Here's a child's guide to the economic crisis
A simple babysitting co-op in Washington could shed light on how economic depression happens and how to solve it. The way the childcare co-op operates also helps to explain what central banks around the world are doing right now.
The current economic crisis in Europe and the US has negatively affected millions of people across the globe, but it also provides an opportunity to learn about economics.
How economies work baffles not just ordinary people but also economists and those who claim to be experts. Given the conflicts of opinion between experts appearing in the media, it seems their understanding of the economy is little better than the layman’s.
Yet, there are simple ways to understand the complexity of economic activities.
One way has been pointed out by Paul Krugman, Nobel laureate in economics, who uses the real-life experience of the Capital Hill Babysitting Co-op to explain how economies fall into depression, and how it can be ended. The co-op story was first told in 1977 by Joan and Richard Sweeney in their article “Monetary Theory and the Great Capital Hill Baby Sitting Co-op crisis”, in the Journal of Money, Credit and Banking. It was later popularised by Krugman. Back then, in the 1970s, the co-op’s membership numbered about 150 couples, mainly Congressional staff. They wanted to save money, so agreed to form a cooperative in which each couple looked after other members’ children in exchange for coupons. One coupon was worth half an hour of babysitting, and members use the coupons like money to hire each other as child-minders when they wanted go out for the evening.
After a while, the co-op ran into trouble. Couples were seeking to earn more coupons that would translate as more nights out enjoying dinner at a restaurant, or a movie. This led to lower opportunities for babysitters. The situation was analogous to the falling demand experienced during economic depression, when consumers and firms spend less, leading to economic slowdown.
The rare babysitting opportunities at the coop even meant that couples were reluctant to go out for dinner and thereby offer other members babysitting opportunities, as almost everyone wanted to increase their coupon reserve.
This is analogous to a situation when almost every consumer and firm tries to hoard cash, leading to a downward economic spiral that ends in deep depression.
So, how to solve it?
The co-op manager was persuaded by members who were economists to increase the number of coupons in circulation. It worked well.
We are now seeing the same solution applied by central banks such as the US Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BoJ), which are injecting more liquidity into the economy by printing money.
More coupons helped solve the “economic depression” at the Capital Hill co-op, (though later, too many coupons were put into circulation, which led to “inflation”, or near-worthless of coupons).
Krugman has joined other Keynesian economists in persuading the Fed, ECB and BoJ to inject in more liquidity to solve the current depression. The central banks started by cutting of their policy rate (short-term interest rate) to near-zero and then launched quantitative easing – increasing the money supply in a bid to pull down the long-term interest rate. This should increase demand in the economy.
Meanwhile, other economists are arguing that injecting more money will not solve structural issues, such as the low productivity in the troubled economies of Greece, Portugal, Ireland, Spain and Italy.
But Krugman argues that the co-op problem was nothing to do with productivity – couples failing in their babysitting duties – but was rather a failure of coordination in the form of a coupon shortage.
According to him, curing the economic depression is simply a matter of central banks increasing the supply of money, just as the co-op’s manager increased the coupon supply.
Krugman argues that the current economic depression in the US and Europe is because of a collapse of demand derived from debt deleveraging. In order to pay their debts, everybody in the economy is saving more and spending less in order. This is rational behaviour on an individual basis, but ruinous collectively because it leads to a collapse of demand in the economy.
One person’s debt or spending is another’s income. So when there is no debt or spending there is also no income for others.
When there is no income, or no spending by consumers, firms have no reason to invest or expand their businesses. In contrast, they will try to cut jobs, leading to deeper economic depression.
