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/
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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.