Man Without Qualities

Tuesday, December 02, 2003

The Bad Economist?

A version of one fairly common - if not exactly standard - refrain concerning Herr Doktorprofessor Paul Von Krugman is found in the recent, curious Economist article that suggested that he is a gifted writer and economist, but ... these days his relentless partisanship is getting in the way of his argument.

It's a curious dichotomy. Herr Doktorprofessor qua journalist is widely admitted routinely to distort and even misrepresent the sources on which he relies for his columns. It is also almost universally acknowledged that a sensible reader of Herr Doktorprofessor's columns will not assume that representations of statistics, facts, figures or economic arguments one sees there are as Herr Doktorprofessor presents them to be without independent checking - and that the more difficult the checking and confident the assertion, the more a sensible reader with politely reserve belief until the fact checkers have had their say. The New York Times, of course, has no fact checkers for its columns. [UPDATE: Just by way of amusing example, in light of the recent uproar on the left over President Bush's successful drive to obtain adequate funding for reconstructing Iraq and Afghanistan, this column by Herr Doktorprofessor is worth re-reading to see just how justified his claims to understanding the "real" minds and hearts of the current Administration really are.]

Herr Doktorprofessor's most questionable columns often include what he says he considers to be harmless assumptions - or omit a complex, technical analysis that he asks the reader to trust him he has performed (it's his job and his expertise, isn't it?). The assumption or omission is just to render the column straightforward, you understand. “For simplicity.” In these columns he is, after all, engaged in the controversial and difficult art of popularizing economics. Today's near-paranoid rant (pinned wriggling to the wall by Don Luskin) accusing someone of fixing the new voting machines, for example, includes a typical "trust me, I have done the hard, scientific work" line: "The details are technical, but they add up to a picture of ..." In other columns, he assures us, he is making the kinds of simplifying assumption that theorists make all the time, abstracting somewhat from the real world in order to increase explanatory power—sacrificing some realism to gain tractability, he might say. Such assumptions, he comforts the reader, if slightly less than realistic, are basically innocuous: he has done the hard work, nothing vital hinges on it, anyway - and to relax the assumption would make for a messier argument that leads to the same place.

Of course, all of that isn't true in Herr Doktorprofessor's important academic writing - right?

Well, maybe that's not so clear. Herr Doktorprofessor's most shining credential is his John Bates Clark Medal, which he was awarded in 1991. The official American Economic Association summary of the work for which he was given that award makes clear that the so-called "new trade theory" was what caught the AEA's attention and admiration, beginning with his paper “Increasing Returns, Monopolistic Competition, and International Trade.” Journal of International Economics, 1979 9(4): 469-479.

What is the "new trade theory?" A Federal Reserve Bank paper on the topic dated late last year explains it this way:

Since the early 19th century, economists have used the theory of comparative advantage ... According to this classic theory, nations are made better off through trade by capitalizing on their inherent differences in natural resource or capital endowments. ...

But over the last 20 years, international trade economics has undergone what some have termed a “revolution” because of a new theory that gives very different answers to the same kinds of questions. This new trade theory is often summed up in the simple words “increasing returns”—shorthand for “increasing returns to scale,” a term synonymous with “economies of scale.”

The new theory, then, is the idea that trade arises to take advantage of economies of scale: Industries in each country can achieve lower unit costs by producing in large volume and spreading the high start-up expenses (for example, research and development, machinery purchases) over many, many units. If confined to the domestic market, an industry might not be able to achieve the highest level of scale economies, but by producing for both domestic and foreign markets, sufficient volumes can be produced to reap greater economies of scale.

According to this theory, two countries could both get cheaper cars and lamps, for instance, if one specialized in automobile manufacturing and the other devoted its resources to making lighting equipment, regardless of the inherent resource endowments of those countries. By taking advantage of increasing returns to scale, each country could produce its specialty at low unit costs and then trade with the other—both countries will gain through trade, but not because of comparative advantage.

