Nursery Tales

babyPaul Krugman, not for the first time, invokes the Great Capitol Hill Baby Sitting Co-Op Crisis as a metaphor for the macroeconomy.

First things first: Krugman is absolutely right that we learn a lot from well-chosen simple examples. But this particularly example seems poorly chosen.

The Capitol Hill Baby-Sitting Co-Op consisted of about 150 couples who baby sat for each other. They paid each other in scrip — pieces of paper each worth a half hour of baby-sitting time. New members received 20 units of scrip, which they were expected to pay back upon retiring. Aside from that, you earned scrip by baby-sitting, and you purchased baby-sitting with scrip, so that in the long run you’d sit exactly as much as you were sat for.

The problem was that people started hoarding scrip, thinking they might need it someday. As a result, the demand for babysitting services dried up. This made it harder to earn scrip, which encouraged even more hoarding, and so on around the vicious circle. The solution was to issue more scrip — each member got 10 more units. This made the hoarders a little less frantic and a little more willing to go out, which meant more sitting jobs were available, which eased the hoarder’s minds still further, and soon the co-op entered a golden age.

That, says Krugman, is the story of most recessions. People hoard money, which makes it hard to earn money, which makes people hoard still more money, which makes it even harder to earn money. The solution is to issue more money.

But here’s the part of the baby-sitting story that never made sense to me: Why didn’t prices adjust? If everyone’s hoarding scrip, and nobody can find a baby-sitting job, why doesn’t someone offer to babysit for half the usual amount of scrip? Why isn’t that enough to get things moving again?

Presumably the babysitting co-op enforced (implicitly or explicitly) some social norms that discouraged such behavior. The rules said that a unit of scrip was worth a half hour of babysitting time, and to trade at some other rate was to violate the rules. But there are no such rules in the macro-economy. If Dell can’t sell enough computers, and responds by lowering its prices, nobody yells that Dell broke the rules.

So Krugman’s favorite story about recessions — the one that he says “changed his life” — is really just a story about babysitting co-ops, unless it’s supplemented with some other story about what keeps real-world prices from falling. Until he tells us what that supplemental story is, Krugman’s got nothing.

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62 Responses to “Nursery Tales”


  1. 1 1 Mike H

    To what extent is it relevant that wages don’t adjust downwards as easily as other commodities?

  2. 2 2 Morten

    @Mike H
    Absolutely crucial. But I guess Steven never heard about sticky wages.

  3. 3 3 Mike H

    I just noticed that Krugman specifically mentions the possibility of changing the value of scrip in his ‘sidebar’ : http://www.slate.com/id/1937/sidebar/42410/ although he is talking about the stimulatory effect of inflation as a solution for when interest rates hit 0% and can’t go down, not about the possibility of floating the scrip.

  4. 4 4 JLA

    “I guess Steven never heard about sticky wages.”

    All he is saying is that people should justify the assumptions they make in their models if they want to tell a story that’s relevant to the real world.

  5. 5 5 T.Bot.

    Dammit it all, Landsburg, how do you so consistently manage to find a unique, insightful and elegant way to explain flaws in economic reasoning?

    The price mechanism is *exactly* what’s missing from the co-op example, and I didn’t spot it.

    My one suggestion? You’re a smart man with so much insight to offer. When you write a post critiquing anything by Krugman, the tone does seem to drift in to ad hominem- it can be a little off putting at times.

    As long time reader, my only suggestion would be to re-write your Krugman pieces after you draft them to take off that hint of personal attack. Your economic analysis stands on its own two feet without the vitriol- which is, I think you’ve said, the reason you got into this game in the first place.

    Thanks for all the philosophical laughing.

  6. 6 6 AC

    I don’t think Krugman ever even mentions the possibility of price changes in his telling of it. He could argue about “sticky prices” but without doing that I always thought this favorite story of his was not only useless but misleading.

  7. 7 7 GV

    I’m wondering why the coupons were locked into 30 minutes. If I go out and leave the kids with you for 59 minutes, do I give you 2 coupons or 1? How about if I go out for 31 minutes? This system would have been more efficient if the coupons were worth the exact length of time babysat.

    I wonder how many people stayed at that date an extra 15 minutes to use up their full one hour, or rushed to be back to pick up their kids so they didn’t have to issue an extra scrip.

  8. 8 8 Harold

    I suppose the lesson is simpler than you suppose. It is possible, in a simple system mediated by promisory notes to run into “recession”. This can be helped by increasing the supply of the notes, even though the underlying level of needs are not changed. This is a fundamental “proof of concept”. I can see how this could be someones “eureka!” moment. Now, in a more complex system, there are other considerations which may negate this effect. If there were no stickiness, then the effect may disapear altogether. One must be very careful when applying this to the wider economy. Still a valuable lesson, but possibly not quite as much as Krugman supposes.

