The Babysitting Co-op Crisis

I don’t normally stray into the realms of politics, but I am so exasperated by our politicians failing to learn from history that I can no longer restrain myself.

Recently I read “End This Depression Now”, by Paul Krugman, Professor of Economics at Princeton University and 2008 Nobel prize winner, and realised why our current batch of politicians are causing me so much angst.  They have forgotten the lessons of Keynesian economics; and they have forgotten the true story of the Babysitting Co-op first told in 1977 by Jean and Richard Sweeney.

Let me quote Professor Krugman:

“The Sweeney’s were members of a babysitting co-op: an association of around 150 young couples, who saved money on babysitters by looking after each other’s children.

The relatively large size of the co-op offered a big advantage, since the odds of finding someone able to do babysitting on a night you wanted to go out were good.  But there was a problem: how could the co-op’s founders ensure that each couple did its fair share of babysitting?

The co-op’s answer was a scrip system: couples who joined the co-op were issued twenty coupons, each corresponding to one half hour of babysitting time. (Upon leaving the co-op, they were expected to give the same number of coupons back.) Whenever babysitting took place, the babysittees would give the babysitters the appropriate number of coupons. This ensured that over time each couple would do as much babysitting as it received, because coupons surrendered in return for services would have to be replaced.

Eventually, however, the co-op got into big trouble. On average, couples would try to keep a reserve of babysitting coupons in their desk drawers, just in case they needed to go out several times in a row. But there came a point at which the number of babysitting coupons in circulation was substantially less than the reserve the average couple wanted to keep on hand.

So what had happened?   Couples, nervous about their low reserves of babysitting coupons, were reluctant to go out until they had increased their hoards by babysitting other couples’ children. But precisely because many couples were reluctant to go out, opportunities to earn coupons through babysitting became scarce. This made coupon-poor couples even more reluctant to go out, and the volume of babysitting in the co-op fell sharply.

In short, the babysitting co-op fell into a depression, which lasted until the economists in the group managed to persuade the board to increase the supply of coupons.

What do we learn from this story? If you say “nothing,” because it seems too cute and trivial, shame on you. The babysitting co-op was a real, if miniature, monetary economy. It lacked many of the features of the enormous system we call the world economy, but it had one feature that is crucial to understanding what has gone wrong with that world economy – a feature that seems, time and again, to be beyond the ability of politicians and policy makers to grasp.

What is that feature? It is the fact that your spending is my income, and my spending is your income. Isn’t that obvious? Not to many influential people.

This point, that every individual’s income – and every country’s income, too – is someone else’s spending, is clearly not obvious to many German officials, who point to their country’s  turnaround between  the late 1990s and today as a model for everyone else to follow. The key to that turnaround was a move on Germany’s part from trade deficit to trade surplus – that is, from buying more from abroad than it sold abroad to the reverse. But that was possible only because other countries (mainly in southern Europe) correspondingly moved deep into trade deficit. Now we’re all in trouble, but we can’t all sell more than we buy. Yet the Germans don’t seem to grasp that.

And because the babysitting co-op, for all its simplicity and tiny scale, had this crucial, not at all obvious feature that’s also true of the world economy, the co-op’s experiences can serve as “proof of concept” for some important economic ideas. In this case, we learn at least three important lessons.

First, we learn that an overall inadequate level of demand is indeed a real possibility. When coupon-short members of the babysitting co-op decided to stop spending coupons on nights out, that decision didn’t lead to any automatic offsetting rise in spending by other co-op members; on the contrary, the reduced availability of babysitting opportunities made everyone spend less.

Second, an economy really can be depressed thanks to magneto trouble, that is, thanks to failures of coordination rather than lack of productive capacity. The co-op didn’t get into trouble because its members were bad babysitters, or because high tax rates or too-generous government handouts made them unwilling to take babysitting jobs, or because they were paying the inevitable price for past excesses. It got into trouble for a seemingly trivial reason: the supply of coupons was too low, and this created a “colossal muddle,” as Keynes put it, in which the members of the co-op were, as individuals, trying to do something – add to their hoards of coupons – that they could not, as a group, actually do.

