Saturday, 29 April 2017

What Babysitting Can Teach Us About The Economy

Let me tell you a story about babysitting, first told by economist Paul Krugman. The story involves The Capitol Hill Babysitting Co-Op, which consisted of many couples who baby sat for each other using the currency of scrips, which were pieces of paper with 30 minutes' worth of babysitting time on each.

Couples earned scrips by babysitting, and they purchased other couples' babysitting time with scrips. Couples all started with 20 scrips (10 hours of babysitting time), but over time there was a problem, because couples became reluctant to use their scrips, which diminished the demand for babysitters. This made it harder for babysitters to sell their babysitting time, which in turn incentivised couples to hoard their scrips, thereby creating a babysitting recession.

So the story goes, Capitol Hill decided that the solution to kick start the babysitting economy was to issue couples with more scrips, which stimulated the demand for babysitting by making couples keener to go out. As more babysitting jobs became available, couples became more incentivised to go out themselves, and voila, the babysitting economy was back in full flow.

The analogy to macroeconomics, according to Krugman, is that in recessions it is harder to earn money as people spend less money, so the economy can be kick-started Keynesian-style by governments issuing more money. This is flawed for two reasons; firstly, when governments issue more money into the economy there are enormous concomitant deadweight costs to the price system. And secondly, the economy isn't like the Capitol Hill Babysitting Co-Op because money is more dynamic and so are prices.

The problem with the babysitting recession was down to what's called sticky prices. Sticky prices is the term for when prices don't adjust quickly enough to changes in the economy. For example, a chain of ice cream parlours may find that an increase in the price of ingredients makes providing ice cream slightly more expensive. But despite this, changing all the prices on the signs and advertising boards may be not worth their while, so their prices stick. Another example, the marginal value of waitresses may decrease by 50p an hour, but restaurants who've invested time in their waitresses may not wish to reduce their hourly rate or recruit new staff.

Price changes can be costly for businesses, particularly in large organisations with tens of thousands of prices to alter on shelves, and the management time required to research optimal prices, to keep an eye on competitors, organise sales staff and negotiate with consumers - sometimes it pays to remain with the status quo.

Anyway, back to the babysitting co-op - the problem the couples found was that prices were sticky, but also that there was no negotiating to stimulate supply and demand such as you find in a real economy. For example, in a babysitting recession couples could negotiate the value of their scrips to bid up demand for babysitters, which would increase the supply of babysitters.

The place that Krugman's analogy falls short is in the fact that money in an economy is not like the scrips, because the scrips were confined only to babysitting, whereas money is confined to anything you want to spend it on. In other words, unlike the scrip, there is nothing on a five pound note that says it must be spent on babysitting, so not only do prices adjust more freely in a market economy by supply and demand changes in one good or service, they do so in relation to every other good and service too. In the babysitting cooperative, there is not much fungibility - which means you cannot say you don't want a babysitter so you'll go out for the night by buying a toaster instead. In an economy, however, if prices rise for apples, you can always eat oranges, or bananas or cereal.

This is why the government printing money is almost always bad for the economy, even if the intentions are sometimes good. To see why with an illustration, have a look at the graph below. Suppose the product in question is bunches of bananas, and the equilibrium point - the point at which quantity supplied and quantity demanded are equal - is £1.20 a bunch, and 2 million bunches are sold per week in the UK.

Now suppose the market for bananas got thrown off equilibrium by a 20% tax. Bananas are now £1.44 a bunch, and because the tax is passed on to the consumers, let us now say only 1.8 million bunches are sold per week. The tax has effectively reduced banana sales by 10%, which negatively impacts buyers and sellers, and denies society lots of consumer and producer surpluses.

Printing money causes increased inflation, which is rather like a tax because those who hold money lose purchasing power. Inflation is to holding money as income tax is to earning an income, therefore printing money is like increasing the tax on savings, which has a knock on effect of altering consumer prices away from their equilibrium point, which then robs society of some of the value created in a free market of supply and demand.

Other government interference, like price controls, taxes and regulations cause further exacerbation to this problem, because they affect the market value of goods and services, which means many firms lack sufficient information to act, which means falling sales, reduced costs, wage cuts, job losses and reduced consumer demand in a downward circular spiral.