How monopolies, geography, and currency crises affect economies | Interview with Dr. Paul Krugman

00:13Becoming an economist

Jed Macosko: Hi, I’m Jed Macosko at Wake Forest University and AcademicInfluence.com, and today we have a truly special guest, Professor Paul Krugman, famed economist and guest on our show today. So we’re gonna ask Paul the usual question we always ask, which is…

…how in the world did you end up in the field that you’re in? How did you choose economics when you were a young person?

Paul Krugman: Okay, so my story is terminally cute and also actually true. So I was a huge nerd as a teenager, I read a lot of science fiction, and in particular, I read Isaac Asimov ’s Foundation novels, which are, for those who don’t know, they’re sci-fi classics about a galactic civilization that’s collapsing. And there’s this group of mathematical social scientists who have figured out the mathematics of history and set in motion a plan to save civilization from the collapse of the empire, and I wanted to be one of those guys. And economics was as close as I could get, so there we are.

Jed: Wow, that is truly a good story.

And then when did you start pursuing that? Was it in high school? Did you find some economy… Economics classes in high school or it was in college?

Paul: Oh I took economics in college. This was… I’m old enough that… We didn’t have econ in high school in those days. No, I actually… I thought I was gonna do history, I thought I was gonna major in history, but took Econ 10, really liked it, and then had one of those just really lucky things, which was, I took a seminar course that was co-taught by Bill Nordhaus, who did a lot of the illustrious stuff thereafter, and it went… I ended up working as an undergraduate as his research assistant, ended up majoring in economics and just generally economics seemed to be something that was a natural fit for the way I thought. I always wanted more about the “why” than the “what”. History is a lot… Has to be about what happened and economics is largely about why, and so economics seemed to be the natural place to go.

Jed: Yeah, and what was your research like when you were an undergraduate?

Paul: Oh, you don’t do a whole lot of research as an undergraduate. But the… Actually what had caught Bill’s eye was that for that seminar, I did an empirical paper on gasoline demand using international cross-section data, which for some reason hadn’t been done much. And of course there’s huge variation ’cause countries tax gasoline at enormously different rates.

And what I found from the data was that it appeared that actually gasoline demand was quite sensitive to price, which was not what people were saying at the time, people tended to think of it as being unresponsive, and that was interesting. And so I got hired by Bill Nordhaus to work as his research assistant on a big project on energy resources and the long-term future of energy. So I have a very happy memory of two summers spent largely in the geology library at Yale, which had a lot of resources, Bureau of Mines working papers and things. And so I was busy working on all that stuff and it was, I got to work at a very young age with someone who was a really first-rate modeler and empirical economist too, and it was an early great apprenticeship.

Jed: Wow, that is great. In those early days, did you do modeling using FORTRAN punch cards, or was it all…

Paul: Oh boy… It wasn’t… It was… I don’t think it was in FORTRAN, I don’t know what it was… Maybe it was FOR… I don’t remember which language he was using, but those were the days… The computer center was a separate building, and with the giant computers and men behind a glass screen, the high priest, and you handed them a box full of punch cards and you would make one punch error, and what you would get back would be this huge stack of garbage in hexadecimal. So no… Those were… And a lot of work done at two in the morning, ’cause it would be a faster turnaround if you did it in the middle of the night and horrible vending machine coffee, ’cause it was also before coffee in America got decent. So it was a different era.

[laughter]

05:32While at MIT

Jed: Where did you go after Yale and did you just go straight into a PhD program?

Paul: Yeah, I went straight to MIT, which was… At the time, MIT was the place, everybody went to MIT. There was an era there where Harvard had great research, but terrible teaching, and… So MIT was where everybody went. So everybody… Basically everybody you’ve heard of that’s remotely in my age range was somebody I overlapped with MIT, we all knew each other. So MIT was the place to go. And again, I had the good luck of finding a mentor, which was Rudi Dornbusch at MIT. And so there was all the… It was… I was in the right place at the right time, and had good luck with personal connections as well.

Jed: That’s great.

Can you just describe briefly your PhD project?

