Paul Krugman’s Blind Spots

Unwordly Economic Research in the Neoliberal-Anarchic Environment

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version: Paul Krugmans blinde Flecken

Table of Contents

  1. Abstract
  2. Introduction
  3. Krugman and the New Trade Theory
    > Krugman’s Political Influence
    > Krugman’s Scientific Premises
    > The Justification of Krugman’s Nobel Prize
  4. Critical Assessment of Krugman’s Research
    > General Criticism
    > Empirical Evidence
    > Comparative Advantage
  5. Prospect

1. Abstract

U.S. economist Paul Krugman has been awarded the 2008 Nobel Prize for his contribution to the so-called new trade theory. This theory is a typical example for the absurd attempts to depict the anarchic neoliberal processes in models and attribute a quasi-natural inevitability and predictability to them. The increasingly chaotic behavior of the deregulated international trade lets these attempts appear as scientifically dishonest and unworldly.

2. Introduction

In this article I mainly refer to the research of U.S. economist Paul Krugman to show how far removed mainstream economics have already become from the requirements of a future-oriented approach. Krugman is one of a small number of versatile individuals who could be called »cross-border« economists. This referring to the fact that Krugman is not only ambitiously engaged in commenting on the actual economic development, which he does quite self-willedly and critically, but that he is also eager to be perceived as a pioneering theorist in the neoliberal mainstream. With the 2008 Nobel Prize, the Royal Swedish Academy of Sciences has acknowledged Krugman’s versatility, and in doing so, has »officially« approved another questionable theoretical work.

Since the introduction of the Prize in Economic Sciences in 1969, the Swedish Academy and its respective prize committees have been predominantly acting as advocates of economists who try hard to transmute economics into an exact science. The applied method is simply to abstract economic processes from their social and environmental conditions, describe the synthetic remains with mathematical formulas and attest them to reflect the inevitable and predictable economic course. There is no question that this is an outrageous scientific approach, because the original object of inquiry of economics, namely the social (and lately also the environmental) reality, is thereby declared as insignificant and even out-of-place. This is also the reason why neoliberal economists again and again raise the plea that not economics, but politics, bear responsibility for the social and ecological implications of economic activities. This misconception has to be cleared up once and for all.

To start with, it should be noted that economics are a social science, but by no means an exact natural science. The confusion to which the economic protagonists abandon themselves arises from a fundamentally false premise: they assign unlimited, worldwide grantable freedom to each and every economic player. In other words, everyone should be economically absolutely free to do as he/she pleases. That way, an understanding and eventual implementation of economic policies is promoted that is serving nothing but the egoisms of a small number of powerful global players, and is therefore not contributing to a better life for all. By avoiding its social obligations, economics discredit any economic regulation and control, and reinforce the already widespread belief that economic issues are a highly complex matter to be handled by experts only.

With the premise of unlimited economic freedom, neoliberal economists have created a playground of highest complexity that allows them an endless variety of useless and irrelevant mathematical playing. As mathematical formulas and the models composed of them suggest scientific respectability, they are not only admired by the uninformed public, but also by the intellectual elite – as the awarded Nobel Prizes demonstrate. The nimbus of neoliberal economics and the indoctrination conducted by neoliberal players obstruct the critical public awareness of the neoliberal repercussions, and inspire the illusion that the advancing deregulation (»liberalization«) of the world economy was a natural evolution, was scientifically justified, and would ultimately contribute to the benefit of mankind.

3. Krugman and the New Trade Theory

Krugman’s Political Influence

U.S. journalist Michael Tomasky has described Krugman as a »liberal polemist«, getting to the point of Krugman’s political impetus. Economically, Krugman argues for free markets, but as well for government intervention, if market failure is to be countered. He himself feels a strong political affinity with the European social-democratic tradition. Through his trenchant columns in the New York Times he became one of the most famous intellectuals of the United States.

He repeatedly criticized former president George W. Bush and his administration for their tax cuts, which led to increased budget deficits and favored the rich without stimulating the economy. And he made the former Fed chairman Alan Greenspan personally responsible for the financial market crisis, because Greenspan had advocated the trade in hazardous derivatives, claiming that the risks could thus be spread across the strongest shoulders worldwide. Currently, Krugman criticizes the Obama administration for its massive support of U.S. financial institutions and their half-hearted investments in the labor market. He received the Nobel Prize in 2008, as outlined below, for his explanation of international trade patterns and the geographic distribution of production and welfare.

Krugman’s Scientific Premises

Krugman has contributed significantly to the New Trade Theory. His scientific work and his publications, for which he was awarded the 2008 Nobel Prize, originated during the 1979 – 2005 period, i.e. during the emergence of the neoliberal economic globalization. In a negative sense, his work reflects this unique phase of economic history. His scientific approach is selectively analytical and descriptive, but not at all critical and creative: he isolates some decisive phenomena of this development and defines their (alleged) mathematical relationship. Accordingly, he indirectly accepts the globally proliferating economic deregulation as well as the resulting decline of social and environmental standards as God-given – by not mentioning them with a single word. His uncritical comprehension doesn’t allow him anything other than approaching the neoliberal reality in a purely descriptive way. So he ends up with models resembling the neoliberal reality, particularly regarding its detachment from any social and environmental commitment. By ignoring the devastations caused by the neoliberal development, Krugman contributes to the already widespread dehumanized understanding of economic activity.

