Economics Articles by Paul Krugman

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Economics Articlesby Paul Krugman

• There is something about macro ***• The world’s smallest macroeconomic model **• The rise and fall of development economics **• Is capitalism too productive? **• Capitalism’s mysterious triumph *• Soft microeconomics: The squishy case against

you-know-who **• In praise of cheap labor **• The spiral of inequality ***• Economic culture wars **• Ricardo’s difficult idea ***• What economists can learn from evolutionary

theorists **• What should trade negotiators negotiate about: A

review essay *• Requiem for the New Economy: Millennial

optimism confronts reality *

Paul Krugman’s Articles 2

There is something about Macro

Paul Krugman

It's holiday season, and my thoughts have turned to ... course preparation. Classes don't begin until February, butbooks must be ordered, reading packets must receive copyright clearance and go to Graphic Arts, and backgroundnotes must be prepared.

This spring I have a new assignment: to teach Macroeconomics I for graduate students. Ordinarily this course istaught by someone who specializes in macroeconomics; and whatever topics my popular writings may cover, myprofessional specialties are international trade and finance, not general macroeconomic theory. However, MIT has atemporary staffing problem, which is itself revealing of the current state of macro, and I have been called in to fillthe gap.

Here's the problem: Macro I (that's 14.451 in MIT lingo) is a quarter course, which is supposed to cover the"workhorse" models of the field - the standard approaches that everyone is supposed to know, the models thatunderlie discussion at, say, the Fed, Treasury, and the IMF. In particular, it is supposed to provide an overview ofsuch items as the IS-LM model of monetary and fiscal policy, the AS-AD approach to short-run versus long-runanalysis, and so on. By the standards of modern macro theory, this is crude and simplistic stuff, so you might thinkthat any trained macroeconomist could teach it. But it turns out that that isn't true.

You see, younger macroeconomists - say, those under 40 or so - by and large don't know this stuff. Their teachersregarded such constructs as the IS-LM model as too ad hoc, too simplistic, even to be worth teaching - after all, theycould not serve as the basis for a dissertation. Now our younger macro people are certainly very smart, and couldlearn the material in order to teach it - but they would find it strange, even repugnant. So in order to teach this courseMIT has relied, for as long as I can remember, on economists who learned old-fashioned macro before it came to beregarded with contempt. For a variety of reasons, however, we can't turn to the usual suspects this year: Stan Fischerhas left to run the world, Rudi Dornbusch is otherwise occupied, Olivier Blanchard is department head, RicardoCaballero - who is a bit young for the role, but can swallow his distaste if necessary - is on leave. All of whichleaves me.

Now you might say, if this stuff is so out of fashion, shouldn't it be dropped from the curriculum? But the funnything is that while old-fashioned macro has increasingly been pushed out of graduate programs - it takes up only afew pages in either the Blanchard-Fischer or Romer textbooks that I am assigning, and none at all in many othertracts - out there in the real world it continues to be the main basis for serious discussion. After 25 years of rationalexpectations, equilibrium business cycles, growth and new growth, and so on, when the talk turns to Greenspan'snext move, or the prospects for EMU, or the risks to the Brazilian rescue plan, it is always informed - explicitly orimplicitly - by something not too different from the old-fashioned macro that I am supposed to teach in February.Why does the old-fashioned stuff persist in this way? I don't think the answer is intellectual conservatism.

Economists, in fact, are in general neophiles, always looking for something radical and different. Anyway, I haveseen over and over again how young economists, trained to regard IS-LM and all that with contempt if they evenknow what it is, find themselves turning to it after a few years in Washington or New York. There's something aboutprimeval macro that pulls us back to it; if Hicks hadn't invented IS-LM in 1937, we would end up inventing it allover again.

But what is it that makes old-fashioned macro so compelling? To answer that question, I find it helpful to thinkabout where it came from in the first place.


Afficionados know that much of what we now think of as Keynesian economics actually comes from John Hicks,whose 1937 article "Mr. Keynes and the classics" introduced the IS-LM model, a concise statement of an argumentthat may or may not have been what Keynes meant to say, but has certainly ended up defining what the world thinkshe said. But how did Hicks come up with that concise statement? To answer that question we need only look at thebook he himself was writing at the time, Value and Capital, which has in a low-key way been as influential asKeynes' General Theory.

Value and Capital may be thought of as an extended answer to the question, "How do we think coherently about theinterrelationships among markets - about the impact of the price of hogs on that of corn and vice versa? How doesthe whole system fit together?" Economists had long understood how to think about a single market in isolation -that's what supply-and-demand is all about. And in some areas - notably international trade - they had thoughtthrough how things fitted together in an economy producing two goods. But what about economies with three ormore goods, where some pairs of goods might be substitutes, others complements, and so on?

This is not the place to go at length into the way that Hicks (and others working at the same time) put the story of"general equilibrium" together. But to understand where IS-LM came from - and why it continues to reappear - ithelps to think about the simplest case in which something more than supply and demand curves becomes necessary:a three good economy. Let us simply call the goods X, Y, and Z - and let Z be the "numeraire", the good in terms ofwhich prices are measured.

Now equilibrium in a three-good model can be represented by drawing curves that indicate combinations of pricesfor which each of the three markets is in equilibrium. Thus in Figure 1 the prices of X and Y, both in terms of Z, areshown on the axes. The line labeled X shows price combinations for which demand and supply of X are equal;similarly with Y and Z. Although there are three curves, Walras' Law (if all markets but one are in equilibrium, thatmarket is in equilibrium too) tells us that they have a common intersection, which defines equilibrium prices for theeconomy as a whole. The slopes of the curves are drawn on the assumption that "own-price" effects are negative,cross-price effects positive - thus an increase in the price of X increases demand for Y, driving the price of Y up,and vice versa; it is also, of course, possible to introduce complementarity into such a framework, which was one ofits main points.

This diagram is simply standard, uncontroversial microeconomics. What does it have to do with macro?Well, suppose you wanted a first-pass framework for thinking coherently about macro-type issues, such as theinterest rate and the price level. At minimum such a framework would require consideration of the supply and


demand for goods, so that it could be used to discuss the price level; the supply and demand for bonds, so that itcould be used to discuss the interest rate; and, of course, the supply and demand for money.

What, then, could be more natural than to think of goods in general, bonds, and money as if they were the threegoods of Figure 1? Put the price of goods - aka the general price level - on one axis, and the price of bonds (1divided by 1+i, if they are one-period bonds) on the other; and you have something like Figure 2 - or, moreconventionally putting the interest rate instead of the price of bonds on the vertical axis, something like Figure 3.And already we have a picture that is essentially Patinkin's flexible-price version of IS-LM.

If you try to read pre-Keynesian monetary theory, or for that matter talk about such matters either with modern


laymen or with modern graduate students who haven't seen this sort of thing, you quickly realize that this seeminglytrivial formulation is actually a powerful tool for clarifying thought, precisely because it is a general-equilibriumframework that takes the interactions of markets into account. Here are some of the things it suddenly makes clear:1. What determines interest rates? Before Keynes-Hicks - and even to some extent after - there has seemed to be aconflict between the idea that the interest rate adjusts to make savings and investment equal, and that it isdetermined by the choice between bonds and money. Which is it? The answer, of course - but it is only "of course"once you've approached the issue the right way - is both: we're talking general equilibrium here, and the interest rateand price level are jointly determined in both markets.

2. How can an investment boom cause inflation (and an investment slump cause deflation)? Before Keynes this wasa subject of vast confusion, with all sorts of murky stuff about "lengthening periods of production", "forced saving",and so on. But once you are thinking three-good general equilibrium, it becomes a simple matter. When investment(or consumer) demand is high - when people are eager to borrow to buy real goods - they are in effect trying to shiftfrom bonds to goods. So as shown in Figure 4, both the bond-market and goods-market equilibrium schedules, butnot the money-market schedule, shift; and the result is both inflation and a rise in the interest rate.

3. How can we distinguish between monetary and fiscal policy? Well, in a fiscal expansion the government sellsbonds and buys goods - producing the same shifts in schedules shown in Figure 4. In a monetary expansion it buysbonds and "sells" newly printed money, shifting the bonds and money (but not goods) schedules as shown in Figure5.

Of course, this is all still a theory of "money, interest, and prices" (Patinkin's title), not "employment, interest, andmoney" (Keynes'). To make the transition we must introduce some kind of price-stickiness, so that incipientdeflation is at least partly translated into output decline; and then we must consider the multiplier impacts of thatoutput decline, and so on. But the basic form of the analysis still comes from the idea of a three-good general-equilibrium model in which the three goods are "goods in general", bonds, and money.

Sixty years on, the intellectual problems with doing macro this way are well known. First of all, the idea of treatingmoney as an ordinary good begs many questions: surely money plays a special sort of role in the economy. Second,almost all the decisions that presumably underlie the schedules here involve choices over time: this is true ofinvestment, consumption, even money demand. So there is something not quite right about pretending that pricesand interest rates are determined by a static equilibrium problem. (Of course, Hicks knew about that, and was quiteself-conscious about the limitations of his "temporary equilibrium" method). Finally, sticky prices play a crucial role


in converting this into a theory of real economic fluctuations; while I regard the evidence for such stickiness asoverwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that worksbeautifully in practice but very badly in theory.

But step back from the controversies, and put yourself in the position of someone who must reach a judgement aboutthe likely impact of a change in monetary policy, or an investment slump, or a fiscal expansion. It would becumbersome to try, every time, to write out an intertemporal-maximization framework, with microfoundations formoney and price behavior, and try to map that into the limited data available. Surely you will find yourself trying tokeep track of as few things as possible, to devise a working model - a scratchpad for your thoughts - that respects theessential adding-up constraints, that represents the motives and behavior of individuals in a sensible way, yet has nosuperfluous moving parts. And that is what the quasi-static, goods-bonds-money model is - and that is why old-fashioned macro, which is basically about that model, remains so useful a tool for practical policy analysis.


The World’s Smallest Macroeconomic Model

Paul Krugman

I learned this model from Robert Hall back in 1975. It can seem silly and trivial; but it seemed to me then, and stillseems to me now, to capture the essence of what is going on in "demand-side" macroeconomics, and to clarifypoints that both the general public and, I'm sorry to say, quite a few Ph.D. economists often seem to find confusing.It also maps pretty well into my favorite economic parable, the story of the baby-sitting coop ("Baby-sitting theeconomy") that I have put to good use a number of times.

There is only one good, produced at constant returns by the single factor of production, labor. Choose units so thatone unit of labor produces one unit of the good; then the price level and wage rate must be the same, and can bereferred to with a single symbol, P.

There is also only one asset, money. Agents start the current period with M dollars, and end with M' after spendingon consumption and earning from the sale of their labor. They derive utility both from consumption and from theexpected purchasing power of the money they hold at the end of the period. (The utility of money presumablyreflects its usefulness in providing future consumption; but we sweep this implicit dynamic problem under the rug).The utility function is assumed to take a specific form:

U = (1-s) ln(C) + s ln (M'/Pe)

where Pe is the expected price level. However, consumers are also assumed to have static expectations, so that Pe =P.

Finally, people are assumed to be endowed with L units of labor.

First, let us consider the full-employment version of the model. If labor is fully employed, then the budget constraintis

C + M'/P = L + M/P

But if the money supply is constant, M' = M; also, C = L. Given the utility function, consumers will spend a share 1-s of their initial wealth on goods, s on money. So we can represent equilibrium either by the condition that demandfor goods equal supply,

L = (1-s)(L + M/P)

or by the condition that demand for money equal supply,

M/P = s(L + M/P).

Both ways of looking at it imply the price-level equation

P = [(1-s)/s)](M/L)

so the price level is proportional to the money supply.

But now let us introduce some rigidity of prices. Suppose that for some reason - never mind why - the price (wage)level is fixed above the level consistent with full employment, so that real balances M/P are too low. There are two


ways of describing the problem this poses. You could say that at full employment the demand for real balanceswould exceed the supply:

M/P < s(L + M/P)

Or you could say that at full employment aggregate demand would fall short of output:

(1-s)(L + M/P) < L

These are just different ways of looking at the same thing.

What must happen, then, is that output is demand-constrained. But that in turn means that employment, and henceincome, is also demand-constrained: the equation for consumption, which must equal output, is

C = (1-s)(C + M/P)

which has an immediately identifiable "multiplier" flavor.

The clear policy implication is that one should increase output by increasing the money supply; after all,

C = ((1-s)/s)(M/P)

Or, to put it differently, the problem is that at full employment the public would want to hold more real balancesthan there are available; and because P will not fall, M must be increased.

This is presumably the meaning of John Maynard Keynes' famous remark in The General Theory:"Unemployment develops, that is to say, because people want the moon: men cannot be employed when the objectof desire (i.e. money) is something which cannot be produced and the demand for which cannot readily be chokedoff. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a greencheese factory (i.e. central bank) under public control."

What is wrong with this model? Don't get me started ... but actually there are three main objections thatmacroeconomists are likely to raise:

1. What happened to the interest rate? For most purposes we will want at the minimum a theory of employment,interest, and money; that means a model with bonds as well as money and goods, which means IS-LM. (See my note"There's something about macro").

2. More fundamentally, the quasi-static approach here is at best a crude approximation to a dynamic model in whichbehavior results from plans that are based on expectations about the future.

3. Finally, the output effects of money come from the assumption of price rigidity. Where does that come from?(Overwhelming empirical evidence, that's where - but why?).

All these objections help to set the agenda for the last six decades of research.

But if you are one of those people to whom macroeconomics always sounds like witchcraft, who is hung up on Say'sLaw, who cannot even comprehend how a shortfall of aggregate demand is possible - then the world's smallestmacro model is a good place to start on the road to enlightenment.


The Rise and Fall of Development Economics

Paul Krugman

This is not exactly a paper about Albert Hirschman.

In the first place, I am unqualified to write such a paper. My acquaintance with Hirschman's works is very limited.In essence, the Hirschman I know is the author of The Strategy of Economic Development and little else. So I am inno position to write about his larger vision.

Furthermore, while I am a great admirer of The Strategy of Economic Development, I do not think that it washelpful to development economics. That may sound paradoxical, but I'll try to explain what I mean as I go along. Toput it briefly, however, I regard the intellectual strategy that Hirschman adopted in writing that book as anunderstandable but wrong response to what had become a crisis in the field of economic development. Perversely,the very brilliance and persuasiveness of the book made it all the more destructive.

If this paper is not about Hirschman, what is it about? It is some reflections on two intertwined themes. One is thestrange history of development economics, or more specifically the linked set of ideas that I have elsewhere(Krugman 1993) called "high development theory.” This set of ideas was and is highly persuasive as at least a partialexplanation of what development is about, and for a stretch of about 15 years in the 1940s and 1950s it was deeplyinfluential among both economists and policymakers. Yet in the late 1950s high development theory rapidlyunravelled, to the point where by the time I studied economics in the 1970s it seemed not so much wrong asincomprehensible. Only in the 1980s and 1990s were economists able to look at high development theory with afresh eye and see that it really does make a lot of sense, after all.

The second theme is the problem of method in the social sciences. As I will argue, the crisis of high developmenttheory in the late 1950s was neither empirical nor ideological: it was methodological. High development theoristswere having a hard time expressing their ideas in the kind of tightly specified models that were increasinglybecoming the unique language of discourse of economic analysis. They were faced with the choice of eitheradopting that increasingly dominant intellectual style, or finding themselves pushed into the intellectual periphery.They didn't make the transition, and as a result high development theory was largely purged from economics, evendevelopment economics.

Hirschman's Strategy appeared at a critical point in this methodological crisis. It is a rich book, full of stimulatingideas. Its most important message at that time, however, was a rejection of the drive toward rigor. In effect,Hirschman said that both the theorist and the practical policy-maker could and should ignore the pressures toproduce buttoned-down, mathematically consistent analyses, and adopt instead a sort of muscular pragmatism ingrappling with the problem of development. Along with some others, notably Myrdal, Hirschman didn't wait forintellectual exile: he proudly gathered up his followers and led them into the wilderness himself. Unfortunately, theyperished there.

The irony is that we can now see that high development theory made perfectly good sense after all. But in order tosee that, we need to adopt exactly the intellectual attitude Hirschman rejected: a willingness to do violence to therichness and complexity of the real world in order to produce controlled, silly models that illustrate key concepts.

This paper, then, is a meditation on economic methodology, inspired by the history of development economics, inwhich Albert Hirschman appears as a major character. I hope that it is clear how much I admire his work; he is not avillain in this story so much as a tragic hero.


THE FALL AND RISE OF DEVELOPMENT ECONOMICS

The glory days of "high development theory" spanned about 15 years, from the seminal paper of Rosenstein Rodan(1943) to the publication of Hirschman's Strategy (1958).

Loosely, high development theory can be described as the view that development is a virtuous circle driven byexternal economies -- that is, that modernization breeds modernization. Some countries, according to this view,remain underdeveloped because they have failed to get this virtuous circle going, and thus remain stuck in a lowlevel trap. Such a view implies a powerful case for government activism as a way of breaking out of this trap.

It's not that easy, of course -- just asserting that there are virtuous and vicious circles does not qualify as a theory.(Although Myrdal (1957) is essentially a tract that emphasizes the importance of "circular and cumulative causation"without -- unlike Hirschman (1958), which is often treated as a counterpart work -- providing much in the way ofconcrete examples of how it might arise). The distinctive features of high development theory came out of itsexplanation of the nature of the positive feedback that can lead to self-reinforcing growth or stagnation.

In most versions of high development theory, the self-reinforcement came from an interaction between economies ofscale at the level of the individual producer and the size of the market. Crucial to this interaction was some form ofeconomic dualism, in which "traditional" production paid lower wages and/or participated in the market less than themodern sector. The story then went something like this: modern methods of production are potentially moreproductive than traditional ones, but their productivity edge is large enough to compensate for the necessity ofpaying higher wages only if the market is large enough. But the size of the market depends on the extent to whichmodern techniques are adopted, because workers in the modern sector earn higher wages and/or participate in themarket economy more than traditional workers. So if modernization can be gotten started on a sufficiently largescale, it will be self-sustaining, but it is possible for an economy to get caught in a trap in which the process nevergets going.

The clearest and simplest version of this story is in the original paper by Rosenstein Rodan (1943) himself. In thatseminal paper, he illustrated his argument for coordinated investment by imagining a country in which 20,000 (!)"unemployed workers ... are taken from the land and put into a large new shoe factory. They receive wagessubstantially higher than their previous income in natura." Rosenstein-Rodan then went on to argue that thisinvestment is likely to be unprofitable in isolation, but profitable if accompanied by similar investments in manyother industries. Both key assumptions are clearly present: the assumption of economies of scale, embodied in theassertion that the factory must be established at such a large scale, and the assumption of dualism, embedded in theidea that these workers can be drawn from unemployment or low paying agricultural employment.

I regard Rosenstein Rodan's Big Push story as the essential high development model. Admittedly, some of theclassics of high development theory differed in their emphasis from this central vision. On one side, Arthur Lewis'sfamous "Economic development with unlimited supplies of labor" emphasized dualism while ignoring the role ofeconomies of scale and circular causation. On the other side, some authors, notably Fleming (1954), argued thatowing to the role of intermediate goods in production -- what Hirschman would later memorably dub forward andbackward linkages -- self-reinforcing development could conceivably occur even without dualism.

There were also disputes over the nature of the policies that might be required to break a country out of a low-leveltrap. Rosenstein Rodan and others appeared to imply that a coordinated, broadly based investment program -- theBig Push -- would be required. Hirschman disagreed, arguing that a policy of promoting a few key sectors withstrong linkages, then moving on to other sectors to correct the disequilibrium generated by these investments, and soon, was actually the right approach. Indeed, Hirschman structured his book as an argument with what he called the"balanced growth" school. He did not acknowledge that he had far more in common with Rosenstein Rodan andother "balanced growth" advocates like Nurkse (1953) than any of them had with the way that mainstreameconomics was going.

For mainstream economics was, by the late 1950s, becoming increasingly hostile to the kinds of ideas involved inhigh development theory. Above all, economics was going through an extended period in which increasing returnsto scale, so central to that theory, tended to disappear from discourse.


It may not be obvious just how crucial economies of scale were to high development theory. One of thecharacteristics of the writing of many of its expositors was a certain vagueness that makes it hard to know exactlywhat the essence of their arguments were -- a vagueness that, as we will soon see, was no accident. Still, if readscarefully, one finds that increasing returns are invariably crucial to the argument.

Consider, for example, what may have been Hirschman's most cited concept, that of "linkages." Some crudefollowers of Hirschman have identified these directly with having a lot of entries in the input-output table.1 ButHirschman's own discussion makes it clear that the idea involved the interaction between market size and economiesof scale.

In Hirschman's definition of backward linkages the role of market-size externalities linked to economies of scale isquite explicit: an industry creates a backward linkage when its demand enables an upstream industry to beestablished at at least minimum economic scale. The strength of an industry's backward linkages is to be measuredby the probability that it will in fact push other industries over the threshhold.

Forward linkages are also defined by Hirschman as involving an interaction between scale and market size; in thiscase the definition is vaguer, but seems to involve the ability of an industry to reduce the costs of potentialdownstream users of its products and thus, again, push them over the threshhold of profitability.

So economies of scale were crucial to high development theory. Why did that present a problem? Becauseeconomies of scale were very difficult to introduce into the increasingly formal models of mainstream economictheory.

THE EVOLUTION OF IGNORANCE

A friend of mine who combines a professional interest in Africa with a hobby of collecting antique maps has writtena fascinating paper called "The evolution of European ignorance about Africa." The paper describes how Europeanmaps of the African continent evolved from the 15th to the 19th centuries.

You might have supposed that the process would have been more or less linear: as European knowledge of thecontinent advanced, the maps would have shown both increasing accuracy and increasing levels of detail. But that'snot what happened. In the 15th century, maps of Africa were, of course, quite inaccurate about distances, coastlines,and so on. They did, however, contain quite a lot of information about the interior, based essentially on second- orthird-hand travellers' reports. Thus the maps showed Timbuktu, the River Niger, and so forth. Admittedly, they alsocontained quite a lot of untrue information, like regions inhabited by men with their mouths in their stomachs. Still,in the early 15th century Africa on maps was a filled space.

Over time, the art of mapmaking and the quality of information used to make maps got steadily better. The coastlineof Africa was first explored, then plotted with growing accuracy, and by the 18th century that coastline was shownin a manner essentially indistinguishable from that of modern maps. Cities and peoples along the coast were alsoshown with great fidelity.

On the other hand, the interior emptied out. The weird mythical creatures were gone, but so were the real cities andrivers. In a way, Europeans had become more ignorant about Africa than they had been before.

It should be obvious what happened: the improvement in the art of mapmaking raised the standard for what wasconsidered valid data. Second-hand reports of the form "six days south of the end of the desert you encounter a vastriver flowing from east to west" were no longer something you would use to draw your map. Only features of thelandscape that had been visited by reliable informants equipped with sextants and compasses now qualified. And sothe crowded if confused continental interior of the old maps became "darkest Africa,” an empty space.

1 One US industrial policy advocate suggested that we target industries that either "provide inputs to or use inputsfrom a large number of other industries." I have often wondered what industry does not meet this criterion -- handthrown pottery?


Of course, by the end of the 19th century darkest Africa had been explored, and mapped accurately. In the end, therigor of modern cartography led to infinitely better maps. But there was an extended period in which improvedtechnique actually led to some loss in knowledge.

Between the 1940s and the 1970s something similar happened to economics. A rise in the standards of rigor andlogic led to a much improved level of understanding of some things, but also led for a time to an unwillingness toconfront those areas the new technical rigor could not yet reach. Areas of inquiry that had been filled in, howeverimperfectly, became blanks. Only gradually, over an extended period, did these dark regions get re-explored.

Economics has always been unique among the social sciences for its reliance on numerical examples andmathematical models. David Ricardo's theories of comparative advantage and land rent are as tightly specified asany modern economist could want. Nonetheless, in the early 20th century economic analysis was, by modernstandards, marked by a good deal of fuzziness. In the case of Alfred Marshall, whose influence dominatedeconomics until the 1930s, this fuzziness was deliberate: an able mathematician, Marshall actually worked out manyof his ideas through formal models in private, then tucked them away in appendices or even suppressed them whenit came to publishing his books. Tjalling Koopmans, one of the founders of econometrics, was later to refercaustically to Marshall's style as "diplomatic": analytical difficulties and fine points were smoothed over withparables and metaphors, rather than tackled in full view of the reader. (By the way, I personally regard Marshall asone of the greatest of all economists. His works remain remarkable in their range of insight; one only wishes thatthey were more widely read).

