Why Was Paul Krugman So Wrong?

Why Was Paul Krugman So Wrong?

Everyone's favorite Nobel-winning Keynesian is no longer gravely deluded on the global economy. How much can we trust him now? 


Paul Krugman holds his Nobel lecture in Stockholm, December 8, 2008. (AP Photo/Fredrik Persson, Scanpix Sweden)

Paul Krugman, the popular columnist and Nobel economist, recently likened himself to heroic dissenters who stood up to the war whoops and opposed the invasion of Iraq. The go-to-war consensus among policy elites overwhelmed skeptics and tragedy ensued. Professor Krugman evidently sees himself playing a similar role on important economic controversies. 

“What we should have learned from the Iraq debacle was that you should always be skeptical and that you should never rely on supposed authority,” Krugman wrote in his New York Times column. “If you hear that ‘everyone’ supports a policy, whether it’s a war of choice or fiscal austerity, you should ask whether ‘everyone’ has been defined to exclude anyone expressing a different opinion.”

Good advice and good for Krugman. But there's a peculiar snag in his declaration: Paul Krugman was himself a “supposed authority” who gravely misled the American public on how to think about free-trade globalization. As threatening losses and dislocations accumulated for the US, the celebrated economist was like Voltaire’s Dr. Pangloss, assuring everyone not to worry. Pay no attention to those critics dwelling on the dark side of globalization, he said. Economic theory confirms that free trade is the best of all possible policies in this best of all possible worlds.

A good many Americans did not believe him, mainly working people who saw their jobs and middle-class wages decimated by the processes of globalizing production. Krugman said they didn’t see the big picture. Educated professionals whose own livelihoods were not threatened by globalization were more likely to embrace Krugman’s perspective. While he never won the debate with the broad public, his argument prevailed where it counts – among the political elites who influence government policy-making. Both political parties, every president from Reagan to Obama, embraced the same free-trade strategy: support US multinational corporations in global competition, as their success is bound to lift the rest of the country.

Roughly speaking, the opposite occurred, not only for the working class but for the broad US economy. The multinationals did fine, but the nation is now mired in large and permanent trade deficits that translate into huge indebtedness to foreign trading partners in Asia and Europe and that exerts continuing downward pressure on US employment and wages. Yet the Obama government is seeking still more free-trade agreements as the answer. The current fiscal debates in Congress do not even recognize that free trade globalization is a core source of America’s diminished prosperity.

Like Krugman, governing elites dismissed critics and simply stated that free trade will be good for America because US energies and endless creativity are sure to prevail, as they always have in the past. Opponents like organized labor were typically ridiculed as backward Luddites, promoting what Krugman called “disguised protectionism.” That label scared off major media. Reporters take their cues from the “supposed authority” of business leaders and scholarly experts. At the most prestigious newspapers, reporters and editors simply ignored the substantive critiques of free trade orthodoxy as not worthy of their investigation. After thirty years, the case against free trade is still a taboo subject in respectable circles. 

Of course it is unfair to blame Paul Krugman personally. He was perhaps the most influential economist with his flair for condescending put-downs of dissenters, but Krugman was merely representative of the standard beliefs widely shared by his profession and embedded in government policies. The failure belongs to macroeconomics, an intellectual discipline now in shambles. The financial crisis and deteriorating US prosperity made clear the theory failed to predict the future nor does it explain the past. 

Yet failed dogma is still in the saddle, still dominating government and steering the country toward greater problems ahead. The country cannot start anew with clear eyes and fresh thinking so long as established authority figures like Krugman are unwilling to acknowledge error or candidly concede that that America’s weakened economic condition was in large part generated by the very free-trade principles they had espoused. The US needs its own version of a “truth and reconciliation commission” where those who misled the nation can come forward to offer confessions and explanations. A new generation of younger economists could begin to develop new economic theory by asking: Why was Krugman so wrong?

In recent years, as the global system broke down, Krugman had less to say about international trade theory, his academic specialty, because he directed his wrath mostly at conservative Republicans demanding balanced budgets. But for many years Krugman made it his personal duty to act as the watchdog warning the public against non-economists peddling false ideas. In practice, this usually meant skewering progressive writers who criticized globalization from a liberal-labor perspective—offshoring of jobs, stagnating wages, sweatshops and all that. 

