That Fax Machine Must Have Had Some Kind of Impact!

It seems that Paul Krugman's past statements continue to crop up. His 2003 call for Alan Greenspan to create a housing bubble certainly has dogged him, but something he wrote in 1998 exposes even more of his economic ignorance: He claimed that the Internet would not have much effect on commerce and the economy, or at least be no more powerful than the fax machine.

Specifically, he wrote:

The growth of the Internet will slow drastically, as the flaw in "Metcalfe's law" -- which states that the number of potential connections in a network is proportional to the square of the number of participants -- becomes apparent: most people have nothing to say to each other! By 2005 or so, it will become clear that the Internet's impact on the economy has been no greater than the fax machine's. (Emphasis mine)

As the rate of technological change in computing slows, the number of jobs for IT specialists will decelerate, then actually turn down; ten years from now, the phrase information economy will sound silly.

At one level, his statement is understandable. There are diminishing returns to any kind of technological progress and diminishing returns to capital. Even Keynesians like Krugman can grasp the concept of the margin, even if they cannot apply that concept to money and government spending.

My sense also is that Krugman was responding to some of the "New Economy" rhetoric that was floating about at the time. (Although Democrats were claiming then that pushing the top tax rate to 39.6 percent was the real reason the economy was doing well.)

However, it is quite clear now that the Internet has had a huge impact upon the economy, and that is because it not only has changed how people receive economic information, it also has vastly changed the extent of what we would call "the market." For example, a local bookstore in Frostburg now does not have to depend upon walk-in traffic for all its revenue, as it can market its products to almost anyone on the Internet.

Like most academic economists, Krugman depends upon static models that give us the four kinds of "competition," models that over time will slowly morph into every industry turning into an intractable monopoly. Unless the government steps in to stop this inevitable slide, economic competition will disappear.

Those models were what enabled Oskar Lange and others who were debating Ludwig von Mises and Friedrich A. Hayek in what is called the "Socialist Calculation Debate." Lange and his allies were claiming that all anyone needed were the four models, and that a government, through central planning, essentially could recreate a market that would be better than what currently existed because governments could enforce those things that would better allow the economy to remain in a state of virtual perfect competition.

That is where Krugman and most other academic economists are today. They cannot fully articulate the role of private property and even prices in an economy, and they certainly cannot fully understand the role of information and even those things they call "market failures" because they cannot comprehend the entrepreneur and the economic role of the entrepreneur.

To Paul Krugman, the entrepreneur is someone who starts a business in the garage, but over time has little economic impact because all the important economic decisions are made by big companies that bear little resemblance to any competitive models. Instead, like many academic economists, he is stuck in the mentality exhibited by John Kenneth Galbraith when he likened the economy to consisting of a few monopolies that competed in a death match with labor unions. Prices don't mean anything because they are administered and because the economy does not exactly match the model of perfect competition and all its inherent assumptions.

Furthermore, Krugman's regulatory models are purely Pigovian in which the wise, omniscient regulator (if the regulator is a Democrat) knows exactly what lines of production are going to be profitable and sustainable (Industrial Policy), so the fact that the Internet could have a huge impact upon information costs is irrelevant.

In short, Paul Krugman sees the economy as a mechanistic entity that is oiled by a circular flow of money. As long as government regulators and central bankers have a free hand, that machine can go on forever, but if private enterprise gets in the way -- as it invariably does -- then disaster strikes.

Thus, a person who views the economy that way is not going to be able to understand the impact of something like the Internet, which to him is a static entity that will be giving decreasing returns to scale. His 1998 statement was his economic logic in action.