Paul Krugman sings the babysitting blues

In response to the assertion that increasing the money supply cannot benefit the economy, Andrew Chamberlain points an article by Paul Krugman about a babysitting co-op that seems to indicate the increasing the money supply can indeed benefit the economy. I encourage everyone to read the babysitting.jpgoriginal article from Slate on Krugman's website rather than take my word for what it says as it is always fruitful to read the original source to get a true understanding of any argument prior to reading criticism of it.

Krugman's Slate article retells a story originally published in an article called "Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis" in the Journal of Money, Credit, and Banking in 1978. As far as I can tell, this is the original article, although if it is, it differs greatly from the description given by Krugman, to the point of bordering on intellectual dishonesty by Krugman. Again, I encourage everyone to read the original article by the Sweeneys.

The story is of the Capitol Hill Babysitting Co-op, a group of couples with children in the Washington, DC area formed for the provision of babysitting services. The co-op was composed of about 150 couples and used its own currency scrip to ensure that each couple did its own "fair share" of babysitting. A couple would receive a scrip coupon for each hour of babysitting. (In the original article by the Sweeneys, the exchange rate was half-hour per coupon, but Krugman gave a value of 1 hour in his retelling, and that is what will be used in this essay for simplicity's sake.) If the Smiths babysat for the Joneses for 3 hours, the Joneses would give the Smiths 3 coupons that could be used to exchange for the babysitting of their own kids. If the Browns babysat for the Smiths for 2 hours, the Smiths would give the Browns 2 coupons which they could exchange for the babysitting of their kids. In short, a fiat currency was circulated for the purposes of exchange of a single economic good - babysitting. The price of babysitting was constitutionally pegged at 1 coupon/hour.

However, Krugman states, the system ran into trouble. As he describes it, couples would try to accumulate coupons to save up for the times when they would be in need of someone to babysit their kids. However, the other couples were in the same situation, and in order to save coupons, someone else on the other end would have to be willing to part with their own coupons by hiring babysitting services. Yet, if every couple is trying to save up coupons, the system bogs down and no exchanges take place. This is what happened and, as Krugman describes, "the co-op had fallen into a recession." The solution to the problem was the issuing of more coupons, which resulted in the couples becoming more willing to babysit, and the exchanges flowed forth once more.

Krugman places a high importance on this story. As he states,

Twenty years ago I read a story that changed my life. I think about that story often; it helps me to stay calm in the face of crisis, to remain hopeful in times of depression, and to resist the pull of fatalism and pessimism. [...]

Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking. And so, as I said, the co-op's story helps me to resist the pull of fatalism and pessimism.

These conclusions do seem to point to the notion that simple 'technical' problems with the economy can be solved by clear thinking intervention. If I was Paul Krugman, I too would take solace in the ability of economists to wash away dispondency and discontent. But I am not Paul Krugman.

Let's examine a basic assumption here. Is the exchange of one coupon for one hour of babysitting a free exchange? On the surface it appears to be. After all, the couples trade coupons for babysitting services voluntarily. However, truly free exchanges occur when both sides are free to exchange their goods on whatever terms they mutually agree upon. Suppose that the Smiths wanted to babysit for the Joneses for 1 hour in exchange for 2 coupons (rather than 1 coupon). Were the Smiths and Joneses allowed to carry out this exchange? No. Each coupon had to be exchanged for 1 hour of babysitting per the bylaws of the charter. That is what is known as a price cap. The price of babysitting was not allowed to rise to 2 coupons/hour. Just as the inevitable result of price caps on gasoline is a shortage of gasoline, the result of the price caps on babysitting coupons in times of high demand is a shortage of babysitting. Similarly, in times of low demand, there would be a surplus of babysitting.

Consider the case of an occasion when most of the couples desire babysitting services. Perhaps they want to attend the State of the Union address. In the described setup, most couples are going to be left without babysitting services, largely independent of how many coupons each couple holds.

