Paul Krugman on Competitiveness

Here is excerpt from Paul Krugman’s 1995 article
“The Illusion of Conflict in International Trade”,
which originally appeared in Peace Economics, Peace Science, and Public Policy in Winter 1995,
was republished as Chapter 5 of Krugman’s 1996 book Pop Internationalism,
and now appears on the Internet as part of the Berkeley Electronic Press.

The World Competitiveness Report puts [the] threat starkly:

“Today, the so-called industrialized nations employ $50 million people
who are paid an average hourly wage of $18.
However, during the past ten years,
the world economy gained access to large and populated countries,
such as China, the former Soviet Union, India, Mexico, etc.
Altogether, it can be estimated that
a labour force of some 1,200 million people
has thus become reachable, at an average hourly cost of $2,
and in many regions, under $1 ....

“[This] serves to demonstrate the massive pressure that exists today
on labour in industrialized nations
when a significant productivity advantage is not maintained.
There is no doubt that many industries
will be tempted to relocate in countries with low-cost labour.
In a GATT world,
where the right to operate in any country is guaranteed, and
where the flow of goods, services, and capital investment is ensured,
there is nothing to prevent companies from fully exploiting
the respective comparative advantages
of different countries on a global scale ....

[For a book-length analysis of this,
see Alan Tonelson’s 2000 The Race to the Bottom.]

“As a result of this formidable specialization of world markets,
the ‘raison d’être’ of many countries is at stake ....
[An] outflow of manufacturing from Western economies
seems inevitable ....
Thus, the question of wealth creation in industrialized nations
becomes more and more acute.”

This offers a clear and compelling vision.
Low-wage nations are now able to attract capital and technology
from the advanced world.
As a result, they can achieve productivity close to Western levels,
while paying much lower wages.
The result seems obvious:
the low-wage countries will run huge trade surpluses,
creating either large-scale unemployment or sharply falling wags
in the erstwhile high-wage nations.

Sounds persuasive, doesn’t it?
There’s only one problem: it is a vision that quite literally makes no sense.

[So Krugman wrote in 1995.
Unfortunately, looking back from the point of view of 2011,
the vision he just so thoroughly disdained
seems to be exactly what has happened in the U.S since he wrote that in 1995.]

The reason lies in a basic fact of accounting,
perhaps the most essential equation in international economics:

Savings – Investment = Exports – Imports

This is not a hypothetical theory: it is an unavoidable accounting identity,
a statement of an adding-up constraint that
any consistent story about any economy must honor.
And yet it is an equation that
the story in the World Competitiveness Report clearly violates.

Consider that story again.
It asserts that capital will move from Western nations to low-wage countries—
that is,
that those nations will be able to invest more than their domestic savings
because foreign capital will also be investing there.
So for these economies the left-hand side of the equation is negative:
investment exceeds savings.
At the same time, it asserts that
low-wage countries will export much more than they import,
“deindustrializing” the advanced nations.
So the right hand side is … positive?

When I have tried to explain this problem
to people who find the story about low-wage competition persuasive,
their first reaction is to ask what alternative story I propose.
The obvious answer is that as capital and technology flow to low-wage nations,
their wage rates will rise along with their productivity.
As a result they will not run huge trade surpluses with advanced nations, indeed, they will run deficits, as the counterpart to the capital inflows.
The usual reaction to this is that it is implausible, and that it is a typical economist’s assertion that markets will always do the right thing.
I then ask what the questioner proposes;
he replies that he believes that
low-wage countries will run big trade surpluses.
“So you think that low-wage countries
are going to export large quantities of capital to high-wage nations?”
[Of course, that is exactly what has transpired in the ensuing years from 1995 to 2011.]
At this point the conversation gets unpleasant,
with some remark about this kind of thing being the reason why people hate economists.

It might also be worth noting that in these arguments
people often bring in the observation that
when multinational corporations have opened plants in low-wage countries,
they often achieve near-First-World productivity
but continue to pay Third World wages.
The economist’s answer to this is that it is exactly what one should expect:
wage rates should reflect average national productivity,
not productivity in a particular factory;
if only a few modern factories have opened in a country,
they will not raise that country’s average productivity by much
and should therefore not be expected to pay high wages.
(And of course a country with low overall productivity
that is able to achieve near-U.S. productivity in a few goods
will tend to export those goods;
it’s called comparative advantage.)
But no matter how much one tries to explain that this outcome
is exactly what the standard [economic] model predicts,
it seems to be viewed as somehow a decisive rejection of
the economist’s optimism about the trade balance.
[Emphasis added.]

So what do we learn from this example?
First, we learn that there are very simple things in economic theory—
things that are not really debatable, like accounting identities,
or very basic principles,
like the idea that wages should reflect average national productivity
rather than productivity at the plant level—
which are very easy for people who have no familiarity with academic economics
to get wrong....
In other words, economists do seem to know something worthwhile.

And second, we learn that the authors of the books on my reading list [listed above in Krugman’s article]
do not base their disdain for academic economics
on a superior or more subtle understanding.
Rather, their views are startlingly crude and uninformed.

[That comment of Krugman’s is startlingly crude and uninformed.
Actually, the dispute is due to a different choice of
what are the important goals of society.
So far as I can tell
(and I am certainly not an expert on either economic nor academic economists),
the chief goal (“figure of merit”) of most economists is
what they view as the welfare of the consumer,
enabling the consumer in the short term to have
the greatest choice of goods at the lowest cost.
If that entails turning the entire Midwest in the “Rust Belt”, tough noogies.
Who cares what happens to those displaced workers so long as consumers gain.
(The theory that new industries and uses for those workers will spring up
is vitiated by the fact that low-wage competition will eviscerate almost any industry.)]

I [Krugman] have actually made the case
only for the low-wage competition argument,
which figures prominently in only some of the books.
However, all of the authors on my reading list,
both in these books and in their other writings,
display an astonishing range of errors and misconceptions—
errors of fact, mangled statistics,
supposedly sophisticated arguments based on double-counting,
failure to understand basic ideas about competition.
(If you think I am overstating the case,
look at the exchange in the July/August 1994 issue of Foreign Affairs).

It seems, then, that I am asserting that
the conventional wisdom about international trade
is dominated by entirely ignorant men,
who have managed to convince themselves and everyone else who matters
that they have deep insights,
but are in fact unaware of the most basic principles of and facts about
the world economy;
and that the disdained academic economists are at least by comparison
fonts of wisdom and common sense.
And that is indeed my claim....

Here is the conclusion of Paul Krugman’s 1993 article
“What Do Undergrads Need to Know about Trade?”,
which originally appeared in the American Economic Review, May 1993,
and was republished as Chapter 8 of Krugman’s 1996 book Pop Internationalism.
The emphasis, and comment, are added.

In the last decade of the 20th century,
the essential things to teach students are still
the insights of [David] Hume and [David] Ricardo.
That is, we need to teach them that
trade deficits are self-correcting
and that
the benefits of trade do not depend on a country
having an absolute advantage over its rivals.
If we can teach undergrads to wince
when they hear someone talk about “competitiveness,”
we will have done our nation a great service.

[Sic, sic, sic.]

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