[This article by Juan Ramón Rallo was first published on March 16th, 2009, in Spanish for the Instituto Juan de Mariana. I translated it with Rallo's permission.]
The awarding of the Nobel Prize in Economics to Paul Krugman has turned him into a kind of spiritual guide to managing the recovery from the current crisis. However, given that his knowledge of the business cycle leave a lot of be desired, his recommendations are hardly adequate.
Perhaps the easiest way to prove that Krugman’s Keynesian perspective is altogether useless in understanding the workings of an economy is by using the example that he himself sorts to when explaining the business cycle: the baby-sitting cooperative.
In this model, every cooperative member, a parental couple, offers its baby-sitting service to another couple and in return for this service receives scrip that gives them the right to ask that another couple from the cooperative take care of their children in the future (the latter couple would in return receive more scrip redeemable for the same service).
With this very simple scheme, Krugman explains both recessions (for example, the bursting of the dotcom bubble) as well as deflationary depressions (Japan). Recession would take place when the number of scrip in circulation is reduced for some reason (for example, because some couples hoard too much scrip for the purpose of obtaining baby-sitting services in the future), and thus every couple begins to ration its use of scrip for special occasions (that is, they do not go out at night to avoid spending now the scrip); however, if there are no couples spending scrip, the rest of couples would not be able to acquire new scrip and therefore the demand for baby-sitting goes down and, thus, so does supply. The solution is simple: to print more scrip so that new opportunities to become a baby-sitter are created and the circulation of scrip is “reactivated.”
To explain Japan’s depression we must manipulate the model a bit by adding a credit market: every couple can request coupons from the management of the cooperative on the condition that in the future more coupons be returned (the interest from this operation functions here as a means to penalize the abuse of debt).
In this model, the problem can often appear due to the heavy seasonability in the demand for baby-sitters: in the winter, no couple wants to party and requires no baby-sitting so they will try to build up a scrip reserve for the summer when they will want to leave the house. But if no one wants to leave the house, nobody will be able to accumulate scrip (without a present demand of baby-sitters there can be no future demand), therefore the few couples who have scrip reserves would be even less willing to spend them in the winter. Not even if the authority set interest rates to zero would couples demand scrip during winter because they would lose the ability to go out in the summer. In this situation the economy would have fallen into the “liquidity trap.”
The solution for Krugman again becomes equally simple: to depreciate scrip such that if they are not spent in the winter they will become useless in the summer; this way, scrip will continue to circulate. In other words, inflation is the solution for depression. A conclusion that would make Silvio Gesell very happy.
The simplicity of this model does not prevent Krugman from describing reality with great detail. In the article we can see that it “changed [my] life,” that “you can learn more about economic slumps … than you will … from reading … a year’s worth of Wall Street Journal editorials” and even that it “could save the world.”
Let’s see to what extent these pompous conclusions have any substance, and if their assumptions can overcome even the simplest critical analysis:
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Consumption generates income (lack of capital): Keynesian models lack a good theory of capital — something that Keynes himself recognized — because they tend to characterize it as a homogeneous, self-reproducing pool that lacks structure whatsoever. Obviously, this is unrealistic because consumption goods do not magically appear on the market but are rather the product of a whole structure of capital goods that, far from being amorphous, is very complex, heterogeneous, specific and significantly indivisible, and, far from being self-reproducing, can only be maintained insofar as the resources used to reinvest in them were not consumed. In other words, when I sell a car I am obtaining a gross rent not just for the “consumption good” called car but for all of the factors of production that have helped to build it (machinery, workers, mines, electric generators, etc.). Krugman’s model, however, assumes an oversimplification even greater than the Keynesian because in it, capital does not even exist. Every time that a family consumes a baby-sitting service it automatically creates income for other families. The economy is thus turned into a simple barter of services. But without capital or investment there cannot be, by definition, a problem of “malinvestment” and, therefore, the entire issue of the business cycle becomes irrelevant. In other words, Krugman pretends to explain the business cycle by using an economic system where there cannot be a business cycle for reasons that we discuss below.