However, if the price of each coupon is allowed to fluctuate, those who most urgently desire babysitting services will obtain them. Perhaps a price of 5 coupons/hour or perhaps even as high as 10 coupons/hour would be enough to convince some couples to stay and babysit for other couples rather than attend the State of the Union address. The problem with the babysitting co-op was that a single economic good ? babysitting ? was allowed to be exchanged at only a single price ? one coupon/hour. Or more precisely, one hour of present babysitting was allowed to be exchanged only for one hour of future babysitting.

The obvious observation one can make is that not all hours of babysitting are valued equally. One hour of babysitting tonight is not going to be valued the same as one hour of babysitting Saturday night is not going to be valued the same as one hour of babysitting during the State of the Union address. Free market prices are a voluntary rationing mechanism that allocate resources where they are most urgently desired. Without free market prices, potentially mutually beneficial voluntary exchanges are stifled, resulting in surpluses and shortages as the market is not allowed to clear. The babysitting co-op became sluggish not because it lacked coupons but rather because it lacked market prices.

Krugman was right when he says that the problem with the co-op was not inefficient babysitters or inherent values of the members, but he is wrong when he says that the problem was too few coupons. The real problem was top-down price controls. Allowing truly free exchanges would have resulted in the emergence of a market-clearing exchange rate.

The example badly misses the fundamental point that at its root, money is simply a medium of exchange. When the baker exchanges his bread for $5 and subsequently exchanges that $5 for candles from the chandler, in essence, the baker has exchanged his bread for candles. Producers pay each other by exchanging their produce with each other. In a complex economy, money simply enables these kinds of exchanges to an exponentially greater level than in a barter economy. But money itself is not a means of payment; produce is. Money only makes the payment possible.

In a true free market economy, the price of money is subject to the laws of supply and demand like any other good. Its exchange value will rise and fall with changing preferences of individuals to hold money. Consequently, there cannot be ?too much? or ?too little? money as long as the market is allowed to clear. Inflation of the money supply cannot end recessions or benefit the economy in any way in the ?long run? or the ?short run?. It simply benefits those who have access to the new money first, consumes capital, results in a misallocation of resources, destroys savings, and shrinks the real pool of funding.

Rather than showing the benefits of money supply inflation, the babysitting co-op story illustrates the meaninglessness of the promises behind both fiat currency and price fixing. It is unfortunate that Krugman places such high importance on this story from which he makes profoundly incorrect conclusions.

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Glad you liked the Krugman

Glad you liked the Krugman story. It's a fun piece. I may disagree with his politics, but there's a reason he's on the short list for future Nobels.

One point: You mention price changes should've eliminated the co-op "recession". You're right. But only if we assume perfectly flexible prices and wages. There's lots of empirical evidence against that.

In the co-op case, prices should've *fallen* -- since money was relatively scarce -- not risen, as you write. This is an important point. In the actual economy, prices and wages tend to be sticky in the downward direction. This is because contracts, menu costs, and other psychological factors tend to keep prices fixed in the short run. That means what happened in the co-op can easily happen to a larger economy, when prices can fall easily. That's why the co-op story is an instructive metaphor.

I appreciate your skepticism of using monetary policy to "fine tune" the economy. That is bad policy. But even in a free banking system it probably makes sense to increase the money supply in proportion to the growth in economic activity, just to keep prices relatively stable. I mean, can you imagine the US economy functioning today with the same amount of currency that circulated in 1789? At some point, prices would approach zero, and the currency would cease to be useful as an indicator of relative prices.

Or we'd just be in perpetual recession. Like Japan maybe.

Excellent, challenging post,

Excellent, challenging post, Jonathan. The Krugman article was one of the first things I read for Intermediate Macro.

But:

"...even in a free banking system it probably makes sense to increase the money supply in proportion to the growth in economic activity, just to keep prices relatively stable."

I have to agree with this. In a growing economy, with a growing population, it only makes sense to increase the money supply in the long run. Here we get into the definition of inflation again, where some would hold that "zero inflation" (that is, no aggregate price increase) can be maintained while increasing the money supply roughly in proportion to the increase in GDP, and others would say that any increase in the money supply is in and of itself inflation.