Paul: Oh, actually, my thesis wasn’t that great. It was… The MIT advice to students was really, “Don’t do a giant thing, but do a series of related papers.” So I had three related papers all involving work on exchange rates of which, it turns out, the one really really good paper… One pretty good paper, I think. The one that’s lasted that I wrote in grad school wasn’t in the thesis because Rudi didn’t quite get it when I first showed it to him. And so we held it back. But it turned out, he came back to me a few months afterwards and said “That paper, I’ve been thinking about it. Can you describe it to me again?“. But anyway, so… But I was working on exchange rates. The major thing that I did, the breakthrough…

The best paper I did in graduate school was I invented currency crisis. Not the thing itself, but the academic field that came up. That was the paper that… It wasn’t that well written ’cause I was still a novice, but it was thinking about how it is that you can have sudden speculative attacks on currencies. And so that was the core of the stuff I did. But I also got… Was studying a lot of other stuff and it was some of the other stuff that ended up really being the basis for most of my later career.

08:20International Trade and winning the Nobel Prize

Jed: So of course, I wanna hear a little bit more about currency crisis just ’cause it’s interesting. But what was the other stuff that led to the basis of your career? Can you describe the direction you went after MIT?

Paul: Yeah, so I took International Trade from Jagdish Bhagwati who was a very fine international trade economist of what was then the existing school. But I also took a special course. Just one of those things. Again, the luck of these things is enormous. Bob Solow.

Obviously the great Bob Solow, great economist gave a short course. He was at the level where he could give a course on whatever he felt like giving. And there were these new models of monopolistic competition that had just emerged in the mid ’70s. Joe Stiglitz, Mike Spence, that were clever ways to think a little bit more systematically about what happens when firms are not atomistic when they have some monopoly power but not complete monopoly power.

And having taken trade theory, international trade theory and having taken Bob Solow’s course, which was great fun… Actually, after I left grad school for some reason the things meshed in my mind and I said, “You know, we could apply these monopolistic competition models to international trade and they could explain a big empirical puzzle, which is that most international trade… Even more so then than now, but most international trade was among countries that they’re actually fairly similar. Most international trade was among advanced countries with similar wages, similar levels of education and which was a little bit of a puzzle because what conventional trade theory said the country’s trade to take advantage of their differences. One country is a good place to grow wheat, another place is a good country to grow wine grapes. And so what’s all this trade between countries that look pretty much the same?

And the answer was the inherent advantage as a specialization. At least that seemed to be an obvious answer. But that was actually extremely hard to think about in any mathematical model, because its advantages of large scale production are inconsistent with atomistic perfect competition. And I sort of said “A-ha, these monopolistic competition models give me a way to do that in a way that’s still, dot all your I’s and cross all your T’s. You can have these button-down models that… But that they make sense of this… ” The fact that world trade does not at that point, more than half and at this point still a large fraction of world trade, just didn’t fit the story we were telling. So this convergence of having studied trade, knowing the old stuff, knowing the conventional trade stuff really well and having had an early, a very early introduction to the stuff that Solow taught was all papers that had not yet been published, gave me… Put me in a good position.

It was actually one of those things, by the way the… Three people wrote the same paper at the same time essentially. It was like science. The Kelvin Lancaster at Columbia, Avinash Dixit and Victor Norman and I wrote pretty much the same paper simultaneously and independently. I write a little bit faster than the rest of them. Mine actually got into print faster, but it was really… It was all at the same. It really was simultaneous discovery.

Jed: That is fascinating.

Now, was that what you won the Nobel Prize for, this concept of countries trading with one another with goods that they both produce that are not different?

Paul: Or with goods that they both could produce. So they…

Jed: Both could produce.

Paul: So they end up specializing in different stuff.

Jed: Yeah.

Paul: The classic example actually is US-Canadian auto trade. There’s absolutely no difference with the technology, anything else. But Canada is a tenth the size of the US economically, so if Canada produces a limited range of stuff which it produces for the whole North American market, the United States produces others… And it’s all very similar, but we specialize in different ranges of products and so we do a whole lot of trade. So that’s the kind of thing.