    The whole scheme looks a bit odd to me. The “expenses” seem quite large compared to what I would have assumed the average use. Maybe these folk just get out a lot more than I do, but to “pay” yearly dues of 14 hours seems a bit excessive. For the benefit of having someone match up sitters to revelers, these people are paying 14 hours? At their pay rates that would be quite a hefty fee. And since the whole point of scrip to move away from a bookkeeping method of control, there does not seem to be a need for it. If the expenses of the system are so large, it is not surprising it ran into trouble.

  9. 9 9 Thomas Bayes

    This seems like an important quote from Krugman:
    “Eventually, of course, the co-op issued too much scrip, leading to different problems …”

    I agree that this is an interesting example, but, because the system is so constrained, I don’t understand how this “is a story that could save the world.” How, for instance, could we use this toy economy to tell the story of comparative advantage?

    Then again, I’m not an economist, so what the heck do I know?

  10. 10 10 Keshav Srinivasan

    Krugman has on many occasions answered why he thinks deflation can’t get us out of a recession. The sticky price he’s most worried about is not wages, but something even stickier: debt. The price of repaying a debt is fixed in a contract, which specifies exactly how much interest you have to pay. It is very hard to make it go down, even if all other prices are falling.

    Because debtors have a fixed nominal cost they have to pay every month, they don’t have that much money to spend, so they won’t contribute much to demand. It’s true that every dollar they pay in debt payments goes to the pockets of creditors, but Krugman argues that creditors are more likely to save their money rather than spend it, since they have a lower marginal propensity to consume.

    But he doesn’t think this is an insolvable problem. In fact, he (and others) have proposed several possible solutions. You can do a massive bailout of debtors, you can give them an easy and painless way to either default on their loans or declare bankruptcy, or you can encourage (or force) creditors to renogotiate loans. All these schemes have one thing in common: they let the debtor off the hook, so they will encourage people to borrow irresponsibly in the future. For this reason Krugman believes that such policies will be too politically difficult to implement, and so he doesn’t consider deflation as a viable strategy.

  11. 11 11 Daniel Hewitt

    Good post Steve.

    The babysitting co-op example fails on so many levels. More often than not, parents do not swap babysitting services with other parents, but choose to exhange with someone who values the money received more than the time consumed. A teenager, for instance, values the $30 (or whatever is negotiated) more than the 3 hours of lost leisure time. For parents, it’s the opposite. The exchange is therefore mutually beneficial.

    In Krugman’s coop, when parents exchange with other parents, they are exchanging…..an evening of their time for an evening of their time! Where is the mutual benefit? Add in the time consumed for the buyer and seller to locate each other and it’s a net loss.

  12. 12 12 GV

    Daniel: I would say that you’re not exactly correct. If you’re staying in for the night with your kids why not take on the extra kid for a few hours? Would you value the opportunity to have those few hours to yourself next week more than how bad it hurts to watch Sally’s kids and your kids for the night if you were staying in anyways?

  13. 13 13 Manfred

    T.Bot.:”You’re a smart man with so much insight to offer. When you write a post critiquing anything by Krugman, the tone does seem to drift in to ad hominem- it can be a little off putting at times.”
    I respectfully disagree.
    Landsburg strikes the right tone with Krugman. Why? Because Krugman is no dummy, he is a PhD from MIT, worked under the most renowned international economists (Dornbusch and Baghwati), was prof at MIT for many years, got the Nobel in Econ, and is now in Princeton, etc etc, and he should understand these economic issues.
    Krugman deserves a very, very forceful response, even if it can be “a little off putting”. Because nowadays, Krugman is not using his econ knowledge for “the good”, to teach, to edify, to explain good econ reasoning; no, he is using silly econ to be a Keith Olbermann, and this is simply not acceptable from a person with his credentials.

  14. 14 14 Daniel Hewitt

    GV, that is a very good question. And my answer is – sometimes. I prefer the freedom to choose between hiring a babysitter and dropping them off at a friends now to return the favor in the future. I suspect that most other parents feel the same way. Eliminating this choice is another reason why Krugman’s example was poorly chosen. He is essentially removing comparative advantage from his macro-economy.

    Or perhaps it was a wisely chosen example, given the results that he was looking for :)

  15. 15 15 Ken B

    Some people seem to think faling prices are the real problem. Barbers were prosecuted during the New Deal for cutting the cost of haircuts. Food was destroyed to keep prices from falling, quotas were imposed to keep prices from falling. Didn’t Krugman write about “the return of depression economics”? But as Steve notes Krugman exemplifies the return of depression economic fallacies.

  16. 16 16 Harold

    One of the keys to babysitting is that you are not just swapping time at home with time away – you are entrusting your little darlings. Perhaps the people in the coop trust other parents more than teenagers. You are buying trust rather than time. You don’t have enough money to buy the trust on the market, or rather the cost of it is greater than the value of a night out. But you can swap trust in yourself as a parent.

