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Must We Compete?

All this is true enough, but nagging questions still remain. For example, to what extent have we managed to preserve our manufacturing sector only by holding down our workers’ wages so as to prevent American firms from losing out by much more than they actually have? Krugman cites work by several distinguished scholars (most prominently, Robert Lawrence and Matthew Slaughter) showing that foreign competition has had little impact on US wage levels; but other respected researchers (for example, Jeffrey Sachs) have reached different conclusions. To put the same point in a stronger way, what, apart from foreign competition, prevents the United States from running a huge surplus in manufactured goods, not only dominating our own markets for cars and cameras and VCRs at home but also selling American-made products all over the world and using the proceeds to finance other aspects of a high standard of living like foreign vacations, ample oil supplies, and exotic foreign-produced foods? To answer such questions persuasively would require unraveling complicated trade patterns in different markets and different countries, allowing for the fact that not only the quantities of different goods produced but also the prices charged and the wages earned vary depending on the circumstances, and so there is ample room for disagreement. Even so, Krugman is no doubt right that popular perceptions greatly exaggerate the role of foreign competition in accounting for America’s economic disappointments.

The more practical question, however, is just why this particular popular misperception (only one among many others in dealing with economics and economic policy) matters so much. Krugman fears, in part, that excessive concentration on international competition may lead to neglect of important changes in national economic policy—such as reducing the government’s deficit—that are needed for reasons unrelated to competitiveness. But as the example of President Clinton’s 1993 budget package demonstrates, it is also possible to use the threat of losing out to foreign competition to muster support for much needed domestic policies. Narrowing the chronic deficit inherited from the fiscal policy of Presidents Reagan and Bush was a major policy achievement, mostly for reasons related to our own domestic economy. Still, in his 1993 State of the Union Address the President leaned heavily on the assumed imperative to be competitive abroad in order to push his proposed combination of spending cuts and tax increases.

Krugman’s more urgent concern is that an exaggerated emphasis on American competitiveness “can all too easily lead to bad policies.”

What might those bad policies be? Krugman harshly attacks the policy proposals, and in some cases the professional competence, of a readily identifiable group whom he labels “strategic traders.” He has in mind current administration officials like labor secretary Robert Reich and health-policy strategist Ira Magaziner, and he specifically criticizes Reich’s book The Work of Nations and Reich and Magaziner’s The Next American Frontier. He also criticizes Lester Thurow’s Head to Head and works by other private economists. In addition to consistently overestimating the role of international trade in accounting for America’s real economic problems, Krugman writes, “strategic traders” both in and out of the Clinton administration have pushed strongly for specific policies that he—like most other economists—fears would be self-defeating, if not worse. Prominent examples are the administration’s recent attempt to impose specific numerical targets on American trade with Japan; calls for protectionism to shield American producers on a case-by-case basis; and suggestions that the US government subsidize, in one way or another, targeted industries that supposedly would make a difference to the nation’s overall competitiveness.

What runs throughout Peddling Prosperity—indeed, the origin of the title—is Krugman’s anger and frustration that people whom he regards as second- or even third-rate thinkers inevitably take over, and exploit for their own purposes, the serious contributions of first-rate thinkers. During the 1970s, conservative scholars like Milton Friedman and Martin Feldstein mounted a well-thought-out and empirically well-supported attack on at least some aspects of “liberal” economic policies. But the Reagan administration’s “supply-side economists,” many of whom had little if any actual training in economics, badly misused these ideas and left behind an economic mess of vast proportions. (The best-known example of such folly was the claim that across-the-board reductions in US income tax rates would increase tax revenues.)

Similarly, during the 1980s some excellent scholars, including Krugman himself, developed powerful new ways of thinking about important issues in international economics. But, Krugman argues, the people he calls “strategic traders” have perverted these ideas to promote such caricatures as managed trade with Japan, or protectionism and “industrial policy” at home. And like the supply-siders before them, along the way the strategic traders have, in his view, done a pretty good job of promoting themselves as well.

