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Friday, January 4, 2008

Paul Krugman, Doctor of (Bad) Economics

Paul Krugman, the New York Times op-ed writer, has a Ph.D. in economics. Those three magic letters give him an air of authority, as if they represent a valuable accomplishment, yet somehow he manages to consistently give bad economic advice in his twice-weekly column. Go figure.

Krugman is considered an authority on international trade. And although he is generally a statist, he has defended David Ricardo’s law of comparative advantage, a pillar of the economic case for free trade. But now he is having something of a crisis of faith. In Trouble with Trade (Dec. 28, 2007), Krugman writes: In fact, it’s hard to avoid the conclusion that growing U.S. trade with third world countries reduces the real wages of many and perhaps most workers in this country.

Many and perhaps most workers. That’s a serious charge, which he never quite gets around to substantiating.

Ricardo’s law holds that trade can be worthwhile even for a group (nation) that has an absolute advantage over a potential trading partner in the production of all goods. If the superior group’s opportunity costs differ for the production of different products, its members will most likely specialize in the products for which they have a comparative (or overwhelming) advantage. The inferior group will do the same. Then each will trade its surplus with the other and, as a result, will have more total goods than if it tried to produce everything itself. Krugman called his paper in defense of this law Ricardo’s Difficult Idea. Since it is counterintuitive, Ricardo’s law is often illustrated this way: Imagine a talented lawyer who also happens to be the fastest and most accurate typist in the world. He can make $500 an hour lawyering, but he can also outperform any typist he could hire.

Should he do his own typing in his law office? Of course not! An hour’s typing would cost him the $500 he could make lawyering. But the typist doesn’t face such a steep opportunity cost. Typing is likely the typist’s most lucrative way to spend the work day. Each then will specialize in the activity in which he has a comparative advantage.

Thus — as Ricardo taught — the lawyer will see gains from trade with the typist despite his absolute advantage in typing. Opportunity cost (as seen through the eyes of the acting person) is crucial. (For more, see Manuel Ayau’s Freeman article The Most Elusive Proposition.)

Workers Harmed?

Getting back to Krugman, while he thinks trade in manufactured goods between the U.S. and low-wage developing countries benefits highly educated American workers and poor workers in the developing countries, he sees harm to the majority of Americans: [T]rade between countries at very different levels of economic development tends to create large classes of losers as well as winners…. [W]orkers with less formal education either see their jobs shipped overseas or find their wages driven down by the ripple effect as other workers with similar qualifications crowd into their industries and look for employment to replace the jobs they lost to foreign competition. And lower prices at Wal-Mart aren’t sufficient compensation.

He concedes that in the 1990s he, like other economists, thought imports were having only a modest effect on wages: The trouble now is that these effects may no longer be as modest as they were, because imports of manufactured goods from the third world have grown dramatically — from just 2.5 percent of G.D.P. in 1990 to 6 percent in 2006. And the biggest growth in imports has come from countries with very low wages. The original ‘newly industrializing economies’ exporting manufactured goods — South Korea, Taiwan, Hong Kong and Singapore — paid wages that were about 25 percent of U.S. levels in 1990. Since then, however, the sources of our imports have shifted to Mexico, where wages are only 11 percent of the U.S. level, and China, where they’re only about 3 percent or 4 percent.

Krugman does acknowledge that Made in China does not actually mean made in China: For example, many of those made-in-China goods contain components made in Japan and other high-wage economies. Still, there’s little doubt that the pressure of globalization on American wages has increased. (On the issue of product origin, see my article Made Everywhere.)

In sum, Krugman asserts that American beneficiaries of U.S. trade with the newly developing countries are greatly outnumbered by those who probably [sic] lose.

To his credit, he doesn’t call for trade barriers because they would do harm. I hope that we respond to the trouble with trade not by shutting trade down, he writes, but by doing things like strengthening the social safety net. In other words, he wants an expanded welfare state.

