SYNOPSIS: Krugman discusses the last century and the coming one

After 100 years of trial and error--and some mighty dark days during the '30s and '70s--Economic Man is free at last.

There's a new television show, I'm told (I haven't seen it), about seemingly normal high school students who are actually space aliens. I can relate: I sometimes feel as though I got my economics degree on another planet. That planet--the world of the 1970s--was one in which capitalism in general and America in particular seemed to be, figuratively and literally, running out of gas. Every year seemed to bring more bad news: another country falling under communist rule, another bout of inflation despite high unemployment, another poor productivity number.

It was not a world where it was easy to be a free-market economist. Oh, we tried--indeed, academic economists were considerably more in favor of free markets and more skeptical of planning in 1977 (the year I got my Ph.D.) than they had been a decade earlier. But you couldn't help feeling that you were defending a losing cause--that however fuzzy the thinking of those who criticized both the market system and the conventional economists who believed in it, the poor performance of the real economy gave them the rhetorical edge.

And then, bit by bit, the tide turned. Here on the millennial cusp, both the American economy and the free-market system it epitomizes seem everywhere triumphant. Not only are things going well for capitalism; hardly anyone seriously proposes an alternative.

The question that we ought now to be asking is whether this new confidence is as misplaced as our earlier pessimism. What, exactly, went right with the free-market system--and will it continue?

How America Got Its Groove Back

Back in 1967 the futurist Herman Kahn, who had made his reputation with titles like On Thermonuclear War, published a surprisingly upbeat tome entitled The Year 2000. The book's basic premise was that the economic and technological good times of the 1960s were here to stay; low unemployment, rapid productivity growth, and a steady stream of technological improvements would characterize the next 33 years. For a long time it seemed that optimists like Kahn had made a big mistake. Circa 1974 everything seemed to fall apart. Productivity growth slowed to a crawl, inflation and unemployment surged, glitzy new technologies seemed to do little for productivity or the quality of life--and besides, the profits from American technologies always seemed to go to Japan. The national mood went sour, as was reflected in the title of Donald L. Barlett and James B. Steele's influential 1991 book, America: What Went Wrong?

And then, just in time for the millennium, everything started going right again. By the numbers, the economy of the late 1990s looks a lot like the economy of the late 1960s. Productivity is once again growing by a healthy 2% to 3% every year, unemployment is down to around 4%, real wages are rising. Kahn's forecast that Americans in 2000 would live twice as well as they did in 1967, and do it with a 30-hour workweek, has not been realized (real blue-collar wages are about the same now as in 1967, and the workweek has actually gotten a bit longer), but the economy seems once again to have found a groove. Progress--and broad confidence that it will continue--is back.

So what are we doing right? New technology surely plays a big role, especially the use of digital technology to grease the wheels of production throughout the economy. But if technology were solely responsible, the whole world should be doing well; in fact, only the U.S. and a few smaller countries have seen a radical improvement. And those that did well in the era of the industrial robot and the fax machine--Japan in particular--seem to be missing out in the Internet Age.

It's strange now to read the critiques of America's business system during the bad years--the accusations that our companies were too focused on stock prices and financial returns, and that the U.S. was at a disadvantage compared with countries where the government actively regulated competition and promoted particular technologies. These days, those supposed vices sound like virtues: a stock market that does not allow established firms to rest on their laurels, the resulting responsiveness of companies to market incentives, fierce competition to develop the new new thing, and the ability of this wild and crazy system to boldly go where no bureaucrat ever thought there was a potential payoff. Either the old critiques were wrong or the world has changed in a way that turns America's characteristic weaknesses into strengths. Whatever the reason, right now we feel pretty good about our way of doing business.

The End of History? You could say that we have been here before. Our current prosperity would not have amazed a Rip Van Winkle from the 1960s; even our renewed faith in the capitalist system would not have seemed so strange to someone from the early 20th century, another era in which global capital markets ruled and governments mainly tried to keep those markets happy. Still, someone with a sense of history may note that the seemingly total supremacy of free-market capitalism in, say, 1913 turned out to be a lot less secure than expected. Are we going to repeat that experience?

