The world according to Paul

Economist du jour Paul Krugman weighs in on the China standoff, California's energy crisis and whether the economy has hit rock bottom.

By Damien Cave
Published April 6, 2001 1:30AM (EDT)

Paul Krugman loathes fuzzy math. The Princeton economics professor and New York Times columnist has made a career out of cutting through dubious statistics and mathematical manipulation. His 18 books and hundreds of articles -- most of which focus on international trade -- are a testament to clear, efficient writing, not to mention productivity.

They also reveal what makes Krugman unique. Unlike many of his peers, who loll in the academy, stressing econometric models that rarely intersect with public policy, Krugman has repeatedly turned his eye toward the intersection of math and the masses. The focus hasn't always won him praise. Michael Wolff's April 2 profile in New York magazine, for example, portrayed Krugman as something of a media sensation in training -- "the face of gloom," in Wolff's words, who would fall out of favor as soon as the market turned.

But for the most part, Krugman's work has earned him wide acclaim among his peers. Krugman, 47, has won the John Bates Clark Medal (given by the American Economic Association every two years to an economist under 40) and many economists believe that he'll eventually take home the Nobel Prize. But Krugman is equally proud of the criticism he's received. "You know you've achieved something," he says, when you manage to inspire collective anger.

"My belief is that if an op-ed or column does not greatly upset a substantial number of people, the author has wasted the space," he says. "This is particularly true in economics, where many people have strong views and rather fewer have taken the trouble to think those views through -- so that simply insisting on being clear-headed about an issue is usually enough to enrage many if not most of your readers."

These days, Krugman -- who generally votes Democratic but also worked in the Reagan White House as an advisor -- has been particularly busy. He was one of the first economists to criticize Alan Greenspan, and he's used his New York Times column to rail against everything from the Bush tax cut to the electricity generators that manipulated California's energy market.

But with a China-U.S. diplomatic crisis looming, a recession on the horizon and an energy crisis reaching deep into everyone's pockets, even Krugman is cautious with his predictions.

Let's talk about China first. You're an expert on international trade; do you think that China will choose its desire for trade over its penchant for nationalistic showmanship?

China obviously has something to gain from U.S. goodwill, though I don't know that these things usually play a big role when tempers are high. As for U.S. business, some people are anxious to be on good terms with China, but others are not. All I know is the general rule that for all we talk about how "the bond market rules the world," nationalism always trumps economic interest in extreme situations.

Look at the Palestinians in Israel. They essentially have no economy. Their only export is workers having day jobs in Israel, and so intifada II is extremely counter to any concept of economic self-interest.

What might the standoff with China do to the American economy?

Well, nothing per se, nothing you'd notice. China is not a big export market; it's not yet a crucial source of supply for anything in particular.

And yet the markets continued to free-fall this week, in part because of the perceived threat from China. Could the situation with China push us closer to a recession?

I have no idea. One nuclear bomb can ruin your whole day. And actual shooting wars are incredibly expensive. But luckily I'm not contemplating that at the moment.

You recently wrote about the California energy debacle. You argued in your column that generators manipulated the energy market, but that their efforts don't amount to a profit-driven conspiracy. How is that possible?

I'll give you a numerical example. Imagine that you're right at capacity; everything is running flat out. Now, what we know about electricity is that demand is very inelastic -- it takes a big price increase to get people to cut back even a little bit. So suppose that things are working flat out and you are a generator who happens to have 15 percent of the generating capacity. Ask what would happen to your profits if for some reason, one of your plants -- amounting to 1 percent of total capacity -- went offline. It would be a very modest estimate to say that a 1 percent reduction would lead to a 10 percent increase in the price of electricity.

If you work it out, you'll discover that you'll be getting more. You'll still be selling electricity from the other 14 percent you have online. You'll be selling it for a higher price, so you'll actually be receiving more dollars for electricity by taking one of the plants offline. And of course, you also will be saving the cost of fuel that you use to generate the power.

So if you're in that tight situation, there's a clear incentive for a generator who has a substantial share of the generating capacity to take some of it out of service. If he's smart, he'll never say that, which means that [proving the manipulation] requires digging for only circumstantial evidence.

There's a long history behind this. There was a lot of evidence of market manipulation in Britain in the early '90s, which is what alerted people to the possibility even before California deregulated.

What happened in Britain?

They privatized the power system and it was very extreme. There were just two generators and, basically, when you looked at the downtime for most of the generating facilities, they tended to happen during times of peak power demand -- which was a sign that they were doing it to drive up prices.

How did Britain resolve the problem?

It ended up not being particularly controversial that market power was an issue. They ended up reformulating the system, putting in place temporary wholesale price controls and windfall profit taxes on the generators while trying to work out a new system.

You've suggested that wholesale price controls -- put in place by the Federal Energy Regulatory Commission, or FERC -- would help alleviate the problems here too. How would they work and how long should they last?

