One Economic Theory to Explain Everything - Bloomberg 7/27/17, 11'07 PM

One Economic
Theory to Explain
Everything
There may just be one economic theory that explains
everything.
By Noah Smith
43 January 8, 2015, 10:00 PM GMT+8

What goes up, must come down. Photographer: Rick Gershon/Getty Images

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?

https://www.bloomberg.com/view/articles/2015-01-08/one-economic-theory-to-explain-everything Page 1 of 6
One Economic Theory to Explain Everything - Bloomberg 7/27/17, 11'07 PM

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 <http://krugman.blogs.nytimes.com/2015/01/01/recent-

history-in-one-chart/?module=BlogPost-
Title&version=Blog%20Main&contentCollection=Opinion&action=Click&pgtype=Blogs&region=Body>
, 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:

But decades ago, Krugman created a possible Theory of Everything that

might have the power to explain this graph.

The theory Im 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. Im talking about a theory called New
Economic Geography, which Krugman developed <http://www.uni-
miskolc.hu/vrgi/20031002zzz20031231/EcoGeo_2008_article2.pdf> in the
1990s along with Japans 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

https://www.bloomberg.com/view/articles/2015-01-08/one-economic-theory-to-explain-everything Page 2 of 6
One Economic Theory to Explain Everything - Bloomberg 7/27/17, 11'07 PM

to be close to their employers. But customers and workers are the same
people! So theres 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
oces.

So you get a snowball eect. Companies put their big plants and oces
where the people are, and people move where they can get a job. A city
forms. But the city cant 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 heres where the theory gets interesting. As cities grow, the economy
gets richer and richer. Eventually, a critical mass is reached -- its 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
dont 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 -- its smack dab in the middle of Houston, Austin and
Dallas.

Heres where the New Economic Geography becomes a Theory of

Everything. Imagine that the economic units were discussing arent cities,
but countries. Countries are a little dierent, because its hard for people to
move across borders, but easy for capital and goods to move. This creates a
bit of a dierent 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

https://www.bloomberg.com/view/articles/2015-01-08/one-economic-theory-to-explain-everything Page 3 of 6
One Economic Theory to Explain Everything - Bloomberg 7/27/17, 11'07 PM

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 theres 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 Chinas 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 Krugmans 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 Krugmans theory is right, the U.S. and other rich countries
might be about to see an acceleration of growth, as Chinas industrialization
runs its course <http://www.cnbc.com/id/102266550> .

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

To contact the author on this story:

Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:

James Grei at jgrei@bloomberg.net

https://www.bloomberg.com/view/articles/2015-01-08/one-economic-theory-to-explain-everything Page 4 of 6
One Economic Theory to Explain Everything - Bloomberg 7/27/17, 11'07 PM

Terms of Service Trademarks Privacy Policy

2017 Bloomberg L.P. All Rights Reserved
Careers Made in NYC Advertise Ad Choices Website Feedback Help

https://www.bloomberg.com/view/articles/2015-01-08/one-economic-theory-to-explain-everything Page 5 of 6
One Economic Theory to Explain Everything - Bloomberg 7/27/17, 11'07 PM

https://www.bloomberg.com/view/articles/2015-01-08/one-economic-theory-to-explain-everything Page 6 of 6