A long but very interesting profile of probably the most celebrated economist of recent history.
Here is why Keynesian economics makes sense:
[...] he discovered later, a development that Keynes had helped to bring about. In the nineteen-twenties and thirties, economics had been more like history: institutional economics was dominant, and, in opposition to neoclassical economics, emphasized the complicated interactions between political, social, and economic institutions and the complicated motives that drove human economic behavior. Then came the Depression, and the one question that people wanted economists to answer was “What should we do?” “The institutionalists said, ‘Well, it’s very deep, it’s complex, I mean, you just talk about what happened in 1890,’ ” Krugman says. “Keynesian economics, which was coming out of the model-based tradition, even if it was pretty loose-jointed by modern standards, basically said, ‘Push this button.’ ” Push this button—print more money, spend more money—and the button-pushing worked. Push-button economics was not only satisfying to someone of Krugman’s intellectual temperament; it was also, he realized later, politically important. Thinking about economic situations as infinitely complex, with any number of causes going back into the distant past, tended to induce a kind of fatalism: if the origins of a crisis were deeply entangled in a country’s culture, then maybe the crisis was inevitable, perhaps insoluble—even deserved.
“What does it mean to do economics?” Krugman asked on the stage in Montreal. “Economics is really about two stories. One is the story of the old economist and younger economist walking down the street, and the younger economist says, ‘Look, there’s a hundred-dollar bill,’ and the older one says, ‘Nonsense, if it was there somebody would have picked it up already.’ So sometimes you do find hundred-dollar bills lying on the street, but not often—generally people respond to opportunities. The other is the Yogi Berra line ‘Nobody goes to Coney Island anymore; it’s too crowded.’ That’s the idea that things tend to settle into some kind of equilibrium where what people expect is in line with what they actually encounter.”
Krugman wrote his thesis on exchange rates, but another class, on international trade, inspired him. “There was this kind of platonic beauty to the whole thing,” he says. “I remember going through the two-by-two-by-two model—two goods, two countries, two factors of production. The way all these pieces fitted together into a Swiss-watch-like mechanism was beautiful. I loved it.” The traditional theory of international trade, first formulated by the British economist David Ricardo, two hundred years ago, explained trade by comparative advantage: a country exported the goods that it could produce most cheaply, owing to whatever advantages it possessed—cheap labor, climate, technological expertise, and so on. It followed from this theory that countries that were the most dissimilar should do the most trade—countries in the Third World dispatching labor-intensive goods to the First World, the First World selling technology- or capital-intensive goods in return. In the years following the Second World War, however, economists had noticed that much international trade didn’t follow this pattern at all. There was a large amount of trade between countries whose economies were extremely similar, and these countries traded goods that were virtually identical: Germany sold BMWs to Sweden and Sweden sold Volvos to Germany. People had speculated about why this should be so, but nobody had come up with a model that explained it in a rigorous manner.
Krugman realized that trade took place not only because countries were different but also because there were advantages to specialization. If one country was the first to begin manufacturing airplanes, say, it might accumulate an advantage in economies of scale so large that it would be difficult for another country to break into the industry later on, even though there might not be anything about the first country that made it particularly well suited to airplane-making. But why would countries trade goods that were almost the same? Because consumers like to have a choice, and, as Avinash Dixit and Joseph Stiglitz had pointed out a few years earlier, the same logic of increasing returns to scale that Krugman had identified as an essential dynamic in trade could apply to a single brand as well as to a whole industry. Krugman presented his theory to the world in the form of a paper at the National Bureau of Economic Research in July, 1979. “The hour and a half in which I presented that paper was the best ninety minutes of my life,” he wrote later. “There’s a corny scene in the movie ‘Coal Miner’s Daughter,’ in which the young Loretta Lynn performs for the first time in a noisy bar, and little by little everyone gets quiet and starts to listen to her singing. Well, that’s what it felt like: I had, all at once, made it.”
Ahhh...and industrial policy:
One implication of Krugman’s theory was that, contrary to economic orthodoxy, industrial policy might have its benefits. If the location of a new industry was essentially arbitrary, then a government, by subsidizing and protecting its emergence, could enable it to gain such a lasting advantage that other countries would find it difficult to catch up. But Krugman tried to discourage industrial strategists who cited him. For, while in principle industrial policy could be helpful, in practice, he believed, it was so difficult to determine which industry should receive government help, at the expense of all the others—so difficult to predict an industry’s future, and so difficult to determine merit when powerful interests would be trying to influence that determination—that in the end industrial policy would be likely to benefit mostly the owners of a few businesses and hurt everybody else.