  17. 17 17 The Money Demand Blog

    Karl Smith gives us the answer here:
    http://modeledbehavior.com/2011/01/23/why-fairly-sensible-people-are-worried-about-deflation/

    The answer is that the government is preventing the adjustment of one of the most important prices – the interest rate. If the Fed sets the real interest rate at a wrong level, saving and investment will not be properly coordinated. Krugman fears that the zero rate bound will prevent real interest rates from adjusting to correct levels for a long time, so we will get a suboptimally slow recovery. Zero rate bound for interest rates is a perfect justification for the co-op story.

  18. 18 18 The Money Demand Blog

    Two additional points. Prices in long term debt contracts are really fixed. Have you tried to renegotiate your mortgage? This point is very important as the debt/GDP ratio is very high these days. Unanticipated inflation or deflation does a great harm to the financial markets.
    Wage adjustment process is really slow, especially in the public sector.

  19. 19 19 The Money Demand Blog

    If you are interested in Krugman’s supplemental story, here is a good description, analysis and substantive criticism:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/11/some-thoughts-on-the-gauti-eggertsson-paul-krugman-paper.html

  20. 20 20 Ken B

    @Daniel Hewitt: They get a free evening when they want one in exchange for one where they have spare time. So there is benefit. Still you put your finger on a key point: these are affluent folks; they can hire a regular babysitter and use their time more enjoyably. A barter example with poor folk might work better.

  21. 21 21 Babblefrog

    It doesn’t seem to me that debt is that sticky, either. How many people refinance their home-loans? Or pay off a high-interest credit card with a new lower-interest one?

  22. 22 22 neil wilson

    Have any of you actually been in a baby sitting coop?

    I thought it was great. It is very little effort to take care of your friend’s kids. Sometimes it is actually a benefit.

    Given the choice between paying someone $30 for a night and having my friend’s kids entertain my kids; which do you think I prefer? On top of that, I would rather have an adult couple, who I trust, watch my kids than most any teenager.

    We didn’t really have any problems at all with the coop. It basically died a peaceful death as the kids got old enough they no longer needed a sitter. I was left with a bunch of worthless scrip but all it meant was that I got 200 hours of babysitting and I gave 240 hours in return. It was an amazing, AMAZING bargain.

  23. 23 23 Daniel Hewitt

    Ken B, you are correct – I did not consider that parents would place different values on different blocks of time depending on the situation. A silly mistake to make right after I say that parents and hired babysitters both subjectively value time & money differently. So I acknowledge that the co-op can be beneficial.

  24. 24 24 Patrick

    I agree wholeheartedly with many of the above comments – the babysitting coop example is so far removed from real economies that it is hard to see its usefulness in explaining anything. It’s an economic system where successful young DC-area couples with small children are only allowed to “trade” with other successful young DC-area couples with small children. Furthermore, they are only allowed to trade babysitting services. Even more furthermore, they are only allowed to trade at a fixed price.

    Such an arrangement seems doomed from the start. There is no opportunity for comparative advantage – teenagers with no children who are looking for extra cash and like taking care of kids from time to time, for example, have no place in this market. Similarly, there is no room for specialization. Let’s say one couple has a great kid-friendly house with a trampoline, swimming pool, and a Wii – they are not allowed to charge more even though their services are probably more valuable (the kids like going there more and complain less when their parents go out).

    We should ask Krugman if he would write more or fewer economics columns, given that he was only allowed to be paid in the form of economics columns written by other economists (and that he was “paid” exactly one word for every word he writes). I posit that this arrangement would immediately create a “recession” in the economics-oriented editorials industry!

  25. 25 25 Mark

    In the long run prices will adjust. Krugman never says that they won’t, he just says that the adjustment will be slow and painful, painful that is for those who are not working.

    Others, like Landsburg, suggest that the adjustment is instantaneous. So why are people still unemployed?

    Really what it comes down to is that after this financial crises people who are well off, i.e have jobs and are creditors, are doing fine. And Krugman’s solutions, i.e. inflation, deficit spending, will hurt them in order to help those who are unemployed, so they mock Krugman’s solutions.

    But one thing is a fact. Krugman’s economic predictions have a stunning rate of accuracy. The right wing’s economic predictions have been laughable.

  26. 26 26 Thomas Bayes

    I’m pretty sure that John Cochrane is not using the name ‘Mark’ to participate in this discussion:

    http://faculty.chicagobooth.edu/john.cochrane/research/papers/krugman_response.htm

    By the way, John Cochrane identifies this excerpt as his favorite, which is clearly not subtle:

    “If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.

    If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up.

    If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.”

  27. 27 27 John Pettinger

    Hello – It seems to me perhaps important that for each unit of scrip issued there is a corresponding amount of labor required by the recipient. The participants then felt wealthier because – as far as this system is concerned- they really were. That is, by receiving an extra 10 units of scrip they credibly promised to work 5 more hours doing babysitting. When doling out the new scrip one could just as well say “here is your promise to work 5 more hours”. That seems like an honest system and not prone to distortions. I cant for the life of me see how this resembles money creation in a complicated economy.