What is the "new trade theory" good for? A key result of the theory is supposed to be the so-called "home market effect:" Countries will specialize in products for which there is large domestic demand. For example, the Introduction to Krugman’s (1990, p. 5) selected papers says: “The main additional insight from [my article “Scale Economies, Product Differentiation, and the Pattern of Trade,” American Economic Review, 70, 950-959] is the ‘home market effect,’ the tendency of countries to export goods for which they have a relatively large domestic market.” Krugman first considered questions asked by Staffan Burenstam Linder in 1961 in An Essay on Trade and Transformation. Krugman showed that in a world with increasing returns to scale and costs of trade, high demand for a locally produced product would result in a more than one-to-one response from local production, leading exports of the demanded product to rise. Such “home market effects” from demand to production structure, in the presence of trade costs and scale economies, are seen by some as defining characteristics of the "economic geography" later pursued by Krugman as one of his major interests.

But along the way something rather curious happened to the "new trade theory." As the Fed Bank article rather diplomatically puts it:

Harvard economist Donald Davis dealt this flourishing movement what seemed a damaging blow. Krugman had developed his increasing-returns trade theory by looking at a model with two sectors, one, alpha, with increasing returns to scale and the other, beta, with constant returns. To render the mathematics straightforward, he adopted what he considered a harmless assumption. “For simplicity,” Krugman wrote in his seminal 1980 paper, “also assume that beta goods can be transported costlessly.”

It was the kind of simplifying assumption that theorists make all the time, abstracting somewhat from the real world in order to increase explanatory power—“sacrificing some realism to gain tractability,” Krugman wrote. And he believed this assumption, if slightly less than realistic, was basically innocuous—nothing vital seemed to hinge on it. ...

Davis, now chair of Columbia University's economics department, examined the assumption more carefully. Reviewing data on trade costs (including costs of transportation, nontariff barriers, “border effects” and other costs inherent to trade), Davis concluded that Krugman's simplification was unrealistic: “There is little suggestion that total trade costs are higher” for increasing-returns goods, he wrote. If anything, the cost of trading constant-returns goods is likely to be higher than that for increasing-returns goods.

Even more crucially, Davis found that the simplification was far from innocuous; something crucial does hinge on it. In fact, if Krugman's model is duplicated with just one small change: Assume that both sectors—not just the increasing-returns sector—have positive transportation costs, then Krugman's striking finding about trade and industry location evaporates. When “the industries have identical trade costs, the home market effect disappears,” Davis concluded. “Industrial structure then does not depend on market size.”

Professor Davis has not had the last word, as the Fed Bank points out. A still more recent paper by other authors may salvage some of the "home market effect" under some assumptions - although not so much in the area of international trade as the rather curious zone of inter-regional trade.

A brief review of Professor Davis's paper reveals that it is not really all that much more complex than Herr Doktorprofessor's original effort. It does require that one do the work - but it's hard to imagine that someone of Paul Krugman's intensity of involvement in this field would not have at least seriously suspected that what he said he considered a basically innocuous assumption might completely undermine his most eye-catching results in many circumstances.

Of course, if Herr Doktorprofessor had explained all that, it would have made his work seem a lot more like a technical advance, quite possibly a mere curiosity, and less like the breathtaking, revolutionary revision of classical thinking he and his admirers have held it out to be. But would the John Bates Clark committee that evaluated the "new trade theory" in 1991 have the same high opinion of it after reading Professor Davis' article? [Note: Professor Davis is by no means dismissive or hostile towards Paul Krugman, as evidenced here and here.]

Somehow, in certain ways the more one looks at the trajectory of Herr Doktorprofessor's breathtaking, revolutionary academic accomplishments the more that trajectory resembles the trajectory of his breathtaking, revolutionary assessments of the Bush administration and its economic program - assessments that started out pretty hi-falutin, but so far have turned out to be just ludicrous.

No doubt all will be revealed and settled in the fullness of time.

POSTSCRIPT: Don Luskin and others have wondered why Herr Doktorprofessor doesn't really go after President Bush on trade restrictions. After all, he was on the right side with Bill Clinton aginst the rest of the Democratic Party, and otherwise Herr Doktorprofessor seems to get at least some trade matters right.

But maybe Herr Doktorprofessor doesn't think trade restrictions for a country like the US are any big deal, after all:

Yet there is a dirty little secret in international trade analysis. The measurable costs of protectionist policies--the reductions in real income that can be attributed to tariffs and import quotas--are not all that large. The costs of protection, according to the textbook models, come from the misallocation of resources: protectionist economies deploy their capital and labor in industries in which they are relatively inefficient, instead of concentrating on those industries in which they are relatively efficient, exporting those products in exchange for the rest. These costs are very real, but when you try to add them up, they are usually smaller than the rhetoric of free trade would suggest.


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