So that plus… Then a few years later, a corollary to all of that was that you could also use pretty much the same logic to think about why industries concentrate in particular locations, why regions differentiate from each other. Involved thinking about… There had been this old tradition people called… I used to call it the counter-culture in trade, which said, “That countries tend to export things which they have large domestic markets.” Which did not make sense in terms of the old trade theory, but actually did make sense in terms of the new stuff. And some… Basically about almost a decade after I did the original work on trade I said, “Oh, I can do that one too.” And so the new economic geography was the other main part of what the Nobel was about.

Jed: That was what they said when they awarded you the Nobel Prize they…

Paul: That’s right.

Jed: Okay, but it was a corollary of the earlier stuff that said, “Two countries that could produce the same thing end up trading a lot.” And at the time you wrote that it was more than half of the trade… International trade.

Paul: Yeah. And it’s a corollary or a natural extension is the way I’d put it. Yeah, and I guess the Nobel Committee also mentioned… I continued to work on exchange rates and currency crises and all of that, so that’s… So that there were a couple of other… Couple of other items in my resume that mattered. But it was fundamentally this… The increasing returns revolution in trade and geography, which was a bunch of people. But I actually felt I should have shared that prize with some of the others. But anyway, but that was what it was mostly about.

Jed: Yeah. Well, so where were you when you got the phone call, I guess, in October or something like that? And where was your wife and…

Paul: Oh, boy.

Jed: How did that all go down? [chuckle]

Paul: Oh, god. So there’s a well established procedure, you get a call from somebody you know, which they screwed up on. So, I got… I was actually in a hotel room in Washington because there’s a… We had a meeting on international finance that I was attending. And got a call on my cell phone from somebody with an obviously fake Swedish accent, so I thought. And I said, “Okay, this is probably a practical joke, but I’ll check the website in half an hour to see if it’s for real.” And my wife was back in New Jersey, so I… Actually she was also about to get on a train going in a different direction. And called her I said, “I don’t know if this is real, but it might be.” And… Yeah. And so that was… It was all a mess.

Actually, her reaction was… We have a textbook, Krugman, Wells, Wells, is my wife. We have the third best-selling textbook in economic principles, the Bedrock of our Financial Stability. And we were in the middle of final page proofs and… Which were… And we were doing frantic revisions in pages, which is a huge nickel problem, everything has to fit exactly what are we gonna replace this… ’Cause the financial crisis had just broken out. And…

Jed: Oh, man.

Paul: So Robin’s reaction was first, “Oh my god.” Then brief pause. “We don’t have time for this.”

[laughter]

Jed: Classic.

Paul: Which was actually true. Nobel week I had to do all of this formal this stuff. She spent mostly in the hotel room with galleys spread around her on the floor. So, anyway.

Jed: Oh, my gosh, what a woman. How did you guys meet each other? It sounds like you have that love of economics in common.

Paul: Yeah, Robin was a post-doc at MIT when I was teaching. And this is late ’80s, I think. We did not get involved ’cause there are rules about that sort of thing. [chuckle]

Jed: Of course. [chuckle]

Paul: But when we met each other again a couple of years later, things clicked. So that’s…

Jed: Wonderful. That is really wonderful. Sounds like you guys have had a great partnership over the years, classic story about, “We don’t have time for a Nobel Prize.” [chuckle]

Paul: It actually is. Actually, the other thing that she said, which I think was great, was after the whole thing was over she said, “You know, there’s two great things, one is that you got this, the other is that we won’t ever have to go through this again.”

[chuckle]

’Cause it was absolutely exhausting and… Yeah.

Jed: I can’t even imagine. But it’s funny that even in fields as far away as physics I was… I don’t remember exactly where I was at the time, you won that, I think I was at Wake Forest already. We heard about this Nobel Prize, I think it was one of the few prizes in economics that everyone could understand the achievement that you made, and it’s really cool, so thanks for sharing the details of getting that phone call. [chuckle]

Paul: It was a… Actually, I was wondering how they had my cell phone number. It turns out, we have a Swedish friend, who teaches in the US. And now we realize that some of the conversations that we’d had with her a couple of weeks earlier had intimations that we didn’t get. But for some reason, they didn’t manage to arrange to have her make the phone call, so it was really… Anyway. It’s a…

Jed: They screwed it up, but it was all fine. [chuckle]

Paul: Everything… Right, yeah. Seems like a very long time ago which I have to say…

19:22Currency crisis

Jed: It does, doesn’t it? Yeah. That’s what I was trying to remember, where I was at the time, but it was… I’ve been here at Wake Forest for a long time. So it was back then. Anyway, really fun story, I wanna get back to currency crisis…

Paul: Yeah.