The important new ideas that Krugman and other leading scholars of international trade put forward in the 1980s start from the easily understandable notion that what is possible today often depends crucially on what actually happened yesterday. For example, in the abstract there is no reason why a bright college senior with a knack for science cannot go on to medical school and to a career as a physician thereafter. But if the student has never taken the requisite courses in chemistry and biology, that path is closed unless he is willing to spend a year or two of dedicated work that will open it up. Sometimes things have simply gone too far down one path to make switching to another one possible. Many promising athletes can choose which sport to play professionally; but except for the genuinely rare talent like Michael Jordan, that choice, once made, soon becomes irreversible. The basic principle at work here is immediately intuitive to anyone who has ever lamented “you can’t get there from here.”

To illustrate how this kind of “path dependence” applies to economics, Krugman uses Stanford economist Paul David’s example of the QWERTY…configuration of the standard Roman alphabet typewriter. This arrangement of letters was originally designed to slow down typists in their work, in order to avoid problems of sticking mechanical keys. By now mechanical typewriters have almost entirely disappeared, yet the QWERTY arrangement is still around, still slowing down anyone who sits at a keyboard. Why have attempts to introduce a more efficient keyboard layout failed? Because typists are all used to QWERTY. And why are typists today all used to QWERTY? Because the typewriter industry adopted it more than a century ago.

The general principle that the QWERTY example illustrates is that the initial conditions prevailing at any point in time matter importantly, and those conditions in turn depend in part on the path previously taken. What Krugman and other scholars of international trade did in the 1980s was to bring sophisticated applications of this concept of path dependence—the QWERTY idea, as he calls it in Peddling Prosperity—to bear on questions like why some countries have an aircraft industry while others do not, and why a country that has no aircraft industry today may now find it impossible to start one.

The overwhelming conclusion from looking at the actual pattern of trade is…that exports from one industrial country to another don’t give us much indication that they are based on any underlying national resource or characteristic.

Consider, for example, the strong US presence in the world aircraft industry. Is there something about the US mix of resources that makes Americans particularly adept at making aircraft? It is hard to argue that there is. Aircraft manufacture is a business in which the cost of capital is important, because investments in new generations of aircraft take so long to yield a return; but the US cost of capital is no lower and often higher than the cost of capital in Japan or Europe. The aircraft industry requires highly skilled workers and engineers—but so does production of, say, autos, in which the United States runs massive trade deficits.

The United States does, of course, have a large pool of workers and engineers with the very specific skills and knowledge required to design and build aircraft. But where did this pool of skills and knowledge come? Was it innate in the US character? Of course not. US workers developed the skills they needed to build aircraft because there was a large demand for those skills in the United States, arising from our dominant position in the world aircraft industry.

But of course our dominance in aircraft is in large part due to the fact that we have such a large pool of people with the right skills and knowledge. And you know where that puts us: squarely in the land of QWERTY.

Now there is a special reason why the virtuous circle that sustains the US aircraft industry got started: the huge base of demand for aircraft that arose from the needs of the US military during World War II and the early years of the Cold War. The interesting thing, however, is that even though that special advantage is long gone, the dominant position of the US aircraft industry endures (indeed, it would be complete, were it not for Europe’s support of Airbus…).

The point is that that there are many industries like aircraft, industries in which an international competitive advantage can be self-reinforcing. And the presence of such industries explains why countries that are similar at a broad level do so much trade. American and German industry are nowadays very similar in their overall levels of technology and in the resources available to them. Time and chance have, however, caused the two countries to develop different competences at a more detailed level, with America leading in aircraft, semiconductors, computers, and Germany leading in luxury automobiles, cameras, machine tools. From a distance, the two economies look more and more alike; in close-up, we are sufficiently different to find reasons to engage in an ever-growing volume of international trade.

In contrast to Krugman’s emphasis in such discussions on “time and chance,” and on cumulative historical circumstances, the “strategic traders” want to foster the conditions for competitive advantage through explicit public policy. Today’s initial conditions are simply what they are. But tomorrow’s initial conditions are yet to be created. The strategic traders’ objective is to take actions today that will create the initial conditions we will want to have years from now. For example, if only a few countries will be able to have successful computer industries in the year 2020, what path can we pursue over the next quarter century to ensure that the United States will be one of them? If the aircraft industry is likely to consolidate to just one predominant producer, what can we do to be sure the surviving firm will be Boeing or McDonnell Douglas, not Airbus?

Why would a scholar who helped pioneer the theory of path dependence as a useful way of thinking about international trade be resistant to applying the theory to policy questions like these? Surely the notion provides a theoretical justification for “industrial policies” aimed at creating the right initial conditions for tomorrow’s success. And if it does, why shy away?