Krugman was notorious among opponents for a snide polemical style. An old friend, another liberal author, once confided to me that he had “inoculated” his own forthcoming book against a blistering Krugman review. He attacked Krugman in print first, which effectively disqualified Krugman as a potential reviewer.

So Krugman chewed on my new book instead—One World, Ready or Not: The Manic Logic of Global Capitalism—which he described as “a thoroughly silly book.” He made a nasty campaign against it, first on Slate, Microsoft’s online magazine, next a harsh review in The Washington Post, then again in his book entitled The Accidental TheoristI have to admit it. In Krugman’s telling, I did sound like a drooling idiot.

I don’t intend to reargue the matter, but my book was bound to provoke authorities like Krugman because I concluded from my reporting that the global system was careening toward “wrenching catastrophes” and eventual breakdown. I essentially argued that the global trading system, despite its fabulous wealth-creating powers, was generating new production far faster than it created new consumers with the wherewithal to buy all the stuff. Someone in the system would have to close some factories. The US effectively accepted the role of “buyer of last resort” for the world’s over-capacity, every year buying and borrowing more from abroad than it produced at home. That is where the trade deficits and swelling debt came from and the rising inequality. They all persist under Obama.

* * *

At the time, Krugman dismissed trade deficits as the self-interested complaints of organized labor or weak-minded analysis by folks like me. He belittled critics like Robert Kuttner and the Economic Policy Institute for maintaining “a steady drumbeat of warnings about the threat that low-wage imports pose to U.S. living standards.” Krugman lamented the gloom-and-doom warnings. 

“The truth, however, is that fears about the economic impact of Third World competition are almost entirely unjustified,” he wrote in the Harvard Business Review in 1994. “Economic growth in low-wage nations is in principle as likely to raise as to lower per capita income in high-wage countries; the actual effects have been negligible.”

“How can so many sophisticated people be so wrong?” he asked. He explained that complex feedback relationships distribute incomes, jobs, trade and investment among nations in ways difficult for non-economists to grasp. “I hope to have made clear,” he added, “that the seemingly sophisticated view that the Third World is causing First World problems is questionable on conceptual grounds and wholly implausible in terms of the data.”

But what would happen if the low-wage countries also managed to generate large increases in productivity? “These emerging economies would see their wage rates in terms of chips rise—end of story,” he said. “There would be no impact, positive or negative, on real wage rates in other, initially higher-wage countries.”

In any case, Krugman was skeptical that poor countries could become high-tech producers. “A likely outcome is that high-tech goods will be produced only in the North [the advanced industrial economies], low-tech goods only in the South [low-wage developing economies], and both regions will produce at least some medium-tech goods,” he wrote.

But what if capital investment from the US and other advanced economies begins to flow heavily into the low-wage economies? Wouldn’t that undercut US wages as labor unions feared? “The short answer is yes in principle but no in practice,” the professor assured. “As a matter of standard textbook theory, international flows of capital from North to South could lower Northern wages. The actual flows that have taken place since 1990, however, are far too small to have the devastating impacts that many people envision.”

Krugman’s over-confident answers to his own questions proved to be mostly wrong, as subsequent events made clear. So was the textbook theory in many instances. His most egregious error was perhaps the assertion that wages always rise with an economy’s rising productivity. Certainly that had been the American experience for many years, but Krugman did not seem to grasp that globalization liberated American businesses from sustaining that relationship. If US labor costs became a burden, the multinational corporations and even smaller firms can now move the production to low-wage countries or merely threaten to do so. In my experience as a reporter, workers on the factory floor recognized this shift in power long before conventional economists figured it out. 

Krugman, nevertheless, stuck with standard theory. “One last assertion that may bother some readers is that wages automatically rise with productivity,” he wrote. “Is this realistic? Yes. Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages.”

Actually, as Krugman was writing this, US industrial wages were already diverging from the old pattern, no longer keeping up with the curve of rising productivity. US hourly wages have essentially been flat or falling in real terms since the early 1970s when Japanese imports started to penetrate US markets. American industrial wages had once led the world. 

* * *

By 2007, the facts were so visible and overwhelming, Krugman and other economists were compelled to alter their conclusions. “Fears that low-wage competition is driving down US wages have a real basis in both theory and fact,” he now announced in his Times column. It seems that organized labor was right, after all. “So there is a dark side to globalization,” Krugman wrote. But this time he had only a sheepish response to his own question. “What’s the answer?  I don’t think there is one, as long as the discussion is restricted to trade policy.”    

