Babysitting story reveals path to economic recovery
The Kansas City Star
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.