What are the Economic theories?

April 9, 2015
Artist depiction of funeral

What if there were one economic Theory of Everything? One theory to rule them all, encompassing the vast sweep of history beneath its mighty wings?

Well, maybe there is. And maybe the author of it is none other than your friendly neighborhood economics columnist, Paul Krugman.

In a recent post, Krugman showed a graph (originally from economist Branko Milanovic) that he calls “recent history in one chart.” It shows how income (measured by purchasing power parity) has skyrocketed in emerging middle-class countries such as China in the last few decades, while middle-class individuals in rich countries such as the U.S. haven't done so well:

income chart

But decades ago, Krugman created a possible Theory of Everything that might have the power to explain this graph.

The theory I’m talking about isn't Keynesian economics, which Krugman often praises in his blog and his twice-weekly column in the New York Times. Nor is it the New Trade Theory, which is probably what Krugman is best known for as an academic. I’m talking about a theory called New Economic Geography, which Krugman developed in the 1990s along with Japan’s Masahisa Fujita and the U.K.’s Anthony Venables.

At its core, New Economic Geography is a theory about cities. The basic idea is simple. Companies want to be close to their customers, and workers want to be close to their employers. But customers and workers are the same people! So there’s a natural incentive for people and companies to be close to each other. Now consider that companies have economies of scale: instead of building a million little factories (as Mao Zedong tried to do in the disastrous Great Leap Forward), it makes sense to have a few big plants or offices.

So you get a snowball effect. Companies put their big plants and offices where the people are, and people move where they can get a job. A city forms. But the city can’t get too big, because it still has to be supplied from distant farms and mines and forests (and because land prices get too high).

Now here’s where the theory gets interesting. As cities grow, the economy gets richer and richer. Eventually, a critical mass is reached - it’s time for a new city. Suddenly, a new city appears somewhere else, and grows rapidly. Eventually, as the economy grows, there are a whole bunch of cities, although some are bigger than others.

One result of this theory is that a new city rarely grows up halfway between two existing cities. The big cities are already trading with each other; they don’t need a new baby brother so close to them. This explains why my hometown, College Station, Texas, will have a hard time becoming a major industrial hub - it’s smack dab in the middle of Houston, Austin and Dallas.

Here’s where the New Economic Geography becomes a Theory of Everything. Imagine that the economic units we’re discussing aren’t cities, but countries. Countries are a little different, because it’s hard for people to move across borders, but easy for capital and goods to move. This creates a bit of a different dynamic, which was worked out by Krugman and Fujita.

The results are astonishing. Industrialization - which is basically just urbanization at the level of a whole country - spreads like a virus. It springs up in one country first, then spreads to nearby countries, or to countries with strong trade links with the existing industrial countries. Think of how industrialization started in the U.K., then spread to France, then to the U.S. and Germany, then to Japan, South Korea and Taiwan.

Each time a new country starts its journey from a resource-dependent backwater to an industrial powerhouse, the change comes suddenly. As time goes on, and there are more and more developed countries to provide capital, each new industrialization goes faster than the ones before, leading to ever more spectacular “growth miracles.”

But there’s a small downside to this process. Because industrialization isn't a smooth process, each time a new country makes its development sprint, the existing rich countries experience a growth slowdown. In other words, the industrialization of the U.S. and Germany in the late 19th and early 20th centuries might have caused a temporary slowdown in the U.K. and France. And China’s titanic growth might have caused growth to slow a bit in the U.S., Japan, South Korea and Europe.

New Economic Geography theory therefore might provide part of the explanation for Krugman’s graph, as well as for the generally slower growth that rich countries have experienced since China joined the World Trade Organization in 2000.

Ultimately, the New Economic Geography tells a story that is both hopeful and frustrating. It is hopeful because it says that eventually, the blessings of industrialization will spread to every country on Earth - all we have to do, really, is wait. But it is frustrating because this spread will take many, many years, and even if countries do all the right things, they have to wait their turn in line. It also suggests that the process of globalization will periodically cause incomes in rich countries to temporarily grow slowly, or even decline a bit, before resuming their upward climb. This could cause periodic waves of protectionist sentiment that might derail globalization.

In any case, if Krugman’s theory is right, the U.S. and other rich countries might be about to see an acceleration of growth, as China’s industrialization runs its course.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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