Right in the Short Run

As one of my professors once put it, Paul Krugman has an interesting mind. He has a knack for coming up with simple models that capture the essence of a phenomenon. One blogger from this site (who shall go unnamed, although it’s not me) says that personally hearing Krugman talk about one of these models inspired him to pursue economics in the first place. I can’t say I had a golden moment like that, but the elegance of Krugman’s explanations has strongly influenced the way that I look at economic problems. Oh, and I read his column religiously.

So on that note, I’m pasting an excerpt from a piece he wrote nearly a decade ago for the NY Times. In it he relates an old story about a babysitting co-op that experienced a recession. No, Krugman did not create this story on his own, but his prose tidies it up and gets down to the core cause of recessions.

Even baby-sitting can’t avoid recessions: Back in the early 1970s, a group of families in Washington formed a baby-sitting cooperative — that is, an arrangement under which couples would baby-sit for each other’s children. Such cooperatives are fairly common, but this one had two unusual features: It was bigger than most (containing about 150 couples), and two of its members, Joan and Richard Sweeney, not only understood what was happening but also wrote about it in an article entitled “Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis.”

Such a co-op requires some system to ensure that members do their fair share. Like many co-ops, the Capitol Hill organization used a scrip system. New members were issued a certain number of coupons, each responding to one hour of baby-sitting time. When one couple watched another’s children, the baby sitters received the appropriate number of coupons from the baby sittees — coupons which the sitting couple would then “spend” on some other occasion.

What the co-op eventually discovered, however, was that this system worked only if there were neither too many nor too few coupons in circulation. Couples made decisions both about whether to baby-sit and whether to go out for the evening based on their reserves of coupons. If they had small reserves, couples were reluctant to use them up, preferring to save them for a rainy day; but they were quite willing to baby-sit to build up their hoard. If they had large reserves, they were eager to go out but reluctant to sit.

But one couple’s decision to go out was another’s opportunity to baby-sit, and vice versa. In the early days of the co-op, it turned out that there was too little scrip in circulation. that meant people were eager to baby-sit but reluctant to go out — which meant that many people who were willing to baby-sit could not find takers. And the realization that it was hard to find opportunities to replenish their coupons made people even more anxious to save their reserves for special occasions, which made opportunities to baby-sit even scarcer.

Eventually, the people who ran the co-op issued more coupons. The result was a dramatic improvement: More people went out, which meant coupons were easier to earn, which led to even more people going out, and so on. But then, inevitably, they overdid it. Once there were too many coupons in circulation, people became eager to go out, but it became hard to find baby sitters; as people realized that coupons often could not be used, they became even less willing to baby-sit in order to earn them.

What does all this have to do with the business cycle? the baby-sitting co-op was, in effect, a miniature macroeconomy; its problems were simplified versions of the problems faced by the U.S. economy as a whole. In particular, the downward spiral the co-op experienced when there were too few coupons in circulation was a recession — no more, no less. when America as a whole experiences a slump, the details are more complex, but the principle is the same. And Federal Reserve Chairman Alan Greenspan is simply the man who controls the number of coupons, otherwise known as the money supply.

That’s only an excerpt. Why not read the whole article if you’ve got the chance?