High development theorists followed Marshall's example. From the point of view of a modern economist, the moststriking feature of the works of high development theory is their adherence to a discursive, non-mathematical style.Economics has, of course, become vastly more mathematical over time. Nonetheless, development economics wasarchaic in style even for its own time. Of the four most famous high development works, Rosenstein Rodan's wasapproximately contemporary with Samuelson's formulation of the Heckscher-Ohlin model, while Lewis, Myrdal,and Hirschman were all roughly contemporary with Robert Solow's initial statement of growth theory.

As in Marshall's case, this was not because development economists were peculiarly mathematically incapable.Hirschman made a significant contribution to the formal theory of devaluation in the 1940s, while Fleming helpedcreate the still influential Mundell-Fleming model of floating exchange rates. Moreover, the development field itselfwas at the same time generating mathematical planning models -- first Harrod-Domar type growth models, thenlinear programming approaches -- that were actually quite technically advanced for their time.

So why didn't high development theory get expressed in formal models? Almost certainly for one basic reason: highdevelopment theory rested critically on the assumption of economies of scale, but nobody knew how to put thesescale economies into formal models.

The essential problem is that of market structure. From Ricardo until about 1975, what economists knew how tomodel formally was a perfectly competitive economy, one in which firms take prices as given rather than activelytrying to affect them. There is a standard theory of the behavior of an individual monopolist who faces nocomparably-sized competitors, but there is no general theory of how oligopolists, firms who have substantial marketpower but also face large rivals, will set prices and output. Still less is there any general approach to modeling theaggregate behavior of a whole economy largely peopled by oligopolistic rather than perfectly competitive industries.

Since the mid 1970s economists have broken through this barrier in a number of fields: international trade,economic growth, and, finally, development. The way they have done this is essentially by making some peculiarassumptions that allow them to exploit the bag of tricks that industrial organization theorists developed for thinkingabout such issues in the 1970s. (We'll see an example of the power and limitations of this kind of intellectualtrickery below, when I present a quick formal version of the Big Push story). In the 1950s, although the technicallevel of the leading development economists was actually quite high enough to have allowed them to do the samething, the bag of tricks wasn't there. So development theorists were placed in an awkward bind, with basicallysensible ideas that they could not quite express in fully worked-out models. And the drift of the economicsprofession made the situation worse. In the 1940s and even in the 1950s it was still possible for an economist topublish a paper that made persuasive points verbally, without tying up all the loose ends. After 1960, however, anattempt to publish a paper like Rosenstein Rodan's would have immediately gotten a grilling: "Why not build a


smaller factory (for which the market is adequate)? Oh, you're assuming economies of scale? But that meansimperfect competition, and nobody knows how to model that, so this paper doesn't make any sense." It seems safe tosay that such a paper would have been unpublishable any time after 1970, if not earlier.

Some development theorists responded by getting as close to a formal model as they could. This is to some extenttrue of Rosenstein Rodan, and certainly the case for Fleming (1954), which gets painfully close to being a fullmodel. But others at least professed to see a less formal, less disciplined approach as a virtue rather than an awkwardnecessity. It is in this light that one needs to see Hirschman and Myrdal. These authors are often cited today (by meamong others) as forerunners of the recent emphasis in several fields on strategic complementarity. In fact, however,their books marked the end, not the beginning of high development theory. Myrdal's central thesis was the idea of"circular causation." But the idea of circular causation is essentially already there in Allyn Young (1928), not tomention Rosenstein Rodan, and Nurkse in 1952 referred repeatedly to the circular nature of the problem of gettinggrowth going in poor countries. So Myrdal was in effect providing a capsulization of an already extensive andfamiliar set of ideas rather than a new departure. Similarly, Hirschman's distinctive idea of linkages was moredistinctive for the effectiveness of the term and the policy advice that he derived loosely from it than for itsintellectual novelty; in effect Rosenstein Rodan was already talking about linkages, and Fleming very explicitly hadboth forward and backward linkages in his discussion.

What marked Myrdal and Hirschman was not so much the novelty of their ideas but their stylistic andmethodological stance. Until their books, economists doing high development theory were trying to be goodmainstream economists. They could not develop full formal models, but they got as close as they could, trying tokeep close to the increasingly model-oriented mainstream. Myrdal and Hirschman abandoned this effort, andeventually in effect took stands on principle against any effort to formalize their ideas.

One imagines that this was initially very liberating for them and their followers. Yet in the end it was a vain stance.Economic theory is essentially a collection of models. Broad insights that are not expressed in model form maytemporarily attract attention and even win converts, but they do not endure unless codified in a reproducible -- andteachable -- form. You may not like this tendency; certainly economists tend to be too quick to dismiss what has notbeen formalized (although I believe that the focus on models is basically right). Like it or not, however, theinfluence of ideas that have not been embalmed in models soon decays. And this was the fate of high developmenttheory. Myrdal's effective presentation of the idea of circular and cumulative causation, or Hirschman's evocation oflinkages, were stimulating and immensely influential in the 1950s and early 1960s. By the 1970s (when I wasmyself a student of economics), they had come to seem not so much wrong as meaningless. What were these guystalking about? Where were the models? And so high development theory was not so much rejected as simplybypassed.

The exception proves the rule. Lewis's surplus labor concept was the model that launched a thousand papers, eventhough surplus labor assumptions were already standard among development theorists, the empirical basis forassuming surplus labor was weak, and the idea of external economies/strategic complementarity is surely moreinteresting. The point was, of course, that precisely because he did not mix economies of scale into his framework,Lewis offered theorists something they could model using available tools.

METAPHORS AND MODELS

I have just acknowledged that the tendency of economists to emphasize what they know how to model formally cancreate blind spots; yet I have also claimed that the insistence on modeling is basically right. What I want to do nowis call a time out and discuss more broadly the role of models in social science.

It is said that those who can, do, while those who cannot, discuss methodology. So the very fact that I raise the issueof methodology in this paper tells you something about the state of economics. Yet in some ways the problems ofeconomics and of social science in general are part of a broader methodological problem that afflicts many fields:how to deal with complex systems.

It is in a way unfortunate that for many of us the image of a successful field of scientific endeavor is basic physics.The objective of the most basic physics is a complete description of what happens. In principle and apparently inpractice, quantum mechanics gives a complete account of what goes on inside, say, a hydrogen atom. But most


things we want to analyze, even in physical science, cannot be dealt with at that level of completeness. The onlyexact model of the global weather system is that system itself. Any model of that system is therefore to some degreea falsification: it leaves out some (many) aspects of reality.

How, then, does the meteorological researcher decide what to put into his model? And how does he decide whetherhis model is a good one? The answer to the first question is that the choice of model represents a mixture ofjudgement and compromise. The model must be something you know how to make -- that is, you are constrained byyour modeling techniques. And the model must be something you can construct given your resources -- time,money, and patience are not unlimited. There may be a wide variety of models possible given those constraints;which one or ones you choose actually to build depends on educated guessing.

And how do you know that the model is good? It will never be right in the way that quantum electrodynamics isright. At a certain point you may be good enough at predicting that your results can be put to repeated practical use,like the giant weather-forecasting models that run on today's supercomputers; in that case predictive success can bemeasured in terms of dollars and cents, and the improvement of models becomes a quantifiable matter. In the earlystages of a complex science, however, the criterion for a good model is more subjective: it is a good model if itsucceeds in explaining or rationalizing some of what you see in the world in a way that you might not haveexpected.

Notice that I have not specified exactly what I mean by a model. You may think that I must mean a mathematicalmodel, perhaps a computer simulation. And indeed that's mostly what we have to work with in economics. But amodel can equally well be a physical one, and I'd like to describe briefly an example from the pre-computer era ofmeteorological research: Fultz's dish-pan.

Dave Fultz was a meteorological theorist at the University of Chicago, who asked the following question: whatfactors are essential to generating the complexity of actual weather? Is it a process that depends on the fullcomplexity of the world -- the interaction of ocean currents and the atmosphere, the locations of mountain ranges,the alternation of the seasons, and so on -- or does the basic pattern of weather, for all its complexity, have simpleroots?

He was able to show the essential simplicity of the weather's causes with a "model" that consisted of a dish-panfilled with water, placed on a slowly rotating turntable, with an electric heating element bent around the outside ofthe pan. Aluminum flakes were suspended in the water, so that a camera perched overhead and rotating with the pancould take pictures of the pattern of flow.

The setup was designed to reproduce two features of the global weather pattern: the temperature differential betweenthe poles and the equator, and the Coriolis force that results from the Earth's spin. Everything else -- all the richdetail of the actual planet -- was suppressed. And yet the dish-pan exhibited an unmistakable resemblance to actualweather patterns: a steady flow near the rim evidently corresponding to the trade winds, constantly shifting eddiesreminiscent of temperate-zone storm systems, even a rapidly moving ribbon of water that looked like the recentlydiscovered jet stream.

What did one learn from the dish-pan? It was not telling an entirely true story: the Earth is not flat, air is not water,the real world has oceans and mountain ranges and for that matter two hemispheres. The unrealism of Fultz's modelworld was dictated by what he was able to or could be bothered to build -- in effect, by the limitations of hismodeling technique. Nonetheless, the model did convey a powerful insight into why the weather system behaves theway it does.

The important point is that any kind of model of a complex system -- a physical model, a computer simulation, or apencil-and-paper mathematical representation -- amounts to pretty much the same kind of procedure. You make a setof clearly untrue simplifications to get the system down to something you can handle; those simplifications aredictated partly by guesses about what is important, partly by the modeling techniques available. And the end result,if the model is a good one, is an improved insight into why the vastly more complex real system behaves the way itdoes.


When it comes to physical science, few people have problems with this idea. When we turn to social science,however, the whole issue of modeling begins to raise people's hackles. Suddenly the idea of representing therelevant system through a set of simplifications that are dictated at least in part by the available techniques becomeshighly objectionable. Everyone accepts that it was reasonable for Fultz to represent the Earth, at least for a first pass,with a flat dish, because that was what was practical. But what do you think about the decision of most economistsbetween 1820 and 1970 to represent the economy as a set of perfectly competitive markets, because a model ofperfect competition was what they knew how to build? It's essentially the same thing, but it raises howls ofindignation.

Why is our attitude so different when we come to social science? There are some discreditable reasons: likeVictorians offended by the suggestion that they were descended from apes, some humanists imagine that theirdignity is threatened when human society is represented as the moral equivalent of a dish on a turntable. Also, themost vociferous critics of economic models are often politically motivated. They have very strong ideas about whatthey want to believe; their convictions are essentially driven by values rather than analysis, but when an analysisthreatens those beliefs they prefer to attack its assumptions rather than examine the basis for their own beliefs.

Still, there are highly intelligent and objective thinkers who are repelled by simplistic models for a much betterreason: they are very aware that the act of building a model involves loss as well as gain. Africa isn't empty, but theact of making accurate maps can get you into the habit of imagining that it is. Model-building, especially in its earlystages, involves the evolution of ignorance as well as knowledge; and someone with powerful intuition, with a deepsense of the complexities of reality, may well feel that from his point of view more is lost than is gained. It is in thishonorable camp that I would put Albert Hirschman and his rejection of mainstream economics.

The cycle of knowledge lost before it can be regained seems to be an inevitable part of formal model-building.Here's another story from meteorology. Folk wisdom has always said that you can predict future weather from theaspect of the sky, and had claimed that certain kinds of clouds presaged storms. As meteorology developed in the19th and early 20th centuries, however -- as it made such fundamental discoveries, completely unknown to folkwisdom, as the fact that the winds in a storm blow in a circular path -- it basically stopped paying attention to howthe sky looked. Serious students of the weather studied wind direction and barometric pressure, not the prettypatterns made by condensing water vapor.

It was not until 1919 that a group of Norwegian scientists realized that the folk wisdom had been right all along --that one could identify the onset and development of a cyclonic storm quite accurately by looking at the shapes andaltitude of the cloud cover.

The point is not that a century of research into the weather had only reaffirmed what everyone knew from thebeginning. The meteorology of 1919 had learned many things of which folklore was unaware, and dispelled manymyths. Nor is the point that meteorologists somehow sinned by not looking at clouds for so long. What happenedwas simply inevitable: during the process of model-building, there is a narrowing of vision imposed by thelimitations of one's framework and tools, a narrowing that can only be ended definitively by making those toolsgood enough to transcend those limitations.

But that initial narrowing is very hard for broad minds to accept. And so they look for an alternative.

The problem is that there is no alternative to models. We all think in simplified models, all the time. Thesophisticated thing to do is not to pretend to stop, but to be self-conscious -- to be aware that your models are mapsrather than reality.

There are many intelligent writers on economics who are able to convince themselves -- and sometimes largenumbers of other people as well -- that they have found a way to transcend the narrowing effect of model-building.Invariably they are fooling themselves. If you look at the writing of anyone who claims to be able to write aboutsocial issues without stooping to restrictive modeling, you will find that his insights are based essentially on the useof metaphor. And metaphor is, of course, a kind of heuristic modeling technique.


In fact, we are all builders and purveyors of unrealistic simplifications. Some of us are self-aware: we use ourmodels as metaphors. Others, including people who are indisputably brilliant and seemingly sophisticated, aresleepwalkers: they unconsciously use metaphors as models.

THE BIG PUSH

We can now return to the story of development economics. By the late 1950s, as I have argued, high developmenttheory was in a difficult position. Mainstream economics was moving in the direction of increasingly formal andcareful modeling. While this trend was clearly overdone in many instances, it was an unstoppable and ultimately anappropriate direction of change. But it was difficult to model high development theory more formally, because of theproblem of dealing with market structure.

The response of some of the most brilliant high development theorists, above all Albert Hirschman, was simply toopt out of the mainstream. They would build a new development school on suggestive metaphors, institutionalrealism, interdisciplinary reasoning, and a relaxed attitude toward internal consistency. The result was somewonderful writing, some inspiring insights, and (in my view) an intellectual dead end. High development theorysimply faded out. A constant-returns, perfect-competition view of reality took over the development literature, andeventually via the World Bank and other institutions much of real-world development policy as well.

And yet in the end it turned out that mainstream economics eventually did find a place for high development theory.Like the Norwegians who discovered that the shapes of clouds do mean something, mainstream economicsdiscovered that as its modeling techniques became more sophisticated some neglected insights could be broughtback in.

Since this sounds rather abstract, it will be best if I explicitly present an example of how one can now do a formaltreatment of the classic model of high development theory: Rosenstein-Rodan's Big Push. The treatment is astreamlined version of the exposition in Murphy, Shleifer, and Vishny (1989), and reproduces my presentation inKrugman (1993).

Our paper-and-pencil dish-pan -- our model economy -- consists of a set of assumptions about the supply ofresources; technology; demand; and market structure.

Figure 1


Resources. The only resource in the economy is labor -- that is, we neglect the role of capital, physical or human.Labor is in fixed total supply L. It can, however, be employed in either of two sectors: a "traditional" sector,characterized by constant returns, or a "modern" sector, characterized by increasing returns. Although the samequality of labor is used in the traditional and modern sectors, it is not paid the same wage. Workers must be paid apremium to move from traditional to modern employment. We let w1 be the ratio of the wage rate that must be paidin the modern sector to that in the traditional sector.

Technology. It is assumed that the economy produces N goods, where N is a large number. We choose units so thatthe productivity of labor in the traditional sector is unity in each of the goods. In the modern sector, average laborcost is decreasing in the scale of production. For simplicity, decreasing costs take a linear form. Let Qi be theproduction of good i in the modern sector. Then if the modern sector produces the good at all, the labor requirementwill be assumed to take the form

Li = F + cQi

where c<1 is the marginal labor requirement. Note that for this example it is assumed that the relationship betweeninput and output is the same for all N goods.

Demand. Each good receives a constant share N of expenditure. The model will be static, with no assetaccumulation or decumulation; so expenditure equals income.

Market structure. The traditional sector is assumed to be characterized by perfect competition. Thus for each goodthere is a perfectly elastic supply from the traditional sector at the marginal cost of production; given our choice ofunits, this supply price is unity in terms of traditional sector labor. By contrast, a single entrepreneur is assumed tohave the unique ability to produce each good in the modern sector.How will such a producer price? She cannot raise her price as much as she would like. The reason is that potentialcompetition from the traditional sector puts a limit on the price: she cannot go above a price of 1 (in terms oftraditional labor) without being undercut by traditional producers. So each producer in the modern sector will set thesame price, unity, as would have been charged in the traditional sector.

We can now ask the question, will production actually take place in the traditional or the modern sector?

To answer this, it is useful to draw a simple diagram (Figure 1). On the horizontal axis is the labor input, Li, used toproduce a typical good. On the vertical axis is that sector's output Qi. The two solid lines represent the technologiesof production in the two sectors: a 45-degree line for the traditional sector, a line with a slope of 1/c for the modernsector.

From this figure it is immediately possible to read off what the economy would produce if all labor were allocatedeither to the modern or the traditional sector. In either case L/N workers would be employed in the production ofeach good. If all goods are produced traditionally, each good would have an output Q1. If they are all produced usingmodern techniques, the output is Q2. As drawn, Q2Q1; this will be the case provided that

[(L/N) - F]/c L/N

i.e., as long as the marginal cost advantage of modern production is sufficiently large and/or fixed costs are not toolarge. Since this is the interesting case, we focus on it.

But even if the economy could produce more using modern methods, this does not mean that it will. It must beprofitable for each individual entrepreneur in the modern sector to produce, taking into account the necessity ofpaying the premium wage w -- and also the decisions of all the other entrepreneurs.

Suppose that an individual firm starts modern production while all other goods are produced using traditionaltechniques. The firm will charge the same price as that on other goods, and hence sell the same amount; since thereare many goods, we may neglect any income effects and suppose that each good continues to sell Q1. Thus this firmwould have the production and employment illustrated by point A.


Is this a profitable move? The firm uses less labor than would be required for traditional production, but must paythat labor more. Draw in a ray from the origin whose slope is the modern relative wage w; OW in the figure is anexample. Then modern production is profitable given traditional production elsewhere if and only if OW passesbelow A. As drawn, this test is of course failed: it is not profitable for an individual firm to start modern production.

On the other hand, suppose that all modern firms start simultaneously. Then each firm will produce Q2, leading toproduction and employment at point B. Again, this will be profitable if the wage line OW passes below B. Asdrawn, this test is satisfied.

Obviously, there are three possible outcomes.2 If the wage premium w-1 is low, the economy always"industrializes"; if it is high, it never industrializes; and if it takes on an intermediate value, there are both low- andhigh-level equilibria.

One would hardly conclude from this model that the high development idea that countries can be caught in low-income traps, but that self-reinforcing growth is also possible, is necessarily right. Even within this model, that storyis true only for some parameter values. And the specific assumptions are obviously unrealistic. Yet the modelillustrates several key points about the relationship between mainstream economics and high development theory.

First, it shows that it is possible to tell high development-style stories in the form of a rigorous model. The methodsof mainstream economics may have created a predisposition to constant returns, perfect competition models, butthey need not be restricted to such models.

Second, this example, like Fultz's dish-pan, shows that the essential logic of high development stories emerges evenin a highly simplified setting. It is common for those who haven't tried the exercise of making a model to assert thatunderdevelopment traps must necessarily result from some complicated set of factors -- irrationality or short-sightedness on the part of investors, cultural barriers to change, inadequate capital markets, problems of informationand learning, and so on. Perhaps these factors play a role, perhaps they don't: what we have just seen that a low-leveltrap can arise with rational entrepreneurs, without so much as a whiff of cultural influences, in a model withoutcapital, and with everyone fully informed.

Third, the model, unlike a purely verbal exposition, reveals the sensitivity of the conclusions to the assumptions. Inparticular, verbal expositions of the Big Push story make it seem like something that must be true. In this model wesee that it is something that might be true. A model like this makes one want to go out and start measuring, to seewhether it looks at all likely in practice, whereas a merely rhetorical presentation gives one a false feeling of securityin one's understanding.

Finally, the model tells us something about what attitude is required to deal with complex issues in economics. Thismodel may seem childishly simple, but I can report from observation that until Murphy et al. published theirformalization of Rosenstein-Rodan its conclusions were not obvious to many people, even those who havespecialized in development. Economists tended to regard the Big Push story as essentially nonsensical -- if moderntechnology is better, then rational firms would simply adopt it! (They missed the interaction between economies ofscale and market size). Non-economists tended to think that Big Push stories necessarily involved some richinterdisciplinary stew of effects, missing the simple core. In other words, economists were locked in their traditionalmodels, non-economists were lost in the fog that results when you have no explicit models at all.

How did Murphy et al break through this wall of confusion? Not by trying to capture the richness of reality, eitherwith a highly complex model or with the kind of lovely metaphors that seem to evade the need for a model. They didit instead by daring to be silly: by representing the world in a dish-pan, to get at an essential point.

CONCLUDING THOUGHTS

When I look at the Murphy et al representation of the Big Push idea, I find myself wondering whether the longslump in development theory was really necessary. The model is so simple: three pages, two equations, and one 2 Actually four, if one counts the case where (2) is not satisfied, so that the economy actually producesless using modern techniques. In this case it clearly stays with the traditional methods.


diagram. It could, it seems, have been written as easily in 1955 as in 1989. What would have happened todevelopment economics, even to economics in general, if someone had legitimized the role of increasing returns andcircular causation with a neat model 35 years ago?

But it didn't happen, and perhaps couldn't. Those economists who were attracted to the idea of powerfulsimplifications were still absorbed in the possibilities of perfect competition and constant returns; those who weredrawn to a richer view, like Hirschman, became impatient with the narrowness and seeming silliness of theeconomics enterprise.

That the story may have been preordained does not keep it from being a sad one. Good ideas were left to gather dustin the economics attic for more than a generation; great minds retreated to the intellectual periphery. It is hard toknow whether economic policy in the real world would have been much better if high development theory had notdecayed so badly, since the relationship between good economic analysis and successful policy is far weaker thanwe like to imagine. Still, one wishes things had played out differently.

One would like to draw some morals from this story. It is easy to give facile advice. For those who are impatientwith modeling and prefer to strike out on their own into the richness that an uninhibited use of metaphor seems toopen up, the advice is to stop and think. Are you sure that you really have such deep insights that you are better offturning your back on the cumulative discourse among generally intelligent people that is modern economics? But ofcourse you are.

And for those, like me, who basically try to understand the world through the metaphors provided by models, theadvice is not to let important ideas slip by just because they haven't been formulated your way. Look for the folkwisdom on clouds -- ideas that come from people who do not write formal models but may have rich insights. Theremay be some very interesting things out there. Strangely, though, I can't think of any.

The truth is, I fear, that there's not much that can be done about the kind of apparent intellectual waste that tookplace during the fall and rise of development economics. A temporary evolution of ignorance may be the price ofprogress, an inevitable part of what happens when we try to make sense of the world's complexity.

REFERENCES

Fleming, J.M. 1955. "External Economies and the Doctrine of Balanced Growth." Economic Journal. June.

Hirschman, A. 1958. The Strategy of Economic Development. New Haven, Conn.: Yale University Press.

Leibenstein, H. 1957. Economic Backwardness and Economic Growth. New York: Wiley.

Lewis, W.A. 1954. "Economic Development with Unlimited Supplies of Labor." The Manchester School. May.

----------. 1955. The Theory of Economic Growth. London: Allen and Unwin.

Little, I.M.D. 1982. Economic Development. New York: 20th Century Fund.

Little, I., T. Scitovsky, and M. Scott. 1970. Industry and Trade in Some Developing Countries. Oxford: OxfordUniversity Press.

Murphy, R., A. Shleifer, and R. Vishny. 1989. "Industrialization and the Big Push." Journal of Political Economy.

Myrdal, G. 1957. Economic Theory and Under-developed Regions. London: Duckworth.

Nelson, R. 1956. "A Theory of the Low Level Equilibrium Trap in Underdeveloped Economies." AmericanEconomic Review. May.

Rosenstein-Rodan, P. 1943. "Problems of Industrialization of Eastern and South-Eastern Europe." EconomicJournal. June-September.


Scitovsky, T. 1954. "Two Concepts of External Economies." Journal of Political Economy. April.

Young, A. 1928. "Increasing Returns and Economic Progress." Economic Journal. December.


Is Capitalism Too Productive?

