Paul Krugman

When a fire breaks out in a single-family home, firefighters know what they have to do. Fires in private houses are all pretty much alike. But when a fire breaks out in a warehouse, the firefighters make an effort to find out what is inside before they go to work, lest they do more harm than good. For example, if the warehouse is filled with highly flammable chemicals, dousing the building with water may spread the fire. In the end, the fire department must act regardless, but it is important to act on as much information as one can get about the nature of the problem.

I offer this homily because Ethan B. Kapstein uses an analogy with firefighting to claim that the West, faced with the economic difficulties of inequality and unemployment, has been paralyzed by too much debate over causes ("Workers and the World Economy," May/June 1996). He seems to believe that economic crises are like house fires, all pretty much the same. In particular, he seems to believe that the economic woes of advanced nations in the 1990s are basically similar to the problems of the 1930s. Deficit spending was the answer then and it is the answer now. Money should, therefore, be spent like water.

Economic crises, however, are not all the same, and the problems of the 1990s look very little like those of the 1930s. The good news is that while there is considerable dispute about the relative importance of some factors, economists have reached enough of a workable consensus about the nature of the problem to accommodate helpful policies. The bad news is that much, although not all, of what Kapstein has to say ignores this consensus, and that some of his policy recommendations are mischievous. They would either create the risk of renewed inflation and worsen the already shaky finances of Western governments, or they would contribute to the very policy paralysis Kapstein decries.


The economic difficulties of the advanced nations are not new. Unemployment in Europe has been rising steadily since the early 1970s, while inequality in the United States began rising sharply only a few years later. Nor have they failed to receive attention. Over these 20-plus years, hundreds of conferences and thousands of academic articles and official reports have addressed them. While there is not a total consensus—there never is—a widely held middle-of-the-road position can be summarized by two propositions.

The first proposition is that the problems of wages and employment are mainly—forgive the jargon—structural rather than cyclical. A cyclical economic problem is caused by inadequate demand and can be cured by adopting a more expansionary monetary and fiscal policy—that is, spending more or taxing less. Structural economic problems cannot be solved in this way. Most economists now believe that the Great Depression was essentially cyclical; the slack in employment could have been taken up simply through an aggressive program of demand expansion. But the structural nature of Europe's unemployment was graphically demonstrated by the events of the late 1980s. The later stages of a broad business cycle recovery were marked by a noticeable increase in inflation (drastic in the case of the United Kingdom), despite the fact that the unemployment rate was still nearly nine percent. Demand had recovered, but unemployment could not fall below the nine-percent structural rate without triggering inflation.

What is wrong with trading off lower unemployment for slightly higher inflation? Not much, but that is the wrong question, because there is overwhelming evidence that inflation begets inflation. Suppose the Federal Reserve were to push the U.S. unemployment rate down from its current 5.5 percent to 4.5 percent. In the first year the inflation rate would probably rise only from its current 3 percent to 3.5 or 4 percent. But in the next year it would be 4 or 5 percent, the year after that 5 or 6 percent, and ever upward. The point, then, is not that inflation will explode if the unemployment rate is pushed too low. It is that a sustained effort to keep unemployment below the so-called NAIRU—the non-accelerating-inflation rate of unemployment—merely by stimulating demand will lead to an upward spiral of inflation. And though high rates of inflation would be slow to materialize, they would be equally hard to get rid of. Once the economy has developed six percent inflation, to get it back down to three percent would require a severe recession. Some countries have substantial room for demand expansion, most notably Japan. For the advanced nations as a whole, however, demand expansion is not a solution; indeed, it will only add new problems.

The second and somewhat more controversial proposition of the not-quite consensus is that the growth of international trade is not the main cause of the persistent rise in European unemployment and American inequality. Rather, the main source is a decline in the internal demand for less-skilled labor, probably driven in large part by technological change biased toward highly skilled workers. While Kapstein insists that time should not be wasted debating causes, he nonetheless finds time to pick sides in the dispute here, asserting that "as a general explanation, technology is unsatisfactory. It is never clearly distinguished from other kinds of capital, and there is no reason that its introduction must in principle reduce the wages of the unskilled."

In fact, MIT's Robert Solow won a Nobel Prize in economics in large part for making it very clear why technological progress and capital accumulation are not at all the same—and how to measure the difference. Since his work, in literally thousands of empirical studies of economic change, the distinction between technology and capital has played a crucial role. (My own article in the November/December 1994 Foreign Affairs, "The Myth of Asia's Miracle," was motivated by this very distinction.)

But Kapstein is quite right that technology need not in principle reduce the wages of the unskilled. Whether it does so depends on the bias of the technological change—whether it is sufficiently biased toward skilled and against unskilled workers. But the claim of many economists that technological change is a major factor in recent wage trends is not based on a priori reasoning; it is an empirical proposition, based on facts. Nearly all industries (including those not exposed to international competition) have been increasing the average skill level of their work force by hiring relatively more skilled workers, despite the lower wages of unskilled workers. That indicates that recent technological change has been strongly skill-biased.