Well, this time around both the ideology and the political supremacy of free markets are probably on sounder footings. Not that there won't be bad times ahead--more on that below. But it is hard to see how major challenges to capitalism can ever again command the following they had for much of the 20th century. Suppose some would-be 21st-century Lenin were to try to sell the disgruntled masses (and lest we forget, they're still out there) a utopian vision of a world without greed and injustice. What would he propose? State ownership of the means of production? Worker-run cooperatives? Right. After watching one revolutionary country after another come slinking back down the road in our direction, it's going to be hard to muster much enthusiasm for the next big anticapitalist idea.

In fact, even some of the smaller ideas have lost their shine. For a few decades after World War II much of the Third World was led to believe that the path to development lay in government-directed industrialization, aimed mainly at the domestic market. But all the success stories in the developing world--from Chile to China--turned out to be export-oriented. That is, they prospered by becoming more, not less, linked to the global market economy.

Or consider the strange case of the Asian model. As recently as six or seven years ago one influential bloc of opinion held that Japan, Thailand, Singapore, and a few other regional powers had found a better way. Unburdened by America's naive free-market ideology, they had developed a system of government-guided capitalism that seemed to give them an edge in technology and economic growth. Even then, some of us thought that the effectiveness of this model was a myth, that if anything Asian countries had done well despite bureaucratic intervention rather than because of it. And now that much of that "deep strategic planning" has been exposed as mere crony capitalism, any future claims about a system that trumps the free market are going to face severe skepticism.

There is still the question of whether a market system has to be quite as brutal as America's. A few years ago many thought that not just central planning but even the welfare state had been proved unsustainable--that only countries that lowered their safety net to ground level could compete in the new world order. Now that conclusion seems excessive: Some countries with high taxes and social benefits--most notably Sweden--are turning in American-style growth performance.

The story of economics at the turn of the millennium, then, is that free-market capitalism has proved itself a far more durable system than even its admirers might have expected. It isn't perfect, but it wasn't supposed to be, and the alternative routes have turned out to be dead ends. Capitalism's success in weathering the storms of the 20th century means that both policymakers and the public are now willing to cut it some slack, to stick with markets even when they misbehave.

UP-and-Down Economics

For a few weeks in 1998 the markets misbehaved badly, and it looked as if the millennium might end in a financial meltdown. The crisis that began in Thailand the year before had spread to Russia and Brazil, and finally, via a hedge fund called Long-Term Capital Management, to the U.S. itself. As nervous investors sought safety and liquidity, bond markets froze, and it took all of Alan Greenspan's powerful, if peculiar, charisma to restore confidence.

There are some people who put a positive spin on the 1997-99 financial crisis: They think it showed that we actually do know how to deal with these things, that the worst has happened and it didn't turn out that badly after all. But those closest to the events were not sure they had the answers at the time, and they still aren't quite sure how they got off so easy. Even now, after a turbulent century, it seems that some of the kinks in capitalism have yet to be worked through.

So it turns out that we don't necessarily understand economic crises--or how to prevent them--as well as we thought. Economists, me included, have scrambled to explain how Japan got itself caught in a seemingly permanent slump or how the Asian tigers went from world beaters to disaster areas in just months, but it would be more reassuring if we had predicted these crises instead of rationalizing them after the fact. You can't help having the uneasy feeling that the next crisis, too, will surprise us.

Moreover, the defenses we build against crisis tend to be eroded by the process of economic change itself. Rules of the game that cope pretty well with domestic financial upsets may not work when the problem becomes hot money flowing across borders. Financial safety nets that protect the banking system may not help much when the institutions in trouble are nonbank intermediaries like LTCM. In the 21st century we may face the problem of trying to regulate virtual nonbanks that exist only in cyberspace.

To get a sense of how the 21st-century economy may already be slipping from our grasp, consider the strange death of monetarism. Twenty years ago Milton Friedman and his followers used to claim that the Fed and its counterparts could keep the real economy on an even keel simply by holding the growth of the money supply stable, say at 3% per year. It probably wasn't a very good idea even then, but now it is out of the question because nobody can agree on what the money supply is. Instead of Friedman's rule, central banks have had to fall back on judgment calls--and some of them worry that they may eventually lose even that ability. The Fed and its counterparts abroad still have a lot of power to move the economy because, despite the proliferation of new forms of finance and new kinds of markets, accounts are ultimately settled via pieces of green paper--or via deposits at the Fed that amount to the same thing. But economists are already thinking about a world where physical money has become obsolete and where electronic accounts can be cleared without any officially sanctioned medium of exchange. Who controls the monetary system in such a world? Who rescues it when something goes wrong?