The Justification of Krugman’s Nobel Prize

Firstly, I quote from the (uncritical) acknowledgement of Krugman’s work by the Royal Swedish Academy of Sciences as published with the 2008 Nobel Prize award[1]. Subsequently, I criticize Krugman’s contribution to the New Trade Theory. The following quotation is presented in condensed and analogous form and is set in italics:

Quote: This year’s prize is awarded to Paul Krugman for his research on international trade and economic geography.

Krugman’s research provides the theoretical basis for answering important questions: How are we affected by globalization? What are the effects of free trade? Why do increasing numbers of people flock to large cities, while rural areas become depopulated?

International trade: In the early 19th century, David Ricardo launched the theorem of comparative advantage to explain the range and composition of international trade. In the 20th century, the theorem was supplemented by Eli Heckscher and Bertil Ohlin, with the core message remaining the same: countries should specialize in and export products in accordance with their relative endowment with production factors. Relatively capital-rich countries should, for example, export industrial products and import agricultural products, while relatively capital-poor countries should do the contrary.

During the past 50 years, the trade patterns corresponded less and less to the above mentioned old theoretical assumptions, because the so-called intra-industry trade propagated throughout the world, primarily between rich countries. Intra-industry meaning that each country involved exports and imports almost identical products. Sweden, for example, exports Volvo cars that are considered robust and suitable for families, while the country simultaneously imports BMW cars from Germany, which have a sporty image. Contrary to the old theoretical assumptions, intra-industry trade takes place although the same technologies and equal amounts of labor and capital (equal factor proportions) are used by the trading partners involved.

Krugman explained the increase in intra-industry trade partly with reduced unit costs through mass production, the so-called economies of scale, and partly with the preference of consumers for diversity and variation in their consumption. In intra-industry trade mass production is made possible by selling unique national product variants (Volvo and BMW cars) in global markets so that each manufacturer becomes a global monopolist, resulting in monopolistic (imperfect) competition, because all competitors (in the example Volvo and BMW) are unrivaled in their market segment.

The more countries that participate in intra-industry trade and monopolistic competition, the higher are the economies of scale achieved by each monopolist. At the same time, rising scale economies cause prices to fall, so that more and more countries import these products, subsequently increasing product diversity and consumer choices worldwide.

Krugman’s explanation implies that today’s international trade takes place partly on the basis of comparative advantage – between differently developed and endowed countries – and partly as intra-industry trade, particularly between equally endowed, highly developed countries.

Economic geography: On the basis of his assumptions on international trade, Krugman also explained the geographic distribution of labor, capital and welfare. Areas (or countries) with a higher population density achieve higher economies of scale, because they produce larger quantities of goods, resulting in lower prices, increased diversity, higher wages and ultimately a higher standard of living. This advantage attracts workers and capital from areas (or countries) with a lower population density, reinforcing the geographic disparities.

If goods are exported over long distances, which is the normal case in global markets, the concentration effect can, however, be slowed or reversed due to rising transport costs. These considerations led Krugman to his core-periphery model: when business enterprises decide on the establishment of new locations, they have to find a trade-off between economies of scale in production and cost disadvantages in transport. Because of the rationality of these trade-offs, low transport costs can lead to high geographic concentration and urbanization, whereas high transport costs can have a decentralizing effect. These correlations also explain the so-called home market effect: enterprises concentrate their production facilities as close as possible to their largest sales market in order to minimize transport costs. This also suggests that countries mainly export goods for which they have a large home market.

Practical significance: The New Trade Theory permits predictions as to how trade liberalization influences trade patterns. And it can also be used for welfare analysis.

Conclusion: Krugman has integrated economies of scale into general equilibrium models, thus deepening our understanding of the determinants of trade and location of economic activity. End of quote!

4. Critical Assessment of Krugman’s Research

Most observers of the neoliberal globalization will be familiar with the phenomena described by Krugman – and would presumably rate his conclusions as trivial and obvious. The question remains, however, why the Royal Swedish Academy of Sciences awards prizes to economists who try to model a doctrinaire and chaotic system for the purpose of predicting the future of the global economy. Moreover, a system whose devastating social and environmental impacts are well documented.

General Criticism

Krugman absolutizes economies of scale in his models, that is, he doesn’t limit the arising external costs, and declares the scale economies to be the desirable driving force of the neoliberal development. Thereby he automatically acknowledges the disastrous chain reaction of neoliberalism and spoils his chance for a critical analysis: A simple rundown of current statistics would reveal to him that the striving for maximum economies of scale implies unlimited dumping, unlimited capital concentration, unlimited externalization of costs and unlimited apparent productivity, altogether resulting in high unemployment, unequal distribution of income and assets, and environmental degradation. The state of equilibrium he pretends to describe with his models is a dangerous illusion, for economic equilibrium can never be achieved without pursuing high employment levels, performance-related distribution of income, and internalization of social and environmental costs. In short, only a state of sustainably optimal welfare is synonymous with a state of economic equilibrium (see also the article Scale Economies and Productivity).

