Friday, February 21, 2014

Fighting Recessions: Monetary Policy and the Babysitting Co-op Crisis

During the Great Depression of the 1930s, the average income of an American family dropped by 40 percent from 1929 to 1932.  According to the Bureau of Labor Statistics, in our most recent recession, the number of job openings decreased by 44 percent and the resulting employment decline was greater than that of any recession in recent decades.  But what usually causes a recession, and how do we get out of it?

I’ll get to that in a minute.  But first, some background.

In 1977, Joan and Richard James Sweeney published an article in The Journal of Money, Credit and Banking titled “Monetary Theory and the Great Capitol Hill Baby Sitting Co-op Crisis.”  The point of the article was to explain how economies can find themselves in a recession by drawing an analogy to—you guessed it—a babysitting co-op.  This allegory, popularized in “Peddling Prosperity” by Princeton Economist and New York Times columnist Paul Krugman, is admittedly simpler than the complex economy we actually experience.  But sometimes understanding more sophisticated concepts means first building an intuitive framework—the same way architects use models to communicate design ideas to clients.

The story, by the way, also happens to be true.  The Sweeney’s write that while living in Washington D.C., they joined a babysitting co-op—an association of couples whose members agreed to babysit each other’s children some nights, knowing that other couples would return the favor some other time.  To ensure that everyone did their fair share of babysitting, the co-op developed a “scrip” system using pieces of paper, where one unit of scrip would “pay” for one half-hour of babysitting.

But it wasn’t long before this system ran into trouble.  Most couples behaved the way you would expect them to—they saved up scrip by babysitting for others so that when they wanted to go out, they had enough to give to another couple. That meant that there needed to be a fairly large amount of scrip in circulation to make the whole thing work.  The problem was there wasn’t:

“There was so little scrip to go around that holders were reluctant to squander it by going out.  Those who wanted to go out but didn’t have scrip were desperate to get sitting jobs.  The scrip price of babysitting couldn’t adjust, and the shortage worsened.”

The Capitol Hill Babysitting Co-op was experiencing a recession—a general slowdown in the market for babysitting.

Notice that there was nothing inherently wrong with the underlying inputs in this babysitting economy. That is, there were plenty of couples who wanted to babysit and Washington D.C. didn’t suffer an earthquake, destroying the land and the homes in which babysitting took place.  Rather, the co-op didn’t have enough couples willing to go out and spend their scrip. 

The solution, as any economist will tell you, was simply to issue more scrip.  With couples’ desire to hoard scrip satisfied, more were willing to go out—and because one couple’s decision to go out meant another couple’s chance to babysit, this model economy soon recovered.

Like the babysitting co-op, the U.S. economy sometimes gets into trouble when people demand to hold more money.  To do so, people must reduce their spending on currently produced goods and services.  But since your spending is my income and my spending is your income, the effect of an aggregate reduction in spending is a general slowdown in economic activity. The solution, of course, is to increase the supply of money—and in the most recent recession, that’s precisely what our Chief Scrip Issuer, Federal Reserve Chairman Ben Bernanke, did. Here’s how it works.

When the Federal Reserve (or “Fed”) changes the supply of money in the economy, economists call that “monetary policy.” The Fed typically implements monetary policy by setting a target for the federal funds rate—the interest rate that banks charge each other on overnight loans.  To increase the money supply, the Fed lowers its target rate by buying securities—such as Treasury Bonds—from banks, adding money to their reserve accounts. Awash with cash, banks lower the interest rate they charge each other on overnight loans. This causes other interest rates to decrease as well, stimulating economic activity.

But of course—and you probably guessed this was coming—if it’s really this easy, why has the U.S. had such a difficult time getting out of its most recent recession? Well, it turns out that the Fed can only cut interest rates so far; in particular, it can’t cut them below zero.  Economists call this reaching the “zero lower bound,” and that’s precisely where the U.S. found itself in the most recent crisis.  So with the Fed unable to increase the money supply, what can we do?  I’ll save the answer to that question for a future post.

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