Paul Krugman – NTT and NEG

New trade theory

Prior to Krugman’s work, trade theory (see David Ricardo and Hecksher-Ohlin model) emphasized trade based on the comparative advantage of countries with very different characteristics, such as a country with higher productivity in agricultural goods exporting agricultural goods to a country with higher productivity in industrial goods, in exchange for industrial products. However, in the 20th century, an ever larger share of trade occurred between countries with very similar characteristics, which is difficult to explain by comparative advantage. Krugman’s explanation of trade between similar countries was proposed in a 1979 paper in the Journal of International Economics, and involves two key assumptions: that consumers prefer a diverse choice of brands, and that production favors economies of scale. Consumers’ preference for diversity explains the survival of different versions of cars like Volvo and BMW.[25] But because of economies of scale, it is not profitable to spread the production of Volvos all over the world; instead, it is concentrated in a few factories and therefore in a few countries (or maybe just one). This logic explains how each country may specialize in producing a few brands of any given type of product, instead of specializing in different types of products. Krugman’s model also involved introducing transportation costs, a key feature in producing the “home market effect” which would later become key for Krugman’s work on the new economic geography. The home market effect “states that, ceteris paribus, the country with the larger demand for a good shall, at equilibrium, produce a more than proportionate share of that good and be a net exporter of it.”[23] The home market effect was an unexpected result, and Krugman initially questioned it, but ultimately concluded that the mathematics of the model were correct.[23]

Many models of international trade now follow Krugman’s lead, incorporating economies of scale in production and a preference for diversity in consumption.[6] This way of modeling trade has come to be called New Trade Theory.[23]

When there are economies of scale in production, it is possible that countries may become ‘locked in‘ to disadvantageous patterns of trade.[26] Nonetheless, trade remains beneficial in general, even between similar countries, because it permits firms to save on costs by producing at a larger, more efficient scale, and because it increases the range of brands available and sharpens the competition between firms.[27] Krugman has usually been supportive of free trade and globalization.[28][29] He has also been critical of industrial policy, which New Trade Theory suggests might offer nations rent-seeking advantages if “strategic industries” can be identified, saying it’s not clear that such identification can be done accurately enough to matter.[30]

[edit] New economic geography

It took an interval of eleven years, but ultimately Krugman’s work on New Trade Theory (NTT) converged to what is usually called the “new economic geography” (NEG), which Krugman began to develop in a seminal 1991 paper in the Journal of Political Economy.[31] In Krugman’s own words, the passage from NTT to NEG was “obvious in retrospect; but it certainly took me a while to see it. … The only good news was that nobody else picked up that $100 bill lying on the sidewalk in the interim.”[32] This would become Krugman’s most-cited academic paper: by early 2009, it had 857 citations, more than double his second-ranked paper.[23] Krugman called the paper “the love of my life in academic work.”[33]

The “home market effect” that Krugman discovered in NTT also features in NEG, which interprets agglomeration “as the outcome of the interaction of increasing returns, trade costs and factor price differences.”[23] If trade is largely shaped by economies of scale, as Krugman’s trade theory argues, then those economic regions with most production will be more profitable and will therefore attract even more production. That is, Krugman’s trade theory implies that instead of spreading out evenly around the world, production will tend to concentrate in a few countries, regions, or cities, which will become densely populated but will also have higher levels of income.[6][8]

[edit] International finance

Krugman has also been influential in the field of international finance. As a graduate student, Krugman visited the Federal Reserve Board, where Stephen Salant and Dale Henderson were completing their discussion paper on speculative attacks in the gold market. Krugman adapted their model for the foreign exchange market, resulting in a 1979 paper on currency crises in the Journal of Money, Credit, and Banking, which showed that fixed exchange rate regimes are unlikely to end smoothly: instead, they end in a sudden speculative attack.[34] Krugman’s paper is considered one of the main contributions to the ‘first generation’ of currency crisis models,[35][36] and it is his second-most-cited paper (457 citations as of early 2009).[23]

In response to the global financial crisis of 2008, Krugman proposed, in an informal “mimeo” style of publication,[37] an “international finance multiplier”, to help explain the unexpected speed with which the global crisis had occurred. He argued that when, “highly leveraged financial institutions [HLIs], which do a lot of cross-border investment [....] lose heavily in one market [...] they find themselves undercapitalized, and have to sell off assets across the board. This drives down prices, putting pressure on the balance sheets of other HLIs, and so on.” Such a rapid contagion had hitherto been considered unlikely because of “decoupling” in a globalized economy.[38][39][40] He first announced that he was working on such a model on his blog, on Oct 5th, 2008.[41] Within days of its appearance, it was being discussed on some popular economics-oriented blogs.[42][43] The note was not long after being cited in papers (draft and published) by other economists,[44][45][46][47][48][49][50][51] even though it had not itself been through ordinary peer review processes.

[edit] Macroeconomics and fiscal policy

Krugman has done much to revive discussion of the liquidity trap as a topic in economics.[52][53][54][55] He recommended aggressive fiscal policy to counter Japan‘s lost decade in the 1990s, arguing that the country was mired in a Keynesian liquidity trap.[56][57][58] The debate he started at that time over liquidity traps and what policies best address them continues in the economics literature.[59]

Krugman had argued in The Return of Depression Economics that Japan was in a liquidity trap in the late 1990s, since the central bank could not drop interest rates any lower to escape economic stagnation.[60] The core of Krugman’s policy proposal for addressing Japan’s liquidity trap was inflation targeting, which, he argued “most nearly approaches the usual goal of modern stabilization policy, which is to provide adequate demand in a clean, unobtrusive way that does not distort the allocation of resources.”[58] The proposal appeared first in a web posting on his academic site.[61] This mimeo-draft was soon cited, but was also misread by some as repeating his earlier advice that Japan’s best hope was in “turning on the printing presses”, as recommended by Milton Friedman, John Makin, and others.[62][63][64]

Krugman has since drawn parallels between Japan’s ‘lost decade‘ and the late 2000s recession, arguing that expansionary fiscal policy is necessary as the major industrialized economies are mired in a liquidity trap.[65] In response to economists who point out that the Japanese economy recovered despite not pursuing his policy prescriptions, Krugman maintains that it was an export-led boom that pulled Japan out of its economic slump in the late-90s, rather than reforms of the financial system

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