Jed: So that’s when basically people speculate on some country’s currency, and… Tell us a little bit more about that and how you had the idea to write a paper about that as a grad student?

Paul: Yeah, so the typical things that… At the time, the typical story was that there was… Countries that were trying to keep the value of their currency fixed in terms of other currencies pegged to the dollar, or pegged to the Euro. At the time, there’s no Euro but anyway. But… And countries do that by buying and selling their own currency too. If the price starts to rise, they sell some of it. If the price starts to fall, they buy some of it, using reserves that they hold of foreign currency and then they may also end up altering probably raising interest rates, whatever to defend.

What happens is that under regimes like that, there are occasional episodes when people, investors decide this is not gonna hold, and they start dumping a country’s currency and the attempt to support it leads to whatever reserves they have dwindle very, very fast. So you can talk about tens of billions of dollars now in the modern world can disappear in a day.

We’d seen that back in the break up of the old… The Bretton Woods system in the early ’70s was marked by really huge speculation, what seemed like huge speculation. Everything these days is on a scale that makes the old stuff look slow motion, but still… And you’ve seen it.

And the way I got into that was I’d actually… I had spent three months interning at the Federal Reserve when I was in grad school. They have a program… And I spent three months and… At their international finance section of the Fed. And there was a guy there, Steve Salant who was workin on, among other things, commodity price schemes. There’d been various attempts to stabilize the prices of raw materials and those schemes often end in a sudden speculative collapse. Everybody just stages a run on the stock pile of copper or whatever it is. And gold effectively was that kind of thing and the gold standard collapsed very fast in the late ’60s when people decided that the gold was not gonna stay at $35 an ounce and cleaned out the inventory very fast. And I just said “Hey, you know, something like that could probably work as a story about currencies as well”.

Now, it turned out that currency is a little different because there are… Governments have more options and it also turns out that there are other stories. So we actually now these days talk about first generation currency crises, second generation, third generation, where the generations refer not to historical time, but to generations of models.

So what I came up with was the first generation currency crisis model, which is one in which you have… You have a fundamentally unsustainable system but it breaks down abruptly at a certain moment. Second and third generation are ones where there’s a lot more arbitrariness things. A currency that might be sustainable breaks down anyway. But anyway, so that that was the beginning of end. I think we still have a… Turkey is going through what looks a whole lot like our first generation currency crisis right now.

Jed: And all the same models that you’ve worked out in grad school still pretty much apply.

Paul: Yeah. The model I worked on in grad school was one that was… More complicated than it needed to be ’cause I was still learning my craft and it omitted stuff that certainly the second and especially the third generation currency crisis models need to include. Nowadays, we really need to talk about things like foreign currency debt as a critical factor. That wasn’t a part of my story then.

So if you’re trying to understand what happened to Argentina in the last couple of years, that story… Well, that model is way inadequate in terms of not having enough factors in it. But still it was the… I think it did two things. One, it was… It made it possible to talk comprehensively about this and it elevated the subject, so people started to think much more about it and pay attention to when these things happen.

Jed: ’Cause they are pretty significant especially if you live in Turkey or Argentina. This is a big deal. [chuckle]

Paul: I always tell people that I invented currency crises and business has been good ever since.

[chuckle]

In a lot of ways, what happened in Southern Europe and the Euro crisis, even though it wasn’t… They didn’t have their own currencies, but in a lot of ways that the… What happened to Greece and Spain and Italy had a lot to do with the old currency crisis approach. It’s an enduring feature and I’ve tested really the gold and… The golden age of currency crises was actually in the 1990s, ’cause we had a series of them in Asia and Latin America that really did validate the importance. And in some ways, psychologically, maybe intellectually prepared some of us for the global financial crisis that came a few years later.

25:53The 2008 financial crisis

Jed: Now, were you prepared for 2008 global financial crisis? Were you thinking it might happen or how did you feel?

