The Accidental Theorist

by Krugman, Paul

  But those grim visions persist nonetheless. For smart people like Tonelson (or Gephardt), this cannot be a matter of simple ignorance: It must involve ignorance with intent. After all, it must require real effort for a full-time trade commentator, who not only writes frequently about the Third World threat but also decorates his writings with many statistics, not to notice that most of those countries run trade deficits rather than surpluses, or that wages have in fact increased dramatically in countries that used to have cheap labor. It is, I imagine, equally difficult to pursue such a career without ever becoming aware of the arithmetical necessity that countries attracting big inflows of capital must run trade deficits.

  But perhaps the uncanny ability not to notice these things is acquired by focusing mainly on China, which does appear to run a huge trade surplus even while attracting lots of foreign capital. Most of that trade surplus, as we’ve seen, is a statistical illusion. But it is still, at first sight, hard to understand how China can attract so much foreign investment without running a large current account deficit. Where does the money go?

  A useful clue comes if we look again at the last page of the Economist and ask which country runs the biggest trade surplus of all. And the answer is…Russia. Obviously this isn’t because Russia’s economy is super-competitive. What that trade surplus actually reflects is Russia’s sorry state, in which nervous businessmen and corrupt officials siphon off a large fraction of the country’s foreign exchange earnings, parking it in safe havens abroad rather than making it available to pay for imports.

  China, if you think about it, suffers from a milder form of the same ailment. The reason those inflows of foreign capital don’t finance a trade deficit is that they are offset by outflows of domestic capital. In particular, huge sums are being invested abroad to establish overseas nest eggs for honest Hong Kong businessmen just in case Hong Kong ends up looking like the rest of China, and no doubt to establish similar nest eggs for corrupt Chinese officials just in case the rest of China ends up looking like Hong Kong. To the extent that China does run a trade surplus, in other words, that surplus is a sign of weakness rather than strength.

  None of this should be taken as an apology for China’s thoroughly nasty government. I fear the worst in Hong Kong, and worry as much as anyone about the effects of growing Chinese power on Asia’s political and military stability. One thing I don’t worry about, however, is China’s trade surplus. Neither should you.

  Note to “The East Is in the Red”

  Most China-bashing in this country has concentrated not on China-sans-Hong Kong’s overall trade surplus, but on its apparently even larger bilateral surplus in trade with the United States. I say “apparently” because there is considerable dispute about the numbers. The problem is—not surprisingly—the difficulty of disentangling the Chinese and Hong Kong economies. Many U.S. exports to China go through Hong Kong, and most experts agree that as a result U.S. statistics overstate exports to Hong Kong and understate those to China. That $50 billion number you often hear is surely too large; $30 billion is more like it. Of course, even if this weren’t true it would be as silly to focus on the China–United States balance alone as to evaluate U.S. trade with, say, Canada while ignoring the imports and exports of New York City.

  What a number of analysts have pointed out in particular is that the rise of U.S. imports from China has largely reflected a relocation of production that formerly took place in Hong Kong and Taiwan—and that while America’s deficit vis-à-vis China has surged, its deficits vis-à-vis the other two have plunged. The overall trade deficit with Greater China (all three) has increased over time, but not nearly as much as the simple bilateral balance.

  But I would argue for a deeper way of looking at the emergence of a large United States–China bilateral imbalance. That imbalance does indeed reflect an asymmetry between open markets in the United States and closed markets somewhere else—but that somewhere else is not China. Rather, the problem lies in other advanced countries, notably Japan.

  Bear in mind that overall trade balances are determined by the balance between savings and investment; to a first approximation they have nothing to do with trade policies. Now imagine that a new producer emerges, eager to export labor-intensive products, prepared to import a roughly equal value of skill-or capital-intensive products. But while some countries (like the United States) have markets that are pretty open to that producer’s exports, others (like Japan or France) have tacit barriers making it difficult for the emerging economy to sell there. What will happen, clearly, is that the new producer will sell a large fraction of its exports to the more open market, while it will not buy as large a fraction of its imports from that country. That is why China ends up running a large bilateral surplus with the United States.

  Remember, however, that overall trade balances are tied down by the savings-investment balance. So the open-market United States will make up for its new deficit vis-à-vis China by running larger surpluses or smaller deficits with other countries (with the mechanism for this shift probably being some weakening of the dollar against other advanced-country currencies). Meanwhile, China will offset its trade surplus vis-à-vis the United States by running deficits vis-à-vis other countries. In effect, the world economy engages in a game of scissors-paper-stone: China takes markets previously held by America, America takes markets from other advanced countries, and these countries make up the difference by selling to China. It may seem that America is bearing an excessive burden, being required to accept the lion’s (dragon’s?) share of Chinese exports without gaining a comparable share of the Chinese market. But this is the wrong way to look at it; in fact, on most counts the United States gets the better deal.

  First of all, to suggest that the United States does worse than other countries, because it allows in imports while they don’t, brings to mind the classic comment of the nineteenth-century economist Frédéric Bastiat: It’s like saying that we should block up our harbors because other nations have rocky coasts. By accepting labor-intensive imports from China and producing other things instead, the United States is taking advantage of the opportunity to stop doing things it does relatively badly and concentrate on doing things it does relatively well. Meanwhile, other advanced countries are denying themselves that opportunity: The kinds of goods they will start selling to China will be pretty similar to the goods they stop selling to or start buying from the United States.

  Moreover, to the extent that you think some industries are more important than others—for example, because they yield technological spillovers—the jobs the United States gains by rolling back Japanese and European market shares in computers or semiconductors are surely more likely to produce those benefits than the jobs we give up by allowing in Chinese shirts and footwear.

  The downside—which is significant—is that precisely because our more open markets lead us to gain high-wage jobs but lose low-wage employment, our disproportionate role as a market for Chinese exports may exacerbate the problem of growing income inequality.

  The important thing to bear in mind is that the bilateral imbalance between the United States and China does not mean that the Chinese are taking advantage of our naiveté. (Which is not to say that they wouldn’t if they could.) It is mainly the result of the restrictions third parties place on China’s exports, not the restrictions China places on ours. And we are not being taken advantage of: In fact, the imbalance is actually a sign that America is taking advantage of opportunities that other advanced countries are passing up.

  Part 4

  Delusions of Growth

  Few subjects in economics are as contentious as the business cycle—those fluctuations of output and unemployment around the long-run upward trend. A generation ago economists were all pretty much agreed on what caused business cycles. Then, partly as a result of “stagflation”—the unexpected and unpleasant combination of inflation and unemployment that emerged in the 1970s—but mainly as a result of differences in methodological tast
es, economists studying the business cycle divided into rival factions. Some argued for an updated version of the old, mainly Keynesian approach; others wanted to reject it entirely. The great business cycle theory wars did huge damage to the prestige of economics as a profession; they also created a sense that nobody knew anything, which opened the door for various crank doctrines—most notably supply-side economics.

  Don’t tell anybody, but those wars are basically over. (Princeton’s Alan Blinder calls this the “clean little secret of macroeconomics.”) While the factions still tend to use different language, their actual views have converged—to something not very different from the consensus view of a generation ago. But the damage has proved hard to repair: many people still think that economics has nothing useful to say about the business cycle, and crank doctrines continue to flourish.

  The crank doctrine du jour is something widely known as the “New Paradigm” it amounts to the assertion that new forces such as globalization and technological change have cancelled all the old rules, that old speed limits on growth have been repealed, perhaps that the business cycle itself has been abolished. There are many things wrong with that story line, among them the question of whether globalization and technology are really proceeding as dramatically as its adherents claim. “We Are Not the World” already described my doubts about globalization; the first essay here describes some similar doubts about technology.

  More important, however, the New Paradigm seems to involve confusion about the difference between the business cycle and long-term growth, coupled with a misunderstanding of the things that monetary policy can and cannot do. I try to explain those distinctions in the second essay, “Four Percent Follies.”

  To be skeptical about the prospects for rapid growth is, it turns out, to run the risk of being identified with another, equally misguided camp: that which believes that controlling inflation is the only priority of policy, that nothing can be done to fight recession and unemployment. This belief, especially acute among central bankers, is arguably imposing huge, gratuitous economic pain in much of the world; the third piece here, “A Good Word for Inflation,” focuses mainly on Europe and makes the case against a single-minded emphasis on price stability, while the fourth essay argues that monetary passivity accounts for much (not all) of Japan’s economic malaise.

  Finally, in “Seeking the Rule of the Waves,” I made use of a book review assignment to say some things I always wanted to say about economics, history, and the reasons why the business cycle is surely nowhere near dead.

  Technology’s Wonders: Not So Wondrous

  Lately many business leaders and thinkers have become preoccupied with something called the Information Technology Paradox. It goes like this: We live in an age of unprecedented technological progress, which is making everyone far more efficient than before. Yet where is the payoff? The standard of living of ordinary Americans doesn’t seem to be soaring; if anything, many people are finding it harder, not easier, to make ends meet. If we’re so smart, why aren’t we richer?

  A lot of ingenious things have been said about the reasons for the paradox, but there is one explanation that hardly anyone dares mention: Maybe the wonders of technology we keep hearing about aren’t really all that wondrous.

  To get an idea of what I mean, think about 2001. No, not the year—the movie 2001: A Space Odyssey, which came out in 1968. Most readers must have seen it. The middle part of the movie offered what was supposed to be a realistic picture of life thirty-three years in the movie’s future, but barely four years from now. In that world there were regularly scheduled commercial flights to space stations with Sheraton-style lobbies, and computers smart enough to go on a postal worker–style rampage when they felt unappreciated. But airlines aren’t offering orbital vacations to their frequent flyers; Shannon Lucid could not call room service; and my computer’s idea of murderous revenge is to tell me “An error has occurred in your application. Terminate/Ignore?” If 2001 is actually going to look anything like 2001, technology had better get a move on.