Eventually we will work out answers to those questions. But it may take a few nasty crises to get the method down. And meanwhile there will be other problems.

Knowledge and Ignorance

Although a combination of heavy-handed business tactics, legal ineptitude, and prosecutorial zeal has apparently put Microsoft in the judicial doghouse, the official antitrust trial of the millennium has by no means resolved the bigger issues raised by the case. Microsoft has now been all but ruled a monopolist--and yet the whole point of spending lots of money developing a new technology is to carve out a few years in which you are selling something nobody else can offer. Microsoft stands accused, more dubiously, of overcharging consumers--but what is the fair price for something that cost billions to develop but nothing to make? Microsoft probably did break the rules--but where, exactly, is the rule book?

The standard theoretical case for free markets is based on the proposition that in a market economy the price of a good tends to reflect both what it is worth to consumers and what it costs to produce--and that any divergence between what consumers are willing to pay and the cost of production provides a signal to allocate resources more efficiently. If it costs twice as much to produce another pound of apples as it does to produce another pound of bananas, but consumers aren't buying the apples, then it is time to grow fewer apples and more bananas--and the market will automatically make the adjustment.

But what does it cost to let another consumer use Windows 1998? Nothing; so maybe it should be free--except in that case it wouldn't have been worth developing in the first place. Nor is there any simple rule about what the price should be. Enough to cover the developer's costs? Whatever the traffic will bear? Or somewhere in between? (And whose call is it, anyway?) What looks to the producer like a fair return for the risk he bears can look to the consumer like profiteering--as in the case of prescription drugs. What looks to the developer like a reasonable leveraging of the initial innovation can look to rivals and antitrust officials like robber-baron tactics.

None of this is entirely new. Rather peculiarly, the basic rules of knowledge-based industries like software--that while their products may be very expensive to develop they cost almost nothing to produce, and tend to be more popular the more consumers there are--have long applied to an industry in which, famously, nobody knows anything: entertainment. In terms of their basic economics, Hollywood and Silicon Valley have a lot in common, and Disney and Microsoft are twins separated at birth. But whereas the weird business of entertainment used to be exceptional, the knowledge-based company seems to be becoming the rule--and we don't know how to handle it. It's actually pretty ironic: Just as the free market finally rules unchallenged, the economy is changing in a way that undermines the assumptions on which free-market economics is based.

So what is society going to do about it? One answer is "complain": Among the remarkable achievements of Bill Gates is that he has managed to get cast as a businessman-villain in a country that seemed to have decided wealth was a sign of virtue. But it may also turn out that the problem of how to deal with the peculiar economics of knowledge will give rise to new ideologies, new challenges to the market system.

There may even be calls for more (say it quietly) government. Not central planning, mind you, but if, as the experts predict, the already serious niftiness gap between American cell phones and those in Europe and Japan grows wider; if drug prices keep going up; if, in general, the romance of commerce loses a bit of its allure--well, who you gonna call?

But surely these will be adjustments at the margin rather than big changes in the ground rules. A company broken up here, a government-industry consortium to promote a technology there, maybe even a bit of price regulation; but basically companies will be allowed to make money as best they can, in the belief that the invisible hand will direct them to more or less the right place.

The Perfect and the Good

So what is the bottom line for the economics of the next century? Put it this way: Much of the 20th century was dominated by a search for perfection. Panglossian advocates of laissez faire claimed markets always got it right, then were discredited by the Great Depression; idealistic revolutionaries promised utopia, and delivered the Soviet Union. What we learned by the end of the century was that capitalism is far from perfect, but we were also reminded of the old line that the perfect is the enemy of the good.

As the new millennium begins, one can say of capitalism what Churchill said of democracy: It is the worst system we know, except for all the others that have been tried.

Originally published in Fortune, 3.6.00