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There is only one way to generate wealth: Given that in the model there exists only one good (baby-sitting services), Krugman equates the production of that service with the creation of wealth; thus, stopping its production is equivalent to recession and poverty. This is absurd because a society where every couple always takes care of its children would always be extremely poor, and a society where every couple never takes care of their children (but instead those of another couple) would be extremely wealthy. In this model, the provision of more or less baby-sitting services is in reality not an issue of bad investment (for example, that each couple has financed their outings through debt and when it comes time to repay the debt they must completely stop going out, and, therefore, hiring baby-sitters) but rather of the variability in the consumers’ preferences.
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Money does not exist: The scrip in the cooperative is not strictly money because they are interchangeable only for one good, namely, baby-sitting services. In other words, the scrip holder is a captive consumer of baby-sitting services. He can only choose whether to spend them sooner or later but cannot force a different service from the baby-sitters. Therefore, neither is the consumer sovereign nor, again, is there a problem of malinvestment: the baby-sitting profession will always be the most optimal specialization in this economy.
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There is no uncertainty associated with scrip: Despite scrip only conferring a right to demand a service, Krugman assumes that it does not involve any sort of uncertainty, that is, that every holder can obtain at any given moment and place the desired amount of baby-sitting services that he wishes to consume. Obviously, this makes no sense because merely having the right to a baby-sitter does not guarantee always being able to find someone willing to offer this service, especially if the cooperative prints scrip for baby-sitting services that couples have not accepted to perform. Krugman, in other words, holds that if scrip are artificially printed, couples will always be willing to work extra hours and that, therefore, scrip will never default, not even when the progressive inflationary increment of extra hours leaves couples with less time to carry on other activities. But what would happen when every day there are more rights to baby-sitting hours per couple than there are hours in the day?
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Savings can only come as hoarding: In modern societies, an increase in savings allows an increase in investment, and, therefore, an increase in the amount of future consumption goods. The factors of production are not left unused when saved. Rather, they move from one industry (consumption) to many others (capital goods). Given that in Krugman’s model there are no capital goods, families can only hoard their scrip. And hoarding them necessarily increases the unemployment of factors of production (that is, the rest of the couples who want to baby-sit), which have no other useful purpose. If the model allowed for the existence of investment, it would be clear that if baby-sitting consumption goes down, the demand for capital goods can be increased. As a result, the strong seasonality in the demand for consumption goods — that is, the preference for liquidity that according to Krugman caused the crisis in Japan — only promoted that during times of low demand, “idle resources” would be invested in industries destined to produce more consumption goods for times when they would be high in demand. Yet that cannot happen in this model, for it assumes the impossibility of converting present income to future income through investment (and the consequential increase in the possibility of future consumption).
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Idle resources are only a problem of demand: The corollary of the previous point is that productive activity falls and that couples are left without being able to perform baby-sitting services because people are saving (that is, hoarding) and it is necessary to encourage consumption to see a resurgence in economic activity. Once again, given that there is no capital or malinvestment, Krugman does not realize that in an economy the majority of the factors of productions are used jointly and organically and thus their lack of use (unemployment) signals a lack of complementary capital goods needed to put the idle resources to work, a problem due to the necessity of redirecting previous malinvestment (which, as we have discussed, do not exist in this model).
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Public spending and inflation suffice: Taking the above into consideration — if economic activity and employment are consumption; if money can only be used either to consume a single good or for hoarding; if there exists no uncertainty about the fulfillment of an obligation; and if the use of productive resources is perfectly mobile — of course the solution to the “recessions” is evident: we only need to force the consumption of scrip, either by printing a larger number of them or by lowering hoarding (through inflation or mandatory spending regulation). The problem is that this model has nothing to do with the reality of a capitalist economy where there exist capital goods and where the issue is how to reorient previous malinvestment, not to mention that it is in this economy where the business cycle can take place.
A well-earned Nobel, no doubt.