The conventional view that international trade is only a secondary source of the growth in unemployment and inequality is also an empirical proposition, and one not arrived at lightly. This is an ongoing debate, driven by technical issues rather than ideology. It is risky for nonspecialists to put their faith in an economist merely because they like the sound of what the economist says. For example, Adrian Wood's work, approvingly cited by Kapstein, has been subjected to devastating criticism; Wood's own numbers do not support his strong claims, and he arrives at large estimates of trade's effect only by finessing a basic calculation that indicates the opposite conclusion.[1]

Does the distinction between internal and international causes matter? Yes, it does. Although Kapstein forswears protectionism, it is not at all clear why. After all, if international trade is the main cause of the problem, why not use import restrictions as one line of defense? But if international trade is only 10 or 20 percent of the problem, a protectionist response will bring a whole new set of problems without resolving the ones we already have.


Suppose the middle-of-the-road position on unemployment and inequality is correct: the main source of these problems is a structural, not cyclical, decline in the internal demand for less-skilled labor within advanced countries. One may then conclude that neither a simple policy of overall demand expansion nor one of protectionism against Third World imports is the answer. What, then, can be done?

This is actually not such a hard question. In the United States, which has managed to maintain relatively full employment but has experienced rising inequality, the incomes of low-wage workers need support; but that must be done, so far as possible, without raising the cost to employers of hiring those workers. The obvious answer is something like a much bigger version of the earned income tax credit—an income supplement for workers with low earnings that falls off as a worker's earnings rise, but not so rapidly as to negate pay increases and discourage work. Such a program would be subject to some abuse, but so are all government programs.

Europe has nearly the opposite problem. The poor receive relatively generous support, but not enough people are employed. What Europe needs to do is reduce the cost of employing the less skilled, so that the private sector will offer them more jobs. But it must do so without, so far as possible, reducing their incomes. In this case reducing or removing the tax burden associated with hiring low-wage labor, and possibly providing some employment subsidies, are the obvious answers.

The important point—on which I agree with Kapstein—is that it should be possible to make a large difference to the incomes of low-wage workers (in the United States) or to their prospects of employment (in Europe) without devastating effects on the budget. In the United States, the crucial thing to remember is just how poor the poor are and how rich the country is. If the United States were willing to devote, say, two percent of GDP to income supplements for the working poor, the effect would be dramatic.

So why hasn't the United States tried this policy? Surely it is not because economists have quarreled over whether trade explains 10 or 30 percent of the increase in wage disparities. A better target for Kapstein's ire might be influential figures who insist that the only way to help the poor in America is to cut taxes on the rich. But Kapstein at least seems to place most of the blame on those with what he regards as a misguided, indeed mystical, concern over budget deficits.


Kapstein implies that the economic difficulties of the West are due to its governments' obsession with deficit reduction. Let me repeat that the West's economic problems have been building steadily for more than 20 years, while serious budget-cutting has begun only within the last two or three. The term "Eurosclerosis" dates not from the 1990s but from the late 1970s; European unemployment had already risen to double digits by 1985, when budget difficulties were rarely discussed. The Reagan administration took a remarkably relaxed view of unprecedented peacetime deficits during the 1980s, but that fiscal expansion did not prevent inequality in the United States from soaring.

Nor is concern about deficits the reason Western nations have been unwilling to provide more support for low-wage workers. The sums involved are small enough that if governments and voters were truly persuaded that such policies were necessary, they could quite easily be funded with new taxes or reduced benefits to middle- and upper-income families. Governments and voters are not persuaded, but that has nothing to do with the deficit.

The main reason Kapstein is eager to put aside concern about deficits seems to be that, in spite of all the evidence, he is determined to view the 1990s through the lens of the 1930s. He quotes economist Robert Eisner on the desirability of deficit-induced demand. But with the possible exception of Japan, every advanced country has plenty of room to increase demand simply by cutting interest rates. If they do not do so, it is because their central bankers think an increase in demand is unnecessary or dangerous. They might be wrong, but running budget deficits, which will merely lead those central bankers to impose still higher interest rates, will do nothing to help the situation.

Still, would a more relaxed attitude toward budget deficits do any harm? Here Kapstein's article becomes truly mischievous, by suggesting that concern about deficits is motivated entirely by ideology. Would that it were! Unfortunately, the West is past the point at which the virtues and vices of its budget deficits could be discussed in terms of uncertain macroeconomic effects. The stakes now are much cruder and more elemental: the long-term solvency of Western governments.

Debt as a percentage of national income in almost all Western nations is now comparable to the levels that historically have prevailed only at the end of major wars. But there has been no war, and instead of paying down their debts, as peacetime governments always have in the past, Western treasuries are continuing to increase their debt, for the most part faster than the increases in their tax bases. Moreover, in the current situation there are no major emergencies—no big arms races or wars in prospect, no natural disasters that require extraordinary spending. But stuff happens. If governments cannot control their budgets when it is not happening, what will they do when it does?

