trade policy advice to peripheral countries.

(The author, an eminent Norwegian economist, is Professor of Technology Governance and Development Strategies at the Tallinn University of Technology in Tallinn, Estonia.)

No comments: