The Accidental Theorist

by Krugman, Paul

  What does conventional economic history have to say about these “price revolutions”? Well, the two familiar ones are both generally attributed to increases in the supply of money, but with those increases themselves driven by very different factors. The long inflation from 1500 to 1700 is mainly attributed to the flood of silver from Spain’s New World conquests; in the modern world governments can print money instead of mining it, and have done so repeatedly both to pay their bills and, more creditably, in an attempt to trade off higher prices for lower unemployment.

  Fischer regards such explanations as inadequate. He insists both that inflation is only one symptom of a deeper process—one that also produces growing population, rising inequality, declining real wages, and ultimately a crisis—and that this process is repetitive, that in a qualitative sense all price revolutions are alike. In particular, the travails of the West in recent decades are typical of the end game of a price revolution—and we can take comfort from the fact that such difficult periods are inevitably followed by a prolonged “equilibrium.”

  This thesis is both fun to contemplate and comforting in its implication that the worst may already be behind us. What is wrong with it? One problem with The Great Wave is that Fischer shares a common shortcoming of historical writers on matters economic: He would clearly rather spend a year hunting down facts than a day mastering a theory, even if only to learn enough to reject it. As a result, his accounts of what he imagines to be the conventional theories of inflation—theories that he claims to refute with his evidence—are wildly off-base, sometimes ludicrously so.

  Fischer’s impatience with analytical thinking extends to his own ideas; the book contains quite a few whoppers, assertions that fall apart if given even a moment’s serious thought. An illuminating example involves his discussion of the origins of the great price rise after 1500. He points out correctly that prices in Europe began rising well before New World silver began to arrive—which he argues refutes any monetarist explanation. But there is no mystery here: As he admits, there was a surge in European silver production in the late fifteenth century, mainly from mines in Bohemia and Southern Germany. (Coins stamped at one of those mines, at Joachimsthal, were circulated so widely that “thaler” became a generic phrase for any silver coin—and eventually, with some slippage in spelling and pronunciation, for pieces of green paper bearing George Washington’s portrait.) Fischer insists, however, that the rise in European silver production was a result rather than a cause of inflation—that mines were opened and expanded to meet the “desperate need for liquidity” produced by rising prices.

  Think about that for a minute. We can be sure that fifteenth-century German mineowners neither knew nor cared about Europe’s need for liquidity—they were simply trying to make a profit. Now ask yourself: Does inflation (a rise in the price of goods and services in terms of silver) make it more or less profitable to open a silver mine? The clear answer is that it makes the mine less profitable: A pound of silver extracted from the mine would buy fewer goods and services than before. Had Fischer devoted even a few minutes to thinking his story through, he would have realized that. Yet the claim that rising prices necessarily induce increased creation of money is crucial to his whole theory.

  There is, however, an even bigger problem with The Great Wave. Like most efforts to derive lessons for the present from the broad sweep of history, Fischer’s thesis essentially involves denying that the Industrial Revolution led to any fundamental change in the way the world works. But the fact is that beginning in the eighteenth century there was a qualitative change in the nature not only of economic life but of human society in general, a change more profound than any since the rise of civilization itself. That does not mean that we have nothing to learn from earlier centuries; it does mean that we have to be very careful in drawing parallels.

  There are many ways in which the preindustrial world was another planet from the one we now inhabit, but let me focus on two changes that are particularly crucial in this context.

  First, for fifty-five out of the last fifty-seven centuries Malthus was right. What I mean is that for almost all of the history of civilization improvements in technology did not lead to sustained increases in living standards; instead, the gains were dissipated by rising population, with pressure on resources eventually driving the condition of the masses back to roughly its previous level. The subjects of Louis XIV were not noticeably better nourished than those of ancient Sumerian city-states; that is, while they had enough to survive and raise children in good times, they lived sufficiently close to the edge that the Four Horsemen could carry them off now and then, keeping the population more or less stable.

  It was Malthus’s great misfortune that the power of his theory to explain what happened in most of human history has been obscured by the fact that the only two centuries of that history for which it does not work happen to be the two centuries that followed its publication. But this was, of course, not an accident. Malthus was a man of his time, and his musings were only one symptom of the rise of a rationalist, scientific outlook; another symptom of that rise was the Industrial Revolution.

  Because Malthus was right, however, the Great Waves of economic activity in the preindustrial world, while they undoubtedly existed, were driven by forces that have little relevance to more recent fluctuations. In particular, the most important discipline for understanding long swings in preindustrial population and real wages is not macroeconomics but microbe economics. Now and then devastating new diseases would appear (often, as McNeill showed in Plagues and Peoples, as a result either of conquests or of the opening of new trade routes, both of which tended to bring formerly separated populations, and the germs that they harbored, into contact). Initially the population would plunge and real wages would soar. As microbes and humans coevolved into a new equilibrium, population and pressure on resources would rise again, and the increasingly malnourished masses would become vulnerable to the next plague. All this is fascinating; but its relevance to twenty-first-century economic prospects is questionable.

  The other great change is the invention of the business cycle. Economic instability has, of course, always been with us. But economic downturns before 1800 were the result of “supply-side” events such as harvest failures and wars. They bore little resemblance to modern recessions, which are the result of slumps in monetary demand. To have a recession as we understand it today, you must have a structure of paper credit erected on top of or in place of the circulation of gold and silver—otherwise, the credit contraction so central to the phenomenon cannot get started in the first place. And you must also have a substantial part of the economy that is likely to respond to slumping demand by cutting production rather than prices—otherwise a financial contraction will lead to deflation, but not to an actual decline in output. Preindustrial economies could not have recessions as we know them, both because of the simplicity of their monetary systems and because they consisted mostly of farmers, who respond to a drop in demand mainly by cutting prices rather than by growing less.

  Economic historians generally think that the first true recession was the slump that hit England after the end of the Napoleonic Wars—in other words, the first recession occurred, as one would expect, in the first industrial nation. Nations that industrialized later also had to wait for their chance to share the recession experience. My colleague, the distinguished economic historian Peter Temin, tells me that the United States did not experience a true recession until the Panic of 1873. Moreover, he has produced evidence that between 1820 and 1860 there was a clear difference in the behavior of the U.S. and U.K. economies: America was still a “classical” economy in which financial contractions might reduce prices but had little effect on growth, while England was already beginning to look recognizably Keynesian.

  And that brings us both to the reason why people in the business community think that Fischer’s book is relevant to current events, and to the reason why it is in fact not relevant at all.
>
  Anyone who reads the business press knows that the mood these days is one of what-me-worry optimism. After six years of fairly steady growth with surprisingly quiescent inflation, every major newspaper and magazine has either suggested or flatly declared that the business cycle is dead—that the recession of 1990–1991 was the last such slump we will see for many years to come.

  Nay-sayers like myself try to puncture this serenity by insisting that it ignores the lessons of history. It was not that long ago that George Bush got the boot because of the economy, stupid; we had a truly vicious recession in the early 1980s; and for that matter Mexico, Japan, and even Canada (remember them? they’re that country next to us) can attest that the nineties have by no means been always and everywhere as placid as the last few years in the United States. Moreover, we’ve been here before: Near the end of another long recovery, in the late 1960s, pronouncements that the business cycle was dead were just as prevalent as they are today.

  Why does the business cycle persist? Because, as the bumper stickers don’t quite say, stuff happens: The world refuses to stay put, and policy is always playing catch-up. To look at the causes of booms and slumps since the last time the business cycle was declared dead is to be awed at the sheer variety of curve balls history manages to throw at us. Who in 1969 imagined that a recession could be triggered by a war in the Middle East—let alone a fundamentalist revolution in Iran? Who would have thought that the ever-so-controlled Japanese economy could be whipsawed by a financial bubble that drove land and stock prices to ridiculous levels, then burst? Who could have predicted that two well-meaning projects—the political unification of Germany, and the monetary unification of Europe—would interact to produce a disastrous slump? True, we learn from experience: The stock market crash of 1987 didn’t play like that of 1929, because this time Alan Greenspan knew what to do. But as fast as we learn to cope with old sources of boom and slump, new sources emerge.

  Some people tell us that the forces that used to drive many recessions have abated: We are no longer as much of a manufacturing economy, inventories have become less of an “accelerator” of slumps, and so on. And they are surely right: We will not have the same problems in the future that we had in the past. We will have different problems. And because the problems are new, we will handle them badly, and the business cycle will endure.

  But this is not a message business pundits want to hear; and for them Fischer’s book is the perfect answer. Of course, they can now say, the business cycle has been with us for the last 150 years—but the long view tells us that while instability is the norm while you are passing through a price revolution, it is smooth sailing once you pass through the crisis and reach the new “equilibrium.” And guess what—we have just arrived at the promised land.

  But the modern business cycle bears no more resemblance to the economic fluctuations that afflicted preindustrial Europe than NATO does to the Holy Roman Empire. It may be tempting to ignore the very real lessons of the last century because of some alleged parallels with the distant past. To do so, however, would be to use history not as a guide to the present, but merely as an excuse for some very ahistorical wishful thinking.

  Part 5

  The Speculator’s Ball

  The 1990s have been a great age for financial speculation.

  Markets have been rigged, currencies overthrown, vast sums made and lost with an abandon not seen for generations. The essays in this part try to make some sense of it all. The first essay here, “How Copper Came a Cropper,” discusses the amazing story of Sumitomo’s initially successful “corner” on the world copper market. The next, “The Tequila Effect,” turns to a more tragic case—the havoc wreaked on Mexico and other Latin American nations by the currency crisis that erupted at the end of 1994. With “Bahtulism” we move on to the Asian currency crises of 1997; and the final piece here, “Making the World Safe for George Soros,” tries to step back for a broader view, albeit one with a special European focus.

