The Krugman Watch, No. 1 Jude Wanniski January 6, 1999

Memo To: The editors of Foreign Affairs
From: Jude Wanniski
Re: Professor Krugman's discourse

In your Jan/Feb issue, which has some good stuff in it, you have a lengthy article by Paul Krugman, professor of economics at the Massachusetts Institute of Technology. Because of the enormous prestige of your periodical, which I have been reading since college days in the 1950s, I've decided not only to write a critique of his piece, "Depression Economics Returns," but also have decided I will institute a "Krugman Watch," following him around as he propounds his profundities. As Krugman will himself tell you, I have been e-mailing him from time to time, when I have found something useful in his commentary, or when I think he has wandered off into never-never land. The reason it will help you in editing your most prestigious publication is that you will begin to understand both the weaknesses of young Dr. Krugman, as well as his strengths. In reading his "Depression" piece, it dawned on me that the top of your masthead does not include an editor who would have the slightest idea of whether Dr. Krugman is being brilliant, or is just spouting hot air. In this case, it is a bit sniffy.

Now I acknowledge up front that the top editors of Foreign Affairs are not competent to judge a high-powered essay by a high-powered economist like Krugman, especially when he submits a piece about the world economy. I'm sure you ran it past an economist or two, but I don't see anyone on the masthead who would stand up to Krugman's well-known arrogance. My problem with Krugman in this piece about "depression economics" is that it forces us to read 18 pages about the world economy and what is wrong with it and on the 19th and last page tells us there is really not much that can be done about it, excepting "capital controls" of some sort. That is, each country in the world should think about defending itself from the ups and downs of capital flows by having their governments intervene to control the flows. I'm not going to suggest that Krugman is wrong to have governments intervene in malfunctioning "free markets." What I am going to do is suggest that Krugman's inability to reach a conclusion is the result of a key insight to the 20th century — the cause of the 1929 stock market crash. Which is to say, because he does not see, does not even mention, the decisive impact of the Smoot-Hawley Tariff Act of 1930 on Wall Street in the last week of October 1929, he is led into a cul-de-sac of confusion about what set the Great Depression in motion

As with all other demand-side economists, Krugman assumes that monetary policy was the root cause of the Depression in that the Federal Reserve erred in reducing the amount of money in the system, thereby limiting the ability of people to effectively demand goods and services. Why would the Fed do such a thing? Because the market system is imperfect, permitting participants to bid up the value of equities to unreasonable levels. In short, to the level of a bubble. If the market was inefficient then, it is just as susceptible today to speculative excess, irrational exuberance perhaps. If so, bubbles can appear anywhere in the world economy, and if they do, they will eventually burst, effecting not only the local market and its economy, but also those of its neighbors. The fall in demand here causes a fall in demand there.... and there.... and there.... A domino effect, so to speak.

If the shock to the system is such a demand shock, there is really no way of protecting yourself from it. All you can do is defend yourself against the domino effect by imposing capital controls. If you can prevent speculators from coming into your market, bubbles will not arise, and they will not burst!! That is Krugman's message to the world through Foreign Affairs. But if the Crash were triggered by a supply shock, a tariff that put up a wall between producers on either side of the border, prices would fall on either side of the border because of the surplus of goods that had been destined for export but now could not be. The Fed would not have been responsible, nor would the gold standard. We could then look for the supply shocks that deepened the recession into a Great Depression, and would find them in the tariff relations of the other countries of the world, and of the Hoover income tax increases, which imposed high walls between domestic producers and made their production impossible to finance... at the margin. By "margin" I mean the most vulnerable transactions which would have taken place prior to the tariff increase could no longer be financed. The "margin" is where change occurs.

Krugman understands that much, I'm sure, but because he blames gold for rigidities which caused the Depression, he now overlooks the power of gold as a monetary commodity to perform useful functions to policymakers. If he made that simple adjustment, he could analyze the world economy and after trying all possible scenarios, would find one or more that would be compatible with an efficient market. That's what I did more than 20 years ago when I founded Polyconomics after leaving The Wall Street Journal editorial page. In his article, Krugman quotes the Canadian economist Robert Mundell, who was my private teacher of classical economics. It was Mundell who gave me the secret that now baffles Krugman in his cul-de-sac. Mundell taught me more ban 20 years ago that if the world is on a gold standard — as it had been in 1971 -- it is the responsibility of the largest economy in the world to set the gold price in its currency. Smaller economies could not do it, because of the political strains that it would impose on its people by forcing an internal shift in comparative advantage to the financial industry and away from non-financial industry.

In a world of floating currencies, over which Krugman looks, small economies are indeed defenseless if their currencies are guided by a dollar that is fluctuating in more than a minor way against gold. They can't fix to gold themselves, or their economies would be wrecked by the rigidities. But if the United States, the largest economy, fixed the dollar to gold, thereby establishing a unit of account as good as gold, all other currencies would be able to fix to the core currency. The chaos that mystifies Krugman would come to a halt. In his article, he talks about the three options available to a nation, and how it can only choose two of the three at the same time. It thus has to give up something in order to achieve others. That is only true in countries smaller than the largest. If the United States would fix the dollar/gold price, Mundell would say each other country could then have all the benefits of the three options. It does not need to raise or lower interest rates in order to maintain the exchange rate. It only needs to manage its creation of bank reserves, the currency liquidity, to maintain stability with the dollar/gold framework. Its interests rate will then equate with the dollar's.

This is what Fed Chairman Alan Greenspan meant in early 1995, when he told the Senate Banking Committee that Mexico's peso crisis would not have happened if we were on a gold standard. Mexico's trading relationships with the United States would have not been strained because of the changes in the relationship between the dollar, the peso and gold as a proxy for all commodities. Missing this point, Krugman looked at Mexico and reckoned that if it had not attracted so much capital in the years prior to 1994, it would not have been damaged so much by capital leaving Mexico at the time of the devaluation. He actually made a tour of southeast Asia after the Mexico crisis — and helped persuade the government of Thailand to institute capital controls to protect itself against "hot" capital outflows. This was why Thailand was the first domino to fall in southeast Asia, as it had been the one most weakened by taking Krugman's advice. This is why I take the trouble to write you folks about the article you ran which he authored. In a way, it covers up his responsibility for the mess created in Asia, but it also covers up the Fed's, and comes to a conclusion that can only lead to further problems if the readers of your prestigious publication take it seriously. I hope you know what I mean.

I'm not without admiration for Krugman's industriousness, which also is why I've decided to set up a formal "Krugman Watch," which will keep an eye on him as he makes his contributions to the national and international press corps. On other topics, he has been rather good, and I have praised him. On this one, be assured that it is sufficiently flawed that it will produce a negative return for your readers.