I recently came across an analogy that Paul Krugman has been using to make the case for an inflationary monetary policy to lift the economy out of a recession. I suspected Krugman to be wrong even before I read it (Afterall, how can I trust anybody who claims that world war 2 lifted us out of the depression?). After reading, I knew something was fishy, but it took me some time to identify the fallacy. I think I've finally struck the core. I'm posted it here so that others may stumble upon it later when looking for a refutation of this analogy.
This is my first original analysis of something of this sort, so I'd be delighted to hear feedback.
-Michael Hall
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Source: http://www.slate.com/id/1937/
Krugman: "The Sweeneys tell the story of--you guessed it--a baby-sitting co-op, one to which they belonged in the early 1970s. Such co-ops are quite common: A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share."
"The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?"
My response: The monetary unit in this system is the scrip. The Capitol Hill co-op defined it's value as equal to 1 hour of baby sitting time. In other words, it's enforcing a price fixing scheme -- the price of one hour of baby-sitting labor has been decreed equal to 1 scrip, the unit of money in this economy. Keep this in mind.
"Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve--then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation."
"Now what happened in the Sweeneys' co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further."
The "number of coupons in circulation [becoming] quite low" means there was a deflation in the money supply (scrip). Monetary deflation increases the value of the money unit, causing a decrease in prices. Krugman concedes this by admitting that "most couples were anxious to add to their reserves by baby-sitting", indicating an increased demand for a dwindling supply of scrip. Without the price-fix in place, baby-sitters could decrease their labor costs by, say, offering to babysit 2 hours for 1 scrip instead of 1:1. At some point, the price of babysitting would fall enough that couples would be willing to trade away their scrip.
"In short, the co-op had fallen into a recession."
To reiterate, this so-called "recession" was caused by government price-fixing of the cost of baby-sitting labor services which could not adjust to the deflation of the money supply (also presumably caused by the Capitol Hill co-op, the government in this analogy).
"Since most of the co-op's members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems ..."
The legislative approach would have amounted to forced labor! Consumers would have been forced to work extra hours (babysitting) in order to pay for others' babysitting services at rates that were arbitrarily decreed to be too high. The very fact that they weren't exchanging scrip for these services voluntarily indicated that they weren't willing to make that trade!
Printing more coupons and injecting them into the system inflated the money supply (scrip), devaluing the individual money units. The increased supply reduced the desire to hold onto the otherwise rare and valuable units of scrip and so it became more desirable to trade away excess scrip for outings. But the inflation reduced the purchasing power of those who had accumulated reserves of scrip and redistributed it to those who received the newly printed scrip.
Notice the final sentence: "Eventually, of course, the co-op issued too much scrip, leading to different problems..." Unfortunately, Dr. Krugman doesn't elaborate on what those "different problems" were, but we can guess. He's implying that the money supply became over-inflated. With price-fixing in place, that would lead to the reverse situation. That is, nobody would want to babysit because everybody has plenty of coupons! In that case, every couple prefers to spend their supply. But who would offer to babysit at 1 scrip per hour when coupons are in great excess? Without price-fixing, the price of baby-sitting would have to rise, to say, 1 hour in exchange for 2, 3, or more coupons until some couples are enticed to add to their supply.
In summary, the main problem is not that the amount of scrip in circulation was "too small" or "too large" in the face of deflation/inflation, but rather that the price of baby-sitting was not permitted to rise and fall with the demand for the fluctuating supply of scrip. The Capitol Hill co-op was responsible for both price-fixing as well as deflating/inflating the money supply. In our economy, price fixing represents, for example, inflexible union imposed wages or minimum wage laws and deflation/inflation is caused by the central bank's manipulation of the money supply. It's interesting that Krugman's solution of inflating the money reduces the purchasing power of money. The reason it works is because it reduces the purchasing power of wages for workers to the what the level it would have obtained in the absence of price-fixing. But it does so by duping the workers into thinking that their wages have not fallen by keeping the fixed wage rate laws in place. If Krugman framed the solution in those terms, I suspect it would sound much less acceptable to the public. Yet this is exactly what Krugman is proposing, as he admits elsewhere when referring to the babysitting co-op analogy: "shortfalls of overall demand would cure themselves if only wages and prices fell rapidly in the face of unemployment. In the story of the depressed baby-sitting co-op, one way the situation could have resolved itself would have been for the price of an hour of baby-sitting in terms of coupons to fall ... and the co-op would have returned to 'full employment' without any action by its management." So then why isn't the better solution to remove restrictions on wage rates? I propose it's because workers wouldn't stand for open reductions in wages and so it's attempted via inflation under the guise of "stimulus" packages. Indeed, it cannot occur openly, because if workers realized that they purchasing power was being eaten away by inflation so rapidly, they'd likely demand wage increases to keep up.