    When someone gives out new money in order to stimulate things will he also mention that “oh and by the way, by accepting this money you have unconditionally agreed to do a whole bunch of extra work- congratulations!” More likely he just gives out the money so that people feel themselves wealthier (though they are not) so they will be willing to expend more of their current resources. This trickery seems dishonest to me and bound to inflict problems on people who live long enough to find out they are much poorer than they thought- and come to regret the extra spending. (and other associated problems such as the types of things bought and thus encouraged in production).

    And what about how the money gets introduced? It seems very different for 150 couples to each receive 10 more units of script as opposed to Paul Krugman and his wife receiving 1,500 units of script and then spreading them out by spending them.

    One more thing, what is the problem with hoarding scrip if what you value is the security of knowing it will be there in a pinch? Maybe it was this security being purchased first , and then later when more hours of babysitting were circulating then current but less valuable sitting was used.

    Thanks for this blog, I am definetely learning things

  28. 28 28 Patrick V

    Mark: I respectfully disagree.

    “Others, like Landsburg, suggest that the adjustment is instantaneous. So why are people still unemployed?” There are lots of reasons people are unemployed: Price controls, regulations, welfare, protectionism, taxation and finally: the fact work is not fun, having fun is fun. For example, 50% of the population used to be unemployed (women). If this was enough money for them, what is the problem?

    “Really what it comes down to is that after this financial crises people who are well off, i.e have jobs and are creditors, are doing fine. And Krugman’s solutions, i.e. inflation, deficit spending, will hurt them in order to help those who are unemployed, so they mock Krugman’s solutions.” First, this is a baseless poisoning on the well (and there are exceptions to the rule). Second, it is false. By your logic, we could create vast amounts of prosperity by paying half the population to dig holes and the other half to fill them in, without taxing them! And with all due respect, you have no crystal ball to know that, were there no stimulus, unemployment would not be ‘only’ 9%?

    “But one thing is a fact. Krugman’s economic predictions have a stunning rate of accuracy. The right wing’s economic predictions have been laughable.” While it is true that Krugman did predict there may be a housing crisis, why was he not complaining about it? There were many economists on the ‘right’ (whatever that means) who successfully predicted the crash, and warned against the action they said caused it, or do they not exist.

    Also, please explain why the 1921 crisis was, well not a crisis, despite the fact the government did not react?

  29. 29 29 The Money Demand Blog

    @Thomas Bayes

    The conclusion of the co-op parable is that AD management is very important. John Cochrane supports management of aggregate demand:
    http://faculty.chicagobooth.edu/john.cochrane/research/Papers/big_stick.html
    You are mistaken to invoke Cochrane here as an opponent of co-op parable. The only disagreement between Cochrane and Krugman is about the optimal form of AD stimulus. Cochrane supports a technocratic CPI-targeting proposal, while Krugman favors all kinds of wasteful stimulus.

  30. 30 30 The Money Demand Blog

    @Patrick V

    “Also, please explain why the 1921 crisis was, well not a crisis, despite the fact the government did not react?”

    The answer is expectations. After the WWI, according to the well-understood principles of the gold standard, everybody knew that deflationary pressures will emerge. So they prepared. And the crisis was a very short one.

    The Great Recession was caused by the Fed that promised a permanent 2% core PCE inflation, and suddenly broke that promise. QE1, QE2 were just not very successful attempts to restore the broken promise.

  31. 31 31 Thomas Bayes

    @TheMoneyDemandBlog:

    I was referencing Cochrane to point out that not everyone would agree with Mark’s comment:

    “Krugman’s economic predictions have a stunning rate of accuracy.”

    After all, the title of the paper I referenced is “How did Paul Krugman get it so Wrong?”

  32. 32 32 The Money Demand Blog

    I know that many readers of this blog are libertarian. I am a libertarian myself, and I like to recommend those readers an excellent piece by Bill Woolsey, a libertarian economist (and a member of Libertarian Party) who agrees with Krugman that AD is too low:

    http://monetaryfreedom-billwoolsey.blogspot.com/2010/11/why-so-many-critics-of-qe2.html

  33. 33 33 Mark

    Patrick,
    “By your logic, we could create vast amounts of prosperity by paying half the population to dig holes and the other half to fill them in, without taxing them! And with all due respect, you have no crystal ball to know that, were there no stimulus, unemployment would not be ‘only’ 9%?”

    My logic is what I believe Krugman’s is. And that logic is that in this situation, which is after a financial crises with looming deflation, we need inflation. Krugman never says that this is true under normal conditions.

    And its not just about Krugman predicting the crash. Since the crash the right wing has been forecasting daily that we are headed for inflation and higher interest rates. Krugman has been consistently and correctly saying that they have it all wrong and he has been on target the whole way. If you want to lose a lot of money just watch Larry Kudlow and cohorts. Follow their advice and you will be broke in no time.