This is a crucial insight. The current crisis in the global economy – an economy that’s roughly 40 million times as large as the babysitting co-op – is, for all the differences in scale, very similar in character to the problems of the co-op. Collectively, the world’s residents are trying to buy less stuff than they are capable of producing, to spend less than they earn. That’s possible for an individual, but not for the world as a whole. And the result is the devastation all around us.

If we look at the state of the world on the eve of the crisis – say, in 2005 – 07, we see a picture in which some people were cheerfully lending a lot of money to other people, who were cheerfully spending that money. US corporations were lending their excess cash to investment banks, which in turn were using the funds to finance home loans; German banks were lending excess cash to Spanish banks, which were also using the funds to finance home loans; and so on. Some of those loans were used to buy new houses, so that the funds ended up spent on construction. Some of the loans were used to extract money from home equity, which was used to buy consumer goods. And because your spending is my income, there were plenty of sales, and jobs were relatively easy to find.

Then the music stopped. Lenders became much more cautious about making new loans; the people who had been borrowing were forced to cut back sharply on their spending. And here’s the problem: nobody else was ready to step up and spend in their place. Suddenly, total spending in the world economy plunged, and because my spending is your income and your spending is my income, incomes and employment plunged too.

So can anything be done? That’s where we come to the third lesson from the babysitting co-op: big economic problems can sometimes have simple, easy solutions. The co-op got out of its mess simply by printing up more coupons.

This raises the key question: Could we cure the global slump the same way? Would printing more babysitting coupons, aka increasing the money supply, be all that it takes to get Americans back to work?

Well, the truth is that printing more babysitting coupons is the way we normally get out of recessions. For the last fifty years the business of ending US recessions has basically been the job of the Federal Reserve, which (loosely speaking) controls the quantity of money  circulating in the economy; when the economy turns down, the Fed cranks up the printing presses. And until now this has always worked. It worked spectacularly after the severe recession of 1981-82, which the Fed was able to turn within a few months into a rapid economic recovery – “morning in America.” It worked, albeit more slowly and more hesitantly, after the 1990-91 and 2001 recessions.

But it didn’t work this time around. I just said that the Fed “loosely speaking” controls the money supply; what it actually controls is the “monetary base,” the sum of currency in circulation and reserves held by banks. Well, the Fed has tripled the size of the monetary base since 2008; yet the economy remains depressed. So is my argument that we’re suffering from inadequate demand wrong?

No, it isn’t. In fact, the failure of monetary policy to resolve this crisis was predictable – and predicted. I wrote the original version of my book The Return of Depression Economics, back in 1999, mainly to warn Americans that Japan had already found itself in a position where printing money couldn’t revive its depressed economy, and that the same thing could happen to us. Back then a number of other economists shared my worries. Among them was none other than Ben Bernanke, now the Fed chairman.

So what did happen to us? We found ourselves in the unhappy condition known as a “liquidity trap.”

In the  middle years  of the  last decade,  the  U.S. economy was powered by two big things:  lots of housing  construction  and  strong  consumer  spending.  Both  of these things were,  in turn,  driven  by  high and rising  housing  prices,  which  led both to a building  boom  and  to  spending  by  consumers  who  felt  rich.  But the housing price se was, it turns out, a bubble, based on unrealistic expectations.  And when that bubble burst, it brought both construction and consumer   spending down with it. In 2006,  the  peak  of the  bubble, (US) builders  broke ground  for  1.8 million  housing  units;  2010  they broke ground for only  585,000.  In 2006 American consumers bought 6.5 million cars and light trucks; in 2010 they bought only 1.6 million. For about a year after the housing bubble popped, the US economy kept its head above water by increasing exports, but by the end of 2007 it was headed down, and it has never recovered.  The Federal Reserve, as I’ve already mentioned, responded by rapidly increasing the monetary base. Now, the Fed – unlike the board of the babysitting co-op – doesn’t hand out coupons to families; when it wants to increase the money supply, it basically lends the funds to banks, hoping that the banks will lend those funds out in turn. (lt usually buys bonds from banks rather than making direct loans, but it’s more or less the same thing.)