There is no reason to correct one government-imposed problem with another. Without a central bank (and fractional reserve banking), the deflation issue could never have occurred in the first place. But even if it did, unemployment could be prevented by renegotiating the wages of workers. This sounds bad, but it is still better than duping workers by reducing their wages through in a backhanded way via inflation. Renegotiating lower wages is consistent with monetary deflation (which should reduce all prices, including labor) and prevents lay-offs by being able to employ more workers at the same overall cost. If wages are maintained, those workers not laid off are at a temporary advantage, since their purchasing power increases in the face of temporary deflation. But inevitably, the inflationary policies of the government will catch up and wipe out any temporary advantage they have and by the time they see a future increase in their wages, after full employment is once again obtained, it won't likely occur until well after their purchasing power has been eaten away even further by inflation.
Is gold standard just a government price fixing then?
The problem seems to be the coupon supply was inflexible. It did not change to match demand therefore there was a shortage of coupons. Deflationary recession it is.
scineram: Is gold standard just a government price fixing then?
No, the gold standard is simply defining a currency in terms of a certain weight in gold. For example, if the dollar is defined as 1 ounce of gold, then the dollar isn't "fixed" to gold, the dollar IS gold. It's simply a paper receipt for a certain amount of gold; in this case, one ounce.
Price fixing is forcibly setting a good or service equal to a certain amount of a currency instead of allowing the market to set the price.
David Gordon appears to agree with you.
Irish Liberty Forum
scineram: The problem seems to be the coupon supply was inflexible. It did not change to match demand therefore there was a shortage of coupons. Deflationary recession it is.
?
Supply never changes to match demand in the way you seem to be suggesting
Supply and demand intersect in a similar way to how the neo-classicals describe and money works in the same way. As the OP correctly showed, the currency's value should have risen when the demand for money increased, as it would in a free/sound money society. The problem was that the value of the scrip was fixed (i.e. the price of labour was fixed).
This is a case in point of how price fixing leads to problems, not an expose of free market money failing!
Although that said, there is certainly a case for there being a few more scrips as there probably wasn't enough divisibility - imagine conducting all transactions in only $1000 notes or above; when the value of the scrips rose it could have become rather hard to trade for an hour's babysitting as there wouldn't have been a "note" for that transaction.
What is patently obvious is that this is not analogous to what he thinks it is.
The difference between libertarianism and socialism is that libertarians will tolerate the existence of a socialist community, but socialists can't tolerate a libertarian community.
What a great post!
This is the kind of text that could undermine the Nobel pri.. eeh, I mean Swedish central bank prize winner Paul Krugman's inflated media aura. He seems to have won his fame mostly by using his head, because that is where his tounge is located...
It's not fascism when the government does it.
“We must spend now as an investment for the future.” - President Obama
I tend to think that all of these complicated problems arose because only one entity (the co-op) was allowed to issue the notes, resulting in a monopoly calculation problem. Suppose, however, that anybody could issue a promissory note. Suppose that, after you babysit my kids for an hour, I write one note and sign my name on it, a note which I would be obligated to fulfill in the future. This would allow us to keep accounts, making sure that everybody does their fair share. Plus, we wouldn't have to worry about having enough notes to go around.
"As long as there are sovereign nations possessing great power, war is inevitable."
jdcoffey:No, the gold standard is simply defining a currency in terms of a certain weight in gold. For example, if the dollar is defined as 1 ounce of gold, then the dollar isn't "fixed" to gold, the dollar IS gold.
The coupon was simply defined as such. There was no price fixing, a coupon was one hour babysitting.
scineram: The coupon was simply defined as such. There was no price fixing, a coupon was one hour babysitting.
But don't you see that is the price fixing. If I really need a babysitter urgently why can't I offer to pay two or more coupons for an hour?
with a strict translation of some quanity of gold = a dollar, i.e. dollar is just a name for some definite unchanging weight of gold, all dollars are convertable to gold and vice-versa. but in the coop scheme, not all babysitting was convertable to scrips. only babsitting for 'people who have some scrips' is convertable to scrips, hence it is clear that coupon are not one hours babysitting.,
furthermore, under gold standard, as productivity increases, a given gold dollar will have rising purchasing power, some gold will buy more and more goods and services.
under the coop a coupon wont be able to buy more or less than 1hour babysitting, regardless of productivity etc.(or rather the scrip would determine productivty, i.e. no one produces any babysititng, until people come up with some quanity of scrips and demand the performance of production, so the scrip determines production!) (i dont know whether in the co-op scheme there were rules making trading scrips for -non-babysitting-goods illegal or not, i would assume that they would have rules making scrip exchange rates unlawful, it seems the co-opy thing to do)
Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid
Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
Because you cannot enforce the agreement. The coupon legally entitled to one hour babysitting. The parent would not have to pay more than the hours ex post facto.
scineram:Because you cannot enforce the agreement. The coupon legally entitled to one hour babysitting. The parent would not have to pay more than the hours ex post facto.
That's just another was of saying that the coupon scheme is indeed price fixing.
