Paul Krugman, a professor at Princeton and the most recent winner of the Nobel economics prize, says his real talent is his ability to create simple models that represent complex economic phenomena. That’s in his academic work. In his other career, as a blogger and New York Times columnist, he shows a similar talent for getting to the essence of complicated questions. Watch video of Paul Krugman talking about the economy in the HBR Editors’ Blog. What surprised you as the meltdown unfolded? The strength of the international transmission mechanism was shocking. I don’t think anyone would have predicted as coordinated a world slump as it turned out to be. Every country out there took a serious hit. I used to think the idea of financial contagion—the idea that Brazil could get a financial flu from Russia because a failed hedge fund, say, had invested in both—was far-fetched. But such rapid transmission turned out to be at the core of the problem. I didn’t take it as seriously as I should have. The lack of a unified government in Europe turned out to be a real problem, too. European leaders couldn’t figure out how to coordinate with each other. We kept finding bursting bubbles where we weren’t paying attention: Spain and Ireland on one hand and the Eastern European countries on the other. That was a huge, further downdraft on the world economy that we weren’t expecting. Some people thought that the United States had too much entrepreneurial and innovative energy to go into a deep, persistent stagnation. Being innovative, hard driving, and creative is good for long-term economic growth, but it doesn’t insulate you from nasty business cycles. It may actually make you more exposed. America in the 1920s was the most innovative, productive place on the planet. That didn’t protect us against a financial collapse and a very nasty depression. Does this crisis give socialism a better name? No. It gives regulated capitalism a better name. A very short time ago, a significant number of influential people believed that the whole structure of financial regulation and safety nets inherited from the New Deal was unnecessary and distorting. And now you look back on the era of stronger regulation and say, “Gee, we didn’t really have any major financial crises for about 50 years after the 1930s.” Maybe you didn’t get quite as much interest on your bank deposit in those years as you did after regulations were weakened, but that doesn’t seem as important now as it did. What are some of the less-obvious causes of the crisis? You could certainly argue that Harvard economist Michael Jensen, writing in HBR and other publications, got us into this by pointing out that managers’ interests weren’t naturally aligned with shareholders’. The idea that you need to give executives a stake in company profits—in order to give them the right incentives—has been very influential, and arguably it’s caused a lot of damage. On Wall Street, that system has meant that people were given outsize compensation for generating profits for a couple of years, but there was no downside for them when it all turned out to be an illusion. The economics profession doesn’t get off scot-free, by the way. The efficient markets theory—which led to our near-total failure to regulate the financial markets—came from the economists. Do corporate managers need to change their behavior? I have to admit that I don’t think about that very much—the economist’s vice is the working assumption that most of the time the private sector knows what it’s doing. Nonfinancial corporations didn’t seem to be the villain in this thing at all. Productivity growth over the past 10 years has been very high, which suggests that nonfinancial corporations are doing a good job. That said, I assume that some of the issues around executive compensation—which clearly played a big role in the financial sector’s downfall—are to a lesser degree distorting decisions in the rest of the corporate sector. Executive compensation seems excessive in a lot of cases, that’s for sure.
