Heretic to High Priest: Krugman ‘sort of’ Predicted the Asian Crisis Three Years Earlier

Listener: 15 August, 1998

Keywords Business & Finance, Globalisation & Trade, History of Ideas, Methodology & Philosophy, Macroeconomics & Money

“A decade ago, he was the most celebrated heretic. Today, Paul Krugman is the high priest of economics, his career transformed by the unintended consequences of his own iconoclasm. Some of his radical instincts remain; but they now serve a different purpose. The vigour with which Krugman once probed the outer limits of economics is now used to protect its core values. Through his popular writings, he defends the dismal science by exposing fallacies in the public discussion of economics issues.” (Prospect, April 1998)

Ex-heretic, 45 year old, Paul Krugman is in New Zealand, giving the University of Auckland’s Chancellor’s lectures. They will be a treat. While this Massachusetts Institute of Technology (MIT) professor has produced high power economics, he is committed to communicating with the public. His popular book, The Age of Diminished Expectations (one of 16), opens with “there are three kinds of writing in economics: Greek-letter, up-and-down, and airport.” Greek letters refer to the technical literature to which he has made numerous contributions. Up-and-down is his dismissive term for business journalism which reports statistics go up or down. Airport are the over-optimistic or over-pessimistic bestsellers.

Krugman writes for “the intelligent reader who wants to be well informed but doesn’t want to study for a PhD.” Judge for yourself from this summary of an equally accessible chapter (by one of the world’s top international trade theorists).

“There is a better intellectual case for protection than there use to be, and the case for freer trade is often overstated. Nonetheless, there is still a good case for free trade as a rule of thumb – not as an absolute ideal, but as a reasonable rule of thumb. American interests would probably be best served by a world of free trade with the temptations of strategic trade policy kept out of reach by international treaty.”

(The term “strategic trade policy” comes from Krugman’s theoretical contribution to the “new trade theory” which points out that David Ricardo’s theory of comparative advantage is too static and does not explain where the advantage initially came from. Historical accident has a role – Boeing is the world’s top aircraft producer partly because the US had to expand its military aircraft production during the Second World War. A country can therefore consciously create these “accidents” although Krugman cautions that politicians will make serious mistakes.)

You can see here the iconoclast, tearing apart the conventional wisdom for its slovenly thinking, while championing an economic analysis demanding higher intellectual standards. He is even-handed, ripping into the right wing Chicago School and their acolytes, but also into left wing protectionists. Much of what he says has relevance to our economic policies, because the New Zealand reforms were based heavily on the right wing economics analysis lifted uncritically from the US.

Today we are slowly and clumsily moving towards a position on exchange rate policy which Krugman took over a decade ago. When we get there he will probably have moved on.

Even a decade ago he was seen as promising. Paul Samuelson listed his own generation of great policy economists as “Walter Heller, Milton Friedman, John Kenneth Galbraith, Arthur Okun, Herbert Stein and Peter Druker” (to which should be added Samuelson himself), and described Krugman as “the rising star” of the next. He is particularly fashionable at the moment, because he “sort of” predicted the Asian economic crisis three years ago. (All credit to Auckland University inviting him before the crisis started.)

He pointed out that the East Asian economies had very poor productivity growth and would not be able to sustain their GDP growth. So he did not quite predict the financial crisis. But he was one of the first to offer a coherent and cogent account.

An ill-disciplined financial sector speculated on the economic growth continuing indefinitely: it has not. Krugman would be very disappointed if we were to pursue his policies and prognostications without trying to understand the underlying analysis. After all, he goes out of his way to make it accessible.


Krugman’s Seven Habits of Highly Defective Investors

Krugman has proposed the “pangloss” effect, where investors focus on the best possible scenario, ignoring that it is not very likely. (Dr Pangloss was the excessively optimistic character in Voltaire’s Candide. Economists dont have to be poorly read.) Following attending a meeting of major financial investors – those whom we currently depend upon, he articulating seven habits of highly defective investors, describing them as “financial sheep” rather than “speculative wolves”:

1. Short term thinking.

2. Greed.

3. Believing everyone else is the greater fool: instead of getting out when one’s target return has been reached, hanging on for a little bit longer.

4. Running with the herd: wanting the conventional wisdom reinforced rather then challenged.

5. Overgeneralisation: instead of looking at each case on its merits.

6. Being trendy: and ignoring well established analysis.

7. Playing with other people’s money: or money you have not really got.

Krugman’s rules echo Maynard Keynes’ “Worldly wisdom teaches it is better to fail conventionally than to succeed unconventionally.” His career path refutes it.