RockyRaccoon: If Krugman framed the solution in those terms, I suspect it would sound much less acceptable to the public. Yet this is exactly what Krugman is proposing, as he admits elsewhere when referring to the babysitting co-op analogy: "shortfalls of overall demand would cure themselves if only wages and prices fell rapidly in the face of unemployment. In the story of the depressed baby-sitting co-op, one way the situation could have resolved itself would have been for the price of an hour of baby-sitting in terms of coupons to fall ... and the co-op would have returned to 'full employment' without any action by its management." So then why isn't the better solution to remove restrictions on wage rates? I propose it's because workers wouldn't stand for open reductions in wages and so it's attempted via inflation under the guise of "stimulus" packages.
If Krugman framed the solution in those terms, I suspect it would sound much less acceptable to the public. Yet this is exactly what Krugman is proposing, as he admits elsewhere when referring to the babysitting co-op analogy: "shortfalls of overall demand would cure themselves if only wages and prices fell rapidly in the face of unemployment. In the story of the depressed baby-sitting co-op, one way the situation could have resolved itself would have been for the price of an hour of baby-sitting in terms of coupons to fall ... and the co-op would have returned to 'full employment' without any action by its management." So then why isn't the better solution to remove restrictions on wage rates? I propose it's because workers wouldn't stand for open reductions in wages and so it's attempted via inflation under the guise of "stimulus" packages.
This appears to be disinformation. You can see at Google Books: The Return of Depression Economic (p.55) that Krugman says this:
"The drift was partly the result of theoretical disputes within economics, which--as the so often do--gradually filtered out, in somewhat garbled form, into wider discourse. Briefly, the source of the theoretical disputes was this: shortfalls of overall demand would cure themselves if only wages and prices fell rapidly in the face of unemployment. In the story of the depressed baby-sitting co-op, one way the situation could have resolved itself would have been for the price of an hour of baby-sitting in terms of coupons to fall ... and the co-op would have returned to 'full employment' without any action by its management. In reality, this doesn't happen or, if it does, takes a very long time; but economists have been unable to agree about exactly why."
I can't spot any other problems with your critique, though. I lack the expertise, but it seems to make sense. I don't know if Krugman is wrong or right in the above quote. It seems, though, that if the problem were prevented in the first place, it shouldn't matter how long it takes to correct.
It seems to me that it is both facts that supply was fixed and value was fixed that this is analagous to price-fixing. Had either one of these been allowed to float, there shouldn't have been a problem.
With a floating value, as demand for scrips went up, people could babysit more hours for less scrip.
But I like the solution of allowing each member to issue his own scrip, each one being an hour of his time in the future babysitting. And so, if someone did nothing but go out, and issue a bunch of his own scrip, when others tried to redeem for hours of babysitting, this individual would not be able to fulfill all these obligations and his scrip would become worthless and he would no longer be able to issue his own scrip to go out, he would have to earn someone else's and then trade that for babysitting time. A private money system, the issuers who can back their scrip by paying the obligation will see their scrip circulate.
I've been trying to read Krugman's book (I find it heavy on rhetoric and short on logic) and have been thinking about this babysitter analogy. I see you point about the price-fixing. Maybe I'm wrong, but it seems to me there are other problems as well. In this analogy, the money is originally distributed equally in an amount set by the "government", and they clearly did not forsee the need of the members to have a reserve of coupons. Of course, even our fiat money system does not work this way (although perhaps we are headed in that direction), but this raises the question of how a real money system works.
It seems to me that real money is a real commodity, like metal, that has worth in an of itself. This means that there is not a fixed amount of money, since there is not a fixed amount of goods. If we ran out of gold, something else could be used for money. As productivity goes up, so can the amount of money in circulation. When we trade in a real money society, we are really trading goods for goods. The total wealth of society can and does increase over time because new and more things are produced.
Krugman's analogy seems to imply that this cannot occur, and this causes problems for his illustration. In his illustration, there is no way for a parent to get more coupons except to trade them back and forth with someone else. That is, they must obey the law of conservation of money--it cannot be created or destroyed. They cannot make more money themselves--they cannot produce wealth, only trade it back and forth. This leads to a problem if the total amount of goods originally present is exactly enough to meet the needs of everyone, and no more. In such a case, one person's hoarding means that others don't get what they need.
In the real money world, there is not a fixed amount of goods that exactly matches society's needs. There is an excess of goods and new and more goods can be produced. In other words, there is not a fixed number of coupons (money) because there is not a fixed amount of products (babysitting). If the analogy is to be realistic, the babysitting must stand for products. But it really does not work well for this purpose. There is no provision in Krugman's analogy for increases in productivity or innovation. His "economy" is a static one. It cannot grow.
And his solutions are worse. Even in his frozen economy, his solution of printing coupons only, as you said, devalues the coupons. If I have been saving coupons, I do not want to hear that everyone is going ot get a whole bunch of new ones. Or, at least, I want to be the first to get and use the new coupons.
Let me know if I am missing something. I am new to this.