The demographic time bomb makes this situation particularly worrying. The budgets of advanced countries are in large part engines that transfer money from workers to retirees, a system that runs smoothly as long as the population is steadily growing, so that the working-age population is large relative to the retired population. But Western populations have not grown steadily. Baby boom was followed by baby bust, and it is therefore certain that the demands on the social insurance systems of advanced countries will greatly exceed their resources beginning only a bit more than a decade from now. Or to put it differently, to the already huge explicit debts of Western nations one should add implicit debt in the form of their unfunded promises to future retirees. In short, concern about the budget deficits of Western nations can no longer be considered a matter of ideology. These days it is a matter of straightforward accounting, and one must deliberately stick one's head in the sand to imagine otherwise.


The aspect of Kapstein's prescriptions I found most puzzling is his insistence that a prerequisite for effective action is coordination of economic policies among the major economies. His suggestion seems to be fairly close to the textbook model for macroeconomic coordination. In that much-beloved classroom exercise, each country would like to expand its domestic demand but fears that such an expansion will worsen its trade balance or lead to a depreciation of its currency. In that case a coordinated expansion offers a way out. Increased imports are matched by increased exports, and flight capital has nowhere to go. It is a perfectly reasonable scenario in principle. It may even be a good model for the economic situation during the 1930s. But does this story about the need for coordinated expansion bear any resemblance to the current situation?

Let's get specific. Which major economies are actually constrained from expansion by concerns about the balance of payments or the reaction of international financial markets? Surely not the United States, which may huff and puff about trade conflicts but whose monetary and fiscal policies treat the trade balance and the exchange rate with benign neglect. Surely not Japan, which is worried about an excessive trade surplus, not a deficit, and which is plagued by a yen that is too strong, not too weak. Japan would actually welcome a bit of capital flight. Surely not Germany; with the deutsche mark the key currency of what remains of the European Monetary System, Germany can expect its neighbors to match any reduction it chooses to make in its interest rates. Probably not Britain; since it stopped pegging the value of the pound in 1992, Britain has felt free to follow an independent monetary policy. If it has tightened recently, it is not because it fears the reaction of international markets, but because its domestic economy is again showing signs of inflationary pressures.

What we are left with, I guess, is France, which is indeed pursuing a more restrictive monetary policy than it would if it were not concerned about the value of the franc. But the reason for France's concern is not any inherent need to keep the franc strong—inflation is almost zero—but precisely the commitment of the French government to the Maastricht criteria. France, in other words, is the victim of too much international coordination, not too little. So Kapstein's demand for coordinated economic policy seems to arise more from his general sense that such coordination ought to be a good thing than from any consideration of the real economic situation. Still, does it do any harm?

Whatever your assessment of the economic case, there is one overwhelming empirical observation that can be made about macroeconomic policy coordination: it never happens. Well, hardly ever. Whole forests have been leveled to print reports about the Plaza, the Louvre, the Group of Seven, and so on, but it is hard to find a single case in which a major economic player has altered monetary or fiscal policy at the behest of the other major players. One often hears about the G-7 process; the reason aficionados like to talk so much about the process is that there have been so few results.

To say, as Kapstein does, that "international policy coordination is necessary so that countries can develop expansionary policies within a collective framework," is in effect to say that real action should be postponed for years while countries engage in endless rounds of content-free summitry. Perhaps if there were a compelling case for coordinated policies there might be a way to turn these photo ops into real negotiations (although recent experience in noneconomic affairs is not encouraging), but there is no such compelling case.

None of this should be taken as a counsel of inaction. There is a great deal that can be done to improve the economic situations of the ill-paid and unemployed. However, there is no reason to tie responsible, realistic proposals to raise incomes and create jobs either to irresponsible demands for bigger deficits or to unrealistic expectations about international coordination.

PAUL KRUGMAN is Professor of Economics at Stanford University.


Robert Z. Lawrence

Kapstein is correct in saying that the problems of workers in the developed world are serious. I agree, too, that ignoring their plight could have tragic political consequences. But by overstating the effects of the world economy and ignoring the other sources of these problems, Kapstein could well promote the tragedy he seeks to avoid. I also take strong exception to his proposal that governments increase spending. Expansionary fiscal policy would severely set back the progress governments are finally making in bringing their expenditures in line with their revenues. First, expansion driven by a fiscal stimulus is not needed. To the degree that there is insufficient demand in the developed countries—in Europe and Japan, but not the United States—domestic monetary policies are quite adequate for the task. Second, demand-side expansion can do little to solve the structural supply-side problems about which Kapstein is concerned. Economic growth is fundamentally limited by the expansion of productive capacity. Any demand expansion beyond that capacity will translate purely into inflation.


Kapstein argues strongly that serious labor market problems such as slow productivity growth, growing inequality, and rising unemployment in the developed countries reflect the increasing influence of the world economy on local conditions. As every student of statistics knows, however, correlation should not be confused with causation. Globalization has increased at a time of poor domestic performance, but is globalization truly culpable or just an innocent bystander?