This  sounds  very  different  from  what  the  co-op  did,  but the difference isn’t actually very big. Remember, the rule of the co-op said that you had to return as many coupons when you left as you received on entering, so those coupons were in a way a loan from management. Increasing the supply of coupons therefore didn’t make couples richer. They still had to do as much babysitting as they received. What it did, instead, was make them more liquid, increasing their ability to spend when they wanted without worrying about running out of funds.

Now, out in the non-babysitting world people and businesses can always add to their liquidity, but at a price: they can borrow cash, but have to pay interest on borrowed funds. What the Fed can do by pushing more cash into the banks is drive down interest rates, which are the price of liquidity and also, of course, the price of borrowing to finance investment or other spending. So in the non-babysitting economy, the Fed’s ability to drive the economy comes via its ability to move interest rates.

But here’s the thing: it can push interest rates down only so far. Specifically, it can’t push them below zero, because when rates get close to zero, just sitting on cash is a better option than lending money to other people. And in the current slump it didn’t take long for the Fed to hit this “zero lower bound”: it started cutting rates in late 2007 and had hit zero by late 2008. Unfortunately, a zero rate turned out not to be low enough, because the bursting of the housing bubble had done so much damage. Consumer spending remained weak; housing stayed flat on its back; business investment was low, because why expand without strong sales?  And unemployment remained disastrously high.

And that’s the liquidity trap: it’s what happens when zero isn’t low enough, when the Fed has saturated the economy with liquidity to such an extent that there’s no cost to holding more cash, yet overall demand remains too low.

Let me go back to the babysitting co-op one last time, to provide what I hope is a helpful analogy. Suppose for some reason all, or at least most, of the co-op’s members decided that they wanted to run a surplus this year, putting in more time minding other people’s children than the amount of babysitting they received in return, so that they could do the reverse next year. In that case the co-op would have been in trouble no matter how many coupons the board issued. Any individual couple could accumulate coupons and save for next year; but the co-op as a whole couldn’t, since babysitting time can’t be stored. So there would have been a fundamental contradiction between what individual couples were trying to do and what was possible at the co-op-wide level: collectively, the co-op’s members couldn’t spend less than their income. Again, this comes back to the fundamental point that my spending is your income and your spending is my income. And the result of the attempt by individual couples to do what they could not, as a group, actually do would have been a depressed (and probably failed) co-op no matter how liberal the coupon policy.

That’s more or less what has happened to America and the world economy as a whole. When everyone suddenly decided that debt levels were too high, debtors were forced to spend less, but creditors weren’t willing to spend more, and the result has been a depression – not a Great Depression, but a depression all the same.

Yet surely there must be ways to fix this. It can’t make sense for so much of the world’s productive capacity to sit idle, for so many willing workers to be unable to find work. And yes, there are ways out. Before I get there, however, let’s talk

The essential point is that what we need to get out of this current depression is another burst of government spending.

Is it really that simple? Would it really be that easy? Basically, yes. We do need to talk about the role of monetary policy, about implications for government debt, and about what must be done to ensure that the economy doesn’t slide right back into depression when the government spending stops. We need to talk about ways to reduce the overhang of private debt that is arguably at the root of our slump. We also need to talk about international aspects, especially the peculiar trap Europe has created for itself. All of that will be covered later in this book. But the core insight – that what the world needs now is for governments to step up their spending to get us out of this depression – will remain intact. Ending this depression should be, could be, almost incredibly easy.

So why aren’t we doing it?”

The answer is politicians who refuse to make the decisions on increased spending because they are ignoring history.  They could start by fixing the pot holes and lines on our roads; they could tidy our public spaces, paint the fences and cut the grass in our parks. There are many easy, quick wins. And wins that would make us feel better as well as better off.

Tom Craig
About the author

Tom founded Craig Corporate in 1985. He is now Chairman of Craig Corporate and sits on the board (as a non-executive or Chairman) of several companies...
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by Tom Craig