Apart from accusations of sloppy research and a relaxed use of facts (including, he claims, outright confusion of facts with non-facts in some cases), the most specific criticism Krugman makes of the use of path dependence by the strategic traders is their tendency to conceive a country as analogous to one large firm and then to apply to it standard concepts of corporate strategy familiar from the 1960s. (Milk the “cash cow” industries, nurse the “stars,” sell off the “dogs,” etc.) The resulting work hardly constitutes a front-ranking intellectual contribution, and Krugman’s frustration is perhaps understandable in view of the attention given to what he may see as naive variations on the pioneering analyses he and others have made. But the question here is not who is going to win a Nobel Prize. What matters for public policy is practical usefulness, not intellectual creativity for its own sake. Aside from the sloppy research and questionable factual claims by specific writers—what Krugman calls “crude misconceptions, presented as if they were sophisticated insights”—what exactly is wrong with the idea of applying principles of path dependence to policies bearing on specific industries in this way? And regardless of whether the strategic traders’ concepts of corporate strategy are fresh or dated, why are policies based on them more likely to do harm than good?

Krugman’s explicit arguments notwithstanding, I believe the real answers to these questions center on economists’ usual skepticism about the ability of government decision-makers to improve on market outcomes in the absence of clearly demonstrable market failure. In part this is a matter of competence at analysis and prediction, and here Krugman’s charge that the strategic traders offer up poor research is relevant (although if this were the only problem, presumably one could solve it by assigning the task to researchers of Krugman’s proven quality). The standard example cited nowadays to cast doubt on the ability of policy-makers to “pick winners” is the US government’s misguided push to develop synthetic fuels as an alternative to expensive foreign oil in the late 1970s, but a recent study by the McKinsey consulting firm of attempts at industrial policy here as well as in Germany and Japan draws the same kind of negative conclusion more broadly. But as Krugman puts the broader point, “an acknowledgement of the power and effectiveness of the market as a mechanism is a central part of the professional identity even of liberal economists.”

In addition, however, industrial policies entail further problems because government policy-making is inevitably a political process and, at least in the United States, its participants too often seek policies to benefit specific constituencies at the expense of those that would be best for the nation as a whole. The issue at the heart of the debate over industrial policy is probably not so much whether it is in principle possible to pick winning industries for the government to subsidize and protect. It is whether, in practice, the government is likely to hand out its subsidies in a genuinely strategic way. The strategic traders may believe the government would play the game straight, or at least that politicians are capable of being reasonably objective about the future of the particular companies on whose behalf they seek subsidies and protection. By contrast, Krugman, like most economists these days, is far more skeptical:

Perhaps the most important reason that economists [who pioneered in applying path dependence to international trade] were diffident about making policy pronouncements based on their new theory was their fear that it would be used, not to make better policy, but to rationalize bad policies. Concepts such as strategic trade policy can all too easily be used to rationalize good old-fashioned protectionism.

So far, at least, there is little evidence that the influence of the “strategic traders” within the Clinton administration has caused real harm. The administration has apparently backed away from its goal of negotiating quantitative trade targets with Japan. (This retreat has not paid off in major Japanese concessions, but in this respect the Clinton administration is neither more nor less successful than its predecessors. Because of all the borrowing from abroad that this country has done as a consequence of the government’s huge budget deficit, America now negotiates from weakness, especially when it negotiates with Japan.) In contrast to Krugman’s fear that “the direct threat from the ascendancy of strategic traders is that their fixation on the supposed problem of competitiveness will set off a trade war,” protectionist measures have mostly gotten nowhere.

Instead, the Clinton administration showed good sense and real courage in defying both Ross Perot and the AFLCIO on NAFTA. In doing so it not only made a useful contribution to international trade but also made clear how flimsy were the threats made by both of these opponents of the treaty. Mr. Perot’s “giant sucking sound” of American jobs migrating to Mexico is so soft as to be inaudible, and despite organized labor’s repeated threat to defeat Congressmen who voted for NAFTA, it now seems likely that not a single incumbent will lose his or her seat because of a pro-NAFTA vote. The Clinton administration also deserves high marks for successfully concluding the latest round of GATT negotiations, although the task of selling the result to Congress will be tricky because of the need, under current budget procedures, to make up the federal revenues to be lost from lower tariffs.