Globalization is important in Western economies. International trade and investment have expanded rapidly, but consider some facts about the United States. Eighty-eight percent of the goods and services Americans buy, they produce themselves. Eighty-two percent of Americans are employed in sectors like government, construction, nonprofit organizations, services, utilities, and wholesale and retail trade, in which international trade is barely a factor. Moreover, America's international interaction with developing countries remains even smaller. In 1994, U.S. non-oil imports from developing countries amounted to just 3 percent of GNP; exports to developing countries were just 2.5 percent. Employment in the foreign affiliates of U.S. multinationals in developing countries is less than 5 percent of overall U.S. manufacturing employment. I am not saying this interaction has not grown rapidly or even that its effect at the margin may not be greater than these numbers suggest, but to point only to trade with developing countries as the source of workers' problems is to wag a very large dog with a rather small tail.

Most problems in the developed economies would exist even if those economies were not increasingly open to trade and investment. Similarly, most of the remedies require changes in domestic policies unconstrained by international forces. By focusing on the convenient scapegoat of international trade, Kapstein gives short shrift to other important problems, some unique, some shared, that developed countries confront. He overlooks the fact that in the United States, slow domestic productivity growth in service sectors not exposed to trade has led to wage stagnation; that in Europe, sclerotic labor markets and overextended government regulations inhibit structural change, regardless of whether the source is internal or external; and that in Japan, the current recession reflects the aftermath of a splurge sparked by domestic monetary policy, and the recession's persistence stems from failures to deregulate domestic markets and deal with a domestic banking crisis. Kapstein is also too cavalier about the fact that in all countries these problems have been compounded because technological change has shifted demand away from the less-skilled and less-educated workers.

With very few exceptions, economists who have studied the impact of trade with developing countries on labor markets conclude it plays a relatively minor role.[2] In the 1980s, during which Americans experienced widening inequality in their income levels, neither the quantities of imported goods nor the changes in prices the imports caused were large enough to give trade much of a role. Even those in the United States who believe trade to be significant suggest it explains no more than a fifth of the growth in the relative wages of educated workers. Almost all economists assign a much larger role to the technological changes associated with the introduction of computers and to the changes in management practices that have skewed demand toward more skilled workers while at the same time providing disappointing increases in productivity.

Kapstein dismisses studies by me and others with the claim that trade induces technological change. He argues that "a significant share of new technology, for example, has been induced by foreign competition." In fact, research on the effects of trade on both productivity growth and research-and-development spending confirms the maxim: sometimes a kick in the pants gets you going, and sometimes it just hurts. Some firms, typically in concentrated industries with surplus profits, are spurred to innovate and to spend more on research and development. But other firms, especially those in highly competitive industries, are more likely to respond to international competition by cutting back on investment. It turns out that most trade with developing countries occurs in sectors such as clothing and footwear that are highly competitive. This suggests that when it comes to trade with developing countries, the innovation caused directly by trade is relatively small; indeed, it is more likely to be slowed by trade than sped up. Moreover, to the extent that some trade does lower the wages of unskilled workers throughout the economy, it discourages labor-saving innovation.

Kapstein's account of the role of trade is also imprecise. Does he have in mind all international trade or just trade with developing countries? Since wages in developed countries are quite similar, it must be developing countries he has in mind when he invokes the Stolper-Samuelson theory to argue that trade lowers the welfare of the least-skilled workers in the developed countries. But at another point he talks about the investment-generating effects of trade in industries such as automobiles and steel, in which the developing countries are not major players.


I share with Kapstein the view that government should assist workers in adjusting to change. Training and education are crucial in helping workers adjust, but it is impractical and unrealistic to see them as the only answer. I also concur that the tax system should be used to boost the incomes of the working poor and facilitate job turnover. Europe's strength is that it helps its poor; its problem is that its inflexible labor markets fail to create jobs. America's strength is its flexibility and job creation; its problem is that the income of the least-skilled workers has been depressed. The ideal system would combine American efficiency with European compassion. A deregulated labor market and a generous earned income tax credit would do exactly that. Let wages be freely determined in the market, but let the government safeguard the workers through the tax system.

Where I part company with Kapstein is on his call for coordinated expansionary fiscal policies. Indeed, I think his prescription of tight money and loose fiscal policies has it exactly wrong. Loosen money, perhaps, but keep fiscal policy tight. Currently, there may be some room in Europe and Japan for monetary expansion and, in my heretical view, in countries such as France even room for exchange rates to float. But soon this expansion in demand will strike the ceiling set by the supply capacity of the economy. In a fully employed economy, that capacity is equal to the rise in output per worker plus the growth of the labor force. Once that ceiling is reached, efforts to expand demand can only produce inflation. There is some controversy over whether the United States has already reached the maximum growth rate. I would err on the side of caution, but if you think more stimulus is called for, leave it up to the Federal Reserve. However, calling for bigger budget deficits and more public works programs could not be more wrongheaded. If the problem is slow productivity growth, the country surely needs more investment. But change the mix and not the size of public spending. Let fiscal policy contribute to supply growth by substituting public investment for public consumption, but not through bigger deficits. Increased government borrowing leads to higher interest rates and crowds out private investment. Public works programs delay market adjustments and fail to give workers the skills they need for viable long-run employment. Moreover, such fiscal expansion reinforces the tendency to deny the need for adjustments by piling up debt for future generations.