Paul Krugman

The great majority of those who voted for Lionel Jospin's Socialists in the recent French election were surely votingagainst, not for: they were protesting high unemployment and the aloof austerity of Alain Jupp’s government, notendorsing the specifics of the opposition's program. Nonetheless, Jospin's elevation to Prime Minister is aremarkable event. Sooner than anyone might have expected, a radical economic doctrine has emerged fromobscurity to become, in principle at least, the official ideology of a major advanced nation's government.

Let me give that economic doctrine a name, and call it the doctrine of global glut. It may be summarized as the viewthat capitalism is too productive for its own good - that thanks to rapid technological progress and the spread ofindustrialization to newly emerging economies the ability to do work has expanded faster than the amount of workto be done. In its milder forms, the global glut doctrine involves the belief that policies should be aimed atincreasing demand rather than supply; thus its American advocates have opposed efforts to eliminate the budgetdeficit or increase national savings, claiming that such efforts will actually reduce the economy's growth. In its moreextreme forms, the doctrine calls for actual reductions in the economy's capacity, in particular through "work-sharing" schemes that reduce the length of the work week. And it was this extreme form that was a central plank ofJospin's program: he called for a mandated reduction in France's work week from 39 to 35 hours.

Heterodox doctrines, in economics and elsewhere, often fail to get adequately discussed in their formative stages:both the intellectual and the political establishment tend to regard them as unworthy of notice. Meanwhile, thosedoctrines can seem compelling to large numbers of people (some of whom may have considerable political clout,large financial resources, or both). By the time it becomes apparent that such influential ideas demand seriousattention after all, reasoned argument has become very difficult. People have become invested emotionally,politically, and financially in the doctrine; careers and even institutions have been built on it; and the proponents canno longer allow themselves to contemplate the possibility that they have taken a wrong turning.

The doctrine of global glut - unlike, say, supply-side economics - has probably not yet reached that point. EvenJospin's Socialists could still quietly drop work-sharing from their program without much backlash (provided theydeliver in other ways). And with only a few exceptions those American intellectuals and politicians who have beenflirting with some version of the doctrine can still modify their views without too much embarrassment. But now isthe time to discuss the doctrine seriously, before it becomes a dogma impervious to logic and evidence.

Let me not be too coy about the verdict. The idea of a global glut does not stand up to examination; it isconceptually confused, and its advocates seem oddly unaware of even very basic facts. But it is evidently a doctrinethat many intelligent people find compelling; it is therefore important both to lay out the case against a global glutand to try to understand why the doctrine is so appealing despite its intellectual vulnerability.

TOO MUCH OF A GOOD THING?

Concerns that capitalism might be too productive for the good of its workers, perhaps even too productive for thegood of the capitalists themselves, have been with us almost since the beginning of the Industrial Revolution. Theslump that followed the end of the Napoleonic Wars, and the brutal displacement of handweavers by the powerloom, forced even the classical economists to consider the possibility that the introduction of improved technologymight have some adverse effects. Thus David Ricardo's 1817 Principles of Political Economy, which among otherthings first demonstrated rigorously the virtues of free trade, also included a chapter entitled "On Machinery", aboutthe possibility of technological unemployment.


More or less modern concerns about excessive productivity emerged in the 1930s and 1940s. It was natural thatsome observers would tie the lack of jobs during the Depression to the widespread introduction of mass-productiontechniques in the 20s. And Keynesian economics, which legitimized concerns about overall inadequacy of demand,helped to provide an intellectual framework. Indeed, during the late 30s and early 40s many economists temporarilysubscribed to a doctrine - often referred to as "secular stagnation" - that is quite similar to the current doctrine ofglobal glut. (As Keynes himself famously put it: "Practical men, who believe themselves exempt from anyintellectual influence, are usually the slaves of some defunct economist.”) Secular stagnationists pointed out thatwell-off families tend to save a higher fraction of their income than poorer ones; thus, they argued, per capitaconsumer spending would not keep pace with growth in per capita income. The economy could therefore onlymaintain full employment if investment spending grew much more rapidly than income - and this seemed unlikely.So the secular stagnationists (backed, incidentally, by forecasts made using early econometric models) predicted areturn to Depression conditions once World War II was over, and a tendency toward ever-growing unemploymentrates over time.

Postwar developments in economic theory, together with the actual experience of the postwar boom, pretty mucheliminated secular stagnationism as a view among professional economists. The doctrine did live on in more popularwritings, often tied to concerns about the impact of "automation,” the supposedly imminent widespread replacementof workers by machines. But by and large concerns that capitalism might simply be too productive went dormantfrom the early 1950s to the 1980s.

The rise of the current doctrine of global glut can be tied to three main developments. First, mass unemployment hasreemerged in Western Europe, though not in the United States. Most economists and business leaders blame thelong-term rise in European unemployment on "Eurosclerosis,” a condition brought on by excessive taxation andregulation. But many of Europe's trade union leaders and some of its political leaders have concluded instead thatthere simply is not enough work to go around, and that this problem is becoming ever more acute as laborproductivity rises. Thus Jospin-like proposals for work-sharing have been common on the European scene for adecade or more. Demands for work-sharing became particularly intense when Europe went into an economic slumpin the early 90s; the concept even received a somewhat blurry endorsement in the European Commission's 1993White Paper Growth, Competitiveness, Employment.

Second, there is a widespread perception that productivity growth in the advanced countries, especially in the UnitedStates, has dramatically accelerated. In particular, what turned out in the end to be a temporary period of "joblessrecovery" in 1991-2 - that is, of growing GDP but rising unemployment - apparently had a permanent impact onsome economic writers, convincing them that the traditional link between growth and jobs had been severed.

Finally, the spread of industry to newly emerging economies, and the rapid growth in exports from those economies,has fed the sense that global productive capacity is growing at a headlong pace, far too fast for demand to keep up.Indeed, some of the global glut doctrine's adherents - notably William Greider - not only believe that growth will lagbehind capacity, but warn that the growing gap between potential supply and demand will provoke a 1930s-styleeconomic crisis, with output actually plunging. The doctrine of global glut, then, is a response to some real changesin the world economy. But is it a reasonable response? Does it make sense conceptually? Does it fit the facts?

IS THERE REALLY A GLOBAL GLUT?

To get some perspective on the global glut, it may be useful to focus on three propositions that are crucial to thedoctrine - one proposition about supply and two about demand. (Why two propositions about demand? Because, aswe will see, we need to ask somewhat different questions about demand in advanced and in developing countries).The propositions are:

1. Global productive capacity is growing at an exceptional, perhaps unprecedented rate.2. Demand in advanced countries cannot keep up with the growth in potential supply.3. The growth of newly emerging economies will contribute much more to global supply than to global demand.

Are these propositions true about the present, or likely to be true about the future?


Productive capacity

Popular economic discussion tends to be driven by impressions and anecdotes rather than statistics. There issomething to be said for this attitude, especially in times of rapid change: statistics designed to track last generation'seconomy can easily miss crucial aspects of what is happening right now. On the other hand, anecdotes tend toemphasize the exciting and different, and to miss the continuities. The fundamental things remain as time goes by,but you may not remember this if you focus too much on the interesting anecdotes.

The belief of commentators like Greider that there is a huge growth in productive capacity seems to be drivenlargely by tales of individual industries that clearly do have a problem of overcapacity, notably automobiles. Theproblem with such stories is that in an unpredictable world the emergence of excess capacity in particular industriesthat overestimated their market prospects is just a normal hazard of business as usual - as is the emergence ofcapacity shortages in industries that underestimated demand. At times the balance is clear: at the bottom of a severerecession, or even after a more modest slump like 1990-91, there is a clear predominance of excess supply. But atthe moment there are clearly shortages of some things - such as office space in many cities, coffee beans, and skilledmachinists - at the same time that there are excess supplies of others, like auto assembly plants. Which stories shouldwe regard as defining, and which as incidental?

Another source of belief in surging productive capacity is the impression of breakneck progress created by thetriumphs of digital technology, where Moore's Law - the rule that says that the price of a given computation halvesevery 18 months - implies a state of permanent revolution. But there is more to production than computation. Evenin manufacturing reports of the workerless factory have repeatedly proved premature; the much-hyped arrival ofindustrial robotics in the 1980s turned out to be no more than a modest addition to the arsenal of productiontechniques. And evidence for a productivity revolution is even harder to find outside the manufacturing sector. Thepaperless, secretary-less office, for example, is something that is always about to happen but somehow never does.

For what they are worth, official estimates of the overall rate of capacity growth in advanced countries are distinctlyunimpressive. The OECD and the IMF both estimate the rate of growth of potential GDP in the advanced economiesas a group at no more than 2-3 percent - about the same as in the previous 20 years, and well below the growth ratesof the 50s and 60s. But can such estimates be trusted? Technological enthusiasts are quick to point to qualitativeimprovements that are missed by normal estimates of real GDP - like the convenience offered by automatic tellermachines. On the other hand, such poorly measured quality improvements were arguably equally important inearlier decades; it is anybody's guess whether the undermeasurement is greater now than before.

There is one point nobody would dispute: the stunningly rapid industrialization of some developing countries,mainly in Asia, has contributed to an acceleration in the growth of world capacity.

When you put the evidence together, what do you find? Averaging the dreary official estimates of potential growthwith the impressive actual growth rates in Asia suggests that overall world productive capacity is growing atsomething close to 4 percent per year. This is better than the 3 or so percent growth of market economies in the1970s and 1980s, but somewhat less than the rate of growth achieved by market economies in the 1950s and 60s.Perhaps the estimates are wrong now, to a greater extent than they were wrong then; but the case for unusually highgrowth in productive capacity is weak at best, and there is no case at all for the more breathless claims aboutunprecedented expansion.

Demand in the advanced countries

Even if the growth in capacity is more modest than the hype would have it, the capacity will go unused unlessconsumers provide sufficient demand. Will they? Conventional economists don't see any problem here. After all, ifthe growing capacity of advanced countries is in fact used, income will rise in line with that capacity; and if incomerises, why won't consumer demand rise too? Somewhat oddly, none of the main proponents of the global glutdoctrine seem to offer any direct counter to this standard view. Greider, Rifkin, and even Heilbroner (who should atleast be aware of the conventional argument) seem to take it for granted that if growth in supply is too rapid it willoutstrip growth in demand. Judis has pointed out that the 1930s did happen, proving that demand need not alwaysequal supply; but this says nothing about whether growing capacity itself (as opposed to, say, monetarymismanagement) need provoke a slump.


Reading between the lines a bit, however, it seems likely that the global glutters, like the secular stagnationists ofyore, have in mind the idea that as income rises, consumers become saturated - that having bought all theirnecessities, they become reluctant to increase spending even if their income rises. This idea seems confirmed byordinary experience: well-off families typically do save much more of their income than the poor. Some of theglobal glutters follow this logic a bit further, suggesting that consumer demand is further limited by themaldistribution of income within advanced countries (or at least within the United States). Struggling families wouldspend more if they could; but income gains go instead to the rich, who hoard their incomes instead of spendingthem.

It's evidently a persuasive story. But it runs up against an awkward fact: consumer spending in the United States haskept up with rising income for a very long time. Real per capita income today is roughly triple what it was in the late1940s, the heyday of secular stagnationism. And that income is substantially more unequally distributed. Yet thefraction of personal income that consumers save is actually lower now than it was then. Somehow or other mostAmericans, including many of those in the upper echelons of the income distribution, have found ways to spendtheir income without becoming saturated.

If you think about it, this does not seem all that amazing. Most readers of Foreign Affairs surely know people whohave annual incomes of $300,000 or more. Indeed, a fair number of readers probably meet that descriptionthemselves. In reality, how hard is it to find ways to spend that money? A really nice home, a second home or nicevacations, private colleges for the children, two good cars ... Yet even if median family income in the United Statesgrows at 2 percent per year, it will take a century before that median family has an income equivalent to $300,000 intoday's prices.

It is true that people with above-average incomes tend to save more than people with lower incomes. But economistshave long realized that this is mainly a sort of statistical optical illusion. In any one year, the class of people withhigh incomes includes a number of people who are doing better than usual and saving for a rainy day, while theclass of people with low incomes includes a number of people who are doing worse than usual and drawing downtheir savings from the past. But when peoples' normal or typical (or, in the jargon of economists, "permanent")income rises, as it does as the economy grows, their spending grows right along with it. In short, it is hard to see anyjustification at all for the belief that consumer demand in advanced countries cannot keep up with growing capacity.

The Third World

It is when we come to the role of newly industrializing economies that emotions and confusion run highest. Perhapsthe best way to sort things through is to present the story as a Panglossian conventional economist might tell it; seehow the global glut advocates differ from that story; and look at the relevant facts.

The agreed starting point is that there has been a rapid increase in the productivity of labor in some developingcountries. This means that hundreds of millions of workers who were previously of little account in the globaleconomy are now an important productive resource, adding to the world's productive capacity.

The conventional economist sees no problem in this development. To be sure, the world's productive capacity isincreased; but higher productivity will also mean higher incomes. And since one can hardly claim that consumersare already saturated in such poor nations, demand will increase along with supply. The newly industrializingeconomies will in general, says conventional theory, spend about as much as they earn - or, what is the same thing,import as much as they export.

Actually, a conventional economist might well predict that emerging economies will in general run trade deficits.After all, one might expect these economies to attract inflows of investment from abroad. And a country whichattracts a net inflow of capital must, by definition, be a country where domestic investment exceeds domesticsavings, and therefore where spending exceeds income - that is, a country that runs a trade deficit (or more preciselya deficit on the current account, which includes services and the income from past investments).


But how can this be? Won't countries that have very low wage rates be extremely cost-competitive, and thereforerun trade surpluses? Well, the conventional economist has a pat answer for that too: wages will rise in line withproductivity, so that these countries won't be all that cost-competitive after all.

To believers in an emerging global glut, this all seems naively optimistic. A representative statement of theirposition came in Alan Tonelson's recent review [NYT Book Review, June 15] of Jeffrey Garten's The Big Ten: TheBig Emerging Markets and How They Will Change Our Lives. Tonelson asserts that "consumer markets in theseemerging markets are likely to stay small for decades ... Two reasons stand out. First, largely because most of thesecountries have huge foreign debts to pay off, and therefore need to discourage consumption by their populations,they are pursuing export-led growth strategies. Second, if they don't keep wages and purchasing power low, theywill have difficulty attracting the foreign investment they require, both to service debt and to finance growth.” Inshort, emerging economies will not add nearly as much to global demand as they do to global supply.

This seems clear enough. Yet if one rereads Tonelson's remarks, or similar passages in Greider, and also does someresearch - say, by buying a copy of The Economist on the newsstand, and opening to the "emerging marketindicators" on the last page - one receives a bit of a shock. Tonelson seems to believe that newly industrializingeconomies are currently engaged in "export-led" growth - that is, that they are selling much more to advancedcountries than they buy in return - and that it is naive to expect this to change. Presumably, then, he believes thatthese economies are currently running large trade surpluses. Table 1, however, shows the actual trade and currentaccount balances of Garten's "big ten": six are currently running trade deficits - as is the group as a whole - and allbut one are running current account deficits. More broadly, of the 25 emerging markets covered in The Economist,17 are running trade deficits, 20 current account deficits. This is export-led growth?

Table 1: Trade and current balances in the "Big Ten" ($billion)Trade balance Current account

Argentina -0.9 -4.0Brazil -10.3 -27.8China 23.6 1.6India -5.0 -5.1Indonesia 7.1 -7.8Mexico -2.1 -4.3Poland -9.8 -3.1South Africa 1.9 -2.0South Korea -22.3 -25.9Turkey -18.4 -4.4

Let me put it this way: if you read what the global glut advocates have to say, you might have the impression thatright now the newly industrializing countries are running huge trade surpluses, and that it is merely a dubioustheoretical prediction that at some future date they will begin to import as much as they export. But the truth is justthe opposite: right now the emerging economies as a group run trade deficits, and it is merely a speculativeprediction on the part of the global glutters that at some future date they will start to run large trade surpluses. (Andit is a speculative prediction that seems to have some conceptual problems too. Notice that Tonelson appears to saythat these countries will run large surpluses because they must keep wages low to attract foreign investment. Heseems unaware that a country that attracts a net inflow of foreign investment must, as a matter of sheer accounting,run a current account deficit).

There is a similar inversion of the real relationship between fact and hypothesis when we turn to the behavior ofwages in newly industrializing economies. If you read the global glut writers, you might have the impression thatthus far wages in emerging economies have failed to rise along with productivity, and that assertions that they willrise in future are purely optimistic speculation. In fact, however, those developing economies that have had rapidproductivity growth in past decades have also, without exception, had rapid increases in wages. Japan, one shouldnot forget, was once a low-wage country, and as late as the early 1970s many Western critics accused it ofdeliberately keeping wages low in order to foster a trade surplus. Today its hourly compensation in manufacturing ishigher than that in the United States. And as Table 2 shows, the original four "tiger" economies have experiencedhuge wage increases over the past two decades. In other words, the experience to date is that wages do in fact rise


along with productivity, and it is the assertion by global glutters that they will not do so in the future that is purelyspeculation.

Table 2: Wages in the Asian "tigers" (hourly compensation as % of US)1975 1995

Hong Kong 12 28Singapore 13 43South Korea 5 43Taiwan 6 34

All this is fairly puzzling. The advocates of the global glut doctrine see themselves as being realistic in a way thatconventional economists are not; they see themselves as rejecting an abstract theoretical framework that givesexcessively optimistic assurances in favor of a clear-eyed view of the world as it really is. Yet the actual facts bearout the supposedly naive views of conventional economists quite well, while the global glutters turn out to bespeculative theorists who assert, based on no evidence, that the future will be entirely different from the past andpresent. There must, then, be something peculiarly compelling about the idea of a global glut - so compelling that itpersuades intelligent men not just to reject conventional economics but to overlook inconvenient facts. What is thesource of the doctrine's persuasiveness?

A FAILURE OF IMAGINATION

There are probably many readers who, despite the previous discussion, still find it hard to shake the notion that thereis now or soon will be a massive global oversupply of goods. After all, world productive capacity is increasingsteadily - even if not quite as rapidly as some accounts would have it - and it is hard to imagine how all that capacitycan be used. That, I believe, is at the heart of the global glut doctrine's gut appeal: it is hard to imagine what a muchmore productive world economy will look like. The important thing to recognize is that the deficiency is in ourimaginations, not in the real economy, which will have no trouble at all using that capacity.

The misconceptions that make the idea of a global glut seem plausible probably begin with a fallacy of composition.If you look at individual industries in isolation, both productivity growth and globalization can easily seem to bejob-destroying forces. The U.S. steel industry has experienced a dramatic rise in output per worker since 1980; theresult has been a sharp drop in the number of steelworkers. Many developing countries have become exporters ofclothing; the result has been a decline in advanced-country garment industries. So won't the further rise inproductivity throughout the economy, the further industrialization of the Third World, mean job losses throughoutthe economy?

What this kind of reasoning misses is the indirect effects of these changes. Productivity gains in steel may reduce thenumber of jobs in steel, but they create jobs elsewhere (if only by lowering the price of steel, and therefore releasingmoney to be spent on other things); advanced countries may lose garment industry jobs to developing-countryexports, but they gain other jobs producing the goods that those countries buy with their new export income. Toobserve that productivity growth in a particular industry reduces employment in that same industry tells us nothingabout whether productivity growth in the economy as a whole reduces employment in the economy as a whole. Aslong as consumers find a way to spend the increased income that is generated by economic growth, there is noreason for such growth to lead to any inadequacy of demand. And all the evidence suggests that people will findsomething to buy with whatever income they have.

But what, exactly, will they buy? That is a natural question, but an unfair one. Suppose that you had approached aneconomist in, say, 1840 - a time when most Americans were farmers, and textiles dominated the still-smallmanufacturing sector - and informed him that 150 years later some 2 percent of the labor force could grow all of thefood, and less than 1 percent produce all the cloth. And suppose you had demanded that he explain what everyoneelse would do for a living. He could not have given a very good answer; but he could with justice have argued thaton general principles the economy would find something useful for them to do. (Global glut advocates tend to focusin particular on the loss of jobs in manufacturing, and find it hard to imagine that the service sector could make upfor that loss. Yet we have already seen how it can be done, since the U.S. economy is already overwhelmingly a


service, rather than goods, economy. As a Russian émigré neighbor of mine once put it, "I don't understand thiscountry: it seems very prosperous, but I don't ever see anybody making anything".)

A somewhat different failure of the imagination applies to the populations of the newly industrializing economies.Here it is obvious what consumers will demand: they will want the same sorts of things that people in advancedcountries already have. What seems hard for people to visualize is a world in which Chinese and Indonesiansactually earn decent wages. After all, they have always been poor - and as one distinguished diplomat, journalist,and author said to me, "I can't see how their wages can rise, no matter how productive they become - there are justso many of them". But one cannot argue that an increase in the productivity of Chinese workers is a massive shockto the world economy, because they are so numerous, and at the same time argue that it is too small a force to raisethe wages of so many people. Again, the deficiency is in our imaginations, not in the real world.

Finally, lurking behind the global glut argument may be a very old fallacy about the relationship betweenconsumption and investment. One thing capitalistic economies do is to accumulate capital. That is, not all of theirproductive capacity is used to produce consumption goods; some of it is used to produce capital goods that willexpand future productive capacity. But then not all of that future productive capacity will be used to satisfyconsumers - some of it will be used to expand capacity even more, and so on. Now it is very easy, if one puts it thatway, to start to think of the whole thing as a sort of chain letter or Ponzi game: surely, you may imagine, at somepoint this business of building machines to build machines must come to an end, with disastrous results. (Somethinglike this seems to be what Greider has in mind when he talks of the "manic logic" of capitalism). But in fact - aseven Karl Marx could have told you - there is nothing wrong or unsustainable about an ever-growing capital stock inan ever-growing economy. It has worked for the last 50 years, and there is no obvious end in sight.

TILTING AT WINDMILLS

None of the preceding should be taken as a declaration that all is right with the world economy. There are severereal problems: inequality in the United States (exacerbated though not caused by imports of labor-intensiveproducts), unemployment in Europe (also slightly exacerbated by labor-intensive imports, but mainly due to rigidlabor markets and bad macroeconomic policy), a Japanese economy struggling to overcome the consequences of aburst financial bubble, a number of newly industrializing countries facing potential crises due to financial excessesand lax banking regulation, and so on. On the whole, the condition of humanity - as measured by such raw, crude,but crucial indicators as life expectancy and child malnutrition - is far better now than it was 20 years ago, largelybecause of economic growth in the Third World; but there are many shadows in the picture. One problem capitalismdoes not suffer from, however, is being too productive for its own good.

Imagining problems that do not really exist has real costs. To speak to European advocates of the global glut theoryis to be struck by their fatalism: they really seem to have given up on the idea of actually making the Europeaneconomy grow. And this fatalism already seems, at the time of writing, to have left the new Jospin administration inFrance almost completely ineffectual. Meanwhile, American global glutters seem to spend half their timecomplaining that nothing good can be done unless the country gives up the idea of a balanced budget, the other halfconverting their doctrine into a new justification for good old-fashioned protectionism.

It is a bit funny, but also quite sad: Those who preach the doctrine of global glut are tilting at windmills, when thereare some real monsters out there that need slaying.


Capitalism’s Mysterious Triumph

Paul Krugman

Recently my local public television station has been showing a fascinating series entitled "Russia's War" - a history,produced in Russia, of the Soviet Union's struggle in World War II. It is not a pretty story: the producers do nothesitate to tell the full story of Stalin's brutality, and they do not try to mask the ugliness of war with patrioticromanticism. Yet this stark honesty in a way makes the account of the Soviet Union's wartime achievement all themore impressive. The Soviet Union did not win through military genius: most of its trained officers had been purgedin political witch-hunts, and while the war eventually threw up a new set of leaders, they were competent rather thanbrilliant - and their advice was often overruled by a dictator whose military judgement was usually disastrous.Russian soldiers fought with dogged heroism - but then so did the Germans. Why did the Russians prevail?

The answer is surprising, given the way the 20th century has actually turned out. The Soviet triumph in World WarII was, above all, a victory of production. Despite huge losses in the first months of the war, despite massdislocations of population and the German occupation of many of the country's key manufacturing centers, Sovietindustry managed to build tanks, artillery, and aircraft that were technologically a match for Germany's weapons,and to do so at a rate that consistently exceeded anything their opponents thought was possible. Indeed, the decisiveGerman defeats at Stalingrad and Kursk came about precisely because the Germans launched offensives againstwhat they imagined to be a weaker opponent, and were taken by surprise when counterattacked by thousands oftanks whose existence they had never suspected.

