I know I often give Paul Krugman a hard time. The big reason is he does not always seem to take the responsibilities that come along with his stature seriously. While he has staked out some important positions and defended them vigorously, such as firmly opposing austerity, and took quite a lot of heat for his early opposition to the war in Iraq, in other areas he is often too inclined to fall in with conventional thinking. And don’t get me started on how he defends dubious Obama behavior. The fact that the Republicans are bad guys does not make the the Democrats good guys by default.

A good piece in the Nation by Bill Greider, which focuses on Krugman’s long standing support of free trade, and how, contrary to his predictions, the results were not positive for ordinary American workers. Greider, who has long stressed that our system is not open trade but managed trade, and that other countries manage it with much more attention to protecting their workers than we do, has reason to personalize this discussion. He does point out that Krugman’s positions on trade were widely held among mainstream economists in the 1990s. But it is still fair for Greider to call Krugman out. First, Krugman, as a trade economist, was taken seriously not just in the profession but in wider policy debates. Second, Krugman took it upon himself to act as an enforcer, and went after people who dared suggest that opening up more sources of low wage labor might reduce pay levels in the US. In particular, he savaged Greider:

….for many years Krugman made it his personal duty to act as the watchdog warning the public against non-economists peddling false ideas. In practice, this usually meant skewering progressive writers who criticized globalization from a liberal-labor perspective—offshoring of jobs, stagnating wages, sweatshops and all that…

So Krugman chewed on my new book instead—One World, Ready or Not: The Manic Logic of Global Capitalism—which he described as “a thoroughly silly book.” He made a nasty campaign against it, first on Slate, Microsoft’s online magazine, next a harsh review in The Washington Post, then again in his book entitled The Accidental Theorist. I have to admit it. In Krugman’s telling, I did sound like a drooling idiot.

I don’t intend to reargue the matter, but my book was bound to provoke authorities like Krugman because I concluded from my reporting that the global system was careening toward “wrenching catastrophes” and eventual breakdown. I essentially argued that the global trading system, despite its fabulous wealth-creating powers, was generating new production far faster than it created new consumers with the wherewithal to buy all the stuff. Someone in the system would have to close some factories. The US effectively accepted the role of “buyer of last resort” for the world’s over-capacity, every year buying and borrowing more from abroad than it produced at home. That is where the trade deficits and swelling debt came from and the rising inequality. They all persist under Obama.

So why did Krugman and all of his colleagues get the trade equation so wrong? The simplest explanation is a failure to test theory against reality. Krugman simply dismissed emerging economies, and China in particular as a threat to America, as did pretty much anyone who looked at Japan in the 1960s. Greider excerpts sections of a 1994 Harvard Business Review article by Krugman:

“I hope to have made clear,” he added, “that the seemingly sophisticated view that the Third World is causing First World problems is questionable on conceptual grounds and wholly implausible in terms of the data.”

Huh? Did he miss the 1985 Plaza Accord, where the G-7 made a full court press to drive up the yen precisely because Japanese imports were making huge inroads, particularly in automobiles? The fact that Japan had gone awfully quickly from post war devastation, described in Japan as the starving years, to advanced economy powerhouse status was apparently a fluke. Back to Greider:

But what would happen if the low-wage countries also managed to generate large increases in productivity? “These emerging economies would see their wage rates in terms of chips rise—end of story,” he said. “There would be no impact, positive or negative, on real wage rates in other, initially higher-wage countries.”

In any case, Krugman was skeptical that poor countries could become high-tech producers. “A likely outcome is that high-tech goods will be produced only in the North [the advanced industrial economies], low-tech goods only in the South [low-wage developing economies], and both regions will produce at least some medium-tech goods,” he wrote.

But what if capital investment from the US and other advanced economies begins to flow heavily into the low-wage economies? Wouldn’t that undercut US wages as labor unions feared? “The short answer is yes in principle but no in practice,” the professor assured. “As a matter of standard textbook theory, international flows of capital from North to South could lower Northern wages. The actual flows that have taken place since 1990, however, are far too small to have the devastating impacts that many people envision.”