    Don’t know about 1921. I do know that in the 1800′s when the government did nothing there was an endless series of depressions.

  34. 34 34 Thomas Bayes

    @TheMoneyDemandBlog:

    I’ll have to study this more to appreciate the common ground between Krugman and Cochrane. Here is something Cochrane wrote in November that was entitled “Stimulus: neither needed nor free”

    http://articles.latimes.com/2010/nov/14/opinion/la-oe-economists-20101114-web

    First line of the essay:
    “Should the government do more to “stimulate” the economy? No.”

  35. 35 35 Seth

    “In Krugman’s coop, when parents exchange with other parents, they are exchanging…..an evening of their time for an evening of their time! Where is the mutual benefit?” -Daniel Hewitt

    While Ken B successfully convinced you this was incorrect, and it could be incorrect because some parents might find mutual benefit in trading babysitting time, the actual results are with you.

    The parents in this co-op did not perceive mutual benefit for some reason and I’m not convinced it had much do with, “The problem was that people started hoarding scrip, thinking they might need it someday,” but I do think it had more to do with the pricing system not adjusting to comparative advantage and substitution effect.

    Not every parent’s babysitting time would be worth the same price. The price system didn’t reflect that. The co-op price system didn’t reflect it because co-op creators implicitly restrained the truth by pegging the scrip value.

    There may be good reason why I’d be willing to trade 5 scrips for a half hour Mary Jo’s time (who keeps a nice clean homes, has respectful kids, is very responsible and happens to be a nurse which is handy for first aid) while I wouldn’t trade anything for Bob’s time (who lets the kids ride go-karts and has an older daughter who has a weird fetish for your son). But, I’ll probably find it hard to get on Mary Jo’s calendar for 1 scrip.

    Also, pegging the scrip to one thing – babysitting time – is like trying to extends a family/friend-like favor based set of interactions beyond the extent where those work well.

    In the end, other more flexible private solutions probably replaced the co-op. Once the parents found the people they felt comfortable trading with and developing a friendship with them, they could go off the scrip system and just exchange favors like most normal human beings.

  36. 36 36 The Money Demand Blog

    @Thomas Bayes
    So in October 2010 Cochrane supports CPI-targeting to prevent deflation in his new paper, and in November 2010 Cochrane opposes stimulus in a LA op-ed. The conundrum can be resolved by noting that Krugman’s stimulus proposals have costs (higher taxes in the future, higher risk of dollar crisis, etc.) that are absent in Cochrane’s CPI-targeting proposal. But the driving force in Krugman’s and Cochrane’s analysis is the same – there are various frictions that can be illustrated by the co-op story. It is a mistake to use Cochrane to bash the co-op story.

    The problem with Krugman is that he ignores the cost of government. Apart from this, he is one of the best economists in the world.

  37. 37 37 The Money Demand Blog

    @Thomas Bayes
    Here is another proof that a common co-op ground between Krugman and Cochrane exists. Krugman’s right-hand man Brad DeLong wrote a long blog entry after he attended Cochrane’s seminar. Money quote: “Important things that I had not known before that I learned from the [Cochrane's] paper”:
    http://delong.typepad.com/sdj/2010/04/liveblogging-the-berkeley-finance-seminar-john-cochrane-2010-understanding-policy-in-the-great-recession-some-unpleasan.html

  38. 38 38 Patrick V

    MDB+Mark: Firstly, we need to understand that the majority of inflation is caused not by direct printing money, but by Fractional Reserve banking. Basically, if you save $100 in a bank, it can lend out ~$90, and this is deposited and then another $81 is lent out, leading to inflation. Because of this, in the short term, deflation may be possible, but as the economy ‘recovers’ and people start saving, inflation will sky-rocket (given how much money the Fed has printed).

    Another problem with calculating inflation is that house-prices are counted, yet this will clearly distort figures. Shops cutting prices to attract sales will again lower the effect of the change in the money supply (what inflation actually is).

    Because of this, I am sceptical of inflation to be able to cure us any more than cocaine can cure a hangover. As for Larry Kudlow, I have only now heard of him, his support for cash for clunkers makes me doubt his adherence to the free market. However, the dollar will collapse, maybe not as soon as he believes, but FRB combined with loose monetary policy cannot last.

  39. 39 39 The Money Demand Blog

    @Patrick V
    Fractional reserve banking has nothing to do with inflation. Reserves are government liabilities, their value is much more suspect than the value of residential and commercial loans that back the value of dollars created by the fractional reserve banking system.

