Thursday, February 21, 2013

What’s Wrong with Krugman’s Baby-Sitting Co-Op Model?

The famous Keynesian economist Paul Krugman says a story about a baby-sitting co-op “changed my life”, and he argues that it’s a “story that could save the world”. From his 1998 Slate article:

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.

Okay, so an economy with “money” that can only be used for one thing. This is not really money, more like barter. Couples trade baby-sitting services for promises to babysit in the future. Note also, prices are fixed to one hour of babysitting per coupon.

The story continues:

[F]or 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.

In short, the co-op had fallen into a recession.

In other words, the supply of coupons was reduced, increasing demand for the remaining coupons. Evidently, unlike the real economy, prices were not allowed to adjust. One coupon was officially worth one hour, even though the market clearing price was higher. Naturally couples preferred hoarding/saving the more valuable coupon instead of getting one hour of babysitting. 

This is where the model completely fails to resemble the market economy. Prices are apparently not free to adjust, and the coupons- good for only one product- don’t even resemble money in the first place. Yet this doesn't stop Krugman, he equates the coupons with money:

Since most of the co-op's members were lawyers, it was difficult to convince them the problem was monetary.

Now in his model, he is correct to say, with prices not allowed to adjust, that increasing the number of coupons to the original ratio would reduce their value to a market clearing price, ending the “recession”. Of course, failure to return the supply of coupons to the original ratio will result in continued supply or demand problems. This is because prices are fixed one coupon equals one hour of baby-sitting, so mismatching obviously leads to trouble.

Thus the story ends:

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 ...

Once again, this model has nothing to do with the real market economy, but Krugman continues as if it does:

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. That is exactly what our head coupon issuer Alan Greenspan did in 1987—and what I believe he would do again. So as I said at the beginning, the story of the baby-sitting co-op helps me to remain calm in the face of crisis.

Money printing in the real economy has entirely different effects. Prices adjust so there is no lack of "aggregate demand" and the only impact is distortion, with those getting the money first effectively taking purchasing power from those who get it last. The distortions temporarily result in false prices, which cause malinvestment, creating an unsustainable boom in some areas that must result in a bust (a.k.a. the business cycle).

Additionally money printing is plain theft and leads to a more powerful government, the latter of which is certainly consistent with Krugman’s ideology.

* * * * *

In January a video was post of economist Hans Herman Hoppe explaining how to deal with Keynesians like Paul Krugman. He strips it down to the fundamental question, does printing more paper money make society as a whole richer?

Krugman, of course, refers us to the babysitting co-op story, which doesn't properly model the market economy:

Well, it may be ridiculous, but it’s also true, under certain conditions — namely, when the economy is suffering from inadequate demand. And you don’t have to use highly abstruse reasoning to see this, either; all you need to do is think in terms of some kind of model, not necessarily of the mathematical kind. The whole point of the true story of the baby-sitting coop, which brings it down to a human scale, is that it’s quite possible for economies to get into a snarl that can be solved by printing more money, or having the government spend more.

So Krugman's answer is yes, in certain conditions. What's the next step in the conversation? Robert Wenzel nails it:

The way to counter this is to continue as Hoppe suggests, keep asking the baby questions of Krugman. By him writing that an economy can suffer "from inadequate demand," he is suffering from the delusion that supply and demand doesn't work. We should ask him if he accepts the proposition, that in a free market economy, market clearing prices will result because of supply and demand. If so, then how can he say that there is such a thing as "inadequate demand?" Prices will simply clear and wages and capital goods will be priced based on the prices of consumer goods. Where's the problem?

Krugman and his babysitting co-op model can’t answer this, without denying that supply and demand works. There is no such thing as inadequate demand, and printing money is never the solution.

Free Markets FTW!

No comments:

Post a Comment