Babysitting story reveals path to economic recovery
About 150 congressional staffers in Washington,DC created a babysitting club. No money was used. Members were paid in coupons for babysitting. Each member of the club was initially issued a set number of babysitting coupons. When a couple ran low on coupons, they did more babysitting. When they had excess coupons, they just used them to spend more nights going out on the town.
This story was first told by Joan and Richard Sweeney in the Journal of Money, Credit and Banking in their 1977 article entitled: “Monetary Theory and the Great Capitol Hill Baby Sitting Co-op Crisis,” and recounted by Paul Krugman in his new 2012 book End This Depression Now!
The babysitting club worked just fine – at first. But as time went on members began to accumulate extra coupons. Perhaps they wanted a reserve in case of a family emergency. More and more members offered to babysit, but fewer and fewer members were willing to give up their precious coupons for a night on the town. The club began to experience a severe period of babysitter unemployment, and members were spending a lot less time rewarding themselves with a night out.
Finally some wise members of the club realized the problem. They were experiencing a liquidity crisis. The amount of coupon currency was not sufficient to sustain an optimal level of babysitting activity. The problem was solved by issuing additional coupons to each member. Demand for babysitting was restored, and members went back to enjoying more nights on the town.
Of course, if the club had issued too many coupons, the opposite problem would have occurred, where everyone wants to go out and nobody is available to babysit. Conservative economist Milton Friedman recognized this problem and suggested an automatic expansion of the money supply each year to keep pace with the full-employment capacity of the economy. He noted that too much money in circulation leads to inflation while too little causes unemployment.
Today the Federal Reserve controls the money supply. However, unlike the babysitting club, the Fed cannot issue money directly to individual citizens. The Fed can only supply more money through the money markets. It generally does this by buying U.S. Treasury bonds from banks and businesses, thereby releasing more money, causing interest rates to fall.
Money in the economy is like blood in your body. You want to keep your blood pressure low (avoid inflation), but make sure you have enough blood in your system to get to all parts of your body. Sometimes, as in congestive heart failure, the blood accumulates in some areas (banks and large corporations), while bypassing others. Sometimes a blockage leads to a stroke, as some part of your body (the middle class) doesn’t get enough blood.
Fortunately, our economy was automatic stabilizers. When the economy slips into a recession, the amount of tax taken from individuals automatically declines as their incomes decline, and federal assistance programs such as unemployment insurance and food stamps kick in to keep demand from falling too abruptly. Ordinarily, this is sufficient to keep the economy from spiraling downward and give it time to recover.
When times are good and the economy is booming the automatic stabilizers adjust to produce a surplus in the federal budget. This excess money can then be used toward paying down the national debt. This is exactly what happened during the Clinton administration when both new tax cuts and new spending initiatives were blocked, resulting in a budget surplus.
This was good because, when the economy is booming and unemployment is minimal, it is a big mistake to spend more or tax less to expand demand further. Adding excess demand in boom times just leads to house price inflation and other forms of inflation that create bubbles in our economy that inevitably burst.
On the other hand, when the economy falls into a recession, the key issue is timing. In a perfectly functioning economy house prices and wages would fall very quickly. If people were only motivated by money, the economy would adjust quickly. Unfortunately banks and people are often motivated more by their pride and reluctance to accept reality. Second only to survival, the primary motive in life is to feel good about yourself. No one wants to accept the idea that they are a loser. No one wants to accept a pay cut or a significant drop in the value of their home.
Banks dragged things out with foreclosure proceedings where they ended up worse off than if they had just renegotiated the loan and accepted a smaller loss than the bigger losses they ended up with. Workers would have been better off immediately accepting a much lower wage or much longer working hours than ending up with no job at all.
Other human emotions like greed and fear produce what behavioral economists call predictable irrationality. Recessions used to be called “panics” because people would rush to the bank to withdraw all their money. The Federal Deposit Insurance Corporation (FDIC) was created to reduce or eliminate this extreme response with a federal guarantee of your bank deposits. In addition the federal government’s automatic stabilizers kick in to mitigate economic disruptions, similar to a doctor providing medicine to help you fight the flu.
The famous British economist John Maynard Keynes understood this. He agreed that in the long run prices would eventually adjust, but it could take many years. He noted that in the long run we are all dead. He called on government to aid in the transition toward a new, more sustainable market equilibrium. Keynes’ plan allows for the fact that wages (and home prices) are sticky downwards and calls on government to temporarily take up the slack in demand.
In our current economic crisis, the Fed’s monetary policy has been insufficient to restore adequate demand to the economy. This is due not just to the fact that the Fed cannot give money directly to middle-class households to increase demand, but also because the Fed cannot drive interest rates below zero. Since people would rather keep their money under their mattress or in a safe deposit box than have to pay a bank to hold their money, a negative interest rate just doesn’t work.
The zero interest rate constraint creates what economists call a liquidity trap. Since the Fed cannot require banks to loan out their money or businesses to invest their money in new plant and equipment, monetary policy is like pushing on a string. Tightening the money supply and raising interest rates in boom times is relatively easy, but money gets trapped in a liquidity pool in banks and large corporations when interest rates reach zero. Consequently, the Fed can only go so far in stimulating the economy.
Ordinarily, fiscal policy could pick up the slack. The stimulus program that was passed in February 2009 attempted to do just that, but it was insufficient. Not enough money made its way to the middle class to adequately restore demand for goods and services. The iv injection of blood (money) into the patient (the economy) was inadequate. The patient needs more blood, but the doctors are too busy quibbling over where to inject it.
At this point, the problem is the stalemate in Congress. Our only hope now is to identify members who have contributed to this morass and remove them in the next election. Only then can we inject enough blood to get this patient moving again.