The simple truth is that, notwithstanding Kapstein's pronouncement, monetary and fiscal policies cannot "be structured in such a way as to ensure . . . that working people can earn a living wage." Successful fiscal and monetary policies may keep inflation low and achieve full employment, but only increased productivity in the private sector can raise the marketplace earnings of working people. If these earnings are inadequate, redistribution may have a role. But bigger government deficits will only pass the burden to future generations.

ROBERT Z. LAWRENCE is Albert L. Williams Professor of International Trade and Investment at the John F. Kennedy School of Government, Harvard University.


Hilary Barnes

Kapstein's "Workers of the World" was interesting but wrong-headed. First, he implicitly equates workers of the world with workers of only the industrial world. They indeed may have something to worry about with the globalization of the economy, but there are billions of workers in other countries who have reason to be happy about what is happening. Second, Kapstein seems to think that deficit spending and monetary stimulus would generate growth and reduce unemployment. But this is the path the industrial countries went down between about 1946 and 1980. They learned that it does not work, and that it would certainly do nothing to solve the U.S. productivity problem. Third, in Europe at least, the notion that governments have broken the postwar contract with workers—full employment and comprehensive social welfare—is only half right. Full employment is gone, but not social welfare. In fact, social welfare is so comprehensive that it is no longer a solution; it is the problem.

In the part of the world from which this response comes, a large portion of the working-age population obtains very little or no financial benefit from taking a job as opposed to exploiting the social welfare system. Governments no longer have coherent policies for employment, only policies against unemployment, which are not the two sides of the same coin one might think. They fight unemployment by setting up programs to lift people off the dole, education programs, leave-from-work-at-taxpayers'-expense programs, early retirement programs, you name it. Cosmetically, these programs support the politically potent slogan, "We have reduced unemployment." But that is an illusion.


One of the great contemporary worries, reflected in Kapstein's article, is that income differentials are widening. But in Scandinavia, the lifetime income of a youngster who leaves school at 16 to become a cashier in a supermarket will be much the same as the lifetime income of an engineer. The modern Swedish economy was built by its engineers, but today Sweden has fewer engineers per capita than South Korea, and the Swedish economy is going downhill fast. It may be unfashionable to say so, but income differentials have their place.

Reform in Europe requires more flexible labor markets and fewer privileges for trade unions. It also requires changes in the social welfare system, but change is extremely difficult. About two-thirds of the voting population in Scandinavia is on the government payroll, either as a government employee or a client of the welfare state. Tampering with this source of income is politically explosive.

One country that seems to have been able to carry out successful reforms is New Zealand, but European politicians generally dismiss those reforms as irrelevant. I realized why when I asked a very senior Scandinavian social democrat if New Zealand hadn't pointed the way. "Yes, but look what happened to the party, the New Zealand Labour Party, that initiated the reforms. Do you think we are going to risk the same fate?" Ultimately, seen from this corner of the world, Kapstein may be right, but for the wrong reasons. Workers are not disaffected. They are mollycoddled. But if failure to reform labor markets and social welfare systems causes the economies of the advanced European welfare states to collapse, the disaffection of a large part of the electorate, and not just the workers, may well cause political mayhem.

HILARY BARNES, Nordic Correspondent for The Economist and Copenhagen Correspondent for the Financial Times, is Editor of The Scandinavian Economies.


Thomas Donahue

Three cheers for Ethan Kapstein for opening a debate on how to address the needs of workers in the so-called global village. He accurately details the good intentions of the framers of post-World War II economic policy and their expressed concern not only that economic reform produce jobs and income growth, but also that mechanisms be created to assist those displaced by trade, changes in technology, or the growth of newly industrialized and developing economies.

In analyzing the early successes and later failures of those mechanisms in the United States, he could also have noted the drying up and practical disappearance of trade adjustment assistance, as successive Republican administrations attempted to eliminate it from the budget; the slashing of worker training and adjustment funds; and the blind dedication of Republican and Democratic administrations alike to "free trade" along lines quite different from those envisioned in the 1947 Havana Charter's call for addressing unfair labor conditions within the international trade regime. These retrenchments have convinced workers in the United States and other developed nations that they are the only people paying the price for economic change in the world and for small improvements in the conditions of workers in developing nations. Meanwhile, workers in the underdeveloped world continue to be exploited by First, Second, and Third World employers alike.

Kapstein has also put in clear focus the absurdity of blaming technology for job losses simply because economists have been unwilling or unable to demonstrate other causes, and the equal absurdity of espousing job training as a magic bullet when job creation is the only real answer. The supply-side idea failed as an economic theory, and it has been no better as an employment program.


