Someone wrote to me today and said they had been reading Paul Krugman’s 1999 book Peddling Prosperity, where he presents the now-famous baby-sitting model. You can read a shortened version of the model HERE. The reader asked me whether the model had any relevance to modern monetary theory. The short answer: yes but not necessarily in the way Krugman thinks (he is still locked into gold standard thinking).
Krugman actually gets the model from a note entitled “Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis” by Joan and Richard Sweeney which was published in Journal of Money, Credit, and Banking in February 1977, pages 86-89.
Krugman says of the note:
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. At this gloomy moment, when Asia’s woes seem to threaten the world economy as a whole, the lessons of that inspirational tale are more important than ever.
So life changing eh? Well before we assess that here is the model in a nutshell.
The story (a personal experience by the Sweeney family) is about a baby-sitting cooperative, which are common arrangements in the US. Accordingly, around 150 couples with young children form the cooperative with the aim of sharing baby-sitting duties among them and avoiding paying cash to a baby-sitter. The problem with the system unadorned is that there were no checks to ensure that all the members took more or less equal loads. There was in other words a potential free rider problem.
To overcome this problem the co-operative introduced a currency – bits of paper – each coupon one worth one half-hour of baby-sitting. To get the system rolling, each member of the co-operative was given 20 hours worth of scrips but had to pay back twenty if they left the cooperative). Only the cooperative as a macro unit could issue the scrip (it had monopoly control over this).
The only power the individuals had was to exchange the scrip. The initial volume of the scrip in the system was determined by the co-operative. So when a couple baby-sat another couples’ child(ren) they received the number of coupons corresponding the hours they were offering. So to get services in return, all couples had to earn the coupons by offering services, which overcame the potential free rider problem.
As it happens what looked like being a self-equilibrating system started to falter. How?
Sweeney and Sweeney (1977: 87) present the problem like this:
A few years ago the co-op had a recession. Few people felt they could go out but many wanted to babysit. Now there is great difficulty rounding up sitters for all those who want to go out. This is a classic sort of inflationary pressure-too much money (scrip) chasing too few goods (sitters).
So for those couples who at any point in time did not want to go out were willing to baby-sit and then accumulate scrip (save) so that they could use those reserves later when they did want to go out. In times where some wanted to save and some wanted to spend there was no real problem – there were enough people wanting baby-sitting as there were offering it. The market thus achieves an equilibrium.
Now if the couples had a desire to save the scrips (the currency of issue), then this required more scrips in circulation than were required at any single time to facilitate the transactions.
The way the couples could save was to offer baby-sitting services. But given an increasing number of couples sought to do the same thing, it became obvious that “employment” as a baby-sitter started to fall. The declining employment, in turn, reduced the capacity of the couples to save. As time went by the desire to save (to maintain what reserves one had) increased in line with the increasing pessimism arising from the lack of employment.
The rise in the desire to save by all couples simultaneously without the requisite injection from the cooperative led to a recession. At the heart of the problem was the overall lack of scrips in the system.
Sweeney and Sweeney (1977: 87) say:
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.
Then the co-operative dictated that every couple had to go out at least once every 6 months. So the cooperative wanted to reduce the saving desire of its members and sought coercive methods to do so. It failed to solve the problem.
The final solution taken was to issue scrip to each member of the cooperative equal in value to 10 more hours of baby-sitting. Now, they were given thirty but still only had to pay back 20 if they left the system.
While Sweeney and Sweeney call this solution a “resort to monetary policy” I see it more in terms of a fiscal injection, creating increased financial assets in the community of couples. Whatever, the solution worked.
Sweeney and Sweeney say:
There shortly arrived a balance between those who wanted to go out and those who wanted to sit. A golden age, on a minor scale. Those people who previously hadn’t wanted to go out must have changed their morals – or maybe it was the ten hours all around.
So you should be able to see this as a simple model of a fiat currency system. The cooperative is the government sector representing the individuals in the non-government sector. The latter is simplified in this example because there is no foreign sector. The simplification makes it easier to understand what is going between the sectors.
As time passed, the couples in the non-government (private) sector revealed a desire to save in the currency of issue. Further, the only way they could realise that desire to save was to work (seek employment as a baby-sitter). But unless that desire to save is financed there are insufficient net financial assets in the system to fill the “spending gap” and so employment falters and the desire to save is thwarted.
Sooner rather than later, the system goes into recession with spending and employment collapsing.
You might try to get the consumers to spend more (save less) but this is unlikely to work if the underlying reasons for their saving preferences are not considered.
The only way the system was restored to its original functioning – that is, to provide baby-sitting so that people could enjoy some time away from their children was when the cooperative (government sector) created sufficient new financial assets in the non-government sector to match the desire of the couples in aggregate to save.
