Paul Robin Krugman was born in 1953 in Albany, New York, the only child of Anita and David Krugman, an insurance industry manager, and grew up in a middle-class neighbourhood in Long Island.

Krugman began studying economics at Yale where he soon attracted the attention of his professors. In 1973, he became a research assistant to William Nordhaus. After graduating from Yale in 1974, Krugman went on to the Massachusetts Institute of Technology (MIT) to study under Paul Samuelson, Robert Solow, and Rudiger Dornbusch, the latter of whom became his PhD adviser.

During this time Krugman was introduced to the distinctive MIT variant of neoclassical economics with its emphasis on small-scale theoretical models tailored around a set of stylized empirical observations. The MIT economics department was rather sceptical toward the rational expectations revolution that was sweeping through macroeconomics at that time and continued to teach “old” Keynesian theory. In particular, Dornbusch’s brand of international macroeconomics, which had a strong influence on Krugman, was largely Keynesian in character.

The years at MIT were formative not only for Krugman’s understanding of economic theory but also for his intellectual style. From Samuelson and Solow he learnt to combine a mathematically rigorous way of thinking with a light and playful style of exposition. From Dornbusch he inherited a strong affinity for policy-oriented issues. In 1977, Krugman finished his doctoral thesis on flexible exchange rates and took a position as assistant professor at Yale where he began to work on what would become the foundation of “new trade theory”. His seminal papers on increasing returns and international trade propelled Krugman to the status of an economic wunderkind and secured him a place among the leading international economists of his generation.

The Increasing Returns Revolution in Trade Theory

Towards the end of the 1970s, international economics was in an unfortunate state. On the one hand, there was a growing sense of dissatisfaction with the dominating neoclassical (Heckscher-Ohlin-Samuelson, HOS) trade model.

This dissatisfaction arose primarily from its inability to explain trade within industries or within firms as opposed to trade between industries. During the 1960s and 1970s, evidence was mounting that intra-industry trade was quantitatively much more important than inter-industry trade.

On the other hand, the only explanations for intra-industry trade available at that time, such as those of Staffan Burenstam Linder (1961), relied implicitly or explicitly on increasing returns to scale. As economists knew since the days of Alfred Marshall, increasing returns to scale cannot be reconciled with the assumption of price-taking behaviour and hence call for a theory of imperfect competition. However, the only available models of non-perfect competition at the time were partial equilibrium models and therefore ill-suited for the analysis of international trade.

This changed in the mid-1970s when Avinash Dixit and Joseph Stiglitz (1977) generalized Chamberlin’s theory of monopolistic competition. It was Paul Krugman who used this innovation to build a new theory of trade. Like so often in the history of economic thought, Krugman was not alone in this discovery. Kelvin Lancaster (1980), among

others, had independently developed similar ideas at around the same time. In fact, the distinguishing feature of Krugman’s contribution is not so much its originality but its analytical elegance.

The core of Krugman’s trade theory (Krugman 1979b) is a Chamberlin-Dixit-Stiglitz view of competition in which there is a large number of differentiated goods, which may be interpreted as varieties of a good. Each firm produces a distinct variety under economies of scale internal to the firm and therefore faces a downward sloping demand curve for its product. The price of each variety is then a mark-up over marginal costs depending on the elasticity of demand for the variety. As long as existing firms are making profits, new firms with new varieties will enter the market reducing demand for existing varieties.

This ensures that firms earn zero pure profits in equilibrium and prices equal average costs. Because of increasing returns, the no-profits condition implies an inverse relationship between the price and the output of each variety. Full employment of labour implies another inverse relationship between the number of varieties produced and the amount produced of each variety.

