Not as Bad as You Thought

Why Paul Krugman deserved the Nobel Prize.

Arnold Kling

Paul Krugman received a Nobel Prize for his contributions to international trade theory. Even for those of us who disagree with his political views and see little value in his recent work as a columnist, this award brings neither surprise nor disappointment.

In 1991, Krugman received the John Bates Clark medal, awarded every other year to the most productive American economist under the age of forty. In the view of many in the economics profession, the Clark medal has been more consistently awarded to deserving winners than the Nobel. Any way you look at it, Krugman is a giant in the field. As Tyler Cowen points out, the really significant honor for Krugman’s Nobel is that he did not have to share it. Unshared Nobel Prizes in economics are on a somewhat loftier plane than shared honors.

International trade theory, when Krugman and I first studied it, was dominated by the theory of factor endowments. If your nation could mobilize a lot of savings relative to its labor supply, the theory went, then you would export capital-intensive goods and import labor-intensive goods. The prevailing assumption in trade and location theory at that time was diminishing returns, which said that increments to productivity are the greatest when you start from low levels of output in a product.

But no one bothered to look at one of the theory’s biggest implications, which was that very little trade should take place within an industry. We should not be exporting some steel products while importing others, in other words. Nor should we be exporting some high-tech manufactures while importing others.

Similarly, no one bothered to look at one of the major implications of diminishing returns, which is that when an industry starts to get big in one city, the next increment of capacity should be built in a different city, where diminishing returns would be less of a drag on production.

Paul Krugman, however, bothered to look. And what he found was that the facts contradicted the theory. Intra-industry trade, it turned out, is more widespread than trade that can be explained by factor endowments. Moreover, industries tend to agglomerate rather than to disperse. Examples of agglomeration include Detroit automobiles, Hollywood movies, Silicon Valley computer startups, and New York fashion.

Krugman attacked these problems by dropping the assumption of diminishing returns. As he points out, he faced a major mathematical hurdle, since the mathematics of diminishing returns had been elegantly worked out, particularly by Paul Samuelson, the first American to win the Nobel in economics. Calculating the mathematics of increasing returns was new and challenging.

With increasing returns, agglomeration emerges as a natural phenomenon, with historical accidents and path dependence playing a key role. Intra-industry trade also makes sense. One country may happen to build an industry of personal computers, while another country may become the leader in television sets. Again, historical accidents and path dependence play a role.

Apart from the math, the theory of increasing returns seems logical and obvious in hindsight. The economic advantages of agglomeration make intuitive sense. But it is important to recognize that Krugman’s highly original contribution was needed to open the minds of the rest of the economics profession to the real-world significance of increasing returns.

David Warsh, in Knowledge and the Wealth of Nations, provided a highly accessible account of the development and significance of the theory of increasing returns. Warsh focused on how Krugman used the theory to explain trade as well as on how Paul Romer used it to explain economic growth.

Krugman’s own writing is also highly accessible. Development, Geography, and Economic Theory
is probably the book to look for if you want to read Krugman’s own explanation of his most important work.

Krugman’s subsequent scholarly work is less clearly of durable value. He has described Japan’s crisis of the 1990’s as a liquidity trap, meaning that interest rates were so low that monetary expansion was no longer effective. Others have argued that Japan’s stagnation was due to poor capital allocation, resulting from a reluctance to close failed banks, which in turn were unwilling to shut off credit to inefficient firms. I find the latter argument more persuasive.

More recently, Krugman has focused on inequality of income and wealth as a phenomenon of political economy. I believe that other factors are more important.

Paul Krugman is motivated by real-world problems and he’s an effective communicator with lay audiences, something that cannot always be said of most economists. His Nobel Prize reflects a breakthrough in the way we think about how trade and the location of economic activity are determined in the real world.

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