But what do we mean by increasing the money supply? For example, in the short run, the Fed significantly mucks with the money supply by buying and selling T-bonds, not necessarily by printing and releasing new bills. It does this in response to higher or lower observed "velocity" of money and higher or lower demand for liquidity (won't get into interest rates here).

Most experiments with LETS,

Most experiments with LETS, likewise, end up with hoards of unspent scrip (although it is arguably because of an imbalance in the kinds of producers participating). This is why I prefer the free banking model of William Greene and Benjamin Tucker to time-based currencies (LETS systems) like those of Josiah Warren.

Even a collectivist like Marx understood that his law of value operated THROUGH competition and price fluctuations, causing prices to approximate production costs in the long run. Deliberately tying the currency to labor time destroyed this market mechanism: it was only by such a market mechanism that resources could be channelled to the most efficient producers and most socially desirable products, and the standard of "socially necessary labor" could be adjusted to changes in technology.

Market-oriented Ricardian Socialists like Thomas Hodgskin, and individualist anarchists like Tucker made similar arguments to that of Marx. For labor to get its full product, it was not necessary to tie currency to some artificial labor standard. It was only necessary to make the State stop intervening in the market on behalf of privileged classes of usurers and landlords. The market mechanism itself would cause the price of land to fall to the labor-value of buildings and improvements; and the interest costs of secured "loans" (really a monetization of assets) to fall to the labor cost of administration. The natural tendency in a free market was for the equilibrium price of goods in elastic supply to approximate labor cost, if the State did not set up market entry barriers or enable privileged owners of land and capital to draw monopoly incomes from them. The cause of exploitation was unequal exchange enforced by the State; the solution was free exchange.

There will probably be a place for local LETS systems in a genuine free market society. But they will exist alongside mutual banknotes and other forms of voluntary commodity-based currencies, exchanging with one another on a market basis.

though I don't care much for

though I don't care much for the "socialist viewpoint" they did have one nice criticism of Krugman from his left (which isn't that far, contrary to what some may have you believe.) It says the model is oversimplified because everyone in it has equal status:

"If the co-op analogy is really going to help illuminate capitalist economic relations, it will have to undergo a few changes in order to provide a more accurate model for the system it purports to reflect. For example, we would have to stipulate that a small minority of the co-op members, through some accident of history, controls almost all the coupons. And because of their vast fortune, the members of this minority actually rule the ?co-op? and operate it in their own interests. Other members of the co-op are transformed into mere means to enhance the status of the minority, but they are assured that this system is operating equally in everyone?s interests. Members of the wealthy minority never baby-sit, of course, but enjoy watching the other couples, the vast majority, who are in desperate need of coupons, compete against one another for babysitting positions for the minority. Finally, members of the wealthy minority offer weekly lectures to the other members of the co-op in which they explain in pompous and ponderous tones that the disparity of wealth in the co-op community is entirely a function of each individual?s personal intelligence, industry, and moral fiber."

pretty good, I'd say.

The idea of a fixed price

The idea of a fixed price for babysitting sounds silly even if you consider the simple case of someone with horrible kids.

Someone with true monsters for children might need to beg a potential sitter to sit for a mere coupon per hour. Similarly, parents with super, darling children might find themselves beseiged by babysitters looking for an easy gig.

Fixing the rate at 1 hour per coupon "constitutionally" cannot compel someone to babysit.

This all presumes either a small or knowledgeable group of parents - who know and care which children are pleasant and unpleasant.

People here seem to be

People here seem to be missing the point of the story. It's not that prices weren't high enough to induce people to baby sit. If you actaully read Krugman's piece, it says everyone *wanted* to babysit. The problem was that no had enough reserve scrip to feel comfortable going out at night and spending some on babysitters. People want to have a little reserve pool of cash at any given time -- what economists call your "money demand". The money supply was not large enough to satisfy money demand, and since prices couldn't adjust downward (a totally realistic aspect of the actual economy) everyone wanted to work, yet no one wanted to spend. Which is a recession. People are are missing the monetary nature of the issue here.