  How Copper Came a Cropper

  In 1995 the world was astonished to hear that a young employee of the ancient British firm Barings had lost more than a billion dollars in speculative trading, quite literally breaking the bank. But when an even bigger financial disaster was revealed a year later—the loss of more than $3 billion in the copper market by an employee of Sumitomo Corp.—the story quickly faded from the front pages. “Oh well, just another rogue trader,” was the general reaction.

  It eventually became clear, however, that Yasuo Hamanaka, unlike Nick Leeson of Barings, was not a poorly supervised employee using his company’s money to gamble on unpredictable markets. On the contrary, there is little question that he was, in fact, implementing a deliberate corporate strategy of “cornering” the world copper market—a strategy that worked, yielding huge profits, for a number of years. Hubris brought him down in the end; but it is his initial success, not his eventual failure, that is the really disturbing part of the tale.

  To understand what Sumitomo was up to, you don’t need to know many details about the copper market. The essential facts about copper (and many other commodities) are (1) it is subject to wide fluctuations in the balance between supply and demand, and (2) it can be stored, so that production need not be consumed at once. These two facts mean that a certain amount of speculation is a normal and necessary part of the way the market works: It is inevitable and desirable that people should try to buy low and sell high, building up inventories when the price is perceived to be unusually low and running those inventories down when the price seems to be especially high.

  So far so good. But a long time ago somebody—let’s say a Phoenician tin merchant in the first millennium B.C.—realized that a clever man with sufficiently deep pockets could basically hold such a market up for ransom. The details are often mindnumbingly complex, but the principle is simple. Buy up a large part of the supply of whatever commodity you are trying to corner—it doesn’t really matter whether you actually take claim to the stuff itself or buy up “futures,” which are nothing but promises to deliver the stuff on a specified date—then deliberately keep some, not all, of what you have bought off the market, to sell later. What you have now done, if you have pulled it off, is created an artificial shortage that sends prices soaring, allowing you to make big profits on the stuff you do sell. You may be obliged to take some loss on the supplies you have withheld from the market, selling them later at lower prices, but if you do it right, this loss will be far smaller than your gain from higher current prices.

  It’s a beautiful idea; there are only three important hitches. First, you must be able to operate on a sufficiently large scale. Second, the strategy only works if not too many people realize what is going on—otherwise nobody will sell to you in the first place unless you offer a price so high that the game no longer pays. Third, this kind of thing is, for obvious reasons, quite illegal. (The first Phoenician who tried it probably got very rich; the second got sacrificed to Moloch.)

  The amazing thing is that Sumitomo managed to overcome all these hitches. The world copper market is immense; nonetheless, a single trader, apparently, was able and willing to dominate that market. You might have thought that the kind of secrecy required for such a massive market manipulation was impossible in the modern information age—but Hamanaka pulled it off, partly by working through British intermediaries, but mainly through a covert alliance with Chinese firms (some of them state-owned). And as for the regulators…well, what about the regulators?

  For that is the disturbing part of the Sumitomo story. If Hamanaka had really been nothing more than an employee run wild, one could not really fault regulators for failing to rein him in; that would have been his employer’s job. But he wasn’t; he was, in effect, engaged in a price-fixing conspiracy on his employer’s behalf. And while it may not have been obvious what Sumitomo was up to early in the game, the role of “Mr. Copper” and his company in manipulating prices has apparently been common knowledge for years among everyone fam
iliar with the copper market. Indeed, copper futures have been the object of massive speculative selling by the likes of George Soros, precisely because informed players believed that Hamanaka was keeping the price at artificially high levels, and that it would eventually plunge. (Soros, however, gave up a few months too soon, apparently intimidated by Sumitomo’s seemingly limitless resources.) So why was Hamanaka allowed to continue?

  The answer may in part be that the global nature of his activities made it unclear who had responsibility. Should it have been Japan, because Sumitomo is based there? Should it have been Britain, home of the London Metal Exchange? Should it have been the United States, where much of the copper Sumitomo ended up owning is warehoused? Beyond this confusion over responsibility, however, one suspects that regulators were inhibited by the uncritically pro-market ideology of our times. Many people nowadays take it as an article of faith that free markets always take care of themselves—that there is no need to police people like Hamanaka, because the market will automatically punish their presumption.

  And Sumitomo’s strategy did indeed eventually come to grief—but only because Hamanaka apparently could not bring himself to face the fact that even the most successful market manipulator must accept an occasional down along with the ups. Rather than sell some of his copper at a loss, he chose to play double or nothing, trying to repeat his initial success by driving prices ever higher; since a market corner is necessarily a sometime thing, his unwillingness to let go led to disaster. But had Hamanaka been a bit more flexible and realistic, Sumitomo could have walked away from the copper market with modest losses offset by enormous, ill-gotten gains.