  40. 40 40 Thomas Bayes

    @TheMoneyDemandBlog:

    Thanks for the reading suggestions and pointers. In addition, I just read Cochrane’s essay entitled “Fiscal Stimulus, RIP”, and I would be very interested in learning his take on the co-op story.

    http://faculty.chicagobooth.edu/john.cochrane/research/papers/stimulus_rip.html

    I don’t have formal training in macroeconomics, so I have to defer to, and learn from, you and others on many of these topics. I may be misunderstanding the intended message completely, but this line from the ‘RIP’ essay doesn’t seem to support Krugman’s reaction to the co-op story:

    One should always distrust advocates that have one fix (“more stimulus”) for everything, like the proverbial two-year-old with a hammer to whom everything looks like a nail. It sounds a lot like the old patent-medicine salesmen: “Recession got you down? Take some fiscal stimulus. Oh, a banking crisis is causing problems? Why it’s fiscal stimulus you need, son! Sclerotic labor markets? No problem, some fiscal stimulus will perk you right up. Nasty trade dispute? Why old Dr. Paul’s fiscal stimulus will perk you right up! Foreclosures giving a you headache? Why fiscal stimulus will solve that any day.”

    A modern economy is a lot more complex than a car, and the answer to car troubles is not always “more gas.” If you see a solution being advocated for every problem, you begin to wonder how serious is the analysis that it solves any problem.

    It seems to me that Krugman views the babysitter co-op problem as a nail.

  41. 41 41 Patrick V

    The Money Demand Blog: But the reserves are tied to the residential and commercial loans given out. If the reserve ratio requirement were 20%, there would be less money (and thus lower prices) than the current rate. I’m not sure what you mean by the ‘reserves’ which have suspect value, are you talking about bank reserves? If so, their ability to be repaid is dependent on the ability of customers being able to repay commercial/residential loans.

  42. 42 42 The Money Demand Blog

    @ThomasBayes

    Cochrane’s essay “Fiscal Stimulus, RIP” starts with”
    “Governments should run deficits in recessions, and pay off the resulting debt in good times. Tax revenues fall temporarily in recessions. Governments should borrow (or dip into savings), to keep spending relatively steady. Moreover, many of the things government spends money on, like helping the unfortunate, naturally rise in recessions, justifying even larger deficits. Recessions are also a good time to build needed infrastructure or engage in other good investments, properly funded by borrowing. For all these reasons, it is good economics to see deficits in recessions – and surpluses in booms.”
    In terms of co-op model, Cochrane argues that government should intervene to keep the circulation of scrip “relatively steady”.

    The co-op model is interesting only if some kind of friction prevents the price adjustment. In “Fiscal stimulus, RIP”, Cochrane says: “Yes, there are many. (“Liquidity constraints” are a common complaint, keeping people from acting based on their estimation of the future.) But if you take any of them seriously, the case for stimulus becomes similarly circumscribed. Each specifies a channel, a “friction,” something fundamentally wrong with the economy that matters some times more or less than others, that restricts what kinds of stimulus will work, and that can be independently checked. And in many cases, these “frictions” that falsify Barro’s theorem suggest much better direct remedies, rather than exploitation by fiscal stimulus.”

    So Cochrane argues that the co-op should be healed by directly addressing the relevant frictions that prevent prices from falling, on the other hand Krugman wants to try all kinds of stimulus. The fundamental difference between Cochrane and Krugman is that Cochrane supports management of aggregate demand that is based on clear automatic rules that make sure that cost of intervention is extremely low, and says that discretion can lead to Madoff-like outcomes. Krugman is naive when he says that ad-hoc fiscal policy will restore the macro equilibrium. Cochrane wants to give fiscal stimulus tools to the Fed so they can be employed in automatic fashion.

  43. 43 43 The Money Demand Blog

    @Thomas Bayes

    I think Cochrane is at his best here:
    http://faculty.chicagobooth.edu/john.cochrane/research/papers/fiscal2.htm

    Here is a description of a co-op problem in the current recession:
    “The bottom line, then, is that people want to hold more of both money and government debt – and don’t particularly care which. Trying to get it, we are trying to buy less of both consumption and investment goods. Again, this is a deflationary pressure. If the government does nothing, deflationary pressure will remain until goods are so cheap that we have the desired real value of nominal government debt. Until deflation happens, output falls.”

    Here is his solution:
    “I would be happiest if the Fed and Treasury satisfied the large demand for government debt and money by transparently buying or lending against high quality corporate and securitized debt, at market prices. I am happiest of all when they buy newly-issued commercial paper and securitized debt, acting as the missing intermediaries to help address the “credit crunch,” as well as supplying government debt. These actions are easiest to unwind. When investors get sick of holding so much money or government debt, the Government can, in effect, take back in government debt in exchange for this private debt, and probably make a good profit.”

  44. 44 44 Thomas Bayes

    TheMoneyDemandBlog:

    Thanks for the comments. Now I have some reading and thinking to do.

  45. 45 45 Scott H.

    It must be a very cold day in hell indeed, becuase I am about to write a defense of Krugman’s position. I am not going to say that Krugman’s example is 100% true, but it has important elements of truth in it. Truths that cannot be totally ignored by just mentioning that Dell can lower prices.

