Yet another TED talk I find quite interesting. If you find yourself wanting to look at the data first-hand as I did, you can download the entire program used in Hans’ presentation.
My apologies for not blogging more frequently, but, having been busy with graduating, finding a career among other things, I simply haven’t had the time to sit down and jot down all my thoughts here. One thing I have managed to do in the time since my last post, however, was attend the annual meeting of The American Economic Association at the Hyatt-Regency in Chicago. My attendance, albeit unexpected, game me unprecedented insight into some of theories of modern economists. Some notable attendees of the event included Rahm Emanuel, Paul Krugman, Larry Summers, Austan Goolsbee and Gregory Mankiw, and I was fortunate enough to make the acquaintance of several other world-renowned economists and Nobel laureates. As those who know me best may know, I took an interest in economics rather recently, at the beginning of my college career and since then my interest has continue to grow. Needless to say I found my experience at the AEA meeting to be incredibly informative, and I even managed to pick up a few books from some of my favorite economists. This blog post, however, relates to a particular analogy – an economic model – used by economist Paul Krugman to describe some of the basic elements of a recession and how it can be dealt with.
The story goes as follows:
The story takes place on Capitol Hill in Washington D.C. In the late 1950′s a babysitting co-op was started by several members of Capitol Hill. The idea was simple, couples take turns babysitting each other’s children and share the burden. As the group grew from about 20 families in the 1960′s to nearly 200 families in the 1970′s, the task of making sure that each couple babysat their fair share became somewhat troublesome and a new system was implemented. The idea is that each couple is issued 20 “scrip“, essentially an I.O.U. for 30 minutes of babysitting, upon joining the co-op and then must pay it back if and when they choose to leave it. In addition, couples may babysit other couples’ children to earn more scrip or go out for a night and pay scrip to other couples to babysit their children. As managing the co-op was no small task, officers and other administrators were paid through annual dues which amounted to 28 scrip per year.
Sounds simple enough right? But here’s where it gets a bit more complicated…
As was to be expected, many couples found that it was desirable to save up scrip, in case they decided to go out several nights in a row. This was especially true with younger couples who seemed reluctant at first to go out and leave their children to be babysat. As a result, the demand for scrip grew and the demand for babysitting fell. People wanted to save their scrip and were eager to babysit whenever the opportunity arose. Because, however, everyone else was also trying to save their scrip at the same time, babysitting opportunities became scarce, further encouraging the couples to save the scrip they had.
The situation just described is precisely what happens in a recession. As spending declines, so does demand for goods and services. As a result, fewer workers are needed to produce the reduced demand of goods and services. With fewer people receiving money, spending declines even further and the cycle continues. To make matters worse, those that have money to spend, begin to save it in fear that they may not be able to earn more money in the future as easily as they had in the past. The result of this is a large number of people looking for work (high unemployment rate) and very low demand for goods and services.
Good, because it gets slightly more complicated.
In response to the “recession”, the officers of the co-op decided to increase the money….I mean “scrip” supply by giving new members 30 scrip instead of 20, but still requiring that they only pay back 20 upon leaving. Within a few years, a new problem arose. As more new members joined, more scrip was added to the system until couples simply had too much and were unable to spend it because no one else wanted to babysit their children. In addition, the administration also began taking in more than it spent.
Now let’s examine a hypothetical issue with the co-op.
Let’s assume that there is an element of seasonality in babysitting. It makes sense that couples would be more likely to go out in the summer when the weather is nice and the days are long, as opposed to winter. If seasonality is weak, relatively little is changed. Some couples may spend more scrip in the summer, but they are able to earn it back by babysitting more in the winter and the system remains table. Consider for a moment, however, if the seasonality is strong. All of a sudden couples are desperate to babysit during the winter in order to save up the much needed scrip to pay for babysitters during the summer months or in case of emergency. The result is a surplus of babysitting supply during the winter and a surplus of babysitting demand during the summer. In order to compensate for the seasonality, the administration begins to administer “loans” to couples which can be repaid in the future with interest. This would allow couples to borrow scrip from the administration in emergencies and pay it back with interest later. Due to the seasonality of demand, interest rates would be higher when there is a large demand for babysitting and lower when demand is small. The result is that the administration is analogous to a central bank.
The same is true on a macroeconomic scale, in theory. During good times when money and jobs are plentiful, interest rates increase, and the cost of borrowing money is generally higher. During times of economic downturn, interest rates decrease in order to encourage lending to stimulate consumption.
Back to the story…
Now let’s suppose that the seasonality is unusually high, that couples do not want to go out at all, but rather prefer to stay in to acquire more scrip for the summer. Suppose that the seasonality is so strong that, even when the administration sets interest rates to zero, parents still refuse to go out, even when they can borrow money for free. In this what is known as a liquidity trap.
A liquidity trap is defined as a situation in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. Put simply, a liquidity trap is a situation in which an increase in the supply of money has no effect on the equilibrium interest rates or output.
In a liquidity trap, couples have no incentive to borrow money, even for free, because they know that the value of their scrip in the winter will be worth exactly the same value the following summer. This is, of course, assuming that there is no inflation. Though many people talk of inflation as though it is something to be avoided, an undesirable consequence of economic policy, the fact of the matter is that inflation is a tool and can be a useful one, assuming that it can be controlled.
Assume now that the co-op system has an inflation rate, and that, as a result, 5 scrip in the winter will be worth 4 scrip the following summer. Now the situation begins to change. Because there is now a penalty associated with saving scrip for the summer, couples become more willing to spend their scrip during the winter in order to get their full value. The result is that saving becomes less desirable and the consequences of a liquidity trap can be avoided. If the inflation rate is too low, however, the co-op can fall back into the same liquidity trap it found itself in before. Contrariwise, if the inflation rate is set too high, couples begin spending all of their scrip, they become desperate to babysit, and the system falls back into a recession as previously discussed.
In several of his books, Krugman notes that, if ever the system is to reach a point where the couples of the co-op are reluctant to spend their scrip no matter the circumstance, then it is the job of the administration to begin spending scrip in order to stimulate demand, effectively creating an economic stimulus. Krugman states that, if the private sector isn’t spending and economic growth is slow, the administration – the government – must step in and provide temporary stimulus in order to promote growth and increase demand. Even a temporary increase in demand can have a ripple effect and lead to a further increase in demand and economic growth.
I suppose that, in conclusion, macroeconomics is a bit more complicated that most are led to believe. The important thing to note here is that, like most things, the ideal situation involves a balance , an equilibrium if you will. I think that the babysitting co-op model is an excellent example of some of the basic principles of economics and it provides a look at how recession-era economics work. As I continue my research, I’m sure I will be posting further updates, but for now I think this provides a fairly basic foundation to build upon.
Further reading: http://en.wikipedia.org/wiki/Capitol_Hill_Babysitting_Co-op