{ 20 comments }
The last line of the section:”There is only one way to generate wealth:” really says it all, that is they are victims of consumer preferences. If consumers don’t want the good or service then the supplier must cut prices until they cease business.
The old business saying: “No Need, No Sale!!!” holds for economies as well. That is the essence of what the powers that be in Washington are trying to fight. That is consumer preferences have changed and suppliers who can not adapt must cease business.
The best jokes are the most evil ones.
Good timing! I just posted my own refutation of this analogy the other day, but I took a different tact with the analysis.
In my view, the co-op engaged in price fixing the moment it fixed the value of 1 scrip equal to 1 hour of babysitting. When the co-op subsequently removed scrip from circulation (through some undefined mechanism that he skips over) that’s basically saying the monetary supply was deflated. A free market system would naturally allow the ratio between scrip and an hour of babysitting to fluctuate (i.e. prices to rise and fall), but in this case the value of 1 hour of babysitting was fixed. I’d be interested in hearing your comments.
http://mises.org/Community/forums/p/7037/110695.aspx
Help me get this right.
It seems that the latest congress (elected in 06) has been on a mission to force a free market banking system to lend money to those who cannot ever hope to repay it under the same system (their attempt to create wealth by printing it).
This in turn started a pyramid scheme of artificially inflated personal net worth by creating over demand for the product and the temporary supply shortage that follows.
When this scheme reached the peak of the pyramid and there was no one left to give the artificially created wealth to, no one to repay the debt that it created or to purchase the product at it’s artificially high price, then the house of cards crumbled.
How can a keynsian model ever actually work given a finite number of consumers, resources and the resulting currency value that comes from the trading between the consumers of the resources?
Doesn’t the market system and society have be allowed to work a lot like the natural selection among plants and animals to remain strong and vibrant like nature itself?
I like Michael Hall’s comment a lot more then the blog post to be honest. One hour of baby sitting during the weekday is obviously not worth the same as during the weekend. One Hour of baby sitting on a school day is not worth the same as a holiday.
I like Michael Hall’s comment a lot more then the blog post to be honest. One hour of baby sitting during the weekday is obviously not worth the same as during the weekend. One Hour of baby sitting on a school day is not worth the same as a holiday.
What about the entrepreneurial approach?
A few couples get together and compare scheduals.
They mark out time periods of availability for each couple, and set a common price/hr.
Then they offer up the accumulated scheduals to the market at large, at that agreed price. The coop is unbounded by the scrip, open to demand, when it is called for, and equally useful to the members at a break-even rate of exchange.
The coop, acting as a group, can change their rates depending on the demands of the market and the value of the time periods is reflected by that demand. Evenings and Weekend hours cost more because there is more demand for those hours etc. etc.
In the Scrip model, the market was restricted to those in the coop itself, and the payment restricted to the “coin of the realm”. Of course it failed. That’s like playing monopoly, eventually the game is over….
Months ago I refuted a Krugman keynesian disciple on another website by simply pointing out, the coop price fixed the babysitting services at the start and it doomed them. The disciple was a gentlman about our discussion but had no retort to the price fixing point.
I then pointed out that when they tried to change the price by changing the scrip supply, they got lucky and got it closer to what supply-demand would price it at. But they then wrecked it and ruined it by further increasing the scrip supply. Then I asked him, if these fairly intelligent capitol hill staffers (which included some economists) couldn’t get the pricing structure of 1 service correct, how in the world would they get the pricing of millions of goods and services correct. Again, no retort.
I love the Krugman babysitting example because it helps point out several fallacies of Krugman style economics. I hope Mr. Krugman and his various disciples keep using it and that it makes its way to the collective mainstream thought of America, then we can use it illustrate the truth.
I would be embarrased to be a Nobel prize winning economist who put forth an example in which the problem of price fixing with a flawed medium of exchange is staring oneself in the face, and yet not be able see it. I would be even more embarrased to pay him for his thoughts.
