As the economy continues to plod along, many voices are clamoring for even more simulative money-printing, as if the more-than-tripling of the monetary base in the last five years was simply a bagatelle, and even as the Federal Reserve continues creating $85 billion a month, a policy to be continued indefinitely until we see significant economic improvement.
As a Nobel Laureate and preeminent economist, New York Times columnist Paul Krugman receives a lot of attention for the economic proposals he advocates. He often tries to dispel right-of-center concerns involving the danger and inefficacy of today's loose monetary policy by telling an economic parable, in which many young couples with small children decide to band together and form a babysitting co-op that will provide each other with childcare services. A number of coupons are printed and issued equally to every couple, each entitling the bearer to one half-hour of babysitting time from another couple.
After a while, many parents start to increase their store of coupons and create a backup stash. The only means of doing so, however, is by watching someone else's kids and obtaining that family's coupons. But since almost every couple wants more coupons, few are willing to give them up by letting their own children be babysat, and increasingly few transactions take place. Thus, the simple economy gets mired down, and everyone ends up stuck at home watching their own kids with no date nights.
The obvious solution to this hang-up, writes Krugman, is to print more coupons for everyone. If families get more coupons, they will be willing to spend more of them on the margin, since they can now maintain a sizable reserve. Coupons will become less valuable relative to consumption (of babysitting services) and the couples will be more willing to give them up and consume more services, getting the co-op back in business. Similarly, a national government can pull its economy out of a slump simply by firing up the printing presses and spurring consumer demand.
But the methods used to jump-start the babysitting co-op would not succeed in stimulating the real-world economy. The advantage of money is that its purchasing power is not constant; it is able to vary in response to changes in accounting and opportunity costs and thus serve as an exchange mechanism among multiple goods. The purchasing power of a coupon, however, is a fixed claim to a certain quantity of a single good, and is insensitive to consumer preferences and production capabilities. It is not a liquid asset, and if the exclusive medium of transaction, as it is in the co-op, the economy would have difficulty getting off the ground.
Let's examine the co-op using a basic supply-and-demand model of babysitting services [graph A]:
with quantity demanded (or supplied) on the horizontal axis and the selling price on the vertical axis. The supply curve (blue line S) slopes upward, since people are willing to supply a greater quantity of services the higher they get paid for them. Similarly, the demand curve (green line D) slopes downward, since people are willing to purchase more services the lower the price they must pay.
The couples as a whole want to offer their babysitting services but won't accept the services of other couples, since that would mean giving up coupons. Thus, the quantity of services supplied exceeds the quantity demanded, creating a surplus of services -- which means that the price is above the free-market equilibrium pe, at which supply and demand are equal and fewer coupons are required to buy childcare. But since the co-op uses coupons, not cash, the price of services is fixed at the purple horizontal line, and cannot fall to equilibrium. Krugman's method of getting the supply and demand curves to intersect at the fixed price pf , rather than at the equilibrium price, is accomplished by shifting the demand curve from the green line D to the black line D' [graph B]:
-- that is, by increasing the services that couples demand and purchase at any given price. This will be the result of printing more coupons.
Look then at the supply and demand for coupons [graph C]:
Quantity demanded exceeds quantity supplied (everyone wants them but no one wants to give them up), creating a shortage, so the price must be below the equilibrium pe, at which the curves intersect. But the price cannot rise to equilibrium, since it is fixed on the horizontal line. The curves can meet at the fixed price pf, however, if the supply curve is shifted from S to S' [graph D]:
which would be the result of creating more coupons and divvying them out among the couples.
Such a shift would indeed revive the babysitting co-op, but so would the free-market solution of letting the price of coupons rise relative to the price of labor (more time would be spent babysitting in order to gain a coupon, and fewer coupons would be required to buy a given amount of babysitting time). Extra coupons would not need to be printed if the existing scrip could gain value (say, from one half to a full hour of babysitting time). The co-op only needed an increase in the supply of coupons because their purchasing power was fixed. (Printing additional money would be necessary if there were simply not enough physical units to accommodate transactions, but nowadays this is hardly a concern, since computers can divide electronic money into infinitesimally small units.)
A more subtle but crucial feature of the co-op is that it is an economy composed solely of consumption goods. Thus there is no such thing as investment, and the virtue of saving becomes the vice of hoarding. In the real world, savings can be used to invest in capital goods that will create more consumption goods in the future. Increasing the money supply, unlike increasing the coupon supply, would wipe out these savings through price inflation and insensibly give sound and hazardous projects alike equal footing on the economic playing field, stunting further development.
In fairness, Krugman does not advocate expansive monetary policy in our current situation, which he deems a "liquidity trap": even when the central bank pushes interest rates down to the limit (zero), people still don't borrow and spend enough to get the economy going. So if monetary policy doesn't do the trick, the state must resort to aggressive fiscal policy; if people won't spend their money even if given more of it, the government will forcibly tax and spend for them. As has been sufficiently documented elsewhere, the merits of publicly-funded projects are assessed more by political cronyism and election cycles than economic growth, since good-hearted as the state's central planners may be, these guardian angels can hardly mind-read millions of citizens and spend their money precisely as they would have.
We can concede the key point that undergirds all of Krugman's macroeconomic analysis -- that increased spending and demand can possibly revive an economy by harnessing otherwise idle resources. But this is only a sure thing in a single-good economy such as the babysitting co-op. In the real world, where there are countless final goods and services for which to put resources to work, identifying the right projects is only possible through the collective knowledge and feedback of a free marketplace. Blindly tossing money into the economy or letting government bureaucrats make some guesses will not promote a recovery, but only prolong the slump.