    It seems to me that his Coop example need only apply at the margins to be fundamentally true. The Coop economy sounded like it went to 0 GBP (gross baby-sitting product); however, our economy only needs to hit a few percentage points of contraction to have all kinds of disasters looming. We all understand these forces as we contemplate our own spending habits. There is clearly a mixture of self interest and morality at play that affects aggregate demand. I’m the only one on this board that sees that?

    I am not an economist. Krugman’s analysis can be illuminating, but is obviously deficient for explaining long term actions and trends (see the Cochrane quotes). I thought we had smart economists in this country. Can’t anyone come up with an aggregate model? Do I have to do everything around here?

  46. 46 46 Ken B

    @TMB: “Fractional reserve banking has nothing to do with inflation.” Nonsense. It was part of why the contraction in the money supply — negative inflation — was so severe in the early part of the great depression. FRB allows some key small effects to be amplified and that can — in the near term — affect the supply of money greatly. Just because the effect is for the short term doesn’t mean it isn’t real.

  47. 47 47 The Money Demand Blog

    @Ken B

    Assuming constant velocity, when money supply contracts we will get deflation, whether we have fractional reserve banking or not.

  48. 48 48 Ken B

    @TMB: I note you have changed your assertion then. First it was FRB has “nothing to do with” and now it’s “assuming X we will still have Y” with no mention of how fast we will have Y.

  49. 49 49 Silas Barta

    Yes, sticky wages would make the parallel to the real world stronger. However, economists seem to severely overestimate wage stickiness. It’s true that there might be a similar norm against cutting the dollar component of an employee’s compensation. However, most people in the real world see their total effective compensation go down when it needs to; it’s just that rather than cutting dollar-wages, the employers will:

    - cut health benefits or 401k contributions
    - decrease spending on workplace amenities and such fringe benefits
    - demand more output in the same time (typically requiring unpaid overtime from salaried employees)

    and so on. No one’s encountering a sticky wage problem that necessitates duping people through monetary policy to solve.

  50. 50 50 The Money Demand Blog

    @Ken B

    Velocity vas very stable in the 70s, the decade when inflation was extremely high.

  51. 51 51 Ken B

    @TMB: So what? You made the claim “X never affects Y” I cited a case where X affected Y.

    I don’t get what you are arguing. You said FRB had “nothing to do” with inflation. Sometimes it can, in the short run. I cited one example. I never asserted anything about the 70s, or that stable velocity is incompatible with high inflation — or anything like that at all.

  52. 52 52 The Money Demand Blog

    @Ken B
    It depends on what you mean by “nothing to do”.

    If what you have in mind is credit channel as described by Bernanke and Gertler, then OK, you have a point.

    But the commenter who started the discussion about fractional reserve banking had something very different in mind.

  53. 53 53 polyglot

    Krugman’s story is about wealth and hysteresis effects- young couples irrationally thought they were ‘poor’ because their precautionary balance of scrip had run down and so they couldn’t go out, but by not going out, they made scrip more difficult to acquire and thus increased the sense that there wasn’t enough of the thing.

    The lawyers make a rule to force these youngsters to go out- a Keynesian solution- but highly irrational coz going out costs money and (presumably) demand for going out is pro-cyclical. So the economists suggest increasing the amount of scrip by a bonus issue. This latter enriches the administrators (through what is in effect a yearly seignorage on scrip) who, surprise, surprise, are quickly persuaded.
    Result, this deplorable Ponzi scheme continues to disgrace that shining City of a Hill.

    Landsburg’s solution is the first step to making the scrip fungible- at which point it ceases to have irrational wealth and hysteresis effects (assuming baby sitting costs are small relative to household budgets)- but it doesn’t enrich the administrators of the scheme.

  54. 54 54 Matt N.

    I might be way off base — carefully examining economic issues is new to me — but doesn’t Krugman’s story suffer from another even more fundamental issue?

    What happens when the supply of scrip is inflated to the point where it seriously outstrips the supply of babysitting service? Since the pool of potential customers is exactly the same size as the pool of potential suppliers I suppose the problem might be ameliorated somewhat, but still it seems like you could end up with a situation where the demand for babysitting was so high — because everyone is sitting on a pile of scrip — that it could be exceedingly difficult to find a babysitter at any given time.

    Applying that thought to reality the problem is even worse, because money can be exchanged for any good or service, and there is not necessarily a 1-to-1 match between demand and supply for any specific good or service. That is, in the real world, increasing the supply of money by X does not necessarily result in the desired increase in “aggregate demand.” People might, for example, park the money in gold or in foreign investments, where it fails to achieve the purpose intended.

    Finally — and perhaps this is what Landsburg is saying, but put in a slightly different way — when the money supply increases and people find themselves sitting on a pile of cash, they tend to value it less. So not only do they let the cash go more easily, but they’re also less interested in letting their goods and services go for the same price… They’ll start raising their prices or reducing the supply that they’re producing.

    Taking this full circle, I’m less likely to offer babysitting services if I’m already sitting on a pile of scrip.