  The point is that if you measure the progress of technology not by Mips and bytes but by how it affects people’s lives and their ability to get useful work done, you realize that the last thirty years have been a time not of unexpected achievement but of persistent disappointment.

  Surely, for example, the startling thing about computers is not how fast and small they have become but how stupid they remain. Back in 1958 the pioneer computer scientist Herbert Simon confidently predicted that a computer would be the world’s chess champion by 1970; this makes the eventual victory of IBM’s Deep Blue over Gary Kasparov a bit of a letdown. And building a computer that plays high-level chess turns out to be an easy problem—nowhere near as hard as, say, designing a robot that can vacuum your living room, an achievement that is still probably many decades away.

  Even where computers have become ubiquitous—such as in the modern office—it is very questionable how much they actually raise productivity. Recently many companies have begun to realize that when they equip their office workers with computers they also impose huge hidden costs on themselves—because a computer requires technical support, frequent purchases of new software, repeated retraining of employees, and so on. That $2,000 computer on your employee’s desk may well impose $8,000 a year in such hidden costs—and that’s even if the worker does not spend a significant part of the work day playing Tetris or surfing the Net.

  And what about technologies that don’t involve manipulating digital information—for example, the technology of daily life? Think, for example, about how a typical middle-class family lives today compared with forty years ago—and compare those changes with the progress that took place over the previous forty years.

  I happen to be an expert on some of those changes, because I live in a house with a late-fifties-vintage kitchen, never remodelled. The non-self-defrosting refrigerator and the gas range with its open pilot lights are pretty depressing (anyone know a good contractor?)—but when all is said and done it is still a pretty functional kitchen. The 1957 owners didn’t have a microwave, and we have gone from black and white broadcasts of Sid Caesar to off-color humor on The Comedy Channel, but basically they lived pretty much the way we do. Now turn the clock back another forty years, to 1917—and you are in a world in which a horse-drawn wagon delivered blocks of ice to your icebox, a world not only without TV but without mass media of any kind (regularly scheduled radio entertainment began only in 1920). And of course back in 1917 nearly half of Americans still lived on farms, most without electricity and many without running water. By any reasonable standard, the change in how America lived between 1917 and 1957 was immensely greater than the change between 1957 and the present.

  In short, the idea that we are living in an age of dramatic technological progress is mainly hype; the reality is that we live in a time when the fundamental things are actually not changing very rapidly at all.

  Now I am not saying that this is anyone’s fault. If Bill Gates turns out to be no Henry Ford, that is no reflection on his abilities. Really productive ideas, like internal combustion and the assembly line, are hard to find. It is no tragedy if we have to make do with second-rate inventions like the personal computer until the next Model T comes along. But the techno-hype that surrounds us has some real costs. It causes businesses to waste money; it causes politicians to seek high-tech fixes (give every child a laptop!) when they should be getting back to the basics (teach every child to read). The slightly depressing truth is that technology has been letting us down lately. Let’s face up to that truth, and get on with our lives.

  Four Percent Follies

  Recently a lot of influential people have been berating Alan Greenspan and his colleagues at the Federal Reserve for not allowing the economy to grow faster. The most prominent of these critics has probably been Felix Rohatyn, who was proposed though never formally nominated to become the vice-chairman of the Fed. It’s important to note that Rohatyn is not arguing
for a modest change in policy, a view that many economists share. What he is arguing for is a massive monetary expansion: instead of the 2 to 2.5 percent growth the Fed seems to be targeting, it should aim for no less than 3.5 or 4 percent over the next decade. In fact, let me refer to Rohatyn and allies for short as the “four-percenters.”

  A talk given to the Economic Club of Washington, April 1996.

  This debate over Fed policy is obviously a crucial issue in its own right; but I also find it a useful illustration of how and why smart people say foolish things about the economy.

  I’m eventually going to get around to some specifics about what the four-percenters have to say, but let me start with some general conceptual issues. Here’s a question you probably don’t ask yourself very often, but should: What gives Alan Greenspan such power? I don’t mean why does he rule the Fed; I mean why do the decisions of the Fed’s Open Market Committee—a group of charisma-impaired economists and bankers sitting around a table every six weeks—matter so much?

  To answer a question like that, you need some kind of model of the role of monetary policy. So let me spend a few minutes laying out such a model.

  At this point you are thinking “Oh no! He’s going to start in with equations and economic jargon!” But don’t worry—it’s not that kind of model. In fact, I hope this will be fun. There will, however, be a quiz on this material—so listen carefully.

  The model that I find most useful for understanding what the Fed can (and can’t) do is one that some of you may have seen described in my book Peddling Prosperity. It was originally described by Joan and Richard Sweeney in an article entitled “Monetary Theory and the Great Capitol Hill Baby-sitting Co-op Controversy.”