David Gordon discusses Krugman’s use of the babysitting co-op story as an explanation for Keynesian stimulus policies. In his post, Gordon mentions Tim Harford’s critique of Krugman’s pedagogical model. Harford’s criticism teaches us an important message, but I want to distinguish between what it tells us and what it doesn’t.
Some of you who have never read Krugman (2009; 2012), or the original Sweeney and Sweeney (1977) article (ungated), might have no idea about what Gordon, Harford, and I are going on about. The story involves the Capitol Hill Babysitting Cooperative (CHBC), which is an organization that provides babysitting services in a very specific way. Basically, new members are given a certain amount of scrip, worth 20 hours of babysitting; these members are asked to return all 20 hours when they decide to end their membership. This scrip is used as money, where those who demand the service pay those who supply it in scrip. To earn more, then, — for future babysitting services, or to repay your debt to the CHBC —, a member has to supply babysitting services.
On average, members thought that they should hold more scrip before demanding services. Those who increased their demand for scrip would work the jobs they could. But, the increase in demand called for more scrip than existed, causing a shortage. Members, on average, rather babysit than go out, but when nobody goes out there is no demand for babysitting services. Since the price of scrip is fixed, a falling “price level” can’t clear the market for babysitting. If the scrip were allowed to appreciate in value, it would take less scrip to fulfill the average person’s demand for babysitting hour IOUs, and excess notes would be exchanged to those who want them, in return for babysitting services. The solution, instead, is to increase the supply of money, or, in this case, scrip.
Harford, however, tells us that in the real story, the monetarist solution eventually led to an oversupply of scrip. This is confirmed by Wikipedia. The CHBC supplied too much new scrip, members sought to spend excess scrip on babysitting, but since now the average member wanted to go out, there was a shortage of babysitters (rather than a surplus, as was the case originally). One way to interpret this is to reject the babysitting co-op story altogether. I don’t think this is the right approach; rather, the whole story teaches us a lesson on monopolized management of the money supply, but it leaves Krugman’s actual point largely unscathed.
Suppose, for the sake of argument only, that the CHBC knows exactly how much scrip to introduce into its babysitting economy. Assume that it distributes this new scrip at random, so that some will have excess holdings. Those with more scrip than they want will spend it, demanding babysitter services. This allows those with inadequate scrip balances to offer their services and earn babysitting money in return — it allows mutually beneficial trade to take place, whereas originally a rigid price disallowed them (which is why we say that demand shortages lead to output gaps). Thus, the monetary solution is the right one.
The CHBC story does warn of the problems of an issuer that is not disciplined by the market — rather, the issuer and the market(s) it helps coordinate are disciplined once the damage has been done. We want a competitive scrip market, where those who over- or under-issue are disciplined (through reflux or foregone profit, respectively) before the market breaks down, coordinating the supply and demand of scrip (money). Moving from the analogy to the real world, this is why competitive free banking is preferable to central banking.
Central banks are not very good at responding to money shortages and judging excess supply, causing volatility and distortions. A competitive private banking system, however, can achieve better results, because individual banks’ constraints on issuing money are much tighter — excess notes circulate back to the issuer, putting pressure on their assets, and interest on deposits limits their ability to attract them (to the margin where it becomes unprofitable). When the demand for money rises and velocity falls, the pressure on banks’ assets falls and they can issue notes. When the demand for money falls, or after an issue of excess notes, the pressure on their assets rises and they are forced to reduce the number of outstanding liabilities. These pressures are much more muted in the current system, where there are no competing notes (and customers can’t discriminate between them), and the ultimate issuer is the central bank.
The CHBC story illustrates the problem of monetary disequilibrium very well. It also shows why monopolizing the currency system can be so damaging to the economy. Unfortunately, most probably only appreciate one of the two lessons, but never both.