Until new capacity has the time to come online. What people have been saying -- those who know a lot about this -- is that you could set prices at a point that's way, way above normal, way above the level at which it would be profitable for people to build new plants. They would just be a way of getting through a transition period.

Could this problem have been avoided if those caps had been in place from the start?

Not really. Suppose California hadn't deregulated; there would probably be a power shortage anyway. It's probably true that the deregulation confused people, so they didn't build plants. But it's a pretty good bet that even if they had never done the deregulation, the surge in the California economy in the late 90s and NIMBY-ism would have led to a shortage of plants.

So there would be power shortages in California, though not as severe as what we're now seeing. What you wouldn't have is a financial crisis. The utilities would be short of power and there would be occasional brownouts, but you wouldn't have $2 billion a month of windfall profits for out-of-state generating companies.

This thing is going to resolve itself in three years, when the capacity is online. The question is whether the consumers and taxpayers should pay whatever it turns out to be -- $30 billion or $40 billion in windfall profits to the generators.

Why don't we just make the generators give back the money?

It's impossible to disentangle who manipulated the market and how much of the windfall profits are due to market manipulation and how much are due to just general shortage.

Is there another way to get some money back from them?

If Tony Blair were president, I would say that there should be a windfall profit tax -- not an extreme one. But really, we should do a little bit of everything. We should be raising rates for consumers, having a wholesale price cap, having a windfall profit tax -- and all of it should have a sharp time limit. Because this is not the way you want to run any market for the long term. We're just talking about managing a crisis for two to three years.

Given that the Bush administration has pretty much said that it won't intervene in California, are taxpayers going to get stuck footing the bill for this crisis?

Well, it's very difficult for the state to do anything. It can't extract any more money out of the utilities. It can't unilaterally impose a price control because it's part of a larger grid [which extends beyond California and California law], and that doesn't really work unless the whole region is under it. It's very difficult to see the state doing the windfall profit tax. Again, a fair amount of capacity is out of state and I'm not sure what the legal ramifications would be. So yeah, roughly speaking it looks like $1,000 will be extracted from each California resident.

Will that figure keep going up? The big debate going on now in California deals with whether the proposed 40 percent rate hike will be enough. What do you think?

It probably won't be enough. But it's the right thing to do. What else can you do when you're stuck? What can you do if you have no help from Washington? The answer is that you can raise consumer prices to encourage people to use less electricity, which reduces the demand for wholesale electricity, and therefore drives down wholesale prices. The virtue of a rate hike is not just that it reduces the subsidy that has to come out of the state budget but that it also probably reduces the prices that the state has to pay.

This gets back to your elasticity comment: Does demand become elastic when prices increase by 40 percent or more?

There's some elasticity. The ideal thing -- and I don't know when they're going to get around to it -- would be time-of-day pricing, real-time pricing. There's probably quite a lot of ability to substitute things around, to put off heavy power-using activities until the middle of the night. This is a situation that fluctuates minute by minute. The story I wrote about generators having an incentive to restrict output -- well, that only works when the system is very close to capacity. Otherwise, if you try to restrict your output, some other generator who has spare capacity is going to say, "Now I have the opportunity to produce some more."

But in order set these prices within real time, and in order to set a cap on wholesale prices, someone would have to simulate the market -- determine what a fair market price should be. Isn't that a dangerous bit of power to give someone or some entity? How is it even possible to simulate a market?

Well, you could do the real-time pricing just by having the actual price paid by users reflect the actual wholesale price at that moment, through a formula. I'm not an expert in this but I know it's being discussed extensively. In fact, I just got a report from the New York state ISO [independent service operator] that goes on at some length about the need for real-time pricing. They know about this stuff, and they're quite obviously very nervous. A hot summer in New York could look a lot like California.

Then it's possible that there's a silver lining in all of this. The California crisis could transform the way we all pay for electricity, across the country? It could make the market more efficient?

I guess so. I suspect, in the long run, if we are going to have deregulated electricity, we're probably going to end up concluding that we need to have something like real-time pricing as a way to limit market power.

Of course, that would seem to be a long way off. Switching gears a bit, it looks like we may be headed into a recession. You've come out and publicly criticized Alan Greenspan for not doing enough to stimulate growth. Where is "the bottom"? Are we there yet?

Wouldn't we all like to know. That's what we're looking for, right?

But do you think we're in danger of falling into a lengthy Japan-like recession? Do you think we could use another rate cut, of say a half-point or whole point?

I've been saying that the rate cuts are inadequate. But I'm not 100 percent sure that they are. I'm just more nervous than the Fed is. But you can see the positive effects of the rate cuts already. It's clear that housing is doing better than it would have been doing without the rate cuts. It's clear that people are getting substantial money in their pocket by refinancing their mortgages. Another full point would be a lot, and even then we have room for more. So a Japan scenario is possible -- but it's not likely.

Damien Cave

Damien Cave is an associate editor at Rolling Stone and a contributing writer at Salon.

MORE FROM Damien Cave

Related Topics ------------------------------------------

China Energy Paul Krugman U.s. Economy