The truth about trade, free trade, and all recent trade negotiations is that none of them can occur in isolation from other economic acts. Negotiating for free trade and opening up markets makes absolutely no sense without consideration of labor markets, exchange rates, government regulations, capital movements, and so on. Unfortunately, free trade has been pushed as the Vitamin E, the all-purpose cure-all, by economic elites who have been further enriched by it, often at the expense of workers.

The global village is a great phrase. It conjures up the image of an American New England town or midwestern village of the idealized past—friendly people, shared values, opportunity for everyone, children at school and play growing up secure in the embrace of the "village." As a slogan for globalism, it's an ad man's delight. As a reality, however, it must be examined a little more closely, for the global village bears no resemblance to the one in Our Town. This is a village without street lights, a police force, or any rules of conduct or standards with which the people in the village can identify. This is a village where, on some of the back streets, children as young as five or six work as bonded slaves in carpet weaving, in clothing factories, and in quarries and mines. Some of the young girls are sold into prostitution. In other manufacturing facilities, workers are badly exploited, with little pay and little or no attention to their health and safety or to environmental damage. On Main Street, along the blocks of fancy retail stores, the products of the back streets sell well to people who would certainly not approve of the abuse of workers, but most of them have never been to the other side of town. The conditions there simply have not intruded on their middle-class consciences. The village council, which has no real power, has created some committees to look at these issues, but they are rarely able to agree on anything other than the concepts of "free trade" and the "free exchange of goods." Their nostrum for the abuses and evils some people hint are the byproducts of free markets is to have still freer markets and more exchanges of goods.

The village council members seem to hear only the analyses offered by the well-to-do merchants and other elites of the village, all of whom seem to be prospering rather nicely, thank you. They occasionally discuss rules of conduct, but their agreements are years in the making and are generally at the level of the lowest common denominator. The truth is, this global village of ours is not a village at all. It remains a world of 190 or so independent and sovereign nations, each trying to get an advantage for itself (and hopefully its citizens), and one in which only the strongest among them, in concert with a few others, can hope to do so. What they have in common is that they are capital-starved and capital-sensitive. They know that capital can move around the world in seconds, and they know they must try to attract it amid very strong competition, with jobs and investments going to those whose wage rates are low and whose environmental and labor standards are either soft or nonexistent. Small wonder, then, that they are frightened by any talk—from within or without—about raising standards, about human rights and worker rights, and about trade sanctions or any other mechanism to enforce any kind of standards or rights. That is the real picture of the global village, and it is not a place you or I should want to live.


In Kapstein's phrase, "growing income inequality, job insecurity, and unemployment are widely seen as the flip side of globalization," and the political debate over what to do about them "will soon turn sour," resulting in xenophobia and pressure for protectionism. A part of the answer does lie in "easing pressures on the 'losers' of the new open economy" with a renewed emphasis on growth, training, education, public job creation, and sharply more progressive income taxes. But the fundamental change that must take place, if there is to be prosperity in the long run, is in the simplistic faith in free trade and free markets. The challenge for the United States and other nations is to devise trade policies and to manage trade in ways that help their citizens within limits that other nations will find tolerable. Trade negotiations must be aimed at establishing rules of fairness, not just openness, and rules for managing trade, currency, and investment flows in ways that begin to redress the enormous imbalance between rich and poor in the world. If that is not done, there can never be real peace and stability.

Basic to redressing that imbalance is an American insistence on trade rules that guarantee the observance in all nations of internationally accepted rights of freedom of association and collective bargaining, health and safety standards, and prohibitions of child labor. These standards have already been developed by the International Labor Organization. The World Trade Organization should make them a requirement for all trade. Successive U.S. administrations have supported this goal—with varying degrees of energy or enthusiasm—but recent efforts have shown that the necessary support among a critical mass of other nations may now be available. If the new U.S. trade representative can secure agreement in the WTO for such standards, the world might for the first time be on its way to a trading system that benefits ordinary people. With that, and with expansionary international economic policies, we might avert the calamities that surely lie ahead on the overly narrow free trade road we have followed for too long.

THOMAS DONAHUE is former President of the AFL-CIO and former Chairman of the Labor Advisory Committee to the U.S. Trade Representative.


Steve Forbes

Kapstein has no need for pessimism. The United States and other advanced industrial countries could easily grow at significantly faster rates than they do now. These countries are on the cusp of a new era that will fundamentally alter the way people live and work, enriching their lives not only materially but spiritually and culturally as well. The transition to this new era doesn't have to be anything like the disruptive, wrenching process industrial nations went through as they changed from agrarian to machine-based economies.

The microchip is extending the reach of the human brain the way machines, beginning nearly two centuries ago, have extended the reach of human muscle. Take one of the early examples of the microchip age—the calculator, which is ubiquitous, cheap, and easy to use. All of us are now in a sense math geniuses in that we can quickly carry out mathematical computations that 50 years ago would have taken math whizzes hours or days to complete. And no one has to be left behind. Just go to a supermarket checkout counter, where the very sophisticated inventory technology can be mastered rapidly by just about anyone.