Paul: I thought we were gonna have a problem ’cause I thought the housing bubble was the most obvious thing I’ve ever seen. So I thought with giant housing bubble when it bursts, it’s gonna be bad. I didn’t realize just how bad things were going to be because I had assumed that banking was secure, that the risks of the 1930s were no longer around because of deposit insurance and so on.

What I didn’t realize ’cause I wasn’t paying attention to it, was that most of modern banking is not actually conventional banks. That it’s all of these shadow banks that are unprotected, unregulated. And so was caught by surprise when all hell broke loose in the way it did. But it wasn’t a hard adjustment.

Basically, I would say that within a few days after Lehman Brothers fell, you could find people walking around the halls of economics departments, muttering to themselves “Diamond-Dybvig, Diamond-Dybvig”’Cause the Diamond-Dybvig model a bank runs, even though that’s the classic standard model of that, even though this wasn’t involving conventional banks, the logic was obvious.

So it was one of those things where, “Oops, we didn’t see this coming, but we understood very quickly what kind of a thing it was.” So it was… If I can say it’s more like there’s a famous… There was a hurricane that hit Britain I think in the ’80s, and caught everyone by surprise and wreaked havoc but it wasn’t… The meteorologists didn’t say, “Oh, we don’t understand weather.” They said, “Oh, we don’t have enough buoys out in the Atlantic to catch these things when we can.” So in this case, it was a failure of data rather than a conceptual failure.

Jed: Do you think that could happen again? Some people say that the housing bubble of 2008 is being reproduced in businesses, so the same stacked commodities, where they stack up bad debt with good debt is happening in the business world, and that they will have the same sort of catastrophic failure and that’ll bring down the whole economy. Is that going to happen and do we have…

Paul: There are certainly parallels. There’s a lot of stuff going on in corporate debt, and in particular, actually there’s a lot of stuff going on in commercial real estate that is reminiscent of the 2000s. And commercial real estate has this special problem, which is that the pandemic means that a lot of… There’s a lot of what… Depending on how persistent the changes and how and where we work remain at, there may be an awful lot of stranded capital out there, but magnitudes matter. The thing is the home mortgage market is enormous, the housing sector is enormous.

Corporate debt, even commercial real estate, are big, but they’re not on the same scale. So it is hard to tell a story where we have as big a bust as we did then. It’s not nothing. And if your standard is, “Will we have a 2008 level crisis?” that’s a pretty high bar to jump over. So could we have some serious problems? Yes, but… I’m having a hard… Just pretty much casual stuff, and I talk to people, and there are some people who are warning me of apocalypse in commercial real estate. I can’t tell whether they’re right or not. But the amounts of money outstanding, while inconceivably large by any human standard, are not on the same scale as what was on the table in 2008.

Jed: Interesting, well, that actually gives me a lot of comfort because I see things and I get worried, and I’m sure a lot of people do, but it’s nice to hear from one of the most beloved economists of our time [chuckle] that things are maybe not as bad as they could be.

Paul: Yeah. No, you gotta say, look, the fact of the matter is that nobody saw 2008 coming, or strictly speaking, there are some people who did predict it, but they also predicted five other crises that didn’t happen. And it’s a good bet that the next crisis will come from a direction that no one was anticipating, or maybe we’re in it. One thing I certainly was not thinking about was pandemics, but yeah, right now, I think understandably a lot of people are looking for a replay of 2008 and, look, what happened to financial markets in March looked a lot like what happened to financial markets in September 2008, but this time, the Federal Reserve, having seen this, they… We do learn, or at least some people learn something. So they stepped in and threw a lot of cash at the problem and stabilized the markets very fast. So probably, famous last words, probably we’re not gonna have a replay of that crisis.

31:48Sign off

Jed: Well, I think that’s a pretty safe bet. We’re not gonna have a replay of that crisis, but I hear what you’re saying, it might not be that magnitude, which is again very reassuring to all of us who are not Nobel Prize winning economists. Which we are just so thankful to have you speak to us today. It’s just such a treat. Thank you, Professor Krugman, for your time and for coming on and talking with us.

Paul: It’s been fun.