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Paul Krugman’s Nobel Prize

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On Monday, the Royal Swedish Academy of Sciences announced that the 2008 winner of the Nobel Prize in Economic Sciences is Princeton University economist Paul Krugman. Krugman, probably the best known economist under the age of 60, is known to the public mainly for his regular column in the New York Times. Yet those columns do not do justice to the extent of his economic knowledge and understanding. Indeed, and I say this with no exaggeration and no malice, when my students read his column, they often tell me they are surprised to find out that he is an economist, let alone a respected one. More on that later.

Besides being an original theorist in international trade and economic geography, Krugman was, at one time, one of his generations best expositors of good economics. His excellent book Pop Internationalism and his popular articles of the 1990s, many of them in the web publication Slate, make a strong case for free trade. One of the shibboleths he took on, more effectively than anyone before or since, is the belief that countries need to be competitive. He laid out clearly why countries are not like firms and, therefore, dont need to be economically competitive at all. As long as productivity per worker grows, living standards will grow.

I hasten to add that Krugman’s defense of free trade is not what earned him the Nobel Prize. Rather, the prize was awarded for his work of the late 1970s explaining patterns of international trade and for his work of the early 1990s on economic geography. This choice of Nobel Prize recipient, like all those since the economics prize was first awarded in 1969, was of someone who, in some way, pushed the frontiers of economics as a science.

To understand how Krugman pushed these frontiers, you must first understand the basic theory of international trade. Economists have known, since David Ricardo wrote almost 200 years ago, that people in each country will produce the item in which they have a comparative advantage. Comparative advantage is best explained by an example: You might be twice as fast at raking leaves as your teenage neighbor down the street. But if you are really good at writing software, you probably have a comparative advantage in writing software, while the teenager has a comparative advantage at raking leaves. So youre better off writing software and using a fraction of your earnings to hire the teenager to rake.

My favorite example of comparative advantage is Dekembe Mutombo, a basketball player with the Houston Rockets. Mutombo attended Georgetown University as an undergrad, determined to become a doctor and go back to his native Congo and help his people. But when he realized that he was an awesome basketball player, he dropped his plans to become a doctor and, instead, had a successful, and very lucrative, career in the National Basketball Association. Mutombo may have dropped his plans, but not his ultimate goal. He took a substantial fraction of his earnings, raised funds from others, and built a 300-bed hospital in Kinshasa to help his fellow countrymen. Now that’s comparative advantage!

But what determines your comparative advantage? The dominant theory before Krugman was the Hecksher-Ohlin model. This model predicted that trade would be based on such factors as the ratio of capital to labor, with capital-rich countries exporting capital-intensive goods and importing labor-intensive goods from labor-rich countries. Krugman noticed, though, that most international trade takes place between countries with roughly the same ratio of capital to labor. The auto industry in capital-intensive Sweden, for example, exports cars to capital-intensive America, while Swedish consumers also import cars from America. Krugman was not the first to notice this fact or even the first to explain it. He was the first, however, to explain it with a simple, yet elegant and rigorous model, a model that made a lot of sense.

Krugman’s explanation is based on economies of scale. Both Volvo and General Motors reduce average costs by producing a large output in particular niches of the market. In presenting his trade model, Krugman planted the seeds for his later work in economic geography, work in which he tried to explain the location of economic activity. He summarized his basic finding as follows:

Because of economies of scale, producers have an incentive to concentrate production of each good or service in a limited number of locations. Because of the cost of transacting across distance, the preferred locations for each individual producer are those where demand is large or supply of inputs is particularly convenient which in general are the locations chosen by other producers. Thus [geographical] concentrations of industry, once established, tend to be self-sustaining.

In his popular writing, Krugman has been at his best when defending free trade. Krugman became passionate, showing a deep concern for the well-being of people around the world. One example is In Praise of Cheap Labor, published in Slate in 1997. In it, Krugman tells of Smokey Mountain, a huge garbage dump in Manila in which men, women, and children made a living combing through garbage for valuable items. Low-wage jobs in multinational companies factories in the Philippines, Bangladesh, and other poor countries, he noted, are much better alternatives. Because multinational companies hired many of these poor workers, he writes, the result has been to move hundreds of millions of people from abject poverty to something still awful but nonetheless significantly better.