The obstacles to fully realizing the potential of this new economy while minimizing any disruptive elements are removable and reformable. All it takes is insight and political will. The principal barrier to progress is nations' tax codes, most of which are not only unnecessarily complex but have high marginal rates that impose needless burdens on the economy. What too many policymakers and economists cannot seem to grasp is that taxes are not only a means of raising revenue, but also a price. Taxes on income, profits, and capital gains are the price for working and being innovative, productive, and successful. Lower the price on these good things and there will be more of them.

Cumbersome, often foolish regulation is another unnecessary burden. America's formidable progress in digital communications, for example, is slowed because regulators and politicians will not let telephone and cable companies combine to wire homes. Computer chips can now handle billions of bits of information per second, while telephone wires can transmit only a few thousand. Hence graphics are maddeningly slow on the Internet, and moving pictures have a jerky quality. Cable wire and fiber optics can handle the volume of data computers require, yet because of regulations, one cannot easily connect a telephone to a cable wire.

In Europe, regulations and labor restrictions frequently are even more ferociously burdensome than they are in the United States, and tax burdens are far heavier. That is why unemployment remains intractably high, growth is anemic, and technological innovation and new business formation are, by American standards, almost nonexistent. Europe needs a dose of Ludwig Erhard-like tax cuts-cum-simplification-and-deregulation. For its part, America is hurt by a substandard education system and an increasingly arbitrary, lottery-like legal system. And the generous welfare systems of Europe, like that of the United States, are undermining the very qualities that enable people to get ahead. While the frequency of murder and rape in Europe is still far behind that in America, rates for robberies and burglaries in many European countries now match or exceed ours.


The prescriptions are straightforward, particularly major deregulation and significant tax reductions and tax simplification. A new Bonn Summit, on the other hand, is not necessary. There is no need for grand attempts at coordination among major nations that at best will be clumsy and ineffective. If the United States does it right, most nations will quickly follow its lead.

The choice that many economists cite between more inflation and more prosperity is a false one. We can have both sound money and healthy growth, as the West generally did in the 1950s and most of the 1960s. Easy money is like a drug—you need more and more of the fix to get high, and the reckoning is invariably painful. But there is a vast difference between price changes that reflect supply and demand and price changes that reflect debasement of the currency. Too many central bankers now believe that growth rates in excess of 2 or 3 percent are inflationary and unsustainable, and the Federal Reserve gets antsy anytime growth exceeds 2.5 percent for a couple of quarters. This is preposterous. Historically, the U.S. economy has grown at a 3.5 percent clip, and the fundamentals are there for a few years of growth equal to that of the early and mid-1960s.

Since the early 1980s, with only a few interruptions, the United States has had an investment boom, making it the world's leading manufacturer. Chrysler, which six years ago was on the financial ropes, now makes more money in one year than the entire Japanese auto industry. The United States is the world's high-tech leader in software, fiber optics, Internet technology, microprocessors, and biotechnology. Real worker compensation is also going up, albeit too slowly. Growing income inequality is more of a social phenomenon than an economic one—a divorced woman raising children almost invariably suffers a sharp drop in her financial well-being. Moreover, studies such as a recent one by the Federal Reserve Bank of Dallas demonstrate what any observer should already know: the American economy is extraordinarily dynamic. Most of those in the bottom quintiles in the early 1980s had moved up, while nearly 40 percent of those in the top quintile had suffered a relative decline.

The dynamic of the machine age was bigness—big companies, big cities, big unions, big government. The dynamic of the microchip era is the opposite—antihierarchical, antiauthoritarian, and profoundly individualistic. The role of government is now a negative one of removing tax and regulatory barriers. The real source of anxiety in the developed world is the fear that those who lose their jobs will not be able to find comparable or better ones. A rapidly growing economy, which Western countries are quite capable of achieving, would allay most of those fears. Such an economy would also see a far healthier rise in personal incomes.

STEVE FORBES is President and CEO of Forbes, Inc.


Ethan B. Kapstein

In The General Theory of Employment, Interest, and Money, Keynes wrote of the power that classical economic theory still had over his discipline during the 1930s, a period remembered as the Great Depression: "That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority."

Like their predecessors, today's trade duo of Paul Krugman and Robert Z. Lawrence conservatively call on governments to "do no harm." They would have us believe that a priestly sect of economists has reached something like a consensus regarding the effects of globalization on workers. This simply is not true. As two economists wrote in response to a famous paper by Lawrence and Matthew Slaughter, "The link between international trade and relative wage behavior remains an open issue." In seeking to monopolize the debate, Krugman and Lawrence denigrate "nonspecialists" like me, who allegedly lack an understanding of the "technical issues" surrounding economic matters. I suppose that in their view working people would also have no right to debate economic policy, just as the soldiers in All Quiet on the Western Front had no right to discuss the conduct of World War I with officers. In taking this line they remind us of the Edward Tellers who once scoffed at efforts by such amateurs as political scientists, religious leaders, lay citizens, and yes, even economists to influence defense policy, much less arms control, during the 1950s and 1960s. Fortunately, an increasing number of economists are troubled by the yawning gap between their theories and reality. As Stephen Roach of Morgan Stanley recently stated, contemporary economic policies have a "fatal flaw," in that "they are built on the back of hollowing out labor."