The Only Constant Is Change

Well, what should we make of this? The first thing to note that is no advocate of free international trade ever contended that competition from low-wage countries doesn’t create difficulty for someone. Life is change, and change requires adjustment. The changes wrought by free trade of course may require some people to alter their job plans. But world trade is hardly the only source of change. Domestic competition and innovation also require workers to make adjustments. Ask the slide-rule and typewriter makers. Krugman would respond that the change is coming from very low-wage countries. Does Krugman worry that workers in low-wage rural states create hardships for people in high-wage urbanized states? Within states there are low- and high-wage regions, so the difficulties in life are endless. Besides, wages won’t stay low in developing countries that permit markets to operate. Wages will rise with productivity. Americans once worried about low-wage Japanese workers.

Krugman himself indicates he may be overstating the potential problem. He acknowledges that while Americans used to import from low-wage countries, we now import from very low-wage countries. It’s not mainly American workers who are losing out to the Chinese and Mexicans, but higher-paid workers in South Korea, Taiwan, Hong Kong and Singapore. Below China and Mexico there is a lower tier of developing countries that is starting to compete and take jobs. That’s how the world works.

American manufacturing jobs have been disappearing for years because better capital goods enable a smaller workforce to produce more today than a larger one did yesterday. Daniel Griswold of the Cato Institute writes, Despite the painful recession in manufacturing from 2000 to 2003, real output of U.S. factories has still increased by 50% since 1994 (American Worry-Mongering about China). Fewer jobs, more products.

Yet despite the job loss and a growing population, unemployment has been low and living standards have increased. And that’s in an economy burdened by corporatist intervention. How can this be accounted for? The answer is the growth in the service sector, such as medical and financial services. Our wants are unlimited and the means of satisfaction scarce. So if workers are not needed to do one thing, they’ll be needed to do something else. What else? Comparative advantage and the price system will help provide the guidance. But there’s a caveat.

Kernel of Truth

But let us acknowledge that there is a kernel of truth in what Krugman says. Some low-wage workers in the U.S. may find themselves caught short by the economic advancement taking place in the developing world. Should the government do something? Yes!

It should undertake the wholesale deregulation and desubsidization of the American economy. The way to make adjustment to economic change as swift and painless as possible is to maximize workers’ options, self-employment included. And the way for the government to do that is to stop interfering with market activities. Every existing tax, regulation, subsidy, patent, and trade barrier is a disadvantage to smaller and potential competitors and a protectionist privilege for incumbent firms. To the extent that the government — unwittingly or not — inhibits competition through intervention, it harms workers. The more precarious a worker’s situation is, the more he’s harmed.

Another thing government should do is give up control over education. Notice that Krugman says workers with less formal education are the ones being hurt. These are the most obvious victims of bureaucratic, unimaginative state-run schools. Americans whose livelihoods are threatened by uneducated, unskilled workers in China or Mexico are proof of the failure of public education. We need schools run by entrepreneurs in a free market not by bureaucrats wielding guns.

We must not do what Krugman proposes. While he insists he does not want trade interfered with, his call for strengthening the social safety net would in fact require interference with trade. Welfare-state programs, which have their own perverse political dynamic, require financing through taxation. Taxation confiscates resources that would go toward creating new productive ventures, i.e., opportunities for the very people Krugman wants to help.

The welfare programs are seen. Opportunities that never materialize are unseen.

Years ago Henry Hazlitt demolished the idea that government can create without destroying. In Economics in One Lesson (Chapter 5, Taxes Discourage Production), he wrote,

[T]axes inevitably affect the actions and incentives of those from whom they are taken. When a corporation loses a hundred cents of every dollar it loses, and is permitted to keep only fifty-two cents of every dollar it gains…, its policies are affected. It does not expand its operations, or it expands only those attended with a minimum of risk. People who recognize this situation are deterred from starting new enterprises. Thus old employers do not give more employment, or not as much more as they might have; and others decide not to become employers at all. …In brief, capital to provide new private jobs is first prevented from coming into existence, and the part that does come into existence is then discouraged from starting new enterprises. The government spenders create the very problem of unemployment that they profess to solve.

How about that! As in so many things, Krugman got it wrong and Hazlitt got it right.

Guess which one got a Ph.D.?

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.