Wednesday, October 15, 2008


We appear to be on the cusp of one of those once-in-a-generation shifts in political alignment in this country (and not soon enough). The most obvious cause is the thorough incompetence, corruption and intellectual bankruptcy of George W. Bush and radical-right movement he has represented and led for the past eight years (as much as movement adherents now try to disown him). That movement continues to go by the name “conservative” although it is anything but – it is truly radical and over the years has become increasingly irresponsible and disconnected from anything but power (and, fortunately, increasingly even from power).

The election of Barack Obama as president (assuming some Earth-shatterging event doesn’t intervene to prevent it) will be by far the biggest manifestation of that political re-alignment. But there are other, smaller manifestations. As an economics junkie, this week’s awarding of the Nobel Prize in economics to Paul Krugman is one.

When Milton Friedman won the Nobel Prize in 1976 it symbolized the mainstream intellectual acceptance of his “monetarist” school of economics (which was the focus of my own undergraduate studies) but also, more broadly, of a new conservative mainstream in politics and policy. His body of work certainly merited the Nobel Prize (although, ironically, the current global financial crisis is undermining some of his theories of the Great Depression – primarily his view that the Great Depression could have been avoided by the injection of liquidity into the system to prevent a fall of the money supply). As symbolism, let’s hope the award to Krugman is as enduring.

Most people know Krugman as a political pundit, primarily though his regular New York Times column. But I used to remind people that he was also a “Nobel-caliber” academic economist (and former colleague of Ben Bernanke at Princeton). Now that characterization is irrefutable. Most people don’t know, for example, that he was chief staffer for international economics at the Council of Economic Advisors early on in the Reagan administration (part of a team that Martin Feldstein assembled that included other young whiz-kids like Larry Summers and Greg Mankiw). Among other minor achievements, he wrote most of the 1983 Economic Report of the President. In 1991, he was awarded the
John Bates Clark Medal, given by the American Economic Association to the top economists under 40 years old, and which many professional economists consider the be more prestigious than the Nobel Prize. Indeed, Krugman is the 12th Clark Medal recipient to go on and win the Nobel (including Friedman, Paul Samuelson, and Joseph Stiglitz).

Krugman’s Nobel Prize was awarded for his work on international trade and economic geography, particularly the integration of economies of scale into general equilibrium models. Back in 1992, long before he became known for his political commentary, he wrote an autobiographical essay on his career to date. Here is his
own summary of the work that would later result in the Nobel Prize:

… I have worked and written on a lot of topics. It is, however, the idea of increasing returns that has been the most important theme in my work. And it is my work in helping to clarify the role that increasing returns plays in economics that is the main excuse I have for my existence. The idea of increasing returns is, of course, a very old one, going back at least to Adam Smith. Nonetheless, until the 1980s economics was heavily dominated by what we may call the Ricardian Simplification: the assumption of constant returns and perfect competition.

There is no mystery or shame involved in that domination: strategic simplification is the essence of all understanding except in the most fundamental physics. The constant returns-competitive model offers a remarkable if somewhat incomplete view of how the world works; in terms of economic policy, 95 percent of the time it would be a blessing if politicians could understand what's right about the constant returns model, not what's wrong with it. Nonetheless, the world isn't really characterized by constant returns, and it was essential to go beyond the Ricardian Simplification, if only to be able to say to the policymakers that we had explored that terrain and found little of use.

If one admits increasing returns into one's economic model, two other consequences follow. First, increasing returns are intimately bound up with the possibility of multiple equilibria. There can be multiple equilibria in constant-returns models, too, but they are rarely either plausible or interesting. By contrast, it is very easy to be persuaded of both the relevance and importance of multiple equilibria due to increasing returns. What technology will be chosen for high-definition television? Which city will be Europe's financial center? These are real and interesting questions. Second, once there are interesting multiple equilibria, you need a story about how the economy picks one. The natural stories involve dynamics -- the cumulation of initial advantages that may be accidents of history.

Speaking loosely, then, traditional economic analysis has -- for very good reasons -- focused largely on static models in which equilibrium is uniquely determined by tastes, technology and factor endowments. An economic analysis that takes increasing returns seriously will normally involve dynamic models in which the choice of equilibrium also reflects history.