In other words, the cooperative had to run a deficit (spend 30 and tax 20) overall to ensure there were sufficient net financial assets to close the spending gap and finance the non-government saving. At that point, employment rose and the system returned to its planned state.
Sweeney and Sweeney then go on to describe a situation where the deficit increased beyond the desire to save which led to too much scrip being issued.
Krugman (Slate article linked above) says:
If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year’s worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op’s story, to play with it and draw out its implications, it will change the way you think about the world.
For example, suppose that the U.S. stock market was to crash, threatening to undermine consumer confidence. Would this inevitably mean a disastrous recession? Think of it this way: When consumer confidence declines, it is as if, for some reason, the typical member of the co-op had become less willing to go out, more anxious to accumulate coupons for a rainy day. This could indeed lead to a slump — but need not if the management were alert and responded by simply issuing more coupons.
Krugman extends the example by introducing a new financial asset. He says:
First, we have to imagine a co-op the members of which realized there was an unnecessary inconvenience in their system. There would be occasions when a couple found itself needing to go out several times in a row, which would cause it to run out of coupons — and therefore be unable to get its babies sat — even though it was entirely willing to do lots of compensatory baby-sitting at a later date. To resolve this problem, the co-op allowed members to borrow extra coupons from the management in times of need – repaying with the coupons received from subsequent baby-sitting. To prevent members from abusing this privilege, however, the management would probably need to impose some penalty — requiring borrowers to repay more coupons than they borrowed.
So now providing the capacity for couples to borrow, the cooperative now had a new policy instrument. The cooperative might react to news that it was hard to find baby-sitters by lowering the “interest” that had to be paid on the loans and vice versa.
Note that the cooperative might set up separate divisions – the treasury and central bank – but the currency dealt with by each would still come from the cooperative and transactions between either division and the non-government sector (the members) would both create or destroy new net financial assets in the non-government sector.
Krugman then notes that if sentiment became very pessimistic then the cooperative could lower the interest rate to zero yet none of the couples would seek to borrow and more couples would be trying to save (seek baby-sitting or employment). As a consequence, baby-sitting opportunities dry up.
As a consequence, Krugman says:
… which means that couples seeking to build up reserves for summer fun will be even less willing to use those points in the winter, meaning even fewer opportunities to baby-sit … and the co-op will slide into a recession even at a zero interest rate.
In this situation, monetary policy (interest rate manipulation) becomes a totally ineffective policy instrument – economists have termed this state a “liquidity trap”. No-one wants to spend and everyone wants to save but cannot find sufficient employment opportunities to achieve those desires. The whole system sinks into a mire.
The only solution is for fiscal policy (issuing of more scrips) to fund that increasing saving desire to allow employment to return to desired levels.
Interestingly, I recalled a review of another Krugman book (The Return of Depression Economics) where the neo-liberal author tried to argue that the simple solution to the shortage of scrip would have been to deregulate the price of scrip (which was set by the cooperative) and allow the “market to work”. You can see a blog about this HERE
The reviewer said:
… nowhere does Krugman mention that another way to solve a problem of excess supply is to let prices fall … It’s not surprising that Krugman left this out: He seems to be biased in favor of having government step in rather than letting markets work things out … In other words, the problem came about because prices were not allowed to adjust.
This is the argument used by neo-classical economists as a defence against Keynes. Keynes argued that his result was general (that is, that employment is a function of effective demand) and was not dependent on the assumption that money wages are fixed (which he noted was an institutional reality with positive benefits in itself).
He said that even if money wages fell, prices would fall in proportion (as unit costs fell and competition prevailed) and so the real wage would be unaltered (or thereabouts).
The neo-classicals (Pigou) retorted that this might be so but the lower prices themselves created a real balance effect where those who held wealth were now wealthier in real terms and would thus start spending.
The problem is that these impacts have only been found to be tiny in the usual range that prices might be expected to fall. I recall reading an article (I think Sydney Weintraub said it – I haven’t time tonight to look it up) where the author said that the real balance effects would occur only when you got penny millionaires! That is, prices had to fall dramatically.
Further, cutting the wage during a recession will only help if it reduces the desire to save. There is no research (ever) that has established this proposition. So cutting wages will just imperil those with nominal contracts (the couples that had borrowed) and reduce their standard of living but do nothing to increase employment. Either saving has to be reduced or funded by deficits.
I also note that Japan struggled continually with deflation in the 1990s and it was only when fiscal policy entered the fray in the form of rising deficits that output started to recover.
Enough on this very sunny day … spring has come early to the East Coast.