The inability of prices to

The inability of prices to adjust downward is a "totally realistic aspect of the real economy"?

Bringing up the computer industry again, one wonders how this view can be maintained. Computer hardware manufacturers have been in an incredibly "deflationary" (price dropping) environment for 20 years on now. The industry seems to be doing quite well despite such a perilous condition...

To Krugman I would counter that situations where prices do not adjust to market realities constitute "social failure" where the market is not developed enough- which, of course, would require restoring market conditions (or removing the barrier to market function). In this particular case, it would be to allow the "price" of a coupon to float, rather than remain fixed.

Andrew, "...People want to

Andrew,

"...People want to have a little reserve pool of cash at any given time -- what economists call your "money demand". The money supply was not large enough to satisfy money demand..."

The demand for money is always a demand for purchasing power to enable the acquisition of future goods and services. As such, an increase in the money supply is a disgusting and deliberate attempt at deceiving people into believing that they have actually accumulated a desired level of said purchasing power when in fact all they have accumulated is a quantity of money with a depreciated and ever-depreciating purchasing power.

Regards, Don

Matt, The socialist

Matt,

The socialist "criticism" isn't any good at all. It doesn't give us any explanation why increasing the money supply is a good or bad idea. Rather, it ignores the relevant question altogether, and instead focuses on a completely unrelated socialist pet-peeve - wealth distribution.

Incidentally, although as I said, this is completely unrelated to this topic, I don't see why wealth must either be earned completely by accident or completely by merit. Why can't it be a combination of both? And even if it is earned completely by accident, so what? Do socialists have a moral argument against lottery winners?

Brian, I think the fact that

Brian,

I think the fact that computer prices have been dropping ever since computers became a consumer good is precisely why "sticky" prices never took hold - people always expected computer prices to drop, so there was never any need to hold them relatively constant. Wages, on the other hand, are expected to increase over time, and certainly not decrease. However, in Japan, wages are less sticky, and workers are much more willing to take a pay cut than in the U.S.

Micha, "...Wages, on the

Micha,

"...Wages, on the other hand, are expected to increase over time, and certainly not decrease. However, in Japan, wages are less sticky, and workers are much more willing to take a pay cut than in the U.S...."

The idea of sticky wages is likely to be largely a statistical myth. For 'sticky wages' to have any significance as a concept, it must be something in addition to the normal tendency of every buyer to want the lowest price and every seller to want the highest price.

The tendency of wages to increase over time is primarily the result of increased productivity. This fact must be controlled for if one is to claim the existence of 'sticky wages'.

While a company sometimes reduces wages across the board instead of implementing layoffs, this is relatively rare. It is more likely to implement selective layoffs, preferentially laying off the lower skilled and lower paid workers, often actually increasing the resulting average wage. This is entirely normal as almost anyone in need of cash will pawn their cubic zirconium rings before their diamond rings.

In times of economic stress, it is likely that laid off workers will only be able to obtain a new job at a reduced wage, if any.

In summary, any statistical study of wages is likely give artificially high results because a study of wages cannot by definition include newly unemployed workers.

Regards, Don

Glad you liked the Krugman

Glad you liked the Krugman story. It's a fun piece. I may disagree with his politics, but there's a reason he's on the short list for future Nobels.

That may be true, but Nobel prizes don't help in meeting the barometer of the person whose opinion matters most to me.

In the co-op case, prices should've *fallen* -- since money was relatively scarce -- not risen, as you write.

Actually, what I wrote was...

Just as the inevitable result of price caps on gasoline is a shortage of gasoline, the result of the price caps on babysitting coupons in times of high demand was a shortage of babysitting. Similarly, in times of low demand, there would be a surplus of babysitting.

...followed by a hypothetical example of a period of high demand.

But even in a free banking system it probably makes sense to increase the money supply in proportion to the growth in economic activity, just to keep prices relatively stable. I mean, can you imagine the US economy functioning today with the same amount of currency that circulated in 1789? At some point, prices would approach zero, and the currency would cease to be useful as an indicator of relative prices.