What does this have to do with the world of 1997? Well, nowadays we take the triumph of capitalism as somethingpreordained by the superiority of our economic system. After all, it now seems obvious to everyone except NorthKorea and Cuba that a market economy is vastly more productive than one controlled from the center - and theCuban economy is imploding, while the North Koreans are quite literally starving to death. Moreover, every time aCommunist regime collapses, it turns out that the actual state of the economy it governed was far worse than anyonehad imagined. For example, typical estimates of the GDP of East Germany before the old regime collapsed put itsreal GDP per capita at 70 or 80 percent of the West German level - meaning that East Germany was actually richerthan some regions in the West. Yet after the fall of the Berlin Wall, visiting Westerners found something that lookedlike a Third World economy, with antiquated factories (and disastrous environmental problems) producingconsumer goods of ludicrously low quality (like the notorious East German Trabant, an automobile that makes aHonda or Ford seem like a Mercedes). We used to think that the Soviet Union had an economy about half as large asAmerica's, that is, bigger than Japan's; nowadays Russia seems to have less economic power than, say, Italy. Weused to think that there was a real technological race between socialism and capitalism; nowadays the symbol ofRussian technology is the hapless Mir space station. It seems obvious to many people in retrospect that theproductive and technological triumphs that Communists used to claim - all those heroic photographs of dams andposters of muscular steelworkers - were mere propaganda; in reality, we think we have learned, socialism is asystem that just can't deliver the goods, while capitalism is a system that can.

But one lesson of "Russia's War" is that matters are not that simple. Were the supposed productive triumphs of theSoviet Union under Stalin merely a hoax? Tell that to the soldiers of Germany's Army Group Center - the few whosurvived. The fact is that Stalin did transform Russia into a massive industrial power - a power tested in the mostunambiguous way imaginable. And his successors did achieve real technological triumphs - not just showy triumphslike sending cosmonauts into orbit, but the creation of a highly sophisticated scientific and engineeringestablishment. True, Russia was never any good at producing high-quality consumer goods. But it was not alwaysthe bumbling, incompetent system we now imagine. What this means is that the collapse of Communism and thetriumph of capitalism need more of an explanation than the stories we usually hear. It is not enough to explain all thereasons why a market economy is more efficient than a centrally planned one. Those explanations are basically right


- but the question is why a system that functioned well enough to compete with capitalism in the 1940s and 50s fellapart in the 1980s. What went wrong?

One possible answer is that changing technology changed the rules. When the communist leader JosephDzhugashvili changed his name to Stalin - "man of steel" - he reflected the times in which he lived, an era in whichheavy industry ruled, in which giant steel plants were the symbol of progress. These days, of course, steel-producingregions throughout the world - not just in the old Soviet Union - are depressed; try visiting southeastern Belgium.And it's not just steel: the age when countries or companies grew rich by making heavy products in big factoriesseems to have passed. One can make a case that whereas old-fashioned heavy industry was susceptible to centralplanning, new technologies, especially in microelectronics, favor free-wheeling competition over centralizedcontrol. Russia could at least appear to hold its own in a technological race defined by the ability to build giantrockets; it was left completely flatfooted when the West started putting powerful computers on a chip. In fact, in thelast few years even Japan's great corporations have started to look a bit like dinosaurs, lumbering helplessly inpursuit of the little startups of Silicon Valley.

Another possible answer is that capitalism triumphed because of "globalization" - a process everyone talks about butwhich we really don't fully understand. For some reason - perhaps some synergistic interaction among decliningtariffs, cheaper transportation, and better communications - it has become possible in the last generation for manycountries to industrialize rapidly, not through massive programs of government-led investment, but simply bythrowing themselves open to the world market and letting events take their course. Socialist economies could notavail themselves of this new opportunity, and so they began to fall behind instead of catching up.

But neither technological change nor globalization can explain the fact that socialist economies did not merely lagthe West: they actually went into decline, and then collapse. Why couldn't they at least hold on to what they had?

I don't think anyone really knows the answer, but let me make a conjecture: the basic problem was not technical, butmoral. Communism failed as an economic system because people stopped believing in it, not the other way around.

A market system, of course, works whether people believe in it or not. You may dislike capitalism, even feel that asa system it will eventually fail, yet do your job well because your family needs the money you earn. Capitalism canrun, even flourish, in a society of selfish cynics. But a non-market economy cannot. The personal incentives forworkers to do their jobs well, for managers to make good decisions, are simply too weak. In the later years of theSoviet Union, workers knew that they would be paid regardless of how hard they tried; managers knew thatpromotions would depend more on political connections than on performance; and nobody was offered rewardslarge enough to justify taking unpopular positions or any sort of serious risk. (There can't have been more than a fewdozen people in the Soviet Union - all of them politicians - who had the kind of lavish life style enjoyed by tens ofthousands of successful entrepreneurs and executives in the United States). So why did the system ever work?Because people believed in it. I don't mean that people went singing to their jobs, praising the motherland. I do meanthat they did not take as much advantage of the system as they might have (and did, in the system's later years). AndI also mean that because people in authority believed in the system, they were willing to impose brutal punishmentson those who did try to take advantage. (Stalin used to shoot unsuccessful generals).

We see this kind of thing all the time, in microcosm. The market does not require people to believe in it; but thecentrally planned economies that live inside a market economy, known as corporations, do. Everybody knows thatfinancial incentives alone are not enough to make a company succeed; it must also build morale, a sense of mission,which makes people work at least somewhat for the good of the company rather than think only of what is good forthem. Luckily, under capitalism an individual company can fail without taking the whole society down with it - or itcan be reformed without a bloody revolution.

Why did people stop believing in socialism? Part of the answer is simply the passage of time: you can't expectrevolutionary fervor to last for 70 years. But perhaps also the unexpected resurgence of capitalism played a role. Bythe 1980s Russia's elite was all too aware that the country, instead of overtaking the capitalist nations, was slippingbehind - that Russia was failing to take advantage of new technology, that if anyone was challenging the West it wasthe rising nations of Asia. Communism lost any claim to the mandate of history well before it actually fell apart, andperhaps that is why it fell apart.


In the end, then, capitalism triumphed because it is a system that is robust to cynicism, that assumes that each man isout for himself. For much of the past century and a half men have dreamed of something better, of an economy thatdrew on man's better nature. But dreams, it turns out, can't keep a system going over the long term; selfishness can.


Soft Microeconomics:The squishy case against you-know-who.

Paul Krugman(posted on Slate – The Dismal Science Thursday, April 23)

I wrote this piece in WordPerfect, not Word, mainly because Word’s equation editor is awful (are you listening, Mr.Myhrvold?), and I may as well use the same software for plain English articles and professional gobbledygook. Isurf with Netscape Navigator and check e-mail in Eudora. So, I am not a fan of Microsoft’s products. Moreover, forreasons explained below, it is in the public interest to have Bill Gates always running a bit scared of the JusticeDepartment. Nonetheless, the more anti-MS propaganda I read, the more pro-MS I get. There is a case againstMicrosoft, but it is not the one you hear, and I would hate to see crude misunderstandings posing as sophisticatedanalysis prevail.

Probably the first thing one ought to say is that the public has no interest in helping Bill Gates’ rivals for their ownsake. It’s easy to think of the people who run software companies other than Microsoft as underdogs fighting BigBad Bill. But those “little” guys are no more in need of extra money than Gates is, and if allowing him to get anextra billion at Larry Ellison’s—or even Marc Andreesen’s—expense is good for the rest of us, so be it. Those of uswho do not get paid in software stock options should not allow ourselves to become pawns, either way, in strugglesamong those who do.

So what is the public interest?

The case for leaving Microsoft alone does not rest on some naive faith in the perfection of free markets. Software isan industry characterized by powerful increasing returns in both production and consumption: The more unitsNetscape ships, the lower its per unit cost; the more copies of Navigator in use, the more attractive it is to the typicaluser. These increasing returns make the kind of atomistic, “perfect” competition that prevails in the market for, say,wheat impossible in the market for browsers or word processors. Necessarily, each type of product will in the end beproduced by only a few companies, perhaps only one.

But how does this concentration of production take place? One of the depressing things about public discussion ofthe Microsoft case, even among supposedly well-informed people, is that much of it has come to be dominated by abasically primitive view about what increasing returns do to markets—namely, that they convey monopoly powerpurely randomly, on whoever happens to be in the right place at the right time—and that this “path dependence”allows clearly inferior technologies to become “locked in.” Now path dependence has its place—but when applied tothe Microsoft case it misses the point. After all, high-technology companies are themselves quite aware ofincreasing returns, and their strategies—above all the prices they charge when they are trying to establish themselvesin a market—are very much affected by that awareness.

Consider, for example, one particular form of increasing returns: The so-called “learning curve,” which says themore units of something you have already produced, the lower the cost of producing the next one. You might thinkthis means that whoever gets into a market first will simply have a snowballing advantage. But as Stanford’sMichael Spence pointed out in a classic, 20-year-old paper on this subject, profit-maximizing companies that knowthey face a learning curve will compete fiercely to move down it more rapidly, selling cheaply in the early stages ofa product cycle (and therefore losing money) in the hope of making the money back later.

The same logic applies to increasing returns on the demand side: As a manufacturer, if I know that a typicalcustomer’s choice of browser depends both on the price and on the number of other people using that browser, I will


initially make my own browser cheap—maybe even free—so as to build market share. In either case I must incurinitial losses that are, in effect, part of the price of entry into the market—an add-on to the cost of developing aproduct in the first place. And because nobody will want to pay this entry fee without a reasonable hope of earning itback, only a few companies will enter a market subject to strong increasing returns. The point is that the eventualdomination of an industry by a few companies—and a high rate of profit on sales for these companies in the laterstages of the cycle—doesn’t happen because these companies just happened to get a head start. On the contrary, it isprecisely because it isn’t purely a matter of luck—because everyone competes so fiercely on prices in an effort toget some of those nice increasing returns—that only a few dare enter.

Of course, there is also an element of luck. It’s not true that whoever gets a head start always dominates themarket—if a company has a small head start but offers a clearly inferior product or has clearly higher costs, rivalscan and will overtake it. But nobody can be sure just what an as-yet undeveloped product will cost to produce, orhow it will go over with consumers. Thus, competition in a market characterized by increasing returns is—as it mustbe—a sort of demolition derby in which only some of those who enter cross the finish line. Those who do make itacross the finish line will typically make big profits. But this profitability is necessary to the enterprise. Who willenter a demolition derby without the incentive of a prize?

So this is the case for leaving Microsoft alone: High-tech competition is, necessarily, a competition that ends upbeing won by a handful of players. Those who make vast fortunes may not always be the most deserving—but sowhat? For the rest of us, what matters is not who wins or loses, but how they play the game. And if they know orsuspect that too much success will be punished—that anyone who does too well will become a target of envy-drivenlitigation—they will have that much less incentive to play hard.

Now there is, of course, also a case against Microsoft. Never mind the crude complaint that it is too big, or tooprofitable, or that nerdy types tend to dislike its products. The real concern is that because Microsoft’s victory in anearlier derby happens to have given it control over a particularly strategic part of the industry—because it suppliesoperating systems—it is in a position to squeeze out rival suppliers of other software. And that is a real concern: IfMicrosoft had, for example, written Windows 95 in a way that made it hard or even impossible for me to useWordPerfect, the Justice Department would have been absolutely justified in calling out the arsonists.

But the fact is that MS has been very careful not to use its undoubted power to practice any crude, obvious versionof what is known in the trade as “vertical foreclosure.” WordPerfect and Netscape work just fine on my Windows-based machine. This restraint may partly reflect Microsoft’s market strategy—after all, Microsoft beat Apple partlybecause Apple did practice vertical foreclosure, and as a result inhibited the development of complementarysoftware (although the main problem was Apple’s persistent belief, despite all the evidence to the contrary, thateveryone would be willing to pay a premium price for a niftier machine). For sure, however, Microsoft has mainlybeen restrained by the knowledge that any crude use of its power would indeed land it in court.

And yet, despite all that restraint, Microsoft is in court anyway. Any nontechnologist ventures into the browser warsat his peril, but here is how I understand it: After initially missing the significance of the Internet, Microsoft hasgone to the other extreme, designing Windows 95 so that it uses an Internetlike metaphor for everything. It makessense, then, for a browser that can find both internal and external documents to be an integral part of the system—unless, that is, you regard browsers and operating systems as still basically different things, and view Microsoft aspracticing vertical foreclosure under the guise of product enhancement. Well, maybe—but it’s a pretty subtle point.Microsoft isn’t preventing anyone from using Netscape or charging Netscape for the right of access; it’s providingInternet Explorer free, but then that would be normal practice in this kind of industry even if IE wasn’t allegedly anintegral part of Windows 95. You can argue that Microsoft has stepped across the line on this one—but surely byonly a few inches.

Here’s what worries me: Given the subtlety of the real issues here, what is the chance that this stuff will be decidedon its merits? When you hear that despite the fact that he has economists who know better, the Justice Department’sJoel Klein apparently either believes or chooses to claim that this case is about path dependence, you start towonder. And when you hear that the anti-Microsoft side has retained the services of that economic and technologyexpert Bob Dole, you start to despair.


Links

An article in the Feb. 25 Wall Street Journal (“QWERTY Spells a Saga of Market Economics”) is a good exampleof the mistaken view that path dependence is the core of the case against Microsoft. Nicholas Economides, whoreally understands these things, took the Wall Street Journal to task in a letter that it, of course, did not print. Hisuseful site also contains a good, slightly anti-MS discussion of the vertical foreclosure issue on browsers as well as aset of links to just about everything relevant to the case.

Paul Krugman is a professor of economics at MIT. His new book, The Accidental Theorist and Other DispatchesFrom the Dismal Science, will be published this month. His home page contains links to many of his other articlesand essays.


In Praise of Cheap LaborBad jobs at bad wages are better than no jobs at all.

Paul KrugmanSlate – The Dismal Science(1,669 words; posted Thursday, March 20; to be composted Thursday, March 27)

For many years a huge Manila garbage dump known as Smokey Mountainwas a favorite media symbol of Third World poverty. Several thousandmen, women, and children lived on that dump--enduring the stench, theflies, and the toxic waste in order to make a living combing the garbage forscrap metal and other recyclables. And they lived there voluntarily, becausethe $10 or so a squatter family could clear in a day was better than thealternatives.

The squatters are gone now, forcibly removed by Philippine police last year as a cosmeticmove in advance of a Pacific Rim summit. But I found myself thinking about SmokeyMountain recently, after reading my latest batch of hate mail.

The occasion was an op-ed piece I had written for the New York Times, in which I hadpointed out that while wages and working conditions in the new export industries of theThird World are appalling, they are a big improvement over the "previous, less visiblerural poverty." I guess I should have expected that this comment would generate lettersalong the lines of, "Well, if you lose your comfortable position as an American professoryou can always find another job--as long as you are 12 years old and willing to work for40 cents an hour."

Such moral outrage is common among the opponents of globalization--of the transfer oftechnology and capital from high-wage to low-wage countries and the resulting growth oflabor-intensive Third World exports. These critics take it as a given that anyone with agood word for this process is naive or corrupt and, in either case, a de facto agent of globalcapital in its oppression of workers here and abroad.

But matters are not that simple, and the moral lines are not that clear. In fact, let me makea counter-accusation: The lofty moral tone of the opponents of globalization is possible only because they havechosen not to think their position through. While fat-cat capitalists might benefit from globalization, the biggestbeneficiaries are, yes, Third World workers.

After all, global poverty is not something recently invented for the benefit of multinational corporations. Let's turnthe clock back to the Third World as it was only two decades ago (and still is, in many countries). In those days,although the rapid economic growth of a handful of small Asian nations had started to attract attention, developingcountries like Indonesia or Bangladesh were still mainly what they had always been: exporters of raw materials,importers of manufactures. Inefficient manufacturing sectors served their domestic markets, sheltered behind importquotas, but generated few jobs. Meanwhile, population pressure pushed desperate peasants into cultivating evermore marginal land or seeking a livelihood in any way possible--such as homesteading on a mountain of garbage.


Given this lack of other opportunities, you could hire workers inJakarta or Manila for a pittance. But in the mid-'70s, cheap laborwas not enough to allow a developing country to compete in worldmarkets for manufactured goods. The entrenched advantages ofadvanced nations--their infrastructure and technical know-how, thevastly larger size of their markets and their proximity to suppliersof key components, their political stability and the subtle-but-crucial social adaptations that are necessary to operate an efficienteconomy--seemed to outweigh even a tenfold or twentyfolddisparity in wage rates.

And then something changed. Some combination of factors that westill don't fully understand--lower tariff barriers, improvedtelecommunications, cheaper air transport--reduced thedisadvantages of producing in developing countries. (Other thingsbeing the same, it is still better to produce in the First World--stories of companies that moved production to Mexico or EastAsia, then moved back after experiencing the disadvantages of theThird World environment, are common.) In a substantial number ofindustries, low wages allowed developing countries to break into world markets. And so countries that hadpreviously made a living selling jute or coffee started producing shirts and sneakers instead.

Workers in those shirt and sneaker factories are, inevitably, paid very little and expected to endure terrible workingconditions. I say "inevitably" because their employers are not in business for their (or their workers') health; theypay as little as possible, and that minimum is determined by the other opportunities available to workers. And theseare still extremely poor countries, where living on a garbage heap is attractive compared with the alternatives.

And yet, wherever the new export industries have grown, there has been measurable improvement in the lives ofordinary people. Partly this is because a growing industry must offer a somewhat higher wage than workers couldget elsewhere in order to get them to move. More importantly, however, the growth of manufacturing--and of thepenumbra of other jobs that the new export sector creates--has a ripple effect throughout the economy. The pressureon the land becomes less intense, so rural wages rise; the pool of unemployed urban dwellers always anxious forwork shrinks, so factories start to compete with each other for workers, and urban wages also begin to rise. Wherethe process has gone on long enough--say, in South Korea or Taiwan--average wages start to approach what anAmerican teen-ager can earn at McDonald's. And eventually people are no longer eager to live on garbage dumps.(Smokey Mountain persisted because the Philippines, until recently, did not share in the export-led growth of itsneighbors. Jobs that pay better than scavenging are still few and far between.)

The benefits of export-led economic growth to the mass of people in the newly industrializing economies are not amatter of conjecture. A country like Indonesia is still so poor that progress can be measured in terms of how muchthe average person gets to eat; since 1970, per capita intake has risen from less than 2,100 to more than 2,800calories a day. A shocking one-third of young children are still malnourished--but in 1975, the fraction was morethan half. Similar improvements can be seen throughout the Pacific Rim, and even in places like Bangladesh. Theseimprovements have not taken place because well-meaning people in the West have done anything to help--foreignaid, never large, has lately shrunk to virtually nothing. Nor is it the result of the benign policies of nationalgovernments, which are as callous and corrupt as ever. It is the indirect and unintended result of the actions ofsoulless multinationals and rapacious local entrepreneurs, whose only concern was to take advantage of the profitopportunities offered by cheap labor. It is not an edifying spectacle; but no matter how base the motives of thoseinvolved, the result has been to move hundreds of millions of people from abject poverty to something still awfulbut nonetheless significantly better.

Why, then, the outrage of my correspondents? Why does the image of an Indonesian sewing sneakers for 60 cents anhour evoke so much more feeling than the image of another Indonesian earning the equivalent of 30 cents an hourtrying to feed his family on a tiny plot of land--or of a Filipino scavenging on a garbage heap?


The main answer, I think, is a sort of fastidiousness. Unlike the starving subsistence farmer, the women and childrenin the sneaker factory are working at slave wages for our benefit--and this makes us feel unclean. And so there areself-righteous demands for international labor standards: We should not, the opponents of globalization insist, bewilling to buy those sneakers and shirts unless the people who make them receive decent wages and work underdecent conditions.

This sounds only fair--but is it? Let's think through the consequences.

First of all, even if we could assure the workers in Third World export industries of higher wages and better workingconditions, this would do nothing for the peasants, day laborers, scavengers, and so on who make up the bulk ofthese countries' populations. At best, forcing developing countries to adhere to our labor standards would create aprivileged labor aristocracy, leaving the poor majority no better off.

And it might not even do that. The advantages of established First World industries are still formidable. The onlyreason developing countries have been able to compete with those industries is their ability to offer employers cheaplabor. Deny them that ability, and you might well deny them the prospect of continuing industrial growth, evenreverse the growth that has been achieved. And since export-oriented growth, for all its injustice, has been a hugeboon for the workers in those nations, anything that curtails that growth is very much against their interests. A policyof good jobs in principle, but no jobs in practice, might assuage our consciences, but it is no favor to its allegedbeneficiaries.

You may say that the wretched of the earth should not be forced to serve as hewers of wood, drawers of water, andsewers of sneakers for the affluent. But what is the alternative? Should they be helped with foreign aid? Maybe--although the historical record of regions like southern Italy suggests that such aid has a tendency to promoteperpetual dependence. Anyway, there isn't the slightest prospect of significant aid materializing. Should their owngovernments provide more social justice? Of course--but they won't, or at least not because we tell them to. And aslong as you have no realistic alternative to industrialization based on low wages, to oppose it means that you arewilling to deny desperately poor people the best chance they have of progress for the sake of what amounts to anaesthetic standard--that is, the fact that you don't like the idea of workers being paid a pittance to supply richWesterners with fashion items.

In short, my correspondents are not entitled to their self-righteousness. They have not thought the matter through.And when the hopes of hundreds of millions are at stake, thinking things through is not just good intellectualpractice. It is a moral duty.

Links

To get a taste of moral outrage against globalization, turn to Corporate Watch, a site dedicated to exposing the"greed" of transnational giants. Or, for a bizarre twist, check out Sweat Gear, a satirical online catalog that attackssweatshops in Central America. Another argument against globalization--that it threatens democracy--is made byBenjamin Barber in the Atlantic. The Clinton administration's word on the subject can be found in a speech by LaborSecretary Robert Reich to the International Labor Organization urging better compliance with core labor standards.For more on Paul Krugman, see a Newsweek profile that dubs him "The Great Debunker." And information onemployment at McDonald's can be found on the Web site of Hamburger U, their worldwide management-trainingcenter.

Paul Krugman is a professor of economics at MIT whose books include The Age of Diminished Expectations andPeddling Prosperity.

Illustrations by Robert Neubecker.


The spiral of inequality

If calling America a middle-class nation means anything, it means that we are a society in which most people livemore or less the same kind of life. In 1970 we were that kind of society. Today we are not, and we become less likeone with each passing year.

Paul Krugman

Ever since the election of Ronald Reagan, right-wing radicals have insisted that they started a revolution in America.They are half right. If by a revolution we mean a change in politics, economics, and society that is so large as totransform the character of the nation, then there is indeed a revolution in progress. The radical right did not makethis revolution, although it has done its best to help it along. If anything, we might say that the revolution created thenew right. But whatever the cause, it has become urgent that we appreciate the depth and significance of this newAmerican revolution—and try to stop it before it becomes irreversible.

The consequences of the revolution are obvious in cities across the nation. Since I know the area well, let me takeyou on a walk down University Avenue in Palo Alto, California.

Palo Alto is the de facto village green of Silicon Valley, a tree-lined refuge from the valley’s freeways and shoppingmalls. People want to live here despite the cost—rumor has it that a modest three-bedroom house sold recently for$1.6 million—and walking along University you can see why. Attractive, casually dressed people stroll past trendyboutiques and restaurants; you can see a cooking class in progress at the fancy new kitchenware store. It’s a cheerfulscene, even if you have to detour around the people sleeping in doorways and have to avoid eye contact with thebeggars. (The town council plans to crack down on street people, so they probably won’t be here next year,anyway.)

If you tire of the shopping district and want to wander further afield, you might continue down University Avenue,past the houses with their well-tended lawns and flower beds—usually there are a couple of pickup trucks full ofHispanic gardeners in sight. But don’t wander too far. When University crosses Highway 101, it enters the grimenvirons of East Palo Alto. Though it has progressed in the past few years, as recently as 1992 East Palo Alto wasthe murder capital of the nation and had an unemployment rate hovering around 40 percent. Luckily, near theboundary, where there is a cluster of liquor stores and check-cashing outlets, you can find two or three policecruisers keeping an eye on the scene—and, not incidentally, serving as a thin blue line protecting the niceneighborhood behind them.

