Ideas as Economic Inputs

I finally got around to reading through Paul Krugman’s Pop Internationalism, which is a collection of his essays and speeches in the 90s that attempted to explain standard trade theory to the public. The essays are readable, and Krugman is reliable here — he won his quasi-Nobel prize for trade theory. He’s actually quite fun as he pillories common misconceptions (and the standout misconceivers who promulgate them).

Consider, as a stylized version of common trade misconception, the claim that, “emerging markets’ low wages and cooperative governments will attract huge capital inflows, which will allow them to industrialize and run huge trade surpluses, taking investment capital from and hurting real incomes in developed economies — as developed countries’ manufacturing sectors become less productive, the job losses will be enormous.” These sorts of claims (1) make a basic error in accounting identities — it is simply impossible to attract net capital inflows and run a trade surplus; (2) get productivity precisely backwards — the more productive manufacturing becomes the more you should expect job losses in that industry, since by definition productivity gains decrease amount of labor required to produce the output that meets demand; (3) ignore pretty much everything else in basic trade theory, such as the fact that, as has been known since Ricardo’s time, each country is best off when it specializes in the enterprises in which it enjoys a comparative advantage, and that American consumers broadly benefit from being able to purchase the goods they want from cheaper foreign manufacturers, which also frees up their income to pay for goods produced by American worker in which America has an actual comparative advantage; and (4) ignore the empirical realities of international trade, such as the fact that, for all Tom Friedman’s columns, it’s actually not economically overwhelming (18% of GDP in 2009 — lower when Krugman was writing and NAFTA was controversial), and so the vast majority of changes in any country’s welfare are attributable to (in the long run) productivity growth and (in the short run) aggregate demand within the domestic economy itself.

Krugman today is known as a cranky stimulus advocate, but he’s apolitical on trade theory, and at times subversively right wing — he writes, for example, that ostensible concerns over labor practices and ‘fair compensation’ in emerging markets are very often a veil for efforts to shut those emerging economies’ exports out of global markets, in ways that hurt poor countries’ chances of developing, while aiding incumbent interest groups such as, e.g., the developed world’s trade unions. He pretty effortlessly dressed down objections to NAFTA (though he also noted, correctly it seems in retrospect, that others had over-claimed for its benefits). He explains the standard economic perspective that rising income inequality is explained by increased specialization, increasing technological complexity, and the rise of ‘tournament economies’ thanks to improved communication technologies (I’ll save the full explanation for a later blog post), rather than just dreaded ‘tax cuts on the wealthy.’

But, now that I’ve submitted my book report, I’ll tell you the thing I found really interesting (as opposed to just a nice rehash of Things Economists Know but Some People Don’t): One point he makes about the Mexico’s impressive growth in 1994 is that a lot of the growth was attributable to a new consensus in development economic theory. That is to say, after the success of the NICs, the global economic commentariat had largely started to agree in the early 90s, in contrast to the preceding decades, that the formula for economic development was (1) opening up to trade and (2) sound, hard money. Now, crucially, both (1) policy makers and (2) investors largely base their decisions off of the conventional wisdom in economics. In Mexico’s case this meant that, starting in the early 90s, Mexico’s policy shakers moved the country toward open trade and hard money, and investors decided that, because Mexico was moving toward open trade and hard money, it was a good bet. So in 1994, capital flowed in to Mexico, boosting its GDP in the act.

Now, in a way, this inflow of investment was a confirmation of the theory that openness to trade and hard money were the key to development. But it’s a peculiar kind of confirmation, because among the key inputs into Mexico’s success were the very volatile assets known as beliefs, and, most importantly, the mutually reinforcing coincidence of the policy-makers’ and investors’ beliefs. Krugman warned, presciently, that the great danger to the Mexican economy was that, rather than its real assets being harmed, some other country’s problems might change development theory itself, which would set off a vicious cycle. In 1995, he was pretty much proved correct, as crises in other emerging markets set off capital outflows, which devastated Mexican GDP, which ‘confirmed’ the belief that motivated the capital outflows, etc.

Which is one of the marvelous and mind-blowing things about social science, particularly the queen of the social sciences, economics: Each person’s ideas, including her ideas about others’ social behavior — her own private social science, as it were — becomes the basis for her behavior, and hence for the social behavior that social science itself is supposed to explain. Economic theory is itself an input into the economy, and so a complete economic theory must be recursive.

Two thumbs up.

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2 thoughts on “Ideas as Economic Inputs

  1. I believe we discussed this on a run. My favorite way of explaining this to people is to pick up a rock and remind my interlocutor that if I drop it, how fast it will fall will not depend upon his or her theory of physics. I then point out that this would not be true if the rock were a stock and he or she were an investor.

  2. Pingback: Here’s all the interesting stuff in Nate Silver’s The Signal and the Noise | This is your brain on economics

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