Empirical Evidence

Empirical data on international trade in deregulated global markets show that the trade pattern is in fact, as argued by Krugman, determined through economies of scale and differences in factor endowment (factor proportions), especially through the lowest unit costs and highest capital investments. However, the alleged benefits of deregulated global markets are not confirmed through this data. Krugman is mistaken, because he does not take into account that, in the absence of economic policy, economies of scale are increasingly achieved through social, ecological and exchange dumping, and that, for example, the declining work volume and the more and more specific labor demand can not be compensated through reductions of working hours or state transfers, since the global cost pressure increases simultaneously.

By the way, the term exchange dumping refers to the devaluation of a national currency against the dollar or euro as neoliberal key currencies. Exchange dumping is not possible for individual euro zone countries, and would also be ineffective for countries exporting only small volumes into the dollar zone. Greece’s trade deficit and over-indebtedness are the latest evidence that the economically inhomogeneous euro zone is a faulty design. For details regarding the euro zone I recommend the article EU: Federal Superstate or Federation?.

Under the prevailing conditions of deregulated global markets, empirical data on economic geography show that market size and wages in fact correlate positively. But again, Krugman’s model creates a false impression, because high wages, raised through dumping induced concentration, are only to the benefit of a dwindling minority of workers who have very specific qualifications, while unemployment and precarious employment increase at the same time. Whereas the massive migration assumed in Krugman’s core-peripheral model can not be evidenced, first and foremost because fewer and fewer workers with ever more specific skills are demanded due to increasing capital intensity. Apart from that, a pure displacement of workers with less specific skills takes place resulting from the process of opening up national labor markets, causing a worldwide decline in wages and social standards.

Likewise, the home market effect can not be evidenced under neoliberal conditions, since countries continually lower (dump) their social, environmental and safety standards under the pressure of the global locational competition, enabling business enterprises to establish and frequently move their branches around the globe to locations where the lowest costs happen to be incurred. Ireland, for example, reduced its standards extremely and successfully years ago at the expense of other countries, just to exuberantly gamble away its profits through investing in worthless financial derivatives, thus contributing to the financial crisis that took its course in 2008.

Comparative Advantage

The assumption that the international trade pattern was at one time or another crucially determined through comparative advantages, is undifferentiated or wrong respectively. It is undifferentiated regarding the entire period of economic history prior to the failure of the Bretton Woods Agreement in the early 1970s (see the article Bretton Woods System). During this historic period, the utilization of comparative advantages, actually requiring negotiations at eye level, was undermined by hegemonic economic strategies and imperialistic policies. The explanation is simply that bilateral agreements on exactly calculated exchange rates and cost-covering export prices would have been (and still are) inevitable for a mutually profitable use of comparative advantages. But such agreements are not proven for that period of time. Furthermore, a profitable trade pattern had to be based on multi-bilateral agreements to avoid the complexity and vulnerability of multilateral relations.

The assumption is wrong regarding the recent period after the failure of the Bretton Woods Agreement, the period during which the neoliberal globalization emerged. Since then, international trade is mostly settled in dollars and partly in euros, with both currencies serving as key currencies. Therefore, all that really does count in this neoliberal trade is the absolute (price) advantage in one of the two key currencies, irrespective of what the exchange rate between national and key currency happens to be, and irrespective of whether the price of a product covers all costs of production or is distorted through dumping. In short, under the neoliberal regime international competition and trade flows are not determined through relative comparative advantages, but through absolute price advantages in key currency. And these price advantages are subject to both deliberate and speculative-accidental interference, affecting inter-industry and intra-industry trade likewise. It’s unbelievable, but obviously characteristic for today’s mainstream economics that Krugman has so mindlessly excluded the neoliberal reality in his modelling efforts.

The following articles explain in more detail how indispensable the use of comparative advantages is for a profitable international trade pattern: Comparative Advantage — Upgraded and Future-Proof Foreign Trade.

5. Prospect

Krugman’s blind spots teach us an unequivocal lesson: economic research is misguided, if it conceives the economic development as a natural evolutionary process determined by the interactions of absolutely free agents. The neoliberal deregulation, whether knowingly or unknowingly emulating the biological principle of »survival of the fittest«, is not suitable to serve as a valid standard for human social and economic life, because it blatantly violates the fundamental right of free development of the personality.

Social and economic life must be governed in order to satisfy human dignity. Commitment and ability to set rules are distinct human qualities and bear witness of the uniqueness of man as a culture-proficient being. In short: man is a rulemaker.

Economic research can only accomplish its mission, if it abandons the playground of economic-darwinistic complexity and starts to creatively develop theoretical models to be based on a set of manageable rules to be targeted at optimal welfare, to be tested in model regions, to be further developed for practical suitability, and ultimately to be recommended to economic policy makers and the general public.

As a compliment see the article Sustainable Social Welfare.
___________________________________________________________________________________

Click here for the German-language version: Paul Krugmans blinde Flecken

References

  1. http://nobelprize.org/nobel_prizes/economics/laureates/2008/press.html

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