Nor do you want to head down 101 to the south, to “Dilbert Country” with its ranks of low-rise apartments, thetenements of the modern proletariat—the places from which hordes of lower-level white-collar workers drive to sitin their cubicles by day and to which they return to watch their VCRs by night.

No. Better to head up into the hills. The “estates” brochure at Coldwell Banker real estate describes the mid-Peninsula as “an area of intense equestrian character,” and when you ascend to Woodside-Atherton, which the NewYork Times has recently called one of “America’s born-again Newports,” there are indeed plenty of horses, as wellas some pretty imposing houses. If you look hard enough, you might catch a glimpse of one of the new $10 million-plus mansions that are going up in growing numbers.


What few people realize is that this vast gap between the affluent few and the bulk of ordinary Americans is arelatively new fixture on our social landscape. People believe these scenes are nothing new, even that it is utopian toimagine it could be otherwise.

But it has not always been thus—at least not to the same extent. I didn’t see Palo Alto in 1970, but longtimeresidents report that it was a mixed town in which not only executives and speculators but schoolteachers, mailmen,and sheet-metal workers could afford to live. At the time, I lived on Long Island, not far from the old Great Gatsbyarea on the North Shore. Few of the great mansions were still private homes then (who could afford the servants?);they had been converted into junior colleges and nursing homes, or deeded to the state as historic monuments. LikePalo Alto, the towns contained a mix of occupations and education levels—no surprise, given that skilled blue-collarworkers often made as much as, or more than, white-collar middle managers.

Now, of course, Gatsby is back. New mansions, grander than the old, are rising by the score; keeping servants, itseems, is no longer a problem. A couple of years ago I had dinner with a group of New York investment bankers.After the business was concluded, the talk turned to their weekend homes in the Hamptons. Naively, I asked whetherthat wasn’t a long drive; after a moment of confused silence, the answer came back: “But the helicopter only takeshalf an hour.”

You can confirm what your eyes see, in Palo Alto or in any American community, with dozens of statistics. Themost straightforward are those on income shares supplied by the Bureau of the Census, whose statistics are amongthe most rigorously apolitical. In 1970, according to the bureau, the bottom 20 percent of U.S. families received only5.4 percent of the income, while the top 5 percent received 15.6 percent. By 1994, the bottom fifth had only 4.2percent, while the top 5 percent had increased its share to 20.1 percent. That means that in 1994, the average incomeamong the top 5 percent of families was more than 19 times that of the bottom 20 percent of families. In 1970, it hadbeen only about 11.5 times as much. (Incidentally, while the change in distribution is most visible at the top andbottom, families in the middle have also lost: The income share of the middle 20 percent of families has fallen from17.6 to 15.7 percent.) These are not abstract numbers. They are the statistical signature of a seismic shift in thecharacter of our society.

The American notion of what constitutes the middle class has always been a bit strange, because both people whoare quite poor and those who are objectively way up the scale tend to think of themselves as being in the middle. Butif calling America a middle-class nation means anything, it means that we are a society in which most people livemore or less the same kind of life.

In 1970 we were that kind of society. Today we are not, and we become less like one with each passing year. Aspoliticians compete over who really stands for middle-class values, what the public should be asking them is, Whatmiddle class? How can we have common “middle-class” values if whole segments of society live in vastly differenteconomic universes?

If this election was really about what the candidates claim, it would be devoted to two questions: Why has Americaceased to be a middle-class nation? And, more important, what can be done to make it a middle-class nation again?

The Sources of Inequality

Most economists who study wages and income in the United States agree about the radical increase in inequality—only the hired guns of the right still try to claim it is a statistical illusion. But not all agree about why it hashappened.

Imports from low-wage countries—a popular villain—are part of the story, but only a fraction of it. The numbersjust aren’t big enough. We invest billions in low-wage countries—but we invest trillions at home. What we spend onmanufactured goods from the Third World represents just 2 percent of our income. Even if we shut out imports fromlow-wage countries (cutting off the only source of hope for the people who work in those factories), most estimatessuggest it would raise the wages of low-skill workers here by only 1 or 2 percent.

Information technology is a more plausible villain. Technological advance doesn’t always favor elite workers, butsince 1970 there has been clear evidence of a general “skill bias” toward technological change. Companies began to


replace low-skill workers with smaller numbers of high-skill ones, and they continue to do so even though low-skillworkers have gotten cheaper and high-skill workers more expensive.

These forces, while easily measurable, don’t fully explain the disparity between the haves and the have-nots.Globalization and technology may explain why a college degree makes more difference now than it did 20 yearsago. But schoolteachers and corporate CEOs typically have about the same amount of formal education. Why, then,have teachers’ salaries remained flat while those of CEOs have increased fivefold? The impact of technology and offoreign trade do not answer why it is harder today for most people to make a living but easier for a few to make akilling. Something else is going on.

Values, Power, and Wages

In 1970 the CEO of a typical Fortune 500 corporation earned about 35 times as much as the average manufacturingemployee. It would have been unthinkable to pay him 150 times the average, as is now common, and downrightoutrageous to do so while announcing mass layoffs and cutting the real earnings of many of the company’s workers,especially those who were paid the least to start with. So how did the unthinkable become first thinkable, thendoable, and finally—if we believe the CEOs— unavoidable?

The answer is that values changed—not the middle-class values politicians keep talking about, but the kind of valuesthat helped to sustain the middle-class society we have lost.

Twenty-five years ago, prosperous companies could have paid their janitors minimum wage and still could havefound people to do the work. They didn’t, because it would have been bad for company morale. Then, as now, CEOswere in a position to arrange for very high salaries for themselves, whatever their performance, but corporate boardsrestrained such excesses, knowing that too great a disparity between the top man and the ordinary worker wouldcause problems. In short, though America was a society with large disparities between economic classes, it had anegalitarian ethic that limited those disparities. That ethic is gone.

One reason for the change is a sort of herd behavior: When most companies hesitated to pay huge salaries at the topand minimum wage at the bottom, any company that did so would have stood out as an example of greed; wheneveryone does it, the stigma disappears.

There is also the matter of power. In 1970 a company that appeared too greedy risked real trouble with otherpowerful forces in society. It would have had problems with its union if it had one, or faced the threat of unionorganizers if it didn’t. And its actions would have created difficulties with the government in a way that is nowunthinkable. (Can anyone imagine a current president confronting a major industry over price increases, the wayJohn F. Kennedy did the steel industry?)

Those restraining forces have largely disappeared. The union movement is a shadow of its former self, lucky to holdits ground in a defensive battle now and then. The idea that a company would be punished by the government forpaying its CEO too much and its workers too little is laughable today: since the election of Ronald Reagan the CEOwould more likely be invited to a White House dinner.

In brief, much of the polarization of American society can be explained in terms of power and politics. But why hasthe tide run so strongly in favor of the rich that it continues regardless of who is in the White House and whocontrols the Congress?

The Decline of Labor

The decline of the labor movement in the United States is both a major cause of growing inequality and anillustration of the larger process under way in our society. Unions now represent less than 12 percent of the privateworkforce, and their power has declined dramatically. In 1970 some 2.5 million workers participated in some formof labor stoppage; in 1993, fewer than 200,000 did. Because unions are rarely able or willing to strike, being a unionmember no longer carries much of a payoff in higher wages.


There are a number of reasons for the decline of organized labor: the shift from manufacturing to services and fromblue-collar to white-collar work, growing international competition, and deregulation. But these factors can’t explainthe extent or the suddenness of labor’s decline.

The best explanation seems to be that the union movement fell below critical mass. Unions are good for unions: In anation with a powerful labor movement, workers have a sense of solidarity, one union can support another during astrike, and politicians take union interests seriously. America’s union movement just got too small, and it imploded.

We should not idealize the unions. When they played a powerful role in America, they often did so to bad effect.Occasionally they were corrupt, often they extracted higher wages at the consumer’s expense, sometimes theyopposed new technologies and enforced inefficient practices. But unions helped keep us a middle-class society—notonly because they forced greater equality within companies, but because they provided a counterweight to the powerof wealthy individuals and corporations. The loss of that counterweight is clearly bad for society.

The point is that a major force that kept America a more or less unified society went into a tailspin. Our wholesociety is now well into a similar downward spiral, in which growing inequality creates the political and economicconditions that lead to even more inequality.

The Polarizing Spiral

Textbook political science predicts that in a two-party democracy like the United States, the parties will compete toserve the interests of the median voter—the voter in the middle, richer than half the voters but poorer than the otherhalf. And since ordinary workers are more likely to lose their jobs than strike it rich, the interests of the median votershould include protecting the poor. You might expect, then, the public to demand that government work against thegrowing divide by taxing the rich more heavily and by increasing benefits for lower-paid workers and theunemployed.

In fact, we have done just the opposite. Tax rates on the wealthy—even with Clinton’s modest increase of 1993 --are far lower now than in the 1960s. We have allowed public schools and other services that are crucial for middle-income families to deteriorate. Despite the recent increase, the minimum wage has fallen steadily compared withboth average wages and the cost of living. And programs for the poor have been savaged: Even before the recentbipartisan gutting of welfare, AFDC payments for a typical family had fallen by a third in real terms since the 1960s.

The reason why government policy has reinforced rather than opposed this growing inequality is obvious: Well-offpeople have disproportionate political weight. They are more likely to vote—the median voter has a much higherincome than the median family—and far more likely to provide the campaign contributions that are so essential in aTV age.

The political center of gravity in this country is therefore not at the median family, with its annual income of$40,000, but way up the scale. With decreasing voter participation and with the decline both of unions and oftraditional political machines, the focus of political attention is further up the income ladder than it has been forgenerations. So never mind what politicians say; political parties are competing to serve the interests of families nearthe 90th percentile or higher, families that mostly earn $100,000 or more per year.

Because the poles of our society have become so much more unequal, the interests of this political elite divergeincreasingly from those of the typical family. A family at the 95th percentile pays a lot more in taxes than a family atthe 50th, but it does not receive a correspondingly higher benefit from public services, such as education. The greaterthe income gap, the greater the disparity in interests. This translates, because of the clout of the elite, into a constantpressure for lower taxes and reduced public services.

Consider the issue of school vouchers. Many conservatives and even a few liberals are in favor of issuingeducational vouchers and allowing parents to choose among competing schools. Let’s leave aside the question ofwhat this might do to education and ask what its political implications might be.

Initially, we might imagine, the government would prohibit parents from “topping up” vouchers to buy higher-priced education. But once the program was established, conservatives would insist such a restriction is unfair,


maybe even unconstitutional, arguing that parents should have the freedom to spend their money as they wish. Thus,a voucher would become a ticket you could supplement freely. Upper-income families would realize that a reductionin the voucher is to their benefit: They will save more in lowered taxes than they will lose in a decreased educationsubsidy. So they will press to reduce public spending on education, leading to ever-deteriorating quality for thosewho cannot afford to spend extra. In the end, the quintessential American tradition of public education for all couldcollapse.

School vouchers hold another potential that, doubtless, makes them attractive to the conservative elite: They offer away to break the power of the American union movement in its last remaining stronghold, the public sector. Not byaccident did Bob Dole, in his acceptance speech at the Republican National Convention, pause in his evocation ofNorman Rockwell values to take a swipe at teachers’ unions. The leaders of the radical right want privatization ofschools, of public sanitation—of anything else they can think of—because they know such privatization undermineswhat remaining opposition exists to their program.

If public schools and other services are left to deteriorate, so will the skills and prospects of those who depend onthem, reinforcing the growing inequality of incomes and creating an even greater disparity between the interests ofthe elite and those of the majority.

Does this sound like America in the ‘90s? Of course it does. And it doesn’t take much imagination to envision whatour society will be like if this process continues for another 15 or 20 years. We know all about it from TV, movies,and bestselling novels. While politicians speak of recapturing the virtues of small-town America (which never reallyexisted), the public— extrapolating from the trends it already sees—imagines a Blade Runner-style dystopia, inwhich a few people live in luxury while the majority grovel in Third World living standards.

Strategies for the Future

There is no purely economic reason why we cannot reduce inequality in America. If we were willing to spend even afew percent of national income on an enlarged version of the Earned Income Tax Credit, which supplements theearnings of low-wage workers, we could make a dramatic impact on both incomes and job opportunities for the poorand near-poor—bringing a greater number of Americans into the middle class. Nor is the money for such policieslacking: America is by far the least heavily taxed of Western nations and could easily find the resources to pay for amajor expansion of programs aimed at limiting inequality.

But of course neither party advanced such proposals during the electoral campaign. The Democrats sounded likeRepublicans, knowing that in a society with few counterweights to the power of money, any program that even hintsat redistribution is political poison. It’s no surprise that Bill Clinton’s repudiation of his own tax increase took placein front of an audience of wealthy campaign contributors. In this political environment, what politician would talk oftaxing the well-off to help the low-wage worker?

And so, while the agenda of the GOP would surely accelerate the polarizing trend, even Democratic programs nowamount only to a delaying action. To get back to the kind of society we had, we need to rebuild the institutions andvalues that made a middle-class nation possible.

The relatively decent society we had a generation ago was largely the creation of a brief, crucial period in Americanhistory: the presidency of Franklin Roosevelt, during the New Deal and especially during the war. That created whateconomic historian Claudia Goldin called the Great Compression—an era in which a powerful government,reinforced by and in turn reinforcing a newly powerful labor movement, drastically narrowed the gap in incomelevels through taxes, benefits, minimum wages, and collective bargaining. In effect, Roosevelt created a new,middle-class America, which lasted for more than a generation. We have lost that America, and it will take anotherRoosevelt, and perhaps the moral equivalent of another war, to get it back.

Until then, however, we can try to reverse some of the damage. To do so requires more than just supporting certaincauses. It means thinking strategically—asking whether a policy is not only good in itself but how it will affect thepolitical balance in the future. If a policy change promises to raise average income by a tenth of a percentage point,but will widen the wedge between the interests of the elite and those of the rest, it should be opposed. If a lawreduces average income a bit but enhances the power of ordinary workers, it should be supported.


In particular, we also need to apply strategic thinking to the union movement. Union leaders and liberal intellectualsoften don’t like each other very much, and union victories are often of dubious value to the economy. Nonetheless,if you are worried about the cycle of polarization in this country, you should support policies that make unionsstronger, and vociferously oppose those that weaken them. There are some stirrings of life in the union movement—a new, younger leadership with its roots in the service sector has replaced the manufacturing-based old guard, andhas won a few political victories. They must be supported, almost regardless of the merits of their particular case.Unions are one of the few political counterweights to the power of wealth.

Of course, even to talk about such things causes the right to accuse us of fomenting “class warfare.” They want us tobelieve we are all members of a broad, more or less homogeneous, middle class. But the notion of a middle-classnation was always a stretch. Unless we are prepared to fight the trend toward inequality, it will become a grim joke.


Economic Culture Wars

For reasons explained below, the editor dares not add a subtitle to this article.

Paul KrugmanSlate – The Dismal Science(1,295 words; posted Thursday, Oct. 24; to be composted Thursday, Oct. 31)

Economics writer Bob Kuttner devotes an essay in the American Prospect,a journal he edits, to an attack on my writings in SLATE and elsewhere.Don't worry, I won't respond here to that attack. If you're interested, youcan read my response in the November-December issue of Kuttner'sjournal. What I would like to discuss is what I think is the true reasonpeople like myself and Kuttner--who also writes columns for BusinessWeek and the Boston Globe--have so much trouble getting along. We areboth, after all, liberals. I have even written for the American Prospect. It isnot, I claim, really a political issue in the normal sense. What we are reallyfighting about is a matter of epistemology, of how one perceives andunderstands the world.

If you try to follow arguments about economics among intellectuals whosepolitics are more or less left-of-center, you gradually become aware that theparticipants in these arguments are divided not only by particular issues--deficit reduction, NAFTA, and so on--but by the whole way that they thinkabout the economy. On one side there are those whose views are informedby academic economics, the kind of stuff that is taught in textbooks. On theother there are people like Kuttner, Jeff Faux of the Economic PolicyInstitute, and Labor Secretary Robert Reich. Some members of this factionhave held university appointments. But most of them lack academiccredentials and, more important, they are basically hostile to the kind of

economics in which such credentials are based

If the anti-academic faction does not draw its ideas from textbookeconomics, however, where does its worldview come from? Well, here's astory that may sound trivial but which I regard as revealing. Back in 1992, Isupplied the American Prospect with an article on the problem of growingincome inequality. In the published piece, the editor, Kuttner, improved on

my drab title, but also added a dreadful subtitle: "The Rich, the Right, and the Facts: Deconstructing the IncomeDistribution Controversy."

Deconstructing? Why on earth would anyone not a member of the Modern Language Association want to use anacademic buzzword that has been the butt of so many jokes? (What do you get when you cross a Mafioso and adeconstructionist? Someone who makes you an offer you can't understand.) How could the cause of liberal revivalbe served by making me sound like a character out of a David Lodge satire?


A strong desire to make economics less like a science and more like literarycriticism is a surprisingly common attribute of anti-academic writers on thesubject. For example, in a recent collection of essays (Foundations ofResearch in Economics: How do Economists do Economics?, edited bySteven G. Medema and Warren Samuels),

James K. Galbraith, a constant critic of the profession (and a frequentcontributor to the American Prospect), urges economists to emulate "vibranthumanities faculties" in which "departments develop viciously opinionated,inbred, sometimes bitter and tyrannical but definitely exciting intellectualclimates." Economics, in short, would be a better field if the MIT economicsdepartment were more like the Yale English department during itsdeconstructionist heyday.

Academic economics, the stuff that is in the textbooks, is largely based onmathematical reasoning. I hope you think that I am an acceptable writer, butwhen it comes to economics I speak English as a second language: I think inequations and diagrams, then translate. The opponents of mainstreameconomics dislike people like me not so much for our conclusions as for ourstyle: They want economics to be what it once was, a field that wascomfortable for the basically literary intellectual.

This should sound familiar. More than 40 years ago, the scientist-turned-novelist C.P. Snow wrote his famous essay about the war between the "twocultures," between the essentially literary sensibility that we expect of a card-carrying intellectual and the scientific/mathematical outlook that is arguablythe true glory of our civilization. That war goes on; and economics is on thefront line. Or to be more precise, it is territory that the literati definitively lostto the nerds only about 30 years ago--and they want it back.That is what explains the lit-crit style so oddly favored by the leftist critics ofmainstream economics. Kuttner and Galbraith know that the quantitative,

algebraic reasoning that lies behind modern economics is very difficult to challenge on its own ground. To oppose itthey must invoke alternative standards of intellectual authority and legitimacy. In effect, they are saying, "You have

Paul Samuelson on your team? Well, we've got Jacques Derrida on ours."

A similar situation exists in other fields. Consider, for example, evolutionary biology. Like most Americanintellectuals, I first learned about this subject from the writings of Stephen Jay Gould. But I eventually came torealize that working biologists regard Gould much the same way that economists regard Robert Reich: talentedwriter, too bad he never gets anything right. Serious evolutionary theorists such as John Maynard Smith or WilliamHamilton, like serious economists, think largely in terms of mathematical models. Indeed, the introduction toMaynard Smith's classic tract Evolutionary Genetics flatly declares, "If you can't stand algebra, stay away fromevolutionary biology." There is a core set of crucial ideas in his subject that, because they involve the interaction ofseveral different factors, can only be clearly understood by someone willing to sit still for a bit of math. (Try to givea purely verbal description of the reactions among three mutually catalytic chemicals.)

But many intellectuals who can't stand algebra are not willing to stay away from the subject. They are thus deeplyattracted to a graceful writer like Gould, who frequently misrepresents the field (perhaps because he does not fullyunderstand its essentially mathematical logic), but who wraps his misrepresentations in so many layers ofimpressive, if irrelevant, historical and literary erudition that they seem profound.

Unfortunately, Maynard Smith is right, both about evolution and about economics. There are important ideas in bothfields that can be expressed in plain English, and there are plenty of fools doing fancy mathematical models. Butthere are also important ideas that are crystal clear if you can stand algebra, and very difficult to grasp if you can't.International trade in particular happens to be a subject in which a page or two of algebra and diagrams is worth 10


volumes of mere words. That is why it is the particular subfield of economics in which the views of those whounderstand the subject and those who do not diverge most sharply.

Alas, there is probably no way to resolve this conflict peacefully. It is possible for a very skillful writer to convey inplain English a sense of what serious economics is about, to hide the algebraic skeleton behind a more appealingfacade. But that won't appease the critics; they don't want economics with a literary facade, they want economicswith a literary core. And so people like me and people like Kuttner will never be able to make peace, because we areengaged in a zero-sum conflict--not over policy, but over intellectual boundaries.

The literati truly cannot be satisfied unless they get economics back from the nerds. But they can't have it, becausewe nerds have the better claim.

Links

Nerds can write, too. Mathematically minded biologist William Hamilton's new book of collected papers, NarrowRoads of Geneland, was recently praised by fellow evolutionary biologist Richard Dawkins in a London Timesreview. (Dawkins' new book, Climbing Mount Improbable, was itself the focus of a recent review by John Horgan inSLATE.) For another argument about how algebra-avoidance leads to shallow thinking, see David Berreby's pieceabout the complexities of human biology that appeared in SLATE last month. For the latest in the Krugman/KuttnerKontroversy, see their debate in the new American Prospect. And to see Krugman face off with James K. Galbraith,see their "Dialogue" in SLATE.

Paul Krugman is a professor of economics at MIT whose books include The Age of Diminished Expectations andPeddling Prosperity.

Illustrations by Robert Neubecker


Ricardo’s Difficult Idea

Paul Krugman

The title of this paper is a play on that of an admirable recent book by the philosopher Daniel Dennett, Darwin'sDangerous Idea: Evolution and the Meanings of Life (1995). Dennett's book is an examination of the reasons whyso many intellectuals remain hostile to the idea of evolution through natural selection -- an idea that seems simpleand compelling to those who understand it, but about which intelligent people somehow manage to get confusedtime and time again.

The idea of comparative advantage -- with its implication that trade between two nations normally raises the realincomes of both -- is, like evolution via natural selection, a concept that seems simple and compelling to those whounderstand it. Yet anyone who becomes involved in discussions of international trade beyond the narrow circle ofacademic economists quickly realizes that it must be, in some sense, a very difficult concept indeed. I am not talkinghere about the problem of communicating the case for free trade to crudely anti-intellectual opponents, people whosimply dislike the idea of ideas. The persistence of that sort of opposition, like the persistence of creationism, is adifferent sort of question, and requires a different sort of discussion. What I am concerned with here are the views ofintellectuals, people who do value ideas, but somehow find this particular idea impossible to grasp.

My objective in this essay is to try to explain why intellectuals who are interested in economic issues so consistentlybalk at the concept of comparative advantage. Why do journalists who have a reputation as deep thinkers aboutworld affairs begin squirming in their seats if you try to explain how trade can lead to mutually beneficialspecialization? Why is it virtually impossible to get a discussion of comparative advantage, not only onto newspaperop-ed pages, but even into magazines that cheerfully publish long discussions of the work of Jacques Derrida? Whydo policy wonks who will happily watch hundreds of hours of talking heads droning on about the global economyrefuse to sit still for the ten minutes or so it takes to explain Ricardo?

In this essay, I will try to offer answers to these questions. The first thing I need to do is to make clear how fewpeople really do understand Ricardo's difficult idea -- since the response of many intellectuals, challenged on thispoint, is to insist that of course they understand the concept, but they regard it as oversimplified or invalid in themodern world. Once this point has been established, I will try to defend the following hypothesis:

(i) At the shallowest level, some intellectuals reject comparative advantage simply out of a desire to be intellectuallyfashionable. Free trade, they are aware, has some sort of iconic status among economists; so, in a culture that alwaysprizes the avant-garde, attacking that icon is seen as a way to seem daring and unconventional.

(ii) At a deeper level, comparative advantage is a harder concept than it seems, because like any scientific concept itis actually part of a dense web of linked ideas. A trained economist looks at the simple Ricardian model and sees astory that can be told in a few minutes; but in fact to tell that story so quickly one must presume that one's audienceunderstands a number of other stories involving how competitive markets work, what determines wages, how thebalance of payments adds up, and so on.

