If one leaves out a fringe group of diehard Marxists and Socialists, there are two types of mainstream economists in the world today: the first group is the free market radicals, who believe that unfeterred lassiez faire is the best economic system. Even regulation ought to be minimal because markets self-correct. This group of economists, with Milton Friedman as its intellectual guru, has dominated policy thinking in the Anglo-Saxon world for much of the last three decades. It has also dominated the thinking of multilateral institutions like the IMF for much of the period, thus influencing policy in developing countries. Not surprisingly this group has cornered a comfortable majority of Nobel Prizes over the last three decades.

There is a second group of mainstream economists who also believe in the good of free market capitalism but who are acutely aware of the possibility of market failure and the need for government intervention when that failure occurs. John Maynard Keynes was perhaps the leader of this pack, which usually catches the public eye?and the eye of the Nobel Prize jury during crises in capitalism. Paul Krugman becomes the latest of these left-of-centre economists to win a Nobel in troubled times for work he did a couple of decades ago. Remember also, how Amartya Sen (known for his work on famine and poverty, not the virtues of unfettered free markets) won the prize in 1998 in the aftermath of the Asian financial crisis and how Joseph Stiglitz, Michael Spence and George Akerlof won the prize in 2001, for their work on market failure in the presence of asymmetric information, just after the dotcom bust.

Paul Krugman won the 2008 Nobel Prize primarily for his work on new trade theory. The new theory modified the old trade theories by relaxing the assumption of constant returns to scale in production (in a perfect market) and incorporating the idea of the existence of increasing returns to scale (in an imperfectly competitive market). New trade theory backed by the rigour of mathematical modeling laid a new foundation for the possibility of government intervention in trade?if economies of scale exist it would be impossible for a newcomer to challenge an existing firm without subsidy or government protection. Yet, it may be necessary to facilitate entry of new firms in the interest of competition: monopoly is a failure of competitive markets.

Krugman did not become a protectionist on trade after he developed this theory. In fact, he qualified the theory by pointing out the serious problems one was likely to face in actually picking which industry needed government help. He also said that real world political economy would probably lead to inefficient intervention. So, free trade was still best, but no longer because old trade theory said as much. Still, his research like that of Sen and Stiglitz, made him instinctively suspicious of the concept of self-correcting free market equilibrium at any point in time. He remained open to the idea of regulation and other forms of government intervention in the market economy.

Krugman?s more recent research has been on currency crises and he was a keen observer of the East Asian financial crisis as well crises in Russia, Brazil and Argentina in the late 1990s. He warned of the dangers of excess foreign debt financed by often fickle capital inflows which were a feature of countries which first went through a banking crisis and then a severe currency crisis. The collapse of the currency worsened the debt crisis in each case as firms had borrowed in foreign currency but held their debt in local currency which lost a lot of value. He stuck his neck out by supporting unpopular (with foreign investors) capital controls imposed by Malaysia and praised Hong Kong?s monetary authorities for taking the fight to, and ultimately defeating hedge funds which were speculating on the HK dollar. For orthodox economists, the level of intervention was unbearable but Hong Kong and Malaysia arguably took less damage than their East Asian peers.

In the context of the current financial crisis in the US, Krugman drew on his understanding of earlier financial crises from the 1990s to send out a dire warning for the US. In his more popular avatar as a New York Times columnist he wrote of a serious crisis coming America?s way in January this year. Controversial at the time, he warned of the dangers of a financial system which had gone ?wild? and was well beyond the competence of existing regulation. He, in fact, suggested that the US financial markets had allocated capital as badly as those in some other emerging economy crisis countries?into a real estate bubble that was going to burst badly. The only reason the US would not go say Argentina?s way was because its debts were in its own currency, which is also the reserve currency of the world economy. But the pain would be bad nevertheless. In October, one can see he was dead right. The other point he has raised, and which is important, is the unsustainability of living in excess debt financed by foreigners. This must be a key lesson for the US and other countries.

In his most recent op-ed piece, Paul Krugman praised Gordon Brown?s rescue plan for the UK, which recapitalises banks through part-nationalisation. At the same time, he criticised Hank Paulson for hesitating to do the same because of his ideology. Paulson has now come around to the Brown-Krugman view. Perhaps the world of economics and policy should also come around to the view that while capitalism (with liberal trade and liberal finance) is the best system we have, it is not perfect. At the same time, while the government has a role in regulation and now rescue, it is far from perfect—in fact, as we well know in India, goverment is capable of inflicting a lot of harm. To his credit Krugman has been better than a lot of others in spotting the workable middle ground in economics. Just for that, even if one disagrees with him, he deserves much praise.

dhiraj.nayyar@expressindia.com