The effects of trade are straightforward. Through foreign trade, consumers have access to more varieties compared with autarky, so they can distribute their expenditures over a greater range of differentiated goods. Hence trade occurs in this model even though there are no comparative advantages, and this trade involves shipping very similar goods between countries. The increased choice of differentiated goods for consumers is one source of gains from trade in Krugman’s model. Surprisingly, as long as the elasticity of demand for each variety is not affected by this greater choice, it is also the only gain from trade. In particular, with constant demand elasticities, trade has no effect on the scale of production of individual firms. Only if one assumes, as Krugman (1979b) did, that the demand for each variety becomes more elastic as the number of available varieties increases, there is also a beneficial scale effect of trade. If, after opening to trade, the demand curve for each variety becomes flatter, the price for each variety will be lower than in autarky. A lower price can only be achieved if firms move down along their average cost curves by increasing output. However, since labour supply is fixed, not all the firms that exist in autarky can actually increase output, so some of them must go out of business as the economy adapts to the new equilibrium. This also means that the number of varieties produced in each country decreases through trade.

The new trade theory, as it was soon to be called, was different from the HOS approach in substance as well as in method. It provided a firm theoretical explanation of a range of phenomena that had hitherto seemed puzzling and it confirmed some of the hypotheses of earlier writers, such as Linder’s home market effect (Krugman 1980).

It was different in method as well in so far as it relied on very special ad hoc assumptions on consumer preferences and cost structures in a way traditional theory did not. Krugman defended such ad-hocery on the grounds that it allowed his theory to remain both rigorous and tractable. He also argued that, although the neoclassical model was indeed more general than his, this generality was bought at the price of making the “big untrue assumption” of constant returns to scale.

Krugman’s contributions to the new trade theory reveal a certain pattern that also appears in his later academic work and distinguish him as a theorist. He typically starts by picking up a heterodox idea that seems outlandish and untenable to mainstream economists, reformulates it in a simple but fully specified general equilibrium model and pushes it to new and sometimes astonishing implications. In this process, he often pays little attention as to whether his is a fair or historically correct interpretation of the original idea.

His treatment of “uneven development” is a case in point. In the 1950s Gunnar Myrdal (1957), among others, had argued that international trade has a tendency to increase worldwide economic inequality, that rich countries become richer at the expense of poor ones. Krugman (1981) reconstructs their argument in a dynamic two-sector two- country model, in which the country with the larger initial capital stock has a higher rate of profits and a higher rate of growth. Owing to increasing returns to scale in the manufacturing sector, faster capital accumulation in the “developed” country reinforces its comparative advantage in manufacturing, leading ultimately to the extinction of the industrial sector in the “underdeveloped” country. The remarkable feature of this model is that it lends support to Lenin’s theory of the two-stage evolution of capitalism. In the first stage, capital accumulation in the developed world is sustained by drawing labour from the agricultural sector into manufacturing.

This stage relies on the export of industrial goods to the poor country. As soon as the richer country is completely specialized in manufacturing, wages start to rise driving down the rate of profits. This in turn induces capital to flow to the underdeveloped country, giving rise to the second “imperialist” stage of accumulation. The lesson Krugman wants to teach here is not that Lenin was right, but rather that the tools of orthodox economics can be employed both to support and to sharpen the ideas of capitalism’s most radical critics.

While Krugman enjoyed exploring unorthodox ideas, he was also striving to reconcile new trade theory with the “old” comparative advantage paradigm. In Market Structure and Foreign Trade (Helpman and Krugman 1985) he, together with Elhanan Helpman, attempted an integrated treatment of the factor endowments and the economies of scale theories of trade. The central insight from their analysis is that the new theory poses no threat to the neoclassical factor endowments approach but can be viewed as complementary to it. Furthermore, and in contrast to some of his fellow “new traders”, Krugman (1987) emphasized that his model did not invalidate but even strengthens the classical view that free international trade is beneficial for all and that protectionist policies are generally harmful.

New Economic Geography

Krugman’s second major contribution to international economics came with his celebrated 1991 paper “Increasing returns and economic geography” which sparked new interest in the economics of spatial concentration of industries. The primary achievement of this research project is perhaps best described as providing microeconomic foundations to “agglomeration economies”, that is, deriving from optimizing behaviour of economic agents general conditions under which industries will disperse or concentrate in space.

As with new trade theory, the idea of agglomeration economies was far from new. Alfred Marshall had written extensively about the tendency of certain industries to agglomerate.