(iii) At the deepest level, opposition to comparative advantage -- like opposition to the theory of evolution -- reflectsthe aversion of many intellectuals to an essentially mathematical way of understanding the world. Both comparativeadvantage and natural selection are ideas grounded, at base, in mathematical models -- simple models that can bestated without actually writing down any equations, but mathematical models all the same. The hostility that bothevolutionary theorists and economists encounter from humanists arises from the fact that both fields lie on the frontline of the war between C.P. Snow's two cultures: territory that humanists feel is rightfully theirs, but which hasbeen invaded by aliens armed with equations and computers.

1. You just don't understand


In scholarly discourse, it is a normal courtesy to give one's debating opponents the benefit of the doubt. If they saysomething that seems confused, one tries to find a charitable interpretation -- although it may seem that they aresaying X, which is patently wrong, perhaps they are merely badly expressing their belief in Y, which could be rightin principle (although it is inconsistent with the data).

Many economists -- myself included -- have tried to extend this same courtesy to people who seem, on a casualreading, not to understand comparative advantage. Surely, we have argued, the problem is one of different dialectsor jargon, not sheer lack of comprehension. What these critics must be trying to do is draw attention to the ways inwhich comparative advantage may fail to work out in practice. After all, economists are familiar with a number ofreasons why the gains from free trade may not work out quite as easily as in the simplest Ricardian model. Externaleconomies may mean underinvestment in import-competing sectors; imperfect competition may lead to a strategiccompetition over industry rents; because of distortions in domestic labor markets, imports may reduce wages orcause unemployment; and so on. And even if national income rises as a result of trade, the distribution of incomewithin a country may shift in a way that hurts large groups. In short, there are a number of sophisticated extensionsto and qualifications of the model introduced in the first few chapters of the undergraduate textbook (typicallycovered later in the book -- for example, in Chapters 10-12 of Krugman and Obstfeld (1994)).

And so one is prepared to be sympathetic after reading a passage like the following, on the first page of Sir JamesGoldsmith's The Trap: "The principal theoretician of free trade was David Ricardo, a British economist of the earlynineteenth century. He believed in two interrelated concepts: specialization and comparative advantage. Accordingto Ricardo, each nation should specialize in those activities in which it excels, so that it can have the greatestadvantage relative to other countries. Thus, a nation should narrow its focus of activity, abandoning certainindustries and developing those in which it has the largest comparative advantage. As a result, international tradewould grow as nations export their surpluses and import the products that they no longer manufacture, efficiencyand productivity would increase in line with economies of scale and prosperity would be enhanced. But these ideasare not valid in today's world." (Goldsmith 1994:1). On close reading, the passage seems a bit garbled; but maybe heis just a careless writer (or the translation from the original French is imperfect). One expects him to follow with adiscussion of some of the valid reasons why one might want to qualify Ricardo's idea -- for example, by referring tothe importance of external economies in a high-technology world.

But this expectation is utterly disappointed. What is different, according to Goldsmith, is that there are all thesecountries out there that pay wages that are much lower than those in the West -- and that, he claims, makes Ricardo'sidea invalid. That's all there is to his argument; there is no hint of any more subtle content. In short, he offers us nomore than the classic "pauper labor" fallacy, the fallacy that Ricardo dealt with when he first stated the idea, andwhich is a staple of even first-year courses in economics. In fact, one never teaches the Ricardian model withoutemphasizing precisely the way that model refutes the claim that competition from low-wage countries is necessarilya bad thing, that it shows how trade can be mutually beneficial regardless of differences in wage rates. The point isnot that low-wage competition never poses a problem. Rather, what is significant is that despite ostentatiously citingRicardo, Goldsmith completely misses one of the essential lessons of his argument.

One might argue that Goldsmith is a straw man, that he is an intellectual lightweight whom nobody would takeseriously as a commentator on these issues. But The Trap is structured as a discussion with Yves Messarovitch, theeconomics editor of Le Figaro; Mr. Messarovitch certainly took Sir James seriously (never raising any objections tohis version of international trade theory), and the book became a best-seller in France. In the United States,Goldsmith did not sell as many books, but his views were featured in intellectual magazines like New PerspectivesQuarterly; he was invited to speak to the US Congress; and the Clinton Administration took his views seriouslyenough to send its chief economist, Laura Tyson, to debate him on television. In short, while Goldsmith's failure tounderstand the basic idea of comparative advantage may seem stunningly obvious to any trained economist, otherintellectuals -- including editors and journalists who specialize on economic matters -- regarded his views as, at thevery least, a valuable addition to the debate.

Or consider the recent anti-free-trade writings of James Fallows, the Washington editor of The Atlantic Monthly andone of America's most prominent intellectuals. In his book Looking at the Sun (1994), Fallows argues that Asiansuccess proves the effectiveness of protectionist policies in promoting economic growth. One might have expectedhim to offer some intellectually cutting-edge explanation of why this might be so, of why comparative advantage is


invalid in the modern world economy. But instead he claims that economists have gone astray by ignoring thenineteenth-century ideas of Friedrich List! One must assume that Fallows actually read List; in which case his praisefor List shows clearly that he does not understand Ricardo. For List's old book, like Goldsmith's new one, is thework of a man who, right from the beginning, just didn't get it; who could not get straight in his mind how tradebetween two countries could raise incomes in both. (A sample List argument: he points out that agricultural landnear cities is more valuable than that far away, and concludes that tariffs on manufactured goods will help farmers aswell as industrialists).

While the ideas of both Fallows and Goldsmith have been well received in intellectual circles, they have not by anymeans persuaded everyone. What is striking, however, is that virtually none of the reviews of their books havepointed out that they appear not to understand comparative advantage. (Indeed, reviews of Fallows's book tended topraise his economic sophistication and question his political and cultural analysis). The explanation, of course, isthat the reviewers don't understand it either -- or, in some cases, that editors who didn't understand the conceptrefused to allow it to be mentioned in the reviews. (I speak from personal experience). I believe that much of theineffectiveness of economists in public debate comes from their false supposition that intelligent people who readand even write about world trade must grasp the idea of comparative advantage. With very few exceptions, theydon't -- and they don't even want to hear about it. Why?

2. The cult of the new

One of America's new intellectual stars is a young writer named Michael Lind, whose contrarian essays on politicshave given him a reputation as a brilliant enfant terrible. In 1994 Lind published an article in Harper's aboutinternational trade, which contained the following remarkable passage:

"Many advocates of free trade claim that higher productivity growth in the United States will offset pressure onwages caused by the global sweatshop economy, but the appealing theory falls victim to an unpleasant fact.Productivity has been going up, without resulting wage gains for American workers. Between 1977 and 1992, theaverage productivity of American workers increased by more than 30 percent, while the average real wage fell by 13percent. The logic is inescapable. No matter how much productivity increases, wages will fall if there is anabundance of workers competing for a scarcity of jobs -- an abundance of the sort created by the globalization of thelabor pool for US-based corporations." (Lind 1994: )

What is so remarkable about this passage? It is certainly a very abrupt, confident rejection of the case for free trade;it is also noticeable that the passage could almost have come out of a campaign speech by Patrick Buchanan. But thereally striking thing, if you are an economist with any familiarity with this area, is that when Lind writes about howthe beautiful theory of free trade is refuted by an unpleasant fact, the fact he cites is completely untrue.

More specifically: the 30 percent productivity increase he cites was achieved only in the manufacturing sector; in thebusiness sector as a whole the increase was only 13 percent. The 13 percent decline in real wages was true only forproduction workers, and ignores the increase in their benefits: total compensation of the average worker actuallyrose 2 percent. And even that remaining gap turns out to be a statistical quirk: it is entirely due to a difference in theprice indexes used to deflate business output and consumption (probably reflecting overstatement of bothproductivity growth and consumer price inflation). When the same price index is used, the increases in productivityand compensation have been almost exactly equal. But then how could it be otherwise? Any difference in the ratesof growth of productivity and compensation would necessarily show up as a fall in labor's share of national income -- and as everyone who is even slightly familiar with the numbers knows, the share of compensation in U.S. nationalincome has been quite stable in recent decades, and actually rose slightly over the period Lind describes.

The question here is not why Lind got these numbers wrong. It takes considerable experience to know where to lookand what to worry about in economic statistics, and one should not expect someone who does not work in the fieldto be able to get it right without some guidance. The question is, instead, why Mr. Lind felt that it was a good idea tomake sweeping pronouncements about this subject, when he clearly was unwilling to invest time and energy inactually understanding it. The short answer in this case is surely that Mr. Lind, who is always looking for ways toenhance his enfant terrible status, saw this as a perfect opportunity. Free trade is a sacred cow of economists, whoare well-known to be boring, stuffy types; what could be a better way to reinforce one's credentials as a radical,innovative thinker than to skewer their most beloved doctrine? (It seems not to have occurred to him that there might


be a reason other than ideological rigidity that the striking fact he thought he knew has not been noticed byeconomists).

This is a fairly extreme case, but by no means unique. Modern intellectuals are supposed to be daring innovators, notrespecters of tradition. As any publisher will tell you, books about startling new scientific discoveries always sellbetter than books about known areas of science, even though the things science already knows are in many waysstranger than any of the speculations in the latest cosmological best-seller. Old ideas are viewed as boring, even iffew people have heard of them; new ideas, even if they are probably wrong and not terribly important, are far moreattractive. And books that say (or seem to say) that the experts have all been wrong are far more likely to attract awide audience than books that explain why the experts are probably right. Stephen Jay Gould's Wonderful Life(Gould 1989) which to many readers seemed to say that recent discoveries refute Darwinian orthodoxy, attracted farmore attention than Richard Dawkins' equally well-written The Blind Watchmaker (Dawkins 1986), which explainedthe astonishing implications of that orthodoxy. (See Dennett for an eye-opening discussion of Gould). RogerPenrose's The Emperor's New Mind, which rejects the possibility of explaining intelligence in terms ofcomputational processes, attracted far more attention than any of the exciting discoveries of cognitive scientists whoare actually trying to understand the nature of intelligence.

The same principle applies to international economics. Comparative advantage is an old idea; intellectuals who wantto read about international trade want to hear radical new ideas, not boring old doctrines, even if they are quiteblurry about what those doctrines actually say. Robert Reich, now Secretary of Labor, understood this pointperfectly when he wrote an essay for Foreign Affairs entitled "Beyond free trade". (Reich 1983). The articlereceived wide attention, even though it was fairly unclear exactly how Reich proposed to go beyond free trade (thereis a certain similarity between Reich and Gould in this respect: they make a great show of offering new ideas, but itis quite hard to pin down just what those new ideas really are). The great selling point was, clearly, the article's title:free trade is old hat, it is something we must go beyond. In this sort of intellectual environment, it is quite hard to getanyone other than an economics student to sit still for an explanation of the concept of comparative advantage. Justimagine trying to tell an ambitious, energetic, forward-looking intellectual who is interested in economics -- WilliamJefferson Clinton comes to mind -- that before he can start talking knowledgeably about globalization and theinformation economy he must wrap his mind around a difficult concept that was devised by a frock-coated banker180 years ago!

3. A harder concept than it seems

To a trained economist, the basic Ricardian model seems almost trivial. Two goods, two countries, one productivefactor, perfect competition: what could be simpler? Indeed, one of the fierce joys of being an international tradeeconomist is that so many seemingly sophisticated tracts can be revealed as nonsense, so many self-important menunmasked as poseurs, using such a minimalist framework.

And yet if one tries to explain the basic model to a non-economist, it soon becomes clear that it really isn't thatsimple after all. Teaching the model, to docile students, is one thing: they get the model in the course of a broaderstudy of economics, and in any case they are obliged to pay attention and learn it the way you teach it if they want topass the exam. But try to explain the model to an adult, especially one who already has opinions about the subject,and you continually find yourself obliged to backtrack, realizing that yet another proposition you thought wasobvious actually isn't. Just before this paper was written, I was trying to explain to an editorial writer for a majorU.S. newspaper why international trade is probably not the main cause of the country's ills. After a confusedinterlude, it became clear what one of the blocks was: he just didn't understand, even after being told the numbers,why a situation in which productivity increases were not being shared with workers would necessarily be reflectedin a decline in the labor share of income -- and therefore why the stability of that share in practice is a crucial pieceof evidence. Eventually I was reduced nearly to baby-talk ("suppose the factory produces 10 tons of cheese, andpays out wages equal in value to 6 tons; now suppose that the workers become more productive and turn out 12 tonsof cheese, but that wages haven't changed ..."). This was not a successful conversation: he wanted to talk aboutglobal trends, and instead I was teaching him first-grade arithmetic.

That particular confusion is more common than one might expect. But even at a somewhat higher level, there are, Ibelieve, at least three implicit assumptions that underlie the most basic Ricardian model, assumptions that arejustified by the whole fabric of economic understanding but are not at all obvious to non-economists. Here they are:


- Wages are determined in a national labor market: The basic Ricardian model envisages a single factor, labor,which can move freely between industries. When one tries to talk about trade with laymen, however, one at leastsometimes realizes that they do not think about things that way at all. They think about steelworkers, textile workers,and so on; there is no such thing as a national labor market. It does not occur to them that the wages earned in oneindustry are largely determined by the wages similar workers are earning in other industries. This has severalconsequences. First, unless it is carefully explained, the standard demonstration of the gains from trade in aRicardian model -- workers can earn more by moving into the industries in which you have a comparative advantage-- simply fails to register with lay intellectuals. Their picture is of aircraft workers gaining and textile workerslosing, and the idea that it is useful even for the sake of argument to imagine that workers can move from oneindustry to the other is foreign to them. Second, the link between productivity and wages is thoroughlymisunderstood. Non-economists typically think that wages should reflect productivity at the level of the individualcompany. So if Xerox manages to increase its productivity 20 percent, it should raise the wages it pays by the sameamount; if overall manufacturing productivity has risen 30 percent, the real wages of manufacturing workers shouldhave risen 30 percent, even if service productivity has been stagnant; if this doesn't happen, it is a sign thatsomething has gone wrong. In other words, my criticism of Michael Lind would baffle many non-economists.

Associated with this problem is the misunderstanding of what international trade should do to wage rates. It is a factthat some Bangladeshi apparel factories manage to achieve labor productivity close to half those of comparableinstallations in the United States, although overall Bangladeshi manufacturing productivity is probably only about 5percent of the US level. Non-economists find it extremely disturbing and puzzling that wages in those productivefactories are only 10 percent of US standards.

Finally, and most importantly, it is not obvious to non-economists that wages are endogenous. Someone likeGoldsmith looks at Vietnam and asks, "what would happen if people who work for such low wages manage toachieve Western productivity?" The economist's answer is, "if they achieve Western productivity, they will be paidWestern wages" -- as has in fact happened in Japan. But to the non-economist this conclusion is neither natural norplausible. (And he is likely to offer those Bangladeshi factories as a counterexample, missing the distinctionbetween factory-level and national-level productivity).

- Constant employment is a reasonable approximation: The standard textbook version of the Ricardian modelassumes full employment in both countries. But in reality unemployment is constantly a concern of economic policy-- so why is this the usual assumption? There are two answers. One -- the answer that Ricardo would have given -- isthat international trade is a long-run issue, and that in the long run the economy has a natural self-correctingtendency to return to full employment. The other, more modern answer is that countries have central banks, whichtry to stabilize employment around the NAIRU; so that it makes sense to think of the Federal Reserve and itscounterparts acting in the background to hold employment constant. This is not at all the way that non-economiststhink about the issue. Both supporters and opponents of free trade normally claim that their preferred policies willcreate jobs; free-traders are forever warning that the Smoot-Hawley tariff caused the Great Depression. And thealternative view does not come at all naturally. During the NAFTA debates I shared a podium with an experienced,highly regarded U.S. trade negotiator, a strong NAFTA supporter. At one point a member of the audience asked mewhat I thought the effect of NAFTA would be on the number of jobs in the United States; when I replied "none",based on the standard arguments, the trade official exploded in anger: "It's remarks like that which explain whypeople hate economists!"

- The balance of payments is not a problem: The standard textbook presentation of the Ricardian model assumesbalanced trade -- indeed, it is usually a one-period model in which trade must be balanced. Yet the news is full ofstories about the balance of payments, of complaints about trade surpluses and deficits. Why are these absent fromthe story?

Again, economists have good reasons for thinking that it is a good approximation to separate balance of paymentsfrom real international trade issues. In Ricardo's case, the essential ingredient was the argument by David Hume thattrade imbalances are self-correcting: a surplus country will acquire specie, leading to rising prices that price itsgoods out of world markets, while a deficit country will correspondingly find its goods increasingly competitivelypriced. In the modern world, again, the channels involve less Invisible Hand and more government intervention:when monetary policies target the unemployment rate, exchange rates do the adjusting. Economists are also awarethat even persistent trade imbalances are not necessarily a problem, and certainly that surpluses are not a sure sign of


health or deficits one of weakness. Trade may be balanced in Chapter 2; but Chapter 13 explains that the tradebalance is equal to the difference between savings and investment, and that a country may justifiably run persistentdeficits if it is an attractive site for foreign investment.

Again, none of this is obvious to non-economists. The essential accounting identity, savings minus investmentequals exports minus imports, is if anything a better-kept secret than the concept of comparative advantage. Thedebate over NAFTA was entirely phrased in terms of the apparent prospect that the United States would run a tradesurplus with Mexico -- that was why the treaty was in our interests -- and the deficit that has actually materialized isuniversally regarded as a bad thing.

In sum, while the concept of comparative advantage may seem utterly simple to economists, in order to achieve thatsimplicity one must invoke a number of principles and useful simplifying assumptions that seem natural andreasonable only to someone familiar with economic analysis in general. ("What do you mean, objects fall at thesame rate regardless of how heavy they are -- if I drop a cannonball and a feather ... you're assuming away airresistance? Why would you do that?") Those principles and simplifying assumptions are indeed reasonable, but theyare not obvious.

4. The Two Cultures

I once had a very unpleasant, but ultimately useful, conversation with the editor of one of America's leadingintellectual magazines. He was in the process of refusing to print a piece I had written at his request, and hisdissatisfaction with what I had written was the main subject at hand. But along the way I somehow mentioned theneed to represent economic ideas with carefully thought-out models, and he responded with a mixture of bafflementand asperity. Clearly the idea that economic ideas could benefit from being modeled was new to him, even thoughhis journal frequently publishes articles on economic affairs; and he suggested to me that in future I would do wellto explain why models are sometimes useful and why they usually are not.

At the time I was fairly flabbergasted: to question the usefulness of economic models at this late date seemed ratherstrange. But the economist's idea that economic theory for the most part consists of models has by no means beenaccepted by intellectuals outside our field. In fact, if one looks at the favorite economic writers of the non-economistintellectual -- Robert Reich, Lester Thurow, John Kenneth Galbraith -- one realizes that they have in common anaversion to or ignorance of modeling. There are model-oriented economists, like Alan Blinder, who also write for abroader audience, and they don't put their equations in their books and articles; but the skeleton of the models thatstructure their thought is visible under the surface to those who know how to look. By contrast, in the writings ofReich or Galbraith what you read is what you get -- there is no hidden mathematical structure to the argument, nodiagram one might draw on a blackboard or simulation one might run on a computer to clarify the point.

In this the situation in economics is virtually identical to that in evolutionary theory. Ask a working biologist who isthe greatest living evolutionary thinker, and he or she will probably answer John Maynard Smith (with nods toGeorge Williams and William Hamilton). Maynard Smith not only has a name that should have made him aneconomist; he writes and thinks like an economist, representing evolutionary issues with stylized mathematicalmodels that are sometimes confronted with data, sometimes simulated on the computer, but always serve as the truestructure informing the verbal argument. A textbook like his Evolutionary Genetics (1989) feels remarkablycomfortable for an academic economist: the style is familiar, and even a good bit of the content looks like thingseconomists do too. But ask intellectuals in general for a great evolutionary thinker and they will surely nameStephen Jay Gould -- who receives one brief, dismissive reference in Maynard Smith (1989). (One of my ill-advisedmoves in the conversation with the editor was to point out that the index to Tyson (1993) contains no referenceseither to Reich or to Thurow).

What does Gould have that Maynard Smith does not? He is a more accessible writer -- but evolutionary theory is, toa far greater extent than economics, blessed with excellent popularizers: writers like Dawkins (1989) or Ridley(1993), who provide beautifully written expositions of what researchers have learned. (Writers like Gould or Reichare not, in the proper sense, popularizers: a popularizer reports on the work of a community of scholars, whereasthese writers argue for their own, heterodox points of view). No, what makes Gould so popular with intellectuals isnot merely the quality of his writing but the fact that, unlike Dawkins or Ridley, he is not trying to explain theessentially mathematical logic of modern evolutionary theory. It's not just that there are no equations or simulations


in his books; he doesn't even think in terms of the mathematical models that inform the work of writers likeDawkins. That is what makes his work so appealing. The problem, of course, is that evolutionary theory -- the realthing -- is based on mathematical models; indeed, increasingly it is based on computer simulation. And so the veryaversion to mathematics that makes Gould so appealing to his audience means that his books, while they may seemto his readers to contain deep ideas, seem to people who actually know the field to be mere literary confections withlittle serious intellectual content, and much of that simply wrong. In particular, readers whose ideas of evolution areformed by reading Gould's work get no sense of the power and reach of the theory of natural selection -- if anything,they come away with a sense that modern thought has shown that theory to be inadequate.

Economics is not as well served by its writers as evolution. Still, the distinctive feature of the writers whose ideasabout world trade play well with an intellectual audience is the same: the successful books are those that not only donot explicitly discuss mathematical models, they are not even implicitly based on mathematical reasoning. A booklike Robert Reich's The Work of Nations (Reich 1991) not only eschews equations and diagrams, it never even triesto present the idea of comparative advantage informally. In fact, it never uses the phrase "comparative advantage" atall, even to criticize it. As a result, books by authors such as Reich or Thurow do not make humanistsuncomfortable. Unavoidably, however, they also give them no sense of the power and importance of economicmodels in general, or of Ricardo's difficult idea in particular. If anything, the message one gets from these books isthat in the new economy nineteenth-century concepts no longer apply.

It might be worth pointing out one exception to the general intellectual aversion to mathematical models.Intellectuals do reserve, both in evolution and economics, a small pedestal for mathematical modelers -- as long astheir models are confusing and seem to refute orthodoxy. Call it the "Santa Fe syndrome". At one point in Dennett'sbook he reports a list of the top ten objections raised to Steven Pinker's theories about the evolution of language; oneof them is "Natural selection is irrelevant, because now we have chaos theory". At about the same time I read thispassage I had received a barrage of protests over an article that tried, without explicit mathematics, to walk throughsome simple models of international trade (Krugman 1994); several of the letters insisted that because of nonlineardynamics it was impossible to reach any meaningful conclusions from simple models. ("Have you ever thoughtabout the implications of increasing returns? You should read the work of Brian Arthur and Paul Romer.")

There are two odd things about the popularity of certain kinds of mathematical modeling among intellectuals whoare generally hostile to such models. One is that the preferred models are typically far more difficult and obscurethan the standard models in the field. The other is that the supposedly heterodox conclusions of these models areoften not heterodox at all. To take a theme common to both evolution and economics: the idea that small randomevents can under certain conditions set in motion a cumulative process of change is the theme both of "peacock'stail" accounts of sexual selection and of external economy accounts of international specialization, both familiarstories that lie well inside the boundaries of academic orthodoxy, stories that can be and are illustrated with simplemodels in advanced undergraduate textbooks like Maynard Smith (1989) and Krugman and Obstfeld (1994). Yetmany intellectuals believe that this idea was discovered at Santa Fe and challenges the foundations of both fields.

The secret to the popularity of certain mathematical modelers, I suspect, is that they are valued precisely becausethey seem to absolve intellectuals from the need to understand the models that underpin orthodox views. Hardlyanyone tries to understand what the Santa Fe theorists are actually saying; it is the pose of opposition to receivedwisdom, together with the implication that in a complicated world you can't learn anything from simple modelsanyway, that is valued, because it seems to say that not knowing what's in the textbooks is OK.

A final note here: there is a new trend among people who don't like conventional economics, toward what issometimes called "bionomics". The manifestos of groups like the Bionomics Institute claim that they are developinga new science of economics that abandons the mechanistic approach of the existing field in favor of a model basedon ecology and evolution. (Speaker of the House Newt Gingrich is reported to be among those who find bionomicsappealing). The irony is that neoclassical economics, with its emphasis on modeling the interactions of self-interested individuals, is no more mechanistic than neo-Darwinian evolutionary theory -- in fact, the theories arevery similar to one another, down to the details of the models and the curves on the diagrams.