Free banking does not preclude new money being brought into circulation.

People here seem to be

People here seem to be missing the point of the story. It's not that prices weren't high enough to induce people to baby sit. If you actaully read Krugman's piece, it says everyone *wanted* to babysit. The problem was that no had enough reserve scrip to feel comfortable going out at night and spending some on babysitters. People want to have a little reserve pool of cash at any given time -- what economists call your "money demand". The money supply was not large enough to satisfy money demand, and since prices couldn't adjust downward (a totally realistic aspect of the actual economy) everyone wanted to work, yet no one wanted to spend. Which is a recession. People are are missing the monetary nature of the issue here.

I have read your explanation above, along with Krugman's piece, and the original article, and I have yet to find a satisfactory monetary explanation for the 'malaise'. From the original Sweeneys article:

In the previously mentioned bad old days, according to long-time members, there was a shortage of scrip. There was so little scrip to go around that holders were reluctant to squander it by going out. Those who wanted to go out but didn?t have scrip were desperate to get sitting jobs. The scrip-price of baby sitting couldn?t adjust, and the shortage worsened.

If I am a holder of scrip and want babysitting services but also want to keep a reserve pool of scrip available for future purchases, then I will look for babysitters who offer a lower price, so that after I pay them for their services, I will still have scrip leftover.

Similarly, if I do not hold scrip and am desperate to get a babysitting job in order to obtain scrip, I offer to work for a lower 'wage'.

With price fixing, a market clearing rate was not able to be reached.

Giving everyone 10 more coupons may have created the impression amongst the couples that they now had a greater reserve pool of scrip for future purchases of babysitting, but this was again largely due to the fixed pricing framework of the co-op which did not allow prices to rise in response. In the 'real world', a similar increase (perhaps by a stuffing everyone's wallet with an extra $10 bill) would not have increased anyone's purchasing power.

You would counter by pointing out the 'sticky wages' as analogous to a government mandated price floor. I would respond by saying that the two ideas are worlds apart. The Sweeneys article was based on an artificial setup that created a monetary 'problem' through price-fixing and fiat currency. They created a 'shortage' of scrip, to which they responded with 'too much' scrip, and then tried to calculate the ideal 'turnover rate' at which to increase the supply of scrip, etc. The entire exercise is based on artificial constraints imposed on the co-op by its constitution.

I'm ore familiar with

I'm ore familiar with economic history than economics, but intuitively I think Andrew has a good point. It doesn't seem that making the prices more flexible is neccesarily a substitute for increasing the money supply. Some couples may value sunday afternoons at 5 coupons, but if there are only nine coupons they will have a difficult time procuring enough to get sunday afternoons off.

It doesn't give us any explanation why increasing the money supply is a good or bad idea. Rather, it ignores the relevant question altogether, and instead focuses on a completely unrelated socialist pet-peeve - wealth distribution.
well, the point is that the model is innaccurate. The problem clearly isn't wealth distribution, in and of itself, but the differences in relative power that result.

Well, all models are

Well, all models are inaccurate - that's why they are called models. They must necessarily ignore the irrelevant or less relevant in order to focus on the important. Now, you could certainly argue that wealth distribution or differences in relative power are so important in this situation that they should be included. But you haven't made that argument. You haven't explained why these inequalities should matter when discussing the money supply.

What about the fact that

What about the fact that there was no way to make small change in the system-- i.e. to use fractions of coupons in payment?

It seems to me that this might be a significant barrier to prices reaching an equilibrium level, especially if the desired direction of movement is downward, i.e. if you want to be able to buy an hour of babysitting for less than one coupon.

By analogy, imagine if the smallest unit of cash available to us was a $5 bill (or even a $1 bill); that would surely induce some serious distortions in the economy.

I thought the socialist

I thought the socialist viewpoint model was sort of funny. It would certainly seem to affect the model drastically though: you'd have to target your "demand stimulus" at the wealthy coupon-holders, because they're sitting on all the coupons. Or you could redistribute wealth or institute a markedly progressive tax on coupons (which would be a tax on inactive capital, basically.)