Even before that, Johann Heinrich von Thunen had developed his famous ring theory of land use, which was extended by German economists to a “theory of central places”. These theories went a long way towards describing how various economic activities locate around urban centres. But they did not provide a satisfactory explanation as to why and how these core-periphery patterns emerge endogenously. That was precisely the goal of the new economic geography (NEG).

The ingredients for NEG models, as exemplified by Krugman (1991), are threefold. First, there are two regions with two sectors: perfectly competitive constant-returns agriculture and monopolistic increasing-returns manufacturing. Second, while industrial workers are fully mobile between regions, agricultural workers are not. Third, trade of manufacturing goods incurs transportation costs of the so-called “iceberg” form: some given fraction of goods disappears when being shipped from one place to another. Now imagine an initial equilibrium in which “footloose” industrial workers are spread evenly across regions and ask: what happens if this equilibrium is disturbed by one manufacturing firm entering region A? There are three effects to consider:

1. Increased competition in region A tends to lower the price index of manufacturing goods and thus lowers demand for each individual firm. This price index effect acts to reduce profits in region A relative to region B and therefore exerts a centrifugal force to restore the initial equilibrium.

2. Increased labour demand invites immigration of industrial workers into region A which in turn increases the demand for varieties produced in this region. This counteracts the price index effect and exerts a centripetal force towards a “concentrated” equilibrium.

3. Since the drop in the price index increases real manufacturing wages in region A, the influx of “footloose” labour into region A must lead to a drop in nominal manufacturing wages there such that real wages stay equalized across regions. This decreases costs for manufacturing firms in A and thus reinforces the tendency to agglomerate.

As Krugman (1991) shows, the relative strength of these effects depends on three parameters. The forces towards agglomeration are stronger the lower the transport costs, the higher the expenditure share of manufacturing goods and the higher the degree of increasing returns to scale. For one set of parameter values the model exhibits diversification, for another set it exhibits agglomeration.

Krugman also showed that if simple dynamics are added to the basic model, it exhibits “order from instability”: starting from a small deviation from the uniform, “disordered” equilibrium, the economy self-organizes into a highly structured landscape. In The SelfOrganizing Economy (Krugman 1996) he elaborated on the idea of spontaneous order that arises from a symmetric but unstable initial state and demonstrated how it can help explain things like size distribution of cities or the emergence of business cycles. In The Spatial Economy (Fujita et al. 1999), co-authored by Masahisa Fujita and Anthony Venables, Krugman synthesized the various models that NEG had produced during the first decade of its existence.

Currency Crises, the Liquidity Trap and Depression Economics

A third theme in Krugman’s rnιvre is the macroeconomics of financial crises. His contributions in this field do not constitute a cohesive theoretical structure as they were mainly motivated by contemporary economic events.

Krugman (1979a) argued that the attempt of a government to peg the exchange rate is similar to a government trying to control the price of an exhaustible resource: at some point, the government may run out of resources (or of foreign exchange reserves) and can then no longer maintain the price control (or the exchange rate peg). When that happens, the currency will suddenly depreciate leaving investors with a windfall capital loss, which they will naturally try to avoid. Hence forward-looking investors will “flee” from the pegged currency before the foreign exchange reserves are actually depleted and thus trigger a speculative attack on the currency. Such an attack necessarily occurs at a point where the government would have had sufficient reserves to uphold the peg for some time, but the anticipating behaviour of investors forces the government to liquidate its foreign exchange reserves.

Krugman’s model served as a starting point for the first of three “generations” of currency crisis models. In first generation models, speculative attacks are the natural consequence of rational investors anticipating an inevitable future crisis in the balance of payments. However, the crisis of the 1990s in East Asia and Latin America led him to reconsider the possibility of purely self-fulfilling crises that occur regardless of fundamental economic conditions. Krugman (1999) conceded that those crises could not be adequately explained by his 1979 model, but are best understood in terms of multiple equilibria: the economy remains in the “good” equilibrium as long as everybody believes so and can suddenly, through a minor change in expectations, shift to a “bad” equilibrium and hence suffer a crisis.