    So, in summary:

    (1) Even if reality gave us a fixed value for money (which it doesn’t) and prices would therefore not change (which would not be the case), supply would diminish.
    (2) In reality money doesn’t necessarily go where the central planners intend it to go, so increasing the money supply won’t necessarily do what they expect it to. [in fact, with >100M independent actors in the national economy, and billions worldwide, I don't even find it plausible]

  55. 55 55 Pingry

    “But here’s the part of the baby-sitting story that never made sense to me: Why didn’t prices adjust? If everyone’s hoarding scrip, and nobody can find a baby-sitting job, why doesn’t someone offer to babysit for half the usual amount of scrip? Why isn’t that enough to get things moving again?”

    Both Krugman and Landsburg acknowledge that this is a simple example to explain more sophisticated material like an economy.

    Implicit in Krugman’s story, however, is that wages and prices are inflexible. A good economist would understand this, and would assume the same thing about the macroeconomy because there’s a plethora of evidence for it despite what these freshwater guys believe.

    Seriously, how could you not get this?

    The fact of the matter is that prices and wages would adjust, but too slowly and in the meantime, unemployment rises. Even so, what real economist wants wages and prices to adjust downward in a recession anyway?

    Is he just making a mistaken assumption, if implicitly, the wages and prices adjust in an efficient manner at the macro level?

    This is truly bizarre.

    –Pingry

  56. 56 56 Bob D

    Krugman looks at the world through Keynesian colored glasses and therefore has a distorted view of it!

  57. 57 57 Craig

    “Really what it comes down to is that after this financial crises people who are well off, i.e have jobs and are creditors, are doing fine. And Krugman’s solutions, i.e. inflation, deficit spending, will hurt them in order to help those who are unemployed, so they mock Krugman’s solutions.”

    Well, that’s where you go off the rails. The creditors will be the first to get the profits from the Fed’s newly-created money. Therefore, they will be able to spend it before it loses its value.

    They win again!

    Yes, it’s true that loans owed to them will be paid back in less-valuable dollars (or baby-sitting scrip), but the money they’re making on the front-end will go a long way toward making up for what they’re supposedly losing on the back.

    The effects of inflation do not hit everyone at the same time and with the same intensity.

  58. 58 58 Russell Nelson

    Why do people worry about what Krugman the former economist thinks? Because he’s misrepresenting himself as an economist? Or because he used to be a pretty good economist, and now he’s just a disappointing political commentator?

  59. 59 59 Russell Nelson

    Pingry. Wages and prices aren’t sticky except in the brains of Keynesians. Do people NOT want to lower wages and prices? Of course they don’t. It’s not happy-making, it’s not fun. But people will do it. If there’s a job going for $50K/year, and you have two former $100K/year people looking at it, guess what? One of them is going to get the job first. The incentives all line up for non-stickiness. It’s just that people need time to realize that there are no $100K/year jobs out there waiting for them, plus they need to realize that their old standard of living is unsupportable.

    Not happy-making, but people will do it. The alternative is to go without a job, and that lasts only as long as your savings, or as long as the government is willing to pay you to not take a job. You know, unemployment compensation. Like the government has extended. Oh, and who has to pay for it? The employers. But who pays them? The consumers.

    Wages and prices aren’t immutable, but people are reluctant to lower them. If you want to call that stickiness, feel free, but don’t claim that stickiness means that people won’t accept lower wages and prices.

  60. 60 60 RonJ

    It seems clear to me that Krugman’s lessonn is correct, but incomplete. Inflating the script certainly removed the reluctance to use the script in the short run, but it set up the loss of value in the long run.

    The last person holding the script would find no services available, and therefore the price of babysitting would become infinite, not 1 per 30 minutes.

    The lesson, it seems, is to avoid being the last person in line holding inflated script… or inflated dollars.

  61. 61 61 Jacob Oost

    Thomas Sowell often teaches econ by using real-world examples of what happens when an important mechanism is missing. This baby-sitting co-op strikes me as such an example: it has many important elements missing. It doesn’t have floating prices but fixed ones, the “money” is redeemable for only one thing, rather than having a true division of labor people are generally producing the same thing they are “buying,” and so forth.

    I find it hard to believe a truly qualified economist would use this example to draw conclusions about what happens in a larger, real-world economy that does *not* lack all of these mechanisms. Rather, it makes sense to use this as an example of what happens in an economy where these mechanisms and institutions do not exist or are hampered from functioning properly.

  62. 62 62 Steve Landsburg

    Jacob Oost (and others): I quite agree with you that it’s useful to have stories about what can go wrong when some important mechanism is missing. My problem with the baby-sitting story is that the missing adjustment mechanism is missing for a reason that has no close analogue in the macroeconomy. So it’s important to realize that if you’re using this story to explain recessions, there’s a huge and important component missing. It’s therefore misleading to suggest that this story can get to the heart of what causes recessions. It illustrates, at best, the part of the Keynesian story that’s easy to grasp, while ignoring the hard parts.

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