Krugman’s fears that excessive concerns about competitiveness will lead to poor policies in other spheres have also not been realized. True, President Clinton exaggerated the role of international trade in making the case for his 1993 budget plan. But surely the more important points by far are that the President (a) proposed a plan to narrow the budget deficit by some hundreds of billions of dollars over the next five years, (b) pushed vigorously for that plan, and (c) succeeded in getting Congress to adopt it (without a single Republican vote in the Senate). More important still, as of now the plan is clearly working. Growth of government spending has slowed, growth of tax revenues has picked up, and for now the deficit is steadily declining. It is difficult to imagine such an outcome under either Ronald Reagan or George Bush. Krugman’s fears to the contrary—and putting aside the administration’s plans for health-care reform, which he seeks to compare to the strategic trade idea—economic policy is the most impressive of the accomplishments of the Clinton administration to date. There is certainly no evidence of what Krugman calls “a sort of Gresham’s Law in which…bad ideas drive out good ones.”

Just what, apart from avoiding the strategic traders’ calls for industrial policy and protectionism, would Krugman have us do? His list of recommendations at the end of Peddling Prosperity is fairly familiar, at least among economists. Although he deprecates the importance of the federal budget deficit throughout his book, the first item on his list of policy recommendations is to cut spending and/or raise taxes so as to narrow the deficit further. He is also hardly alone in calling for such measures as reforming health care, substituting taxes and other market-based incentives for costly and ineffective regulation, and doing more to help the children of poor families.

Krugman is surely right in arguing that, over the long term, it is productivity growth that delivers rising standards of living and that we should therefore do whatever we know how to do to boost our productivity growth—even just a little at a time, if that is all we can manage. That is, after all, why so many other economists have paid so much attention to such matters as improving education and worker training, increasing tax and other incentives for firms to undertake research and development, and narrowing the budget deficit so that more saving will be available to finance new factories and machines. But for all the emphasis on the central importance of productivity growth, Peddling Prosperity is not about any of these matters, and Krugman mentions them merely in passing. The book is mostly a plea to forget competitiveness and, above all, to dismiss the recommendations of the strategic traders.

Should Americans ignore their country’s success, or lack of it, in international competition? No doubt many foolish things are being said about the subject, and Krugman effectively demolishes many of them. But in the end, should we really not care whether Boeing or Airbus gets the orders, or whether the next generation of personal computers relies on operating systems by Microsoft or some Japanese competitor whose name nobody yet recognizes?

We certainly should care about such matters. The question is what to do about them. Just as we prefer a strong dollar to a weak one—as long as we can balance our trade—we also prefer that US companies get the business instead of someone else. But that does not mean we want to give up more than these objectives are worth in order to achieve them.

We want a strong dollar, ultimately, so that we can afford to buy more goods from abroad without having to pay more for them. But artificially pushing the dollar to levels not sustainable by our needs and abilities only makes us borrow from abroad and ultimately makes us all pay more. We want American firms to have more business, but if the government subsidizes them so that they become artificially low-cost producers, or uses tariffs and quotas to protect their sales at home, this only forces the rest of us to pay more for these firms to get foreign business than it is worth for them to have it. As Krugman correctly argues, the right way to get business is to be more productive in the conventional sense. Whether we have the analytical ability to figure out which “path” will encourage US companies to be productive in just the right ways, some years from now, is an open question. If so, whether the government could exploit that knowledge without being sidetracked into subsidizing people who are influential rather than activities that are important is even more doubtful.

And, finally, what should we think about our competitors? Does it matter whether or not US productivity grows as rapidly as everybody else’s? Paul Krugman is right in arguing that, from a strictly economic perspective, the comparison with other countries doesn’t make much difference. But it certainly does matter if we also care about America’s ability to take a leading part in world affairs—whether in protecting other nations against aggression, or in assisting them in economic development and environmental protection, or in influencing their attitudes toward human rights and democratic institutions. Poor countries do not lead in such matters. They lack the capacity. (Historically, so do debtor countries, and that is a further reason for regret at America’s new status as a debtor nation.) If we want the United States to be able to accept international responsibilities, and to project abroad not only American interests but American values and institutions as well, then we should want not merely to do as well as we can for ourselves but also to outpace the competition.

Letters

Technology’s Lesson January 12, 1995

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