5. What can be done?


I cannot offer any grand strategy for dealing with the aversion of intellectuals to Ricardo's difficult idea. No matterwhat economists do, we can be sure that ten years from now the talk shows and the op-ed pages will still be full ofmen and women who regard themselves as experts on the global economy, but do not know or want to know aboutcomparative advantage. Still, the diagnosis I have offered here provides some tactical hints:

(i) Take ignorance seriously: I am convinced that many economists, when they try to argue in favor of free trade,make the mistake of overestimating both their opponents and their audience. They cannot believe that famousintellectuals who write and speak often about world trade could be entirely ignorant of the most basic ideas. But theyare -- and so are their readers. This makes the task of explaining the benefits of trade harder -- but it also means thatit is remarkably easy to make fools of your opponents, catching them in elementary errors of logic and fact. This isplaying dirty, and I advocate it strongly.

(ii) Adopt the stance of rebel: There is nothing that plays worse in our culture than seeming to be the stodgydefender of old ideas, no matter how true those ideas may be. Luckily, at this point the orthodoxy of the academiceconomists is very much a minority position among intellectuals in general; one can seem to be a courageousmaverick, boldly challenging the powers that be, by reciting the contents of a standard textbook. It has worked forme!

(iii) Don't take simple things for granted: It is crucial, when trying to communicate Ricardo's idea to a broaderaudience, to stop and try to put yourself in the position of someone who does not know economics. Arguments mustbe built from the ground up -- don't assume that people understand why it is reasonable to assume constantemployment, or a self-correcting trade balance, or even that similar workers tend to be paid similar wages indifferent industries.

(iv) Justify modeling: Do not presume, as I did, that people accept and understand the idea that models facilitateunderstanding. Most intellectuals don't accept that idea, and must be persuaded or at least put on notice that it is anissue. It is particularly useful to have some clear examples of how "common sense" can be misleading, and a simplemodel can clarify matters immensely. (My recent favorite involves the "dollarization" of Russia. It is not easy toconvince a non-economist that when gangsters hoard $100 bills in Vladivostock, this is a capital outflow fromRussia's point of view -- and that it has the same effects on the US economy as if that money was put in a New Yorkbank. But if you can get the point across, you have also taught an object lesson in why economists who think interms of models have an advantage over people who do economics by catch-phrase). None of this is going to beeasy. Ricardo's idea is truly, madly, deeply difficult. But it is also utterly true, immensely sophisticated -- andextremely relevant to the modern world.

REFERENCES

Dawkins, R. (1986), The Blind Watchmaker, New York: Longman.Dennett, D. (1995), Darwin's Dangerous Idea: Evolution and the Meanings of Life, New York: Simon and Schuster.Fallows, J. (1994), Looking at the Sun, New York: Pantheon.Goldsmith, J. (1994), The Trap, New York: Carroll and Graf.Gould, S.J. (1989), Wonderful Life, New York: Norton.Krugman, P. (1994), "Does Third World growth hurt First World prosperity?", Harvard Business Review , July.Krugman, P. and M. Obstfeld (1994), International Economics: Theory and Policy (3rd edition), New York:HarperCollins.Lind, M.List, F. (1856), The National System of Political EconomyMaynard Smith, J. (1989), Evolutionary Genetics, Oxford: Oxford University Press.Penrose, R. (1989), The Emperor's New Mind, New York: Oxford.Reich, R. (1983)Reich, R. (1991), The Work of Nations, New York: Basic BooksRidley, M. (1993), The Red Queen: Sex and the Evolution of Human Nature, New York: Penguin.Tyson, L. (1993), Who's Bashing Whom?, Washington: Institute for International Economics.


What Economists Can Learn From Evolutionary Theorists(A talk given to the European Association for Evolutionary Political Economy)

Paul KrugmanNov. 1996

Good morning. I am both honored and a bit nervous to be speaking to a group devoted to the idea of evolutionarypolitical economy. As you probably know, I am not exactly an evolutionary economist. I like to think that I am moreopen-minded about alternative approaches to economics than most, but I am basically a maximization-and-equilibrium kind of guy. Indeed, I am quite fanatical about defending the relevance of standard economic models inmany situations.

Why, then, am I here? Well, partly because my research work has taken me to some of the edges of theneoclassical paradigm. When you are concerned, as I have been, with situations in which increasing returns arecrucial, you must drop the assumption of perfect competition; you are also forced to abandon the belief that marketoutcomes are necessarily optimal, or indeed that the market can be said to maximize anything. You can still believein maximizing individuals and some kind of equilibrium, but the complexity of the situations in which yourimaginary agents find themselves often obliges you - and presumably them - to represent their behavior by somekind of ad hoc rule rather than as the outcome of a carefully specified maximum problem. And you are often drivenby sheer force of modeling necessity to think of the economy as having at least vaguely "evolutionary" dynamics, inwhich initial conditions and accidents along the way may determine where you end up. Some of you may have readmy work on economic geography; I only found out after I had worked on the models for some time that I was using"replicator dynamics" to discuss the problem of economic change.

But there is another reason I am here. I am an economist, but I am also what we might call an evolutiongroupie. That is, I spend a great deal of time reading what evolutionary biologists write - not only the more popularvolumes but the textbooks and, most recently, some of the professional articles. I have even tried to talk to some ofthe biologists, which in this age of narrow specialization is a major effort. My interest in evolution is partly arecreation; but it is also true that I find in evolutionary biology a useful vantage point from which to view my ownspecialty in a new perspective. In a way, the point is that both the parallels and the differences between economicsand evolutionary biology help me at least to understand what I am doing when I do economics - to get, to bepompous about it, a new perspective on the epistemology of the two fields.

I am sure that I am not unique either in my interest in biology or in my feeling that we economists havesomething to learn from it. Indeed, I am sure that many people in this room know far more about evolutionarytheory than I do. But I may have one special distinction. Most economists who try to apply evolutionary conceptsstart from some deep dissatisfaction with economics as it is. I won't say that I am entirely happy with the state ofeconomics. But let us be honest: I have done very well within the world of conventional economics. I have pushedthe envelope, but not broken it, and have received very widespread acceptance for my ideas. What this means is thatI may have more sympathy for standard economics than most of you. My criticisms are those of someone who lovesthe field and has seen that affection repaid. I don't know if that makes me morally better or worse than someone whocriticizes from outside, but anyway it makes me different.

Anyway, enough preliminaries.


Sister fields

If you are familiar with economics and start reading evolutionary biology in earnest - and presumably viceversa - you quickly realize that these are sister fields. They actually have a remarkable amount in common, not onlyin terms of the kind of questions they ask and the methods they use, but in terms of the way they relate to and areperceived by the rest of the world.

To begin with, there is the similarity in the basic approach. Let me give you my own personal definition of thebasic method of economic theory. To me, it seems that what we know as economics is the study of those phenomenathat can be understood as emerging from the interactions among intelligent, self-interested individuals. Notice thatthere are really four parts to this definition. Let's read from right to left.

1. Economics is about what individuals do: not classes, not "correlations of forces", but individual actors. This is notto deny the relevance of higher levels of analysis, but they must be grounded in individual behavior. Methodologicalindividualism is of the essence.

2. The individuals are self-interested. There is nothing in economics that inherently prevents us from allowingpeople to derive satisfaction from others' consumption, but the predictive power of economic theory comes from thepresumption that normally people care about themselves.

3. The individuals are intelligent: obvious opportunities for gain are not neglected. Hundred-dollar bills do not lieunattended in the street for very long.

4. We are concerned with the interaction of such individuals: Most interesting economic theory, from supply anddemand on, is about "invisible hand" processes in which the collective outcome is not what individuals intended.

OK, that's what economics is about. What is evolutionary theory about?

The answer, basically, is that evolutionists share three of the four concerns. Their field is about the interactionof self-interested individuals - who are often thought of as organisms "trying" to leave as many offspring as possible,but which are in some circumstances best thought of as genes "trying" to propagate as many copies of themselves aspossible. The main difference between evolutionary theory and economics is that while economists routinelysuppose that the agents in their models are very smart about finding the best strategy - and an economist is alwaysdefensive about any model in which agents are assumed to act with less than perfect rationality - evolutionists haveno qualms about assuming myopic behavior. Indeed, myopia is of the essence of their view.

I'll talk later about what difference this makes. My point right now is that because the basic methods are similarif not identical, economics and evolutionary theory are surprisingly similar. It is often asserted that economic theorydraws its inspiration from physics, and that it should become more like biology. If that's what you think, you shoulddo two things. First, read a text on evolutionary theory, like John Maynard Smith's Evolutionary Genetics. You willbe startled at how much it looks like a textbook on microeconomics. Second, try to explain a simple economicconcept, like supply and demand, to a physicist. You will discover that our whole style of thinking, of building upaggregative stories from individual decisions, is not at all the way they think.

So there is a close affinity in method and indeed of intellectual style between economics and evolution. Butthere is another interesting parallel: both economics and evolution are model-oriented, algebra-heavy subjects thatare the subject of intense interest from people who cannot stand algebra. And as a result in each case it is veryimportant to distinguish between the field as it is perceived by outsiders (and portrayed in popular books) and whatit is really like. We all know that economics is a field in which the most famous authors are often people who areregarded, with good reason, as not even worth arguing with by almost everyone in the profession. Do you rememberthat global best-seller The Coming Great Depression of 1990 by Ravi Batra? And I guess it is no secret that evenJohn Kenneth Galbraith, still the public's idea of a great economist, looks to most serious economists like anintellectual dilettante who lacks the patience for hard thinking. Well, the same is true in evolution.

I am not sure how well this is known. I have tried, in preparation for this talk, to read some evolutionaryeconomics, and was particularly curious about what biologists people reference. What I encountered were quite afew references to Stephen Jay Gould, hardly any to other evolutionary theorists. Now it is not very hard to find out,if you spend a little while reading in evolution, that Gould is the John Kenneth Galbraith of his subject. That is, he isa wonderful writer who is bevolved by literary intellectuals and lionized by the media because he does not usealgebra or difficult jargon. Unfortunately, it appears that he avoids these sins not because he has transcended his


colleagues but because he does does not seem to understand what they have to say; and his own descriptions of whatthe field is about - not just the answers, but even the questions - are consistently misleading. His impressive literaryand historical erudition makes his work seem profound to most readers, but informed readers eventually concludethat there's no there there. (And yes, there is some resentment of his fame: in the field the unjustly famous theory of"punctuated equilibrium", in which Gould and Niles Eldredge asserted that evolution proceeds not steadily but inshort bursts of rapid change, is known as "evolution by jerks").

What is rare in the evolutionary economics literature, at least as far as I can tell, is references to the theoriststhe practitioners themselves regard as great men - to people like George Williams, William Hamilton, or JohnMaynard Smith. This is serious, because if you think that Gould's ideas represent the cutting edge of evolutionarytheory (as I myself did until about a year and a half ago), you have an almost completely misguided view of wherethe field is and even of what the issues are.

This is important, because it is at least my impression that what economists who like to use "evolutionary"concepts expect from evolution is often based on what they imagine evolutionary theory to be like, not on what it isactually like. And conversely, you learn a lot about why conventional economics looks the way it does by seeinghow evolutionary theorists have been driven to some of the same positions.

To explain these rather cryptic remarks, let me talk briefly about what - it seems to me, but I am happy to becorrected - economists think an evolutionary approach can give us, then about what evolutionists seem to be sayingin practice.

What evolutionary economists want

I don't think that there are many economists, even among the unconventionally minded, who would quarrelseriously with my basic definition of economics as concerning the interactions among intelligent, self-interestedindividuals. I guess a Marxist would have problems with the whole idea of methodological individualism, and aGalbraithian would have problems with the idea that self-interest can be defined without taking into account theability of advertisers and so forth to shape preferences. But such quarrels apart I would guess that we do not havemuch difference with the basic statement.

Where the dissatisfaction sets in is with how we implement the first two terms in my four-part program. Yes,of course economics is about interaction, and the agents are intelligent; but exactly how intelligent are they, andwhat is the nature of the their interaction?

For there is no question that conventional economics has gone beyond the general ideas of intelligence andinteraction to a much harder-edged, extreme formulation. At least since Paul Samuelson published Foundations ofEconomic Analysis in 1947, the overwhelming thrust of conventional theory has been to say that agents are not onlyintelligent, they maximize - that is, they chose the best of all feasible alternatives. And when they interact, weassume that what they do is achieve an equilibrium, in which each individual is doing the best he can given what allthe others are doing.

Now anyone who looks at the world knows that these are extreme and unrealistic assumptions. I just had somework done on my house; it is painfully obvious, looking at the final bill, that I did not maximize - I did not engage inoptimal search for a contractor. In trying to find someone to do the remaining work, I have discovered that localwages and prices have not caught up with the economic boom in Massachusetts, so that it is extremely hard to findanyone to do carpentry or plumbing - the market is definitely not in equilibrium. So can't we get away from themaximization-and-equilibrium approach to something more realistic?

Well, as I understand it that is what evolutionary economics is all about. In particular, evolution-mindedeconomists seem to want the following:

1. They want to get away from the idea that individuals maximize. Instead, they want to represent decisions as theresult of some process of groping through alternatives, a process in which it may take a long time to get to amaximum - and in which the maximum you find may well be local rather than global.

2. They want to get away from the notion of equilibrium. In particular, they want to have an approach in whichthings are always in disequilibrium, in which the economy is always evolving. Latterly there have also been someeconomists who want to merge evolutionary ideas with the Schumpeterian notion that the economy proceeds viawaves of "creative destruction".


Now as I understand it evolutionary economists basically believe that an evolutionary approach will satisfythese desires. After all, real organisms often look to the discerning eye like works in progress - they are full offeatures that fall short of what would adapt them perfectly to their environment, that is, they have not reallymaximized their fitness. And they also often seem to be stuck on local maxima: dolphins may look like fish, but theystill need to surface for air. Meanwhile, what is evolution but a process of continual change, which has taken us frommicrobes to man? And if you are a reader of Gould and his acolytes, you have the sense that evolution proceedsthrough spasms of sudden change that seem positively Schumpeterian in their drama.

So the attractiveness of an evolutionary metaphor - especially if you believe that economics has gotten off onthe wrong track by basing itself on physics - is understandable. But before we get too carried away with theprospects for an evolutionary revolution, we had better look at what the evolutionists themselves really do.

What evolutionary theory is really like

To read the real thing in evolution - to read, say, John Maynard Smith's Evolution and the Theory of Games, orWilliam Hamilton's new book of collected papers, Narrow Roads in Gene Land, is a startling experience to someonewhose previous idea of evolution comes from magazine articles and popular books. The field does not look at alllike the stories. What it does look like, to a remarkable degree, is - dare I say it? - neoclassical economics. And itoffers very little comfort to those who want a refuge from the harsh discipline of maximization and equilibrium.

Consider first the question of maximization. Clearly it is a crucial point about evolution that it must proceed bysmall steps, which means that maxima must be approached only gradually and that you could easily be trapped on amerely local maximum. But do these observations actually play a large role in evolutionary theory? No, not really.

Look, for example, at William Hamilton's deeply influential paper "The genetical basis of social behavior". Inthe first part of that paper he introduces a model of population dynamics and shows that a gene will tend to spread ifit enhances not an organism's individual fitness, but its "inclusive fitness": a weighted sum of the fitness of all theindividual's relatives, with the weights proportional to their closeness of relationship. (An alternative way to think ofthis is to think of the gene spreading if it is good for its own fitness, never mind the organisms it lives in; this is thetheme of Richard Dawkins's book The Selfish Gene). Now Hamilton's derivation concerns process - it is a dynamicstory about which direction the next small step will proceed in. But when it comes to the second part, in which heuses the idea to discuss the real world - why birds expose themselves to predators by warning their neighbors, whyinsects have such massively organized societies - he simply assumes that what we actually see can be viewed as theculmination of that process, that the creatures we see have already maximized. In short, even though evolution isnecessarily a process of small changes, evolutionary theorists normally take the shortcut of assuming that theprocess gets you to the maximum, and pay surprisingly little attention to the dynamics along the way.

What about the possibility of being trapped on local maxima? Well, this is a big concern for some theorists,like the Santa Fe Institute's Stuart Kauffman - but Kauffman is not a central player in the field. The general attitudeof evolutionary theorists seems to be that Nature can often find surprising pathways to places you would havethought unreachable by small steps; that over a few hundred thousand generations a slightly light-sensitive patch ofskin can become an eye that appears to be perfectly designed, or a jaw-bone can migrate around and become a pieceof exquisitively sensitive sound-detection equipment. This is the theme of Richard Dawkins's new book ClimbingMount Improbable. It is also, if I understand it, the point of what philosopher Daniel Dennnet calls Leslie Orgel'sSecond Law: "Evolution is smarter than you are". (Alternative version, according to Dennett: Evolution is smarterthan Leslie Orgel).

In practice, then, evolutionary theorists generally end up assuming that organisms (or genes, when that is themore useful perspective) do maximize; the process, the necessary caveat that they must get wherever they are goingby small steps, gets put to one side.

What about equilibrium? To outsiders, it appears that evolutionary theory must be a theory of continuing,progressive change. Indeed, Stephen Jay Gould's latest book is an argument against the supposed orthodoxy thatevolution must be a matter of continuing progress toward ever-higher levels of complexity. But who defends thatorthodoxy? The really amazing thing I have found when reading evolutionary theory is how little they talk aboutevolution as an ongoing process. Instead, they tend to try to explain what we see as the result of a finished process,in which each species has adapted fully to its environment - an environment that includes both other members of itsown species and members of other species. It is revealing that the title of the classic book by George Williams that is


often credited with a seminal role in modern evolutionary theory - a book that essentially established the principlethat social behavior should be explained in terms of the self-interest of genes - is Adaptation and Natural Selection."Evolution" isn't in the title, and certainly isn't in the text if it is taken to mean some kind of inexorable drive towardgreater perfection. The working assumption of Williams and most other evolutionary theorists, at least as far as I cantell, is that we should model the natural world not as being on the way but as being already there.

The most telling example of this preference is the widespread use of John Maynard Smith's concept of"evolutionarily stable strategies". An ESS is the best strategy for an organism to follow given the strategies that allothers are following - the strategy that maximizes fitness given that everyone else is maximizing fitness, with eachtaking the others' strategies into account. Does this sound familiar? It should: the concept of an ESS is virtuallyindistinguishable from an economist's concept of equilibrium.

And by the way: Maynard Smith's textbook is explicitly skeptical of claims that evolution is necessarily anongoing process, let alone that it need have any particular direction. Not only do the models normally settle down toan equilibrium; so do experiments, for example with RNA evolution. And any evolutionist has got to be aware thatlife appears to have stayed happily single-celled for several billion years before something led to the next big step.

Now you can understand why I say that a textbook in evolution reads so much like a textbook inmicroeconomics. At a deep level, they share the same method: explain behavior in terms of an equilibrium amongmaximizing individuals.

But why does evolutionary theory in practice fail to take advantage, if we can call it that, either of the myopiaor of the dynamics inherent in any evolutionary story?

Why evolutionists don't do evolution

What I have argued to this point is that even though evolution is a theory of gradual change, of myopicdynamics, in practice most evolutionary theory focuses on the presumed end result of such dynamics: an equilibriumin which individuals maximize their fitness given what other individuals do. Why should the theory have taken thisturn?

The answer is surely the ever-present need to simplify, to make models that are comprehensible. The fact isthat maximization and equilibrium are astonishingly powerful ways to cut through what might otherwise beforbidding complexity - and evolutionary theorists have, entirely correctly, been willing to adopt the useful fictionthat individuals are at their maxima and that the system is in equilibrium.

Let me give you an example. William Hamilton's wonderfully named paper "Geometry for the Selfish Herd"imagines a group of frogs sitting at the edge of a circular pond, from which a snake may emerge - and he supposesthat the snake will grab and eat the nearest frog. Where will the frogs sit? To compress his argument, Hamiltonpoints out that if there are two groups of frogs around the pool, each group has an equal chance of being targeted,and so does each frog within each group - which means that the chance of being eaten is less if you are a frog in thelarger group. Thus if you are a frog trying to maximize your choice of survival, you will want to be part of the largergroup; and the equilibrium must involve clumping of all the frogs as close together as possible.

Notice what is missing from this analysis. Hamilton does not talk about the evolutionary dynamics by whichfrogs might acquire a sit-with-the-other-frogs instinct; he does not take us through the intermediate steps along theevolutionary path in which frogs had not yet completely "realized" that they should stay with the herd. Why not?Because to do so would involve him in enormous complications that are basically irrelevant to his point, whereas -ahem - leapfrogging straight over these difficulties to look at the equilibrium in which all frogs maximize theirchances given what the other frogs do is a very parsimonious, sharp-edged way of gaining insight.

Now some people would say that this kind of creation of useful fictions is a thing of the past, because now wecan study complex dynamics using computer simulations. But anyone who has tried that sort of thing - and I have, atgreat length - eventually comes to realize just what a wonderful tool paper-and-pencil analysis based onmaximization and equilibrium really is. By all means let us use simulation to push out the boundaries of ourunderstanding; but just running a lot of simulations and seeing what happens is a frustrating and finally unproductiveexercise unless you can somehow create a "model of the model" that lets you understand what is going on.

I could multiply examples here, but I think the point is clear. Evolutionary theorists, even though they have aframework that fundamentally tells them that you cannot safely assume maximization-and-equilibrium, make use of


maximization and equilibrium as modelling devices - as useful fictions about the world that allow them to cutthrough the complexities. And evolutionists have found these fictions so useful that they dominate analysis inevolution almost as completely as the same fictions dominate economic theory.

What is neoclassical economics?

I just said that these fictions dominate economics. But the question in economics is whether we understand thatthey are fictions, rather than deep-seated truths. For there, perhaps, is where economists have something to learnfrom evolutionists.

In economics we often use the term "neoclassical" either as a way to praise or to damn our opponents.Personally, I consider myself a proud neoclassicist. By this I clearly don't mean that I believe in perfect competitionall the way. What I mean is that I prefer, when I can, to make sense of the world using models in which individualsmaximize and the interaction of these individuals can be summarized by some concept of equilibrium. The reason Ilike that kind of model is not that I believe it to be literally true, but that I am intensely aware of the power ofmaximization-and-equilibrium to organize one's thinking - and I have seen the propensity of those who try to doeconomics without those organizing devices to produce sheer nonsense when they imagine they are freeingthemselves from some confining orthodoxy.

That said, there are indeed economists who regard maximization and equilibrium as more than useful fictions.They regard them either as literal truths - which I find a bit hard to understand given the reality of daily experience -or as principles so central to economics that one dare not bend them even a little, no matter how useful it might seemto do so.

To be fair, there is some justification in the insistence of some economists on pushing very hard on theprinciples of equilibrium and in particular of maximization. After all, people are smarter than genes. If I offer amodel in which people seem to be passing up some opportunity for gain, you may justifiably ask me why they don'tjust take it. And unlike the case of genes, the argument that the alternative is quite different from what my imaginedagent is currently doing is not necessarily a very good one: in the real world people do sometimes respond toopportunities by changing their behavior drastically. In biology purely local change is a sacred principle; ineconomics it has no comparable justification.

And yet I think that despite the differences, it would be better if economists were more self-aware - if theyunderstood that their use of maximization-and-equilibrium, like that of evolutionary biologists, is a useful fictionrather than a principle to be defended at all costs. If we were more modest about what we think our modelingstrategy is doing, we might free ourselves to accommodate more of the world in our analysis.

And so let me conclude this talk by giving two examples of how a more relaxed, "evolution"-style approach toeconomics might help us out.

Two economic examples

As you know, one of my areas of research has been the study of economic geography. Perhaps the most basicinsight in these models has been the possibility of a cumulative process of agglomeration. Suppose that there are tworegions, and one region starts with a slightly larger concentration of industry. This concentration of industry willprovide larger markets and better sources of supply for producers than in the other region, perhaps inducing moreproducers to locate in that region, further reinforcing its advantage, and so on. It's a good story, and I am quite surethat in some sense it is correct. Yet when I and my students try to present this work, we often run into a surprisingdifficulty: theorists get very upset about the dynamics. Why, they ask, don't individuals correctly anticipate thefuture location of industry? How can you have such a model without forward-looking agents and rationalexpectations?

Now the fact is that when you try to do rational expectations in such models they become vastly more difficult,and the basic point becomes obscured. In short, here is a situation in which going all the way to full maximizingbehavior - and trying to avoid the disequilibrium, evolutionary dynamics I assume - makes life harder, not easier. Itseems to me, at least, that this is a situation where economists would do a better job if they understood thatmaximization is a metaphor to be used only to the extent that it helps understanding.


