Opposite Poles

Two eminent economists, Meltzer and Krugman, dispute the issue of whether inflation or deflation will be the next great challenge facing the US (and world) economy. A lot depends on which period of history is used as an analogue for this one.

Allan H. Meltzer is a professor of political economy at Carnegie Mellon University. He has authored the book “A History of the Federal Reserve.” He believes that the US is headed for “severe inflation”. In an op-ed piece for the NY Times, he points out that

the interest rate the Fed controls is nearly zero; and the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain (Inflation Nation, 3 May 2009).

He pins the blame on both political and monetary authorities, in particular

the (doubtful) commitment of the administration and the (lack of) autonomy of the Federal Reserve ... under Mr. Bernanke, the Fed has sacrificed its independence and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages.…
It doesn’t help that the administration’s stimulus program is an obstacle to sound policy. It will create jobs at the cost of an enormous increase in the government debt that has to be financed. And it does very little to increase productivity, which is the main engine of economic growth.

Meltzer recounts the Fed under Paul Volcker (who is presently advising the Obama administration) which tamed spiralling inflation following the Oil Shock of the 1970s. As some have argued, the present crisis could have been instigated and deepened by the Oil Shock of 2007. Meltzer further points to one indicator that inflation is already here; he argues

(S)ome of my fellow economists, including many at the Fed … point to the less than 1 percent decline in the consumer price index for the year ending in March as evidence that deflation is a threat. But this statistic is misleading: unstable food and energy prices may lower the price index for a few months, but deflation (or inflation) refers to the sustained rate of change of prices, not the price level (emphasis mine). We should look instead at a less volatile price index, the gross domestic product deflator. In this year’s first quarter, it rose 2.9 percent — a sure sign of inflation.

Quoting the father of monetarism, he says

Milton Friedman often said that “inflation was always and everywhere a monetary phenomenon.” The members of the Federal Reserve seem to dismiss this theory because they concentrate excessively on the near term and almost never discuss the medium- and long-term consequences of their actions.

Paul Krugman is on the opposing side of the debate. He teaches at Princeton University and has made a living out of studying economic crises. His latest book is entitled “The Return of Depression Economics.” He counters Meltzer in his blog with a graph that depicts the “lost decade” in Japan in the 1990s where the growth of money supply, high deficits coincided with deflation. Krugman’s attention is devoted to avoiding wage deflation, as he writes in his column for the NY Times that

…according to the Bureau of Labor Statistics, the average cost of employing workers in the private sector rose only two-tenths of a percent in the first quarter of this year — the lowest increase on record. Since the job market is still getting worse, it wouldn’t be at all surprising if overall wages started falling later this year (Falling Wage Syndrome, 3 May 2009).

His view is that wage deflation is a symptom of a deeper problem in the economy. And his prescription is for “more stimulus, more decisive action on the banks, more job creation”. Quoting the father of stimulus economics, he argues that

(T)hings get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: “The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period.” And a rise in the effective interest rate is the last thing this economy needs.

So there you have it: two renowned experts fighting over the appropriate fiscal and monetary measures to take in this crisis. Both use staitstics and history to bolster their arguments. The disagreement ultimately comes from which previous recession is deemed relevant for this present crisis – whether the Great Depression of the 1920s and lost decade in Japan of the 1990s or the post-Oil Shock era of the 1970s.

Krugman and Bernanke, the deficit hawks, believe that constricting growth particularly at this moment could hamper economic recovery, while Meltzer, the institutionalist, believes that protecting growth at all costs has consequences far greater than we imagine.

The triumph of Krugman’s Economic Geography over Porter’s Industry Clusters

(WARNING: Readers of the following may experience minor bouts of dizziness resulting from a re-balancing of mental perceptions of what governments can and cannot do. These symptoms should ease after a day or two. Should they persist, consult any handbook on new international trade theory for relief.)

He is probably the foremost economics blogger to win the Nobel Prize for his theoretical work on international trade and economic geography. Princeton Professor, Dr Paul Krugman in a succinct, yet elegant manner, explains both the sectoral and spatial implications of global production, something that Porter attempts with 800+ pages but fails at achieving the same level of clarity.

Both men began their work at relatively the same period in the late 70s. Of the two, it was Porter who gained prominence and notoriety in the speaker’s circuit for his depiction of competitive forces, which can be regarded as industrial organization for dummies.

While Krugman sought to explain the specialization of regions in producing certain goods deductively through mathematical reasoning, Porter used induction, studying specific cases of concentrated clusters of industry activity. The result is that Krugman provides a policy tool that is easily wielded unlike Porter’s bulky analysis.

Mercantilist Revival

Applied to the firm, Porter’s notion of strategic competition has its use. But when public policy tries to appropriate the same approach to cities, regions and countries, it loses validity according to Krugman. In fact, he calls those who seek to improve the competitiveness of a place to the detriment of all others Mercantilists.

The notion that we can drive up exports by competing as firms do through Strategic Trade Policy is beset with all the pitfalls of selective government intervention. Although it may have had a few instances of success, when applied more broadly the impacts are too minute, while the chances of getting it wrong and the costs associated with failure are too big to ignore.

Porter takes us through several hundred years of history in which nothing is guaranteed to reiterate even if conditions could somehow be duplicated today. Around the world, there are thousands of government supported science parks and export processing zones intended for cluster development, but a few successful ones truly produce value creating innovation. They are usually informal networks that came about more from benign neglect than through selective intervention, i.e. the software hubs of Bangalore India did not have a decent ICT infrastructure during its genesis.