Quick, someone get Mr. Krugman to the Chicago Board of Trade, NYMEX, or an auction, so he can see how price discovery of commodities and other goods or services happens as numerous buyers and sellers bid on prices. He obviously can’t see how it happens in brick and mortar store environments, so maybe it would be easier for him to see it in a direct auction environment.
Months ago I refuted a Krugman keynesian disciple on another website by simply pointing out, the coop price fixed the babysitting services at the start and it doomed them. The disciple was a gentlman about our discussion but had no retort to the price fixing point.
I then pointed out that when they tried to change the price by changing the scrip supply, they got lucky and got it closer to what supply-demand would price it at. But they then wrecked it and ruined it by further increasing the scrip supply. Then I asked him, if these fairly intelligent capitol hill staffers (which included some economists) couldn’t get the pricing structure of 1 service correct, how in the world would they get the pricing of millions of goods and services correct. Again, no retort.
I love the Krugman babysitting example because it helps point out several fallacies of Krugman style economics. I hope Mr. Krugman and his various disciples keep using it and that it makes its way to the collective mainstream thought of America, then we can use it illustrate the truth.
I would be embarrased to be a Nobel prize winning economist who put forth an example in which the problem of price fixing with a flawed medium of exchange is staring oneself in the face, and yet not be able see it. I would be even more embarrased to pay him for his thoughts.
Quick, someone get Mr. Krugman to the Chicago Board of Trade, NYMEX, or an auction, so he can see how price discovery of commodities and other goods or services happens as numerous buyers and sellers bid on prices. He obviously can’t see how it happens in brick and mortar store environments, so maybe it would be easier for him to see it in a direct auction environment.
I started a thread about Krugman’s article on Slate with some comments on this nonsense.
I can’t believe how ridiculously lame his thinking is.
I’ll post the starting text of my thread below in case they delete it.
Brian Macker wrote: “This is not the level of thinking one would expect from a Nobel laureate”.
Come on, Al Gore won the Nobel for his Scientific Explanation for Global Warming. Just think, a professional Politician explaining and Interpreting Complicated Physical Science while refusing to debate REAL Climate and Atmospheric Scientists.
Wouldn’t want the FACTS to screw up Gore’s Hypothesis……..
Michael Hall
I really liked your counter analysis, those points surely deserve an inclusion in the above article.
In simple words in January, the couples who wanna save more scrips for the summer will offer more number of hours of baby-sitting for same amount of scrips, like 2 hours for 1 scrip, 3 hours for 1 scrip and so on….
Similarly, in Summer, since more people wanna go out and there is demand for more hours than scrips, then people will offer more scrips for same hours, like 2 scrips for one hour of baby-sitting, 3 scrips for 1 hour and so on…
This is the Market’s way of reallocating resources, but Krugman comes from a school where he does not believe in Market’s allocation of resources.
Take for example in a free market economy with gold standard the market will allocate the money from a low interest rate time to a high interest rate time, just like it allocates apples from a low apple producing region to a high apple producing region.
Krugman believes that only a central planner can allocate money from a low demand time to a high demand time, so he goes on explaining with this example of baby-sitters.
Any individual who wants to make profit would be accumulating the scrips in summer by baby-sitting, and exchanging them for something else in winter(if not hours), but unfortunately, in Krugman’s example that approach is severely restricted considering that the there is only one job – Babysitting.
Actually, Gene Callahan already mentioned the price fixing problem in Krugman’s scenario in his book, Economics for Real People.
Socialism forces and establishes inequalities upon societies, thus strengthening the suggestion that “Socialists love the idea of society, but hate and detest peopleâ€. A lasting and eventual result of Socialism is increased societal tension owing to restricted and restrained self-determinism and self-expression and eventually leads to explosive and violent actions from the lower classes that have been established through socialistic evolution. This may be the reason that Karl Marx concluded that Capitalism evolves to Socialism then Communism, because Communism is complete dictator, military control of the masses and lessens and/or subverts the inevitable results of violent retribution on public leaders from the general public. Advantages of Socialism only are for the selected few. Socialism can be a tool used to manipulate supply/demand curves through pricing while disrupting natural equilibrium in the system but communism is the only way to fully determine, predict, and establish through mathematics a permanent and constant supply/demand curve through price action. Now, this is how to achieve TRUE PRICE FIXING……
Is it allowed to babysit more than one child at a time?