Japan’s financial crash in the early 1990s and its subsequent stagnation caused another change of opinion in Krugman. Prior to the Japanese experience, Krugman shared the consensus view of the time that recessions can, at least in principle, always be avoided by expansionary monetary policy and that John Maynard Keynes’ idea of the “liquidity trap” - a situation where nominal interest rates have sunk so low that ordinary monetary policy ceases to be effective - was a mere theoretical anomaly. He was at first certain that a liquidity trap could never arise in a fully “micro-founded” model, and discovered to his own surprise that this was not so.

In his 1998 paper (Krugman 1998b) he demonstrated how such a trap could arise in a simple macroeconomic model with maximizing agents: consider an economy in which individuals must hold money to pay for consumption and can invest their savings in riskless bonds, and assume that output, price level and interest rate are fixed from the second period onwards. In the first period, consumption smoothing implies an inverse relationship between current output and the (real) interest rate. If the price level in period one is fixed, monetary policy can choose any point on this curve by controlling the nominal interest rate via open market operations. However, there is a natural limit to such operations when the interest rate has dropped to zero. In this event, individuals hold money, at the margin, not to purchase goods but as a store of value, so any expansion in the money supply has no effect on output. The economy will be caught in such a trap whenever present consumption demand is sufficiently depressed either by fears of future deflation or an expected decline in future output.

This analysis, not least because of its immediate importance for the Japanese crisis, led to a return of the liquidity trap to macroeconomic theory. The relevance of the subject became even more apparent after the global financial crisis of 2008 and the deep recession that followed it. The rediscovery of the liquidity trap entailed a turn in Krugman’s thinking on macroeconomics in general. The existence of a “zero lower bound” on interest rates implies, in his view, that there are two kinds of economics: one for normal times when the central bank can prevent major deviations from full-employment and another for depression times when it cannot. Whereas in normal times government deficits are harmful, they stimulate the economy in depression times. Whereas in normal times monetary policy should keep inflation down, it should try to generate inflation expectations in depression times.

Popular and Political Writings

Beginning in the mid-1990s, Krugman shifted more and more towards writing for a broader audience. The Age of Diminished Expectations (Krugman 1990), intended as a primer on the state of the US economy, became the first in a series of treatises on current issues of economic policy. In these books Krugman, on the one hand, provided his own pessimistic account of America’s economic history and, on the other, attacked popular writers who, in his judgement, were spreading fallacies and falsehoods about economic matters, comprising both supply-side economists and left-wing critics of globalization.

The controversial election of George W. Bush in 2000 marked a turning point in Krugman’s career, leading him to focus almost exclusively on political writing. In his biweekly opposite the editorial page (op-ed) columns for the New York Times, Krugman vigorously attacked the economic and social policies of the Bush administration. In The Conscience of a Liberal (Krugman 2007) he elaborated on his critique of the ruling conservative political agenda which, he argued, rooted in free-market dogmatism and aimed at rolling back the welfare state. He was also a pioneer of the economic “blogosphere”, a rapidly growing network of internet blogs covering economic issues that emerged during the 2000s.

Krugman’s celebrity status received a further boost in 2008 when he was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel “for his analysis of trade patterns and location of economic activity”. During the global financial crisis that broke out the same year, Krugman took a leading role in advocating expansionary fiscal and monetary policies to fight unemployment, harshly criticizing those economists who, in his opinion, had discarded the lessons of the Great Depression and clung to a “Panglossian” world-view of self-correcting markets (Krugman 2009).

In his popular writings, Krugman frequently commented on more “philosophical” issues, including questions of methodology in economics, about which he had remained rather mute in his academic work. His approach to economic theory is perhaps best described in this remark:

You can’t do serious economics unless you are willing to be playful. Economic theory is not a collection of dictums laid down by pompous authority figures. Mainly, it is a menagerie of thought experiments - parables, if you like - that are intended to capture the logic of economic processes in a simplified way. (Krugman, 1998a: 19)

Max Godl

Paul Robin Krugman was born in 1953 in Albany, New York, the only child of Anita and David Krugman, an insurance industry manager, and grew up in a middle-class neighbourhood in Long Island.

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