My purpose here is not to elaborate on the crisis in modern economic theory. It is instead to remind my critics that societal outcomes ultimately reflect the pulling and hauling of political processes, and this is as true for economic policy as it is for health care or defense. All of us seem to agree that many workers are on the losing end of contemporary economic change. This outcome, I argue, did not arise spontaneously but as the consequence of a change in policy priorities—priorities that now relegate workers to the back seat. I agree with Steve Forbes and Hilary Barnes when they say that Europe's labor markets need reform, but labor must have a voice in that process. Indeed, what is lacking in Europe is a viable political strategy for renegotiating the postwar bargain. Economists would do themselves an analytical favor if they put the "political" back into economy.

Krugman and Lawrence say that the villain in the story is technical change, and again, nowhere do the economists define what they mean by technology. But let's simplify the story—as economists like to do—and define technology as computers. The widespread introduction of computers in industry, they say, has had a bias against unskilled labor, thus lowering wages in the United States and causing unemployment in Europe. They accuse me of being a closet protectionist, but this argument makes them closet Luddites. If technological change is hurting workers, why on earth would we encourage such investment? In the event, that's exactly what we do. Tax policy favors investment in "capital" (including technology) but not labor. Do we have the balance right?

I suppose they would agree with me that while we should encourage technical change, we must at the same time compensate those who lose in the process. This compensation, however, costs money, and here their position as deficit hawks is awkward. Krugman, for example, calls on the United States to devote "say, two percent of GDP to income supplements for the working poor." Two percent of GDP is a big number—it's over $100 billion, substantially more than the $80 billion I suggest in my article as a first step—especially at a time when welfare, education, and training programs are being cut. Does he really believe that the U.S. Congress would appropriate these funds? And if so, does he believe it could be done in the current climate of balancing the budget? Krugman's spending plan gives his contention that my "mischievous" proposals would spur inflation and render Western governments insolvent a hollow ring. I of course agree that money must be spent on these problems and, indeed, that it should be a national priority. I would also prefer to change the composition of government spending rather than increase the deficit. But I would rather help working people now than not, in the face of those who say the budget must first be balanced.

Krugman and Lawrence assert that the limits of noninflationary growth have been reached and that trust should be put in the leadership of the Federal Reserve. But the definition of noninflationary unemployment has changed over time; today it is somewhere between five and six percent, but at an earlier time it was lower. Would they really wish to conclude that nothing can be done for the unemployed or underemployed in this country, especially among youth, women, and minorities where the numbers are still high? Is an expansion of the already existing earned income tax credit the best that 200 years of accumulated economic knowledge can offer to workers? If so, is it any wonder that nonspecialists like me are entering the fray? In this light it is interesting that other nonspecialists like Forbes are questioning the limits-of-growth theme.


The economists' disconnect from the world of politics is evident throughout their comments. For example, Krugman criticizes the parallels I draw between the 1990s and the 1930s. What he does not seem to understand is that it is European leaders who are drawing those parallels, not I. The reason Kohl and Chirac are pushing so hard for a monetary union—which Krugman, curiously, seems to oppose—is that they fear an outbreak of the very beggar-thy-neighbor economic policies that characterized and deepened the depression. Being of an older—and wiser—generation, they still believe that international economic policy coordination can be a force for peace and prosperity. The paradox is that in pushing for monetary union on the one hand they are undermining domestic social welfare programs on the other, thus eroding political support for the union they wish to achieve. The great challenge of contemporary European politics revolves around dealing with this paradox, and I would argue that the United States really does have a dog in that fight. After all, it was the breakdown of European politics that caused the two great world wars of this century. Doesn't the United States have a national interest in promoting global economic growth, given this historical record?

Economics is vastly more sophisticated today than it was in Keynes' time. It uses mathematical models that even specialists trained in an earlier era find difficult to understand. But there is little evidence that it has become wiser as a discipline. Lawrence says that economic policy cannot be structured in such a way as to help people earn a living wage. If that is so, what is the point? That is the very question with which Keynes struggled his entire career, and his victory over classical economics came only after a depression and a world war. Is that what it will take for a new Keynes to arise in our midst?

ETHAN B. KAPSTEIN has recently been appointed the Stassen Professor of International Peace at the University of Minnesota.

[1] For a detailed dissection of Wood's work, see William Cline, Trade and Wage Inequality, Washington: Institute for International Economics, forthcoming. The majority view that technology is the main story while trade is a secondary factor may be wrong, but one certainly should not take sides on this subject unless one is thoroughly familiar with the technical issues involved.

[2] For a more extensive discussion, see my Single World, Divided Nations?The Impact of Trade on OECD Labor Markets, Washington: Brookings Institution, forthcoming.

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