All of this is fairly obvious, and indeed the history of thought in economics is littered with manifestos on the need to take into account increasing returns, multiple equilibria, dynamics, and the role of history. Nicholas Kaldor, for example, delivered strident attacks on constant-returns economics in the late 1960s; Thomas Schelling offered elegant little parables about dynamics and multiple equilibria in a series of papers during the 1970s. Nonetheless, it wasn't until the 1980s that increasing returns really got into the mainstream of economics. I wasn't the only one in the
movement: Paul Romer, in particular, wrote several papers I wish I had written
(I can think of no higher praise!) applying increasing returns to economic growth. But I think it's fair to say that my work first on trade and then on geography did as much as anyone's to really put increasing returns on the professional map.

In the new trade theory, the basic point was that increasing returns are a motive for specialization and trade over and above conventional comparative advantage, and can indeed cause trade even where comparative advantage is of negligible importance -- for example, among industrial countries with similar resources and technology. The pattern of specialization and trade caused by increasing returns is, however, somewhat arbitrary; one must appeal to historical accident to explain who produces what. This seems pretty obvious, yet until the new trade theorists got going it was not part of mainstream thinking. It is a fact of life that trained economists find it very difficult to see the obvious unless it has been encapsulated in a clear formal model. (That's not an attack on the enterprise of modeling: those
who believe that by engaging in fuzzy thinking they can widen their horizons almost always see even less). The few existing models of trade under increasing returns were somehow too awkward to be persuasive. My own view is that the problem was largely one of style, something I'll turn to shortly, and that my big contribution was to break through an intellectual style barrier. Whatever the reason, before 1980 the potential role of increasing returns in international trade was virtually ignored by economists; by 1987 or so it had become part of the standard story. That's a pretty big intellectual shift, and I think it's fair to claim that Elhanan Helpman and I deserve most of the credit.

In the area of economic geography, the basic point is that the economic landscape is covered with examples of agglomeration -- geographical concentrations of population and activity in general, like Los Angeles, concentration of particular types of business like Silicon Valley. These agglomerations are rarely explainable by special inherent resources of the site; they are, rather, examples of increasing returns at work. And the role of history in their formation is obvious: there has been no important commercial traffic on the Erie Canal since 1850, yet the head start that canal gave to New York City has allowed New York to remain the largest US city to this day. Again, all of this is obvious. And yet the apparent difficulty in modeling the
increasing-returns nature of agglomeration had excluded this obvious story from
the economic mainstream. Even today, the new economic principles textbook by
Joseph Stiglitz contains exactly one reference to cities in its 1200 pages -- a brief discussion of rural-urban migration in the Third World! I'm pretty sure this will change.

The geography models I have been writing since 1990 have inspired a growing number of followers, including a growing body of empirical work. It's a reasonable prediction that ten years from now the new economic geography will be as firmly established as the new trade theory. If so, I will have succeeded in bringing a quite large chunk of increasing-returns-based analysis into the heart of mainstream economics. That, I think, is my main achievement. What has made it possible, however, is not so much special insight -- both in trade and in geography it is possible to point to many people who have expressed similar ideas -- as style. Indeed, I regard the intellectual style I have developed as central to the whole enterprise.

As Krugman notes, he was known in part for his style – his ability to distill complex phenomena into workable models and ultimately into understandable prose. It was probably that ability, as much as his academic reputation, that caused the New York Times to enlist him as a regular columnist in 2000 (he was a regular contributor to Slate, Fortune and other publications before that). That was perhaps the peak of the Clinton-era glamorization of globalization – Thomas Friedman had published “The Lexus and the Olive Tree,” perhaps the Bible of that faith, the year before. Krugman was expected to write on international business, economics and policy. But a not-so-funny thing happened along the way – the Bush administration. By Krugman’s own account he couldn’t abide the mendacity of the Bush administration in silence and became perhaps its most prominent mainstream critic even during times when Bush enjoyed stratospheric approval ratings. And as we all recall, anyone who challenged Dear Leader in those years could be assured of the most vitriolic hate from the right-wing noise machine. Krugman was, indeed, demonized by the right – right up there with George Soros and Michael Moore.

