Despite his political views, free-market economists find it hard to quarrel with a Nobel for Paul Krugman
By William Watson
You don’t get the Nobel Prize in Economics for writing newspaper columns (as I’ve been trying to explain to my mother the last couple of days). So the prize awarded Monday to Paul Krugman, professor of economics at Princeton and well-known Bush-baiting op-ed columnist for The New York Times, should not be read as an endorsement of Krugman’s uber-Democratic newspapering (which the Nobel backgrounder coyly referred to as “spirited”).
This is not to say the Nobel Committee is immune to political trends. Milton Friedman got the prize in 1976, the bicentenary of Adam Smith’s Wealth of Nations, which was perfectly fitting. And the committee tilted distinctly rightward over the next 20 years, with prizes to no fewer than five of Friedman’s University of Chicago colleagues (Schultz, Stigler, Becker, Coase and Lucas).
In recent years, however, Prizes to Joseph Stiglitz and now Krugman indicate the pendulum has been swinging the other way.But even we free-market economists find it hard to quarrel with a Nobel for Krugman. From a young age — I first saw his very large brain in action in graduate school, when, still in his early twenties, he was a prodigy from MIT, working on the problems in international trade for which he won the Prize — he has done elegant, innovative, important work.
But what’s most important is that, like virtually all economists, he remains a strong supporter of free international trade.
David Ricardo remains the most famous trade theorist in economics. In the 1820s he discovered comparative advantage, the idea that countries can better themselves by specializing in what they do best (even if they don’t do anything very well). But his story assumed countries had access to different technologies: Portugal was sunny, England was not, so Portugal would specialize in wine even if it could also do cloth better than England.
In the 1920s, the Swedes Eli Heckscher and Bertil Ohlin (who won the Nobel in 1977), showed that even when technologies could be copied, as in manufacturing, countries’ differing endowments of “factors of production” could produce gains from trade. Capital-rich countries would specialize in goods whose production required lots of capital, labour-rich countries in “labour-intensive” goods. Instead of making goods that required lots of the “factor” they lacked, countries could trade for them and have more goods overall.
But trade wouldn’t benefit everyone. Labour in capital-rich countries would lose from imports of labour-intensive goods — which explains why labour unions in rich countries are usually anti-trade. Likewise, capitalists in low-wage countries would oppose trade with capital-rich countries for capital-intensive goods since that would threaten their scarcity premium.
Though Heckscher-Ohlin is a compelling story, it predicts countries will trade different goods. Following the Second World War, countries increasingly traded the same goods: Sweden both exported Volvos and imported Volkswagens. Simon Fraser emeritus prof and frequent Post contributor Herbert Grubel noticed this phenomenon early on and his “Grubel-Lloyd index” is still the standard measure for “intra-industry trade.”
What could cause such trade? In the late 1970s, Krugman mathematized a story focussed on economies of large-scale production and consumers’ taste for variety. As firms grew, their unit costs would fall, and if their product was slightly different from rivals’ products, they could sell into the world market — even as consumers in their own country imported similar but slightly different products from other countries.
To some extent the theory is nihilistic about which countries produce what. Competitive advantage can happen almost by accident, as “first-mover” firms and countries slide down their cost curves. Though this possibility has given heart to thousands of industry ministers wishing to arrange such happy accidents Krugman has been a stalwart in pointing out the pitfalls of picking winners, not to mention the temptation to prop up losers.
Moreover, unlike Heckscher-Ohlin trade, Krugman-style trade need not hurt anyone. As he puts it in his best-selling textbook, when similar countries trade — and most world trade involves rich countries trading with rich countries — “The result may well be that despite the effects of trade on income distribution, everyone gains from trade.” In fact, as the Nobel Committee’s message indicates, one of the first empirical applications of Krugman’s approach was by the Canadian economist Richard Harris, who in 1984 used it to predict increases in trade and prosperity from the Canada-U.S. Free Trade Agreement that eventually were realized.
The Committee also cited Krugman for work on “strategic trade theory,” which considers the possibility that in industries like aerospace, with only a handful of competitors worldwide, governments can acquire monopoly profits for their countries by supporting Boeing or Airbus or for that matter Bombardier against their rivals (a policy first analyzed theoretically by James Brander and Barbara Spencer at the University of British Columbia). Krugman’s textbook concludes: “Strategic trade policies are beggar-thy-neighbour policies that increase our welfare at other countries’ expense. These policies therefore risk a trade war that leaves everyone worse off. Few economists would advocate that [their country] be the initiator of such policies.”
As Krugman wrote in a classic article called “Is Free Trade Passé?”: “To establish a blanket policy of free trade, with exceptions granted only under extreme pressure, may not be the optimal policy according to the theory but may be the best policy that the country is likely to get.”
In sum: The New York Times misses most of the Krugman that’s fit to print.
Financial Post
William Watson is a professor of economics at McGill University, Montreal.
Photo of Paul Krugman: Jeff Zelevansky / Getty Images
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