Greider also describes how Krugman later specifically dismissed China as a threat to the US. By contrast, Greider, who had just visited China, saw how American companies were falling all over themselves to get access to its market, and how Chinese officials were demanding technology transfer as the price of entry. Greider thought it was not wise to dismiss the ability of the Chinese to learn. And more generally, Americans suffered from hubris:

The American problem is not trade theory but self-delusion—an overweening confidence that the US as world leader would prevail because it always had. US leaders assumed they would define the architecture of the new global system, much as they had done since World War II, and other nations would sooner or later be compelled to follow—that is, abandon their national strategies of managed trade and accept the American ideology of free markets and free trade. In Washington and Wall Street, American multinationals were given a free hand to design their own strategies, free of government but of course supported by government money.

The problem was, the rest of the world declined to cooperate. If they could, developing nations pursued their own nationalistic strategies not so different from how the US did industrial development in the 19th century. And these newcomers succeeded spectacularly—first Japan, then the Asian tigers, now China and India and many others. Authorities like Krugman whose expectations were so wrong now tell Americans have no other alternative except the ugly protectionism which would be ruinous for all.

That assertion is mistaken too. The most compelling evidence of American self-delusion is not in Asia but in Europe. The best evidence that a nation can both manage its industrial system strategically while participating fully and fairly in global trade is Germany. As an exporting nation with large trade surpluses in advanced technological goods, Germany’s actual experience refutes the lessons taught by orthodox trade theory and macroeconomics in the US. It sets high performance standards for labor relations and for social entitlements. Its goals for the nation’s industrial base accept that some production will be dispersed abroad but the companies must make sure the industrial core—good jobs, high wages and technological invention—remain in Germany.

Now, of course, this view of Europe looks a tad rosy. Even Germany social protections are under attack. But it’s not clear that that was inevitable. One of the triggers was the deflationary impact of the decision to integrate Eastern Germany. That led to pressure on wage rates and later the Hartz reforms. Second has been the disastrous response to the financial crisis. As much as America’s policies have not been great, Europe’s have been worse (well except for not prosecuting bankers, where both have been equally bad). The US did more to clean up its banks and rebuild capital levels. We have more discretionary stimulus. We’ve set lower interest rate targets (while IMHO ZIPR is 1% too low, I was alarmed when the Fed dropped the Fed funds rate below 1%) while the ECB has been hampered by its inflation mandate. And as readers know, the destructive, failing austerity policies being inflicted on the periphery, which are to preserve the solvency of French and German banks, are infecting France and Germany regardless. So if Germany had had been luck and better macroeconomic policies, its labor model would likely still be flourishing.

It’s a shame that the point of view advocated by development economist Dani Rodrik in 2007 doesn’t seem to have a following:

Globalisation’s soft underbelly is the imbalance between the national scope of governments and the global nature of markets. A healthy economic system necessitates a delicate compromise between these two. Go too much in one direction and you have protectionism and autarky. Go too much in the other and you have an unstable world economy with little social and political support from those it is supposed to help.

If there is one lesson from the collapse of the 19th century version of globalisation, it is that we cannot leave national governments powerless to respond to their citizens. The genius of the Bretton Woods system, which lasted for about three decades after the second world war, was that it achieved such a compromise. Some of the most egregious restrictions on trade flows were removed, while allowing governments freedom to run independent macroeconomic policies and erect their own versions of the welfare state. Developing countries were free to pursue their own growth strategies with limited external restraint. The world economy prospered like never before…

It is time, then, to consider a new bargain. When rich and poor nations come together to negotiate the rules of the game they should stop thinking in terms of exchanging market access: “I will open my markets in x if you open yours in y.” They should consider ins-tead exchanging policy space: “I will allow you to protect your national social compact if you allow me to engage in development strategies that conflict with WTO and International Monetary Fund rules of good behaviour.” The challenge is to design procedures that enable the use of policy space for socially desirable purposes while limiting it for beggar-thy-neighbour purposes.

Risky? Yes. There is always the chance that such an approach would slide into protectionism, pure and simple. But the alternative is, if anything, more risky.

Europe, where democracies are being sacrificed on the altar of the bond gods, is a test case of how those risks can play out. We’re seeing rising death rates, deteriorating living standards, and escalating political and social instability. How much and how quickly things get worse is anybody’s guess, but I’d bet with Rodrik: that the downside of protectionism will look pretty compared to what is unfolding.