Larry’s commentaries can be found via Twitter under NDProfMarsh.
George Hunsucker
Northland
8 months, 2 weeks agoThe patient is burdened with too much government spending and regulations. The keynesian BS was tried in the Great Depression and did not work and then tried again with the porkulus bill and all the libs, led by Krugman, can say is “it wasn’t enough”. Well, you libs controlled govt. then, so whose fault is it???
When the economy starts to recover under President Romney, we will have a serious bout of inflation due to Bernacke’s monetization of debt exercise. I cannot believe he is even hinting at a third round of this BS, but he, like other overpaid libs, wants to keep his cushy job.
Luckily under President Romney, gosh that has a nice sound, he will have no chance of being reappointed. He, like the big 0, has not done his job and we are going to have to “let him go” too…
Steven Fetter
66223
8 months, 2 weeks agoThe babysitting analogy is flawed. Two parties negotiate to provide a negotiated service. All good.
Now a “wise member” steps in and upsets the arrangement. If both sides concur, OK. However, this “wise member” provided a service with no fee (tax) attached. No demands were made as to the age of the sitter, the gender, the hours, the condition of the house, the type of food to serve, etc, etc, etc. ” Eventually, the governing authority will inflate the price of babysitting, ultimately effecting the number of nights out and the pool of babysitters.
One thought on housing. If we really wanted to help the poor and those just starting out, we would encourage foreclosures. Allowing housing prices to fall would reduce the main expenditure that any person incurs each month, either as a renter or an owner. Painful for those that bought homes at artificially high prices but beneficial for all in the long run.
JR Beillenhouser
8 months, 2 weeks agoKeynesian economics don’t work. But I can’t blame him, the issue is that in good times, governments are supposed to save for bad time. Also, I’m sure he didn’t expect a government to be in debt 16 trillion dollars.
We would have been better to just let the market correct itself like Reagan in the early 80s. We’d be done with this.
That’s why Obama has to go. You can Obama me once, but you can’t Obama me twice. The only thing he thinks will work is more stimulus and that is exactly what will just continue the slow growth.
Just wait until inflation hits. You can’t artificially keep it down like the Federal Reserve has been doing forever. An actually that would be a good thing, because it would force people to save more. That is exactly the type of policy we should have been pursuing.
Lawrence C. Marsh
Kansas City
8 months, 2 weeks agoIn the past economists thought that everyone acted rationally to maximize their well-being (utility) in a cold, calculating manner with perfect information and foresight. We used to think this way, but experiments in behavioral economics and functional MRI scanning by neuroeconomists have given us a much better understanding about how people actually behave. The old way of thinking assumed that everyone was a Dick Cheney or Vladimir Putin who approached the world with a strictly “I win, you lose” perspective. We now understand people’s behavior to be much more complicated than that. Many people take a more “win-win” approach to life and often set aside their own advantage to help others or otherwise accommodate social norms. The old “I win, you lose” model of economics has been found to not work as well as one that also takes account of people’s “win-win” behavior. For example, consider the congressional staffers and their babysitting arrangements. Since there are more babysitters than kids needing sitters, each kid’s parents could bid the value of a coupon down by offering fewer coupons for the same amount of time. This sounds reasonable in theory, but in reality it turns out to be awkward and seem to be too unappreciative and anti-social to work out in practice. Just distributing more coupons solves the problem much more quickly and without all the angst. In a similar manner during a recession each worker could swallow their pride and offer to work longer hours for a lower wage. Once the wage bill is lower, employers find that they need to lower their prices to restore pre-recession demand for their products. But lowering wages and prices is equivalent to increasing the money supply. Why not just increase the money supply to begin with and solve the problem right away instead of torturing everyone by dragging it out? This is the difference between microeconomics and macroeconomics. It is also the difference between what only works in theory and what is needed to actually solve the problem efficiently in practice. President Obama presented an extensive job plan to get us out of this recession, but so far the leadership of the House of Representatives have blocked it from even being brought up for a vote. Voters need to get rid of congressmen and congresswomen who refuse to work together to solve our problems, and stop trying to follow old theories that do not work well in practice. The people are living in the “win-win” world, while the Congress is still mired in the “I win, you lose” one.
Lawrence C. Marsh
Kansas City
8 months, 2 weeks agoThat sentence in my comment above should read:
“Since there are more babysitters than kids needing sitters, each kid’s parents could bid the value of a coupon up, which is equivalent to driving the wage rate down, by offering fewer coupons for the same amount of time (or, equivalently, more time for the same amount of coupons).”
JR Beillenhouser
8 months, 2 weeks agoYou been shopping lately Lawrence? See the food prices going up?
Additionally, the money supply has been increased…alot. How much more do you need?
Kent Mueller
8 months, 2 weeks agoLawrence, first of all, why would you call Friedman conservative without calling Krugman liberal?
Also, why would you say government debt was paid down during the Clinton Administration, when it wasn’t. Federal government debt rose every year.
And why assume Keynes was right? He wasn’t If Keynes was right, then unemployment would have gone below 14% before the war. Also, Keynes humiliated himself when he predicted economic chaos following WWII. He missed that one 180 degrees.
Obviously, you have take a few econ courses. So have I. Evidently, you missed F.A. Hayek.
Kent Mueller
8 months, 2 weeks agoStill haven’t heard why Lawrence would label Friedman as a conservative economist, but leave Krugman simply as an economist.
George Hunsucker
Northland
8 months, 2 weeks agoDid you seriously expect an answer Kent?????
Kent Mueller
8 months, 2 weeks agoGeorge, if Lawrence is serious, then yes I do expect an answer.