And when I run into this sort of critique I am envious of evolutionary theorists who do models like, say, theFisher theory of runaway sexual selection, and can use myopic, disequilibrium dynamics without apology. (If youdon't know that model, it works like this: suppose that there is one gene that makes peahens - that's the female ofpeacock - like males with big tails, and another that causes males to have big tails. If there is a preponderance offemales that carries this gene, then males with big tails will have more offspring even if they have less chance ofsurviving because of their visibility to predators. But because a male with a big tail is likely to be the son of a femalewho likes big tails, this success will also tend to spread the gene for big-tail preference .... The resemblance toagglomeration is obvious- isn't it?)

Another issue: consider the question of whether and how monetary policy has real effects. In the end thiscomes down to whether prices are sticky in nominal terms. In my view there is overwhelming evidence that they are.But many economists reject such evidence on principle: a rational price-setter ought not to have money illusion,therefore it is bad economics to assume that they do. If neo-Keynesians like me suggest that a bit of boundedrationality would do the trick, the answer is that bounded rationality is too open-ended a concept, and can be used torationalize too many different behaviors.

And yet in evolution the idea that there are limits to the precision of maximization is adopted cheerfully. Whena bird sees a predator, it issues a warning cry that puts itself at risk but may save its neighbors; the reason thisbehavior "works", we believe, is that many of those neighbors are likely to be relatives, and thus the bird mayenhance its "inclusive fitness". But why doesn't the bird issue a warning only its relatives can hear? Well, we justsuppose that isn't possible.

In short, I believe that economics would be a more productive field if we learned something important fromevolutionists: that models are metaphors, and that we should use them, not the other way around.


What should trade negotiators negotiate about: Areview essay

Paul Krugman

If economists ruled the world, there would be no need for a World Trade Organization. The economist'scase for free trade is essentially a unilateral case - that is, it says that a country serves its own interests bypursuing free trade regardless of what other countries may do. Or as Frederic Bastiat put it, it makes nomore sense to be protectionist because other countries have tariffs than it would to block up our harborsbecause other countries have rocky coasts. So if our theories really held sway, there would be no need fortrade treaties: global free trade would emerge spontaneously from the unrestricted pursuit of nationalinterest. (Students of international trade theory know that there is actually a theoretical caveat to thisstatement: large countries have an incentive to limit imports - and exports - to improve their terms oftrade, even if it is in their collective interest to refrain from doing so. This "optimal tariff" argument,however, plays almost no role in real-world disputes over trade policy.)

Fortunately or unfortunately, however, the world is not ruled by economists. The compellingeconomic case for unilateral free trade carries hardly any weight among people who really matter. If wenonetheless have a fairly liberal world trading system, it is only because countries have been persuaded toopen their markets in return for comparable market-opening on the part of their trading partners. Nevermind that the "concessions" trade negotiators are so proud of wresting from other nations are almostalways actions these nations should have taken in their own interest anyway; in practice countries seemwilling to do themselves good only if others promise to do the same.

But in that case why should the tits we demand in return for our tats consist only of tradeliberalization? Why not demand that other countries match us, not only in what they do at the border, butin internal policies? This question has been asked with increasing force in the last few years. In particular,environmental advocates and supporters of the labor movement have sought with growing intensity toexpand the obligations of WTO members beyond the conventional rules on trade policy, makingadherence to international environmental and labor standards part of the required package; meanwhile,business groups have sought to require a "level playing field" in terms of competition policy and domestictaxation. Depending on your point of view, the idea that there must be global harmonization of standardson employment, environment, and taxation is either the logical next step in global trade negotiations or adangerous overstepping of boundaries that threatens to undermine all the progress we have made so far.

In 1992 Columbia's Jagdish Bhagwati (one of the world's leading international trade economists) andRobert E. Hudec (an experienced trade lawyer and former official now teaching at Minnesota) broughttogether an impressive group of legal and economic experts in a three-year research project intended toaddress the new demands for an enlarged scope of trade negotiations. Fair Trade and Harmonization:Prerequisites for Free Trade? (Cambridge MA: MIT Press, 1996) is the result of that project. This massivetwo-volume collection of papers is unavoidably a bit repetitious. One also wonders why only economists


and lawyers were involved - what happened to the political scientists? (More on that later). But thevolumes contain a number of first-rate papers and offer a valuable overview of the debate.

In this essay I will not try to offer a comprehensive review of the papers; in particular I will giveshort shrift to those on competition and tax policy. Nor will I try to deal with the quite different questionof how much coordination of technical standards - e.g. health regulations on food (remember theEurosausage!), or safety regulations on consumer durables - is essential if countries are to achieve "deepintegration". Instead, I will try to sort through what seem to be the main issues raised by new demands forinternational labor and environmental standards.

The economics and politics of free trade

In a way, the most interesting paper in the Bhagwati-Hudec volumes is interesting precisely becausethe author seems not to understand the logic of the economic case for free trade - and in hisincomprehension reveals the dilemmas that practical free traders face. Brian Alexander Langille, aCanadian lawyer, points out correctly that domestic policies such as subsidies and regulations mayinfluence a country's international trade just as surely as explicit trade policies such as tariffs and importquotas. Why then, he asks, should trade negotiations stop with policies explicitly applied at the border?He seems to view this as a deep problem with economic theory, referring repeatedly to the "rabbit hole"into which free traders have fallen.

But the problem free traders face is not that their theory has dropped them into Wonderland, but thatpolitical pragmatism requires them to imagine themselves on the wrong side of the looking glass. There isno inconsistency or ambiguity in the economic case for free trade; but policy-oriented economists mustdeal with a world that does not understand or accept that case. Anyone who has tried to make sense ofinternational trade negotiations eventually realizes that they can only be understood by realizing that theyare a game scored according to mercantilist rules, in which an increase in exports - no matter howexpensive to produce in terms of other opportunities foregone - is a victory, and an increase in imports -no matter how many resources it releases for other uses - is a defeat. The implicit mercantilist theory thatunderlies trade negotiations does not make sense on any level, indeed is inconsistent with simple adding-up constraints; but it nonetheless governs actual policy. The economist who wants to influence thatpolicy, as opposed to merely jeering at its foolishness, must not forget that the economic theoryunderlying trade negotiations is nonsense - but he must also be willing to think as the negotiators think,accepting for the sake of argument their view of the world.

What Langille fails to understand, then, is that serious free-traders have never accepted as valideconomics the demand that our trade liberalization be matched by comparable market-opening abroad;and so they are not being inconsistent in rejecting demands for an extension of such reciprocity todomestic standards. If economists are sometimes indulgent toward the mercantilist language of tradenegotiations, it is not because they have accepted its intellectual legitimacy but either because they havegrown weary of saying the obvious or because they have found that in practice this particular set of badideas has led to pretty good results.

One way to answer the demand for harmonization of standards, then, is to go back to basics. Thefundamental logic of free trade can be stated a number of different ways, but one particularly usefulversion - the one that James Mill stated even before Ricardo - is to say that international trade is reallyjust a production technique, a way to produce importables indirectly by first producing exportables, thenexchanging them. There will be gains to be had from this technique as long as world relative prices differfrom domestic opportunity costs - regardless of the source of that difference. That is, it does not matterfrom the point of view of the national gains from trade whether other countries have different relativeprices because they have different resources, different technologies, different tastes, different labor laws,


or different environmental standards. All that matters is that they be different - then we can gain fromtrading with them.

This way of looking at things, among its other virtues, offers an en passant refutation of theinstinctive feeling of most non-economists that a country that imposes strong environmental or laborstandards will necessarily experience difficulties when it trades with other countries that are not equallyhigh-minded. The point is that all that matters for the gains from trade are the prices at which you trade -it makes absolutely no difference what forces lie behind those prices. Suppose your country has beencheerfully exporting airplanes and importing clothing in return, believing that the comparative advantageof your trading partners in clothing is "fairly" earned through exceptional productive efficiency. Then oneday an investigative journalist, hot in pursuit of Kathie Lee Gifford, reveals that the clothing is actuallyproduced in 60-cent-an-hour sweatshops that foul the local air and water. (If they hurt the globalenvironment, say by damaging the ozone layer, that is another matter - but that is not the issue).You maybe outraged; but the beneficial trade you thought you had yesterday has not become any less economicallybeneficial to your country now that you know that it is based on these objectionable practices. Perhapsyou want to impose your standards on these matters, but this has nothing to do with trade per se - andthere are worse things in the world than low wages and local pollution to excite our moral indignation.

This back-to-basics case for rejecting calls for harmonization of standards is elaborated in two of thepapers in Volume 1 of Bhagwati-Hudec: a discussion of environmental standards by Bhagwati and T.N.Srinivasan, and a discussion of labor standards by Drusilla Brown, Alan Deardorff, and Robert Stern. Ineach case the central theme is that neither the ability of a country to impose such standards nor its benefitsfrom so doing depend in any important way on whether other countries do the same; so why not leavecountries free to choose?

Bhagwati and Srinivasan also raise two other arguments on behalf of a laissez-faire approach tostandards, arguments echoed by several other authors in the volume. The first is that nations maylegitimately have different ideas about what is a reasonable standard. (The authors quote oneenvironmentalist who asserts that "geopolitical boundaries should not override the word of God whodirected Noah" to preserve all species, then drily note that "as two Hindus .. we find this moral argumentculture-specific"). Moreover, even nations that share the same values will typically choose differentstandards if they have different incomes: advanced-country standards for environmental quality and laborrelations may look like expensive luxuries to a very poor nation. Second, to the extent that nations forwhatever reason choose different environmental standards, this difference, like any difference inpreferences, actually offers not a reason to shun international trade but an extra opportunity to gain fromsuch trade. It is very difficult to be more explicit about this without being misrepresented as an enemy ofthe environment - an excerpt from the entirely sensible memo along these lines that Lawrence Summerssigned but did not write at the World Bank a few years ago is reprinted in my copy of The 776 StupidestThings Ever Said - so it is left as an exercise for readers.

The back-to-basics argument against harmonization of standards, then, is completely consistent andpersuasive. And yet it is also somehow unsatisfying. Perhaps the problem is that we know all too wellhow little success economists have had in convincing policymakers of the case for unilateral free trade.Why, then, should we imagine that restating that case yet again will be an effective argument against theadvocates of international harmonization of standards? Confronted with the failure of the public to buythe classical case for free trade, and unwilling simply to preach the truth to each other, trade economistshave traditionally followed one of two paths. Some try to give the skeptics the benefit of the doubt,attempting to find coherent models that make sense of their concerns. Others try to make sense not of theskeptics' ideas but their motives, attempting to seek guidance from models of political economy. Thesame two paths are followed in these volumes, with several papers following each approach.


Second-best considerations and the "race to the bottom"

The general theory of the second best tells us that if incentives are distorted in some markets, and forsome reason these distortions cannot be directly addressed, policies in other markets should in principletake the distortions into account. For example, environmental economists have become sensitized to thelikely interactions between pollution fees - designed to correct one distortion of incentives - with othertaxes, which have nothing to do with environmental issues but which, because they distort incentives towork, save, and invest may crucially affect the welfare evaluation of any given environmental policy.

There is a long history of protectionist arguments along second-best lines. (Among JagdishBhagwati's seminal contributions to international trade theory was, in fact, his work showing that manycritiques of free trade are really second-best arguments - and that the first-best response rarely involvesprotection). Here's an easy one: suppose that an industry generates negative environmental externalitiesthat are not properly priced, and that international trade leads to an expansion of that industry in yourcountry. Then that trade may indeed reduce national welfare (although of course trade may equally wellhave the opposite effect: it may cause your country to move out of "dirty" into "clean" industries, andthereby lead to large welfare gains). However, the advocates of international environmental and laborstandards seem to be offering a more subtle argument. They seem to be claiming that an environmental(or labor) policy that would raise welfare in a closed economy - or that would raise world welfare ifimplemented by all countries simultaneously - will reduce national welfare if implemented unilaterally.Thus the independent actions of national governments in the absence of international standards on theseissues can lead to a "race to the bottom", with global standards far too lax.

What sort of model might justify this fear? In an extremely clear paper in Volume 1, John D. Wilsongives the issue his (second) best shot, showing that international competition for capital - in a world inwhich the social return to capital exceeds its private return, for example due to capital taxation - could dothe trick. Other things being the same, tighter environmental or labor regulation will presumably decreasethe rate of return on investments, and thus any country which has a pre-existing tendency to attract toolittle capital will have an incentive to avoid such regulations; whereas a collective, international decisionto impose higher standards would not lead to capital flight, since the capital would have nowhere to go.

Is this a clinching argument? Not necessarily. For one thing, like all second-best arguments it is verysensitive to tweaking of its assumptions. As Wilson points out, capital importation may have adverse aswell as positive effects, especially from the point of view of an environment-conscious country. In thatcase a positive rate of taxation is appropriate - and if the actual rate of taxation is too low, countries mayadopt excessively strong environmental standards in a "race to the top". If this seems implausible, Wilsonreminds us of the NIMBY (not in my backyard) phenomenon in which no local jurisdiction is willing tobe the site for facilities the public collectively needs to locate somewhere.

Even if you regard a race to the bottom as more likely than one to the top, there is still the questionof whether such second-best arguments are really very important. This is doubtful, especially whereenvironmental standards are concerned. The alleged impact of such standards on firms' location decisionslooms large in the demands of activists who want these standards harmonized. But the chapter by ArikLevinson, surveying the evidence, finds little reason to think that international differences in thesestandards actually have much effect on the global allocation of capital.

So while it is possible to devise second-best models that offer some justification for demands forharmonization of standards, these models - on the evidence of this collection, at any rate - do not seemparticularly convincing. The classical case for laissez-faire on national economic policies is surely notprecisely right, but it does not seem wrong enough to warrant the heat now being generated over the issueof harmonization. Simply pointing this out, however, while important, does not make the phenomenon goaway. So it is at least equally important to try to understand the political impulse behind demands forharmonization, and in particular to ask whether the political economy of standard-setting offers someindirect rationale for insisting on harmonization of such standards.


The political economy of standards

Consider - as Brown, Deardorff, and Stern do - a single industry, small enough to be analyzed usingpartial equilibrium, in which a country is considering imposing a new environmental or labor regulationthat will raise production costs. As they point out, if the costs of the regulation are less than the socialcosts imposed by the industry in its absence, then it is worth doing regardless of whether other countriesfollow suit. But the distribution of gains between producers and consumers does depend on whether theaction is unilateral or coordinated. If one country imposes a costly regulation while others do not, theworld price will remain unchanged and all of the burden will fall on producers; if many countries imposethe regulation, world prices will rise and some of the burden will be shifted to consumers.

So what? Well, it is a fact of life, presumably rooted in the public-goods character of political action,that trade policy tends to place a much higher weight on producers than on consumers. So even thoughthe national welfare case for the regulation is not weakened at all by the fact that the good is traded, thepractical political calculus of getting the regulation implemented could quite possibly depend on whetherother countries agree to do the same. This suggests an alternative version of the "race to the bottom"story. The problem, one might argue, is not that countries have an incentive to set standards too low in atrading world. Rather, it is that politicians, who respond to the demands of special-interest groups, havesuch an incentive. And one might argue that this failure of the political market, rather than distortions ingoods or factor markets, is what justifies demands for international harmonization of standards.

An environmentalist or defender of workers' rights might also make a related argument. He or shemight say "You know that countries aren't in a zero-sum competition, and I know that they aren't, but thepublic and the politicians think they are - and industry lobbies consistently use that misconception as anargument against standards that we ought to have. So we need to set those standards internationally inorder to neutralize that bogus but effective political ploy". It is very difficult for trade economists to rejectthis line of argument on principle. After all, it is very close to the reason why free-traders who know thatthe economic case for liberal trade is essentially unilateral are nonetheless usually staunch defenders ofthe GATT: trade negotiations may be based on a false theory, but by setting exporters as counterweightsto producers facing import competition they nonetheless are politically crucial to maintaining more or lessfree trade. That is, the true purpose of international negotiations is arguably not to protect us from unfairforeign competition, but to protect us from ourselves. (When the United States recently imposed utterlyindefensible restrictions on Mexican tomato exports, an Administration official remarked off the recordthat Florida has a lot of electoral votes while Mexico has none. The economically correct rebuttal to thissort of thing is to point out that the other 49 states contain a lot of pizza lovers; the politically effectiveanswer is to subject US-Mexican trade to a set of rules and arbitration procedures in which the Mexicansdo too have a vote).

While one cannot dismiss such political-economy arguments as foolish, however, the problem is toknow where to stop. Here is where it would have been useful to hear from some political scientists, whomight be able to tell us more about when international negotiations over standards are likely to improvedomestic policies, and when they are likely simply to serve as a cover for protectionist motives. But whileI would have liked to see an analysis from that point of view, much of the legal analysis that occupiesVolume 2 of the Bhagwati-Hudec books does shed light on the problem.

Standards and the rule of law

Economists pronounce on legal matters at their peril: law, even international trade law, is a disciplineall its own, with a jargon just as impenetrable to us as ours is to them. Let me therefore tread cautiously ininterpreting the arguments here. As I understand it, the problem involved in defining the limits of fairtrade is not too different from that of defining the limits of free speech. Take it as a given that countries


can do things that are perceived to be economically harmful to other countries - it does not necessarilymatter whether this perception is correct. Which of these things can realistically be prohibited, and whichshould be tolerated? The answer is a matter of degree. The fellow at the next table who insists on talkingloudly to his partner about marketing is annoying, but one cannot reasonably ask the law to do anythingabout him; the person who shouts "Fire" in a crowded theater is something else again.

Where does one draw the line in international economic relations? The prevailing principle ofinternational law derives from the 17th-century Peace of Westphalia, which ended the Thirty Years' Warby establishing the rule that states may do whatever they like (such as imposing the sovereign's religion)within their borders - only external relations are the proper concern of the international community. Bythis principle labor law, or environmental policies that do not spill across borders, should be off limits.

Now in practice we do not always honor the principle of the hard-shell Westphalian state. We aresometimes willing to impose sanctions or even invade to protect human rights. Even in trade negotiationsit is an understood principle that if a country de facto undoes its trade concessions with domestic policies- for example, offsetting a tariff cut with an equal production subsidy - it is considered to have failed tohonor its agreement. But while borders are fuzzier in legal practice than they are on a map, the basicstructure of trade negotiations is still basically Westphalian. The demand for harmonization of standardsis, in effect, a demand that this should change.

We have seen that the strictly economic case for that demand is fairly weak, but there may be astronger case on grounds of political economy. But what do the legal experts say? The general answer, asI understand it, is that they don't think it is a good idea. A lucid chapter by Frieder Rousseler grants thatthe political argument for harmonization has some force, but concludes that to give in to it would open uptoo wide a range of potential complaints, much the same as would happen if I were allowed to sue peoplewhose words annoy rather than actually slander me. Other authors, such as Virginia Leary and RobertHudec himself, seem to have a similar point of view, suggesting only that nations might want to enter intospecific environmental and labor agreements that would then be enforced by the same institutions thatenforce trade agreements. (One essay, however, a piece by Daniel Gifford and Mitsuo Matsushita oncompetition policy, seems more economistic than the economists: it argues that the internationalacceptability of competition policies should be judged on whether they seem likely, or at least motivatedby the desire, to enhance efficiency).

To an economist, at least, the legal case here seems fairly similar to the economic case for tradenegotiations. We have a purist principle : unilateral free trade, the Westphalian state. We recognize basedon experience that it is useful to compromise that principle a bit, so that we work with mercantilists ratherthan simply castigating them and allow a bit of international meddling in internal affairs. But while a bitof pragmatism is allowed, the principle remains there; and it is not a good idea to stray too far. On theevidence of these volumes, then, the demand for harmonization is by and large ill-founded both ineconomics and in law; realistic political economy requires that we give it some credence, but not toomuch. Unfortunately, that will surely not make the issue go away. Expect many more, equally massivevolumes to come.


Requiem for the New EconomyMillennial optimism confronts reality

Paul KrugmanMIT economist Paul Krugman travels ahead in time to report on the presidential election of 2000:Fortune Magazine November 10, 1997

Like every presidential election in the past 20 years, last week's contest was driven largely byeconomics--specifically, by public dismay over the economy's recent performance. What is strange aboutthe near-hysterical public mood is that objectively, things aren't really that bad. Unemployment isnowhere near as high as in the early 1980s, and most forecasters think the economy either has alreadybottomed out or will do so in the near future. Yet the public is furious and bitter; it feels betrayed. Why?

The answer, surely, is that people feel that they had been led to expect better. Just a couple of yearsago it was virtual dogma among business economists and the media that we had entered a new era, that ofthe so-called New Economy--an economy that would grow at unprecedented rates thanks to the magic ofdigital technology, that would no longer be subject to the vagaries of the business cycle, that would neveragain find its ability to expand hobbled by inflationary pressure. Even Alan Greenspan cautiouslyendorsed the New Economy doctrine. As belief in that doctrine spread, the stock market soared todizzying heights, and the strength of the market only reinforced the sense of millennial optimism.

Yet even three or four years ago it was obvious to anyone who thought about it that there were, tosay the least, some major problems with the whole New Economy idea. Conventional economic measuresshowed no sign at all of an increase in the economy's potential growth rate. From the middle of 1994 tothe middle of 1997, real GDP grew at an annual rate of 2.8%; over the same period the unemploymentrate fell from more than 6% to less than 5%. Since unemployment can't fall indefinitely, this suggestedthat the economy's long-run sustainable growth was considerably less than 2.8%--perhaps no more than2%. And with a growth rate of not much more than 2%, inflation of less than 3%, and long-term interestrates of more than 6%, it was hard to see how profits could possibly grow fast enough to justify the levelof stock prices.

The response of the New Economy enthusiasts to such dismal calculations was to insist that adramatic acceleration of productivity growth had changed the rules. There was not a shred of statisticalevidence for such an acceleration--but the statistics, the enthusiasts insisted, were missing the real story.And wasn't the combination of unexpectedly low inflation and high profits proof that something hadchanged for the better? Critics pointed out in vain that low inflation and high profits could be entirelyaccounted for by slow growth in wages--and that while workers had been cautious about demanding wageincreases, this restraint could not be expected to last as labor markets became ever tighter.

The New Economy crowd also seemed to have failed to grasp the seemingly technical but actuallycrucial point that official measures of productivity, GDP growth, and inflation are not independent of oneanother. If productivity is understated by the official data, so is growth--by exactly the same amount.Even if there was unmeasured productivity growth, there was no reason to think that the economy couldgrow faster than it was already growing.


In short, the New Economy doctrine made no sense at all, and without that intellectual justificationthere was no way to regard the great stock market boom as anything other than a bubble. Yet as long asinflation stayed low and the market continued to rise, skeptical voices were ignored.

So strong was the desire to believe, in fact, that even when inflation did begin to accelerate over thecourse of 1998, the general response was denial. The pundits and the business press insisted it was only astatistical blip. Even Greenspan seems to have been unwilling to face the facts--or perhaps to face thehowls of outrage he knew would greet any rise in interest rates. And so the Fed waited until the evidencethat inflation was back was unmistakable to everyone (except a few hundred die-hard Wall Street gurus).

By that time, it was impossible to manage a soft landing. When the markets woke up to reality, theypanicked. And as millions of people watched their fortunes dwindle, they began cutting back with avengeance: consumer spending spiraled downward. By late last year the Fed--alas, minus Greenspan, whoaverted the possibility of impeachment by resigning of his own accord--was backpedaling, franticallycutting interest rates in an effort to reverse the slump.

All signs point to an incipient recovery, and unemployment is unlikely to rise above 8%. But whilethe economic havoc could have been worse, the political fallout was devastating. Prosperity had been anessential lubricant of the Washington political process during the good years. A hot economy had allowedCongress and the President to offer a little bit to everyone. Once the good times stopped rolling, ideologyran rampant: Republican radicals demanded sweeping tax cuts and a return to the gold standard, whileDemocratic radicals demanded massive public works programs and import quotas. Moderates werecaught in the crossfire. The result was a strange and ugly campaign.

The good news is that the U.S. economy remains fundamentally sound. Our ever resilient privatesector is ready to bounce back; all it really needs are calm, sensible policies at the top. The big question isthis: Can we really count on sensible policies from President-elect Perot?

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Economics Articles by Paul Krugman