That Slate article is my second-favorite of Krugman’s popular work. My favorite is his Ricardo’s Difficult Idea, undated, but published around 1996. In that piece, Krugman shares the frustration that many of us economists have felt that the vast majority of non-economist intellectuals don’t understand David Ricardo’s insight about comparative advantage. Because we will always have a comparative advantage in something, we need never worry about low-wage countries competing us out of jobs. The most they can do is change the items in which we have a comparative advantage. Krugman points out that, although we can explain Ricardo’s insight to our economics students, most non-economist intellectuals are unwilling to take even ten minutes to understand it. But that doesn’t stop them from writing about trade as if they’re informed. Krugman singles out Robert Reich’s 1983 article Beyond Free Trade. The article, writes Krugman, received wide attention, even though it was fairly unclear exactly how Reich proposed to go beyond free trade.

Another strong point in that popular article and in his others on free trade is Krugman’s noting the simple arithmetic fact that if labors share of national income is relatively constant (as it has been for about the last 80 years), then increases in productivity must cause real wages to increase. Wages, he notes, also include benefits. Indeed, in that respect, Krugman’s reasoning about real wages and standards of living is far superior to what he writes on those topics in the New York Times. In 1990, Krugman wrote:

Old-line leftists, if there are any left, would like to make it a single story the rich becoming richer by exploiting the poor. But that’s just not a reasonable picture of America in the 1980s. For one thing, most of our very poor don’t work, which makes it hard to exploit them. For another, the poor had so little to start with that the dollar value of the gains of the rich dwarfs that of the losses of the poor.

I may have missed it, but I haven’t seen that kind of reasoning in his New York Times columns. Indeed, he has even gone the opposite way, blaming the top one percent of the income distribution for how badly (in his estimation) the bottom 90 percent are doing. Only twelve years ago, he thought that pretty much everyone was doing pretty well. In a 1996 Slate column, The CPI and the Rat Race, Krugman wrote, [M]ost families in 1950 had a material standard of living no better than that of today’s poor and near-poor. He confirmed this with direct measures of how peoples living standards had improved: indoor plumbing, telephones, cars, and TVs. If we were to use the Krugman methodology today, as economist Michael Cox and economic journalist Richard Alm have done, we would point to wide-screen televisions and cell phones.

Unfortunately, although his writing in the 1990s was highly educational, Krugman’s columns in the New York Times have often been the opposite. He often heaps scorn on and challenges the motives of those who disagree with him. For example, in a September 14, 2003, article titled The Tax-Cut Con, Krugman took a lot of space to attack the motives of those who advocated tax cuts, but very little to actually analyze the 2001 tax cut. The closest he came was to point out that most of the benefits of the tax cut went to the highest-income people. But he didnt mention two other relevant facts: (1) almost everyone got about the same percent tax cut; and (2) high-income people pay a disproportionate share of taxes. Those two facts together mean, mathematically, that the highest-income people will get a large percent of the benefits of the tax cut. This is the kind of simple arithmetic point that the Krugman of the 1990s would have made. I miss him.

David R. Henderson is a research fellow with the Hoover Institution, an economics professor at the Naval Postgraduate School, and editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008). From1982 to 1983, he and Paul Krugman were senior economists with President Reagan’s Council of Economic Advisers. He delivered a speech entitled The Economics of War at The Future of Freedom Foundations conference Restoring the Republic 2008: Foreign Policy and Civil Liberties.

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    David R. Henderson, a research fellow with the Hoover Institution and an economics professor at the Naval Postgraduate School, was the senior economist for health policy with President Reagan's Council of Economic Advisers. Charles L. Hooper is a visiting fellow with the Hoover Institution and president of Objective Insights, a company that consults for pharmaceutical and biotech companies.