People tend to evaluate political pundits based not on the accuracy of their observations but rather on their agreement with one’s own views. (How else can anyone explain the fact that Bill Kristol – who has been wrong about absolutely everything over the past decade – is still able to command an audience on a street corner, let alone a regular column in the New York Times.) The fact that the pundit is ultimately proven correct does not necessarily increase his credibility among his detractors – indeed, it might only inflame their hostility. That seems to be the case with Krugman. It would be hard to go back over his hundreds of columns over the last eight years and find almost anything of substance he has gotten wrong. It’s a truly extraordinary track record. It is even more impressive when you see those columns collected by subject, as was done in his book The Great Unraveling. In a short column he can generally address only one small aspect of a larger issue or set of issues. His columns often build on each other and illuminate a more complex subject or more general truth when read in sequence by subject. Alas, this is irrelevant to the radical right, which is becoming further unhinged as its grip on power is lost. Krugman’s Nobel Prize, as with anything that challenges their world view, is the object of scorn and rage – evidence of a broader liberal conspiracy rather than intellectual merit. But as Stephen Colbert
famously observed (courageously in the presence of Bush), “reality has a well-known liberal bias.”

There is currently an attempt by the right to spin the global financial crisis with a narrative that blames it all on Fannie Mae, the Community Reinvestment Act, poor minorities, and ultimately on Congressional Democrats. This is a subject I hope to write about more. But given that it is the topic du jour, it seems appropriate to end with a few excerpts from Paul Krugman’s warnings about the housing bubble three years ago as an example of his track record on important policy matters.

From August 8, 2005 (“”That Hissing Sound”)

This is the way the bubble ends: not with a pop, but with a hiss.

Housing prices move much more slowly than stock prices. There are no Black Mondays, when prices fall 23 percent in a day. In fact, prices often keep rising for a while even after a housing boom goes bust.

So the news that the U.S. housing bubble is over won't come in the form of plunging prices; it will come in the form of falling sales and rising inventory, as sellers try to get prices that buyers are no longer willing to pay. And the process may already
have started.

Of course, some people still deny that there's a housing bubble. Let me explain how we know that they're wrong.

One piece of evidence is the sense of frenzy about real estate, which irresistibly brings to mind the stock frenzy of 1999. Even some of the players are the same. The authors of the 1999 best seller "Dow 36,000" are now among the most vocal proponents of the view that there is no housing bubble. …

Meanwhile, the U.S. economy has become deeply dependent on the housing bubble. The economic recovery since 2001 has been disappointing in many ways, but it wouldn't have happened at all without soaring spending on residential construction, plus a surge in consumer spending largely based on mortgage refinancing. Did I mention that the personal savings rate has fallen to zero?

Now we're starting to hear a hissing sound, as the air begins to leak out of the bubble. And everyone … should be worried.

From August 29, 2005:
These days Mr. Greenspan expresses concern about the financial risks created by "the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages." But last year he encouraged families to take on those very risks, touting the advantages of adjustable-rate mortgages and declaring that "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”

If Mr. Greenspan had said two years ago what he's saying now, people might have borrowed less and bought more wisely. But he didn't, and now it's too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath.

How bad will that aftermath be? The U.S. economy is currently suffering from twin imbalances. On one side, domestic spending is swollen by the housing bubble, which has led both to a huge surge in construction and to high consumer spending, as people extract equity from their homes. On the other side, we have a huge trade deficit, which we cover by selling bonds to foreigners. As I like to say, these days Americans make a living by selling each other houses, paid for with money borrowed from China.

One way or another, the economy will eventually eliminate both imbalances.

I could go on. But I want to leave some space for an example of the right-wing attacks he endured for his warnings about the housing bubble. Here is a gem from John Hindracker of the right-wing blog Powerline on the same day as the first of the two Krugman columns quoted above:

It must be depressing to be Paul Krugman. No matter how well the economy performs, Krugman’s bitter vendetta against the Bush administration requires him to hunt for the black lining in a sky full of silvery clouds. With the economy now booming, what can Krugman possibly have to complain about? In today’s column, titled That Hissing Sound, Krugman says there is a housing bubble, and it’s about to burst…

There are, of course, obvious differences between houses and stocks. Most people own only one house at a time, and transaction costs make it impractical to buy and sell houses the way you buy and sell stocks. Krugman thinks the fact that James Glassman doesn’t buy the bubble theory is evidence in its favor, but if you read Glassman’s article on the subject, you’ll see that he actually makes some of the same points that Krugman does. But he argues, persuasively in my view, that there is little reason to fear a catastrophic collapse in home prices.

Krugman will have to come up with something much better, I think, to cause many others to share his pessimism.

Congratulations on the Nobel Prize, Paul! Well, deserved. And keep up the courageous commentary.

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