The Age of Diminished Expectations, by Paul Krugman, Cambridge, Mass.: The MIT Press, 204 pages, $17.95
According to Rimmer de Vries, chief economist and senior vice president at J.P. Morgan, "Paul Krugman is one of the most sought-after economists in the world." Pat Choate says Krugman "may well be the most influential economist of his generation in the world today." And Fred Bergsten says he "is one of the most brilliant and creative economists in the world today." If these superlatives are anywhere near the mark, it would explain why everything touched by establishment economists turns to disaster.
Paul Krugman, a professor at MIT and a consultant to the IMF, the World Bank, the United Nations, and the Trilateral Commission, is certainly a member of the establishment. Without the protection of this far-flung establishment, no one would dare to write a book as misleading as The Age of Diminished Expectations, much less admit in the preface that the Reagan-phobic Washington Post put him up to it. In attempting to diminish Reagan, he diminishes his profession.
Krugman is puzzled at Reagan's political success despite statistics that show a "basically dreary economic record," and he concludes that Americans evidently no longer expect much—hence the title of his book. An alternative conclusion is that academic economists spend so much time playing mathematical games that they no longer have command over basic economic principles and are unable to make even simple statistical comparisons without fooling themselves and the public.
Statistical comparisons, or even the ability to read balance-of-payments statistics, are certainly not Krugman's forte. During 1973–81 there was a drop in median income. Reagan turned it around, but Krugman hides this supply-side accomplishment by comparing the 1947–73 postwar boom with the 1973–88 period. Thus, the income growth under Reagan is canceled by the poor performance of the 1970s, allowing Krugman to write of "the stagnation of real family incomes during the 1970s and 1980s." To show the poor becoming poorer under Reagan, Krugman selects the period 1979–87. This averages four years of Reagan expansion with the drop in median income associated with the last two years of the Carter stagflation and the 1981–82 Volcker recession.
Krugman's choices of periods for comparison are especially puzzling, since they implicitly deny any discontinuity in policy between Reagan's supply-side economics and the previous demand management approach. Yet Krugman asserts supply-side failure on the basis of comparisons that weigh down supply-side economics with the failures of demand management.
It requires no statistical skills to make the real income growth of the 1980s disappear in historical comparisons. Until 1983 the Consumer Price Index over-adjusted for inflation by assuming that people bought a new house every month. When used in historical comparisons, the CPI exaggerates the amount of inflation people actually experienced and, thus, understates the growth in their real incomes.
Krugman's ability to handle statistics does not improve as he moves into the international area. He asserts that an inflow of foreign capital took place during the first half of the 1980s in order to finance the U.S. budget deficit. However, the balance-of-payments statistics contradict his assertion. The figures show no significant change in the inflow of foreign capital during the first half of the 1980s. But they do show a sharp drop in the outflow of U.S. capital, which threw the U.S. capital account into a $100 billion surplus, thereby creating the large trade deficit (by definition a mirror image of the capital surplus).
Krugman is unable to discern why American investors, following the 1981 tax cut, suddenly ceased exporting their capital and instead retained it at home. The fact that the after-tax earnings on real investment in the United States rose relative to those in the rest of the world has no economic consequence in Krugman's analysis.
Instead, he uses noneconomic accounting tautologies to claim, incorrectly, that the budget deficit caused the trade deficit and a need for foreign capital. Krugman's reliance on the discredited "twin deficits" theory is surprising. Many economists have long noted that in the 1980s Canada combined a large budget deficit with a trade surplus, and Britain combined a budget surplus with a trade deficit. Apparently, the "twin deficits" theory is a form of nationalistic economics that applies only to the United States.
Krugman describes countries that export their capital as "in the black," while those whose successful policies attract their own capital as well as the capital of foreigners are in the red and heading for disaster. He uses unadjusted data that price U.S. foreign assets at their historical book values to claim that Reagan wiped out "60 years of American overseas investment" in just four years. He doesn't notice the inconsistency of claiming that the United States is a debtor nation when statistics show a net creditor's income.
After conjuring the vision of the United States as "a giant Argentina," he introduces the nationalistic bogeyman: "growing foreign ownership of U.S. assets compromises our national sovereignty." This, of course, implies that the United States as a creditor nation compromised the sovereignty of other countries. Such an argument is a blatant attack on foreign investment that reflects, perhaps, Krugman's connections to multilateral institutions that have historically favored government-to-government capital transfers.
Krugman's book is just another in a long list of establishment tracts designed to bury the fact that Reagan's supply-side policy produced a record economic expansion without a rise in the inflation rate. According to establishment economists, this was impossible. The Phillips curve mandated that higher employment had to be paid for with higher inflation, and lower inflation had to be purchased with higher unemployment. Reagan's game plan forecast a drop in inflation and unemployment and was dismissed by economic sophisticates as a "rosy scenario."
The human capital of most macroeconomists, heavily invested in demand management, was wiped out by the policy failures of the 1970s. The dreaded Phillips curve trade-offs, far from being an iron law of economics, resulted from pumping up demand with easy money while strangling supply with hlgh tax rates and regulation. Reaganomics reversed this policy mix and relied on incentives instead of monetary demand to spur the economy.
Under Reagan's policies inflation and nominal GNP growth shriveled much faster than predicted, throwing off government revenue estimates and resulting in budget deficits. Most economists misinterpreted these deficits as deliberate "policy" deficits that would overstimulate demand and reflate the economy. The expectation of renewed inflation caused people to leverage their debts, but disinflation continued. The current debt problems have their origin in this miscalculation. Supply-side economics meant what it said, and it delivered. It is the people who did not believe it who overinvested in inflation hedges and are suffering.
Former Assistant Treasury Secretary Paul Craig Roberts is the William E. Simon Fellow in Political Economy at the Center for Strategic & International Studies in Washington, D.C.
This article originally appeared in print under the headline "The Age of Diminishing Economists".