Krugman’s pronouncements may have reflected the American hubris then common among US elites and the obvious condescension toward poorer nations rising rapidly in the global firmament. “The Myth of Asia’s Miracle,” Krugman famously declared in Foreign Affairs, the establishment journal. Fears about Japan and the “Asian tigers” reminded Krugman of the post-Sputnik hysteria during the Cold War when US leaders suddenly thought the Soviet economy was overtaking the American powerhouse. 

“Popular enthusiasm about Asia’s boom deserves to have some cold water thrown on it,” Pangloss instructed. “The future prospects for that growth are more limited than almost anyone now imagines.” Krugman dismissed writers like James Fallows, another non-economist, who argued that capitalist economies were steadily losing their technological advantage. “There are severe conceptual problems with this scenario even if its initial premise is right,” Krugman explained.

China, he allowed, was different and posed a larger challenge than Japan if only because of its enormous size —  1.2 billion people. Even so, Krugman remained skeptical. “While we know that China is growing very rapidly, the quality of the numbers is extremely poor,” he observed. “Chinese statistics on foreign investment have been overstated by as much as a factor of six.”

As it happened, about the time Krugman was belittling China, I was there reporting for my book on the global economy. I toured massive factories and dismal sweatshops, interviewed workers, managers and well-placed economists. Unlike Japan which had been coy and evasive, the communist mandarins running China’s development were quite candid about their ambitions. In the early 1990s, Beijing published a series of industrial policy papers that bluntly laid out the government’s intentions, sector by sector, to become a world-class producer and exporter of technologically advanced goods—autos, aircraft, steel and others. These blueprints have since been largely fulfilled and faster than anyone expected.

When I was in Beijing, the city was abuzz with US corporate types from the best names in US manufacturing—General Motors, Boeing, IBM and many others. They were negotiating deals to make things in China and sell them to Chinese consumers. Multinationals from around the world were scrambling to gain access to what would someday become the largest consumer market in the world. The price of entry, demanded by the government, was that foreign companies would have to share their precious technology with domestic partners, the infant Chinese companies learning to make things that could compete with the best and brightest from America and Europe.

Like Krugman, some western executives were initially skeptical about China’s grandiose goals. But the capitalists rushed in to accept its terms, for fear of being left out. I came home from my travels feeling awe for the dramatic transformations underway and a little anxious for the future of American workers. “People are capable, everywhere in the world,” I decided. Americans who still believed in their inherent superiority were about to learn a little humility.

The American problem is not trade theory but self-delusion—an overweening confidence that the US as world leader would prevail because it always had. US leaders assumed they would define the architecture of the new global system, much as they had done since World War II, and other nations would sooner or later be compelled to follow—that is, abandon their national strategies of managed trade and accept the American ideology of free markets and free trade. In Washington and Wall Street, American multinationals were given a free hand to design their own strategies, free of government but of course supported by government money.

The problem was, the rest of the world declined to cooperate. If they could, developing nations pursued their own nationalistic strategies not so different from how the US did industrial development in the 19th century. And these newcomers succeeded spectacularly—first Japan, then the Asian tigers, now China and India and many others. Authorities like Krugman whose expectations were so wrong now tell Americans have no other alternative except the ugly protectionism which would be ruinous for all.

That assertion is mistaken too. The most compelling evidence of American self-delusion is not in Asia but in Europe. The best evidence that a nation can both manage its industrial system strategically while participating fully and fairly in global trade is Germany. As an exporting nation with large trade surpluses in advanced technological goods, Germany’s actual experience refutes the lessons taught by orthodox trade theory and macroeconomics in the US. It sets high performance standards for labor relations and for social entitlements. Its goals for the nation’s industrial base accept that some production will be dispersed abroad but the companies must make sure the industrial core—good jobs, high wages and technological invention—remain in Germany. 

Could Americans mobilize politics to develop such an approach in the US? It sounds too radical to imagine, yet elements of organized labor have been promoting similar ideas for decades and mostly ignored by politicians in both parties. It would require a profound transformation in public thinking. It would depend upon inventive economists to propose how this could be accomplished. I used to think Krugman or others like him would come forward eventually when the negative facts became too much to soft pedal. I got tired of waiting.

What does it mean for the US to be a "democracy"? Watch John Nichols's take on the dollarocratic revolution. 

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