(from different couples)
And accumulate double scripts for the same time?
I added these additional comments in response to another commenter with the tag “Austrians Are Stupid” who claimed I was pointing out unimportant aspects of Krugmans analogy:
“Of course you aren’t going to make the argument of how you think I got it wrong because you’ve got nothing.
It’s obvious that Krugman’s ridiculous model uses “labor dollars” and is artificially created with a supply and demand mismatch.
One of the major reasons why humans use the biological strategy of voluntary cooperation (division of labor) is because we are heterogeneous. Some animals do so with fixed social castes. Some ants have soldiers, workers (of different sizes), and reproductives. This allows a division of labor with soilders protecting, large workers taking down prey, small workers pulling meat from inside prey, etc. Without heterogenety the advantages of cooperation are highly diminished.
So where are the teenaged girls in Krugman’s ridiculous model of the economy? Where are the singles. Where are the childless couples. Where are the grandparents. Where is the money. Nowhere.
Krugman has build an incredibly lame model here that shows very little understanding of basic economics. It’s as if he never learned anything but Keynesian macroeconomics and never bother to learn any other aspect of economic theory. Like why there is a division of labor.
Of course if you have a fake service only economy with a uniform population, without money, with almost no demand for babysitting in the winter, and little desire to babysit in the summer you are going to have problems.
Krugman’s “solution” to the “problems” his fake “economy” generates are equally ludicrous. There are real world situations that match his example. For instance, there is zero demand for farmers to grow crops in the winter. Thus there is also zero demand for fertilizer in the winter, and zero demand for the service of spreading it in the winter. Krugman’s suggestion is that we use government mandates to force farmers to buy fertilizer in the winter and spread it to keep the economy moving. Which is the typical Keynesian mistake of thinking that aggregate numbers like GDP and GNP are important.
Such mistakes lead economists of his ilk into supporting obviously (to the rest of us) stupid economic policies. For instance, FDR, was destroying farm crops and pigs to keep farm prices up at the height of the Great Depression while people were waiting on line at soup kitchens.
What’s the proper solution in his fake economy. Use money and let people negotiate the prices they are willing to pay and get for baby sitting services. In the winter the wage you get for baby sitting goes down and in summer it goes up. Having true money solves the problem immediately and fairly. Why is Krugman unable to see that?
The reason we are in such economic trouble is that economists who think like Krugman have been running the show all along. Anyone who would agree to run the Fed and try to set prices for interest rates by a central committee believes in central planning by the government. Of course those of us who actually believe in free markets and understand them know that such a scheme CANNOT work. It must lead to shortages and surpluses. In this case the price is interest rates, the price control a price ceiling, and the shortage is of credit. We have now been proven right once again.
Proven correct empirically.”
Krugman’s baby-sitting analogy is just another example of the dishonest technique of arguing by analogy and designing the analogy to insure that your side automatically wins. It’s slightly more sophisticated than the technique of defining terms to guarantee a victory. Socialists must always be dishonest or they can never win any argument. But it doesn’t demonstrate much cleverness, let alone economic knowledge.
Krugman reminds me of the grandfather whose grandchildren were running around, making noise and generally irritating him and his old fart friend, so he lied to them by telling them that grandma had made a batch of cookies and left them on the kitchen table. After the kids left, grandpa got out of his chair and started for the door. His friend asked him where he was going and grandpa replied “to get a cookie.â€
I agree that socialists have to be dishonest to win these arguments, but a lot of people including me can fall for these arguments without being dishonest. I really appreciate Macker and Rallo for so clearly identifying the flaws in this particular argument, and I’m glad that it wasn’t just written off as “arguing by analogy.” This way I have better understanding of the Austrian theory.
A writer for PhillyIMC found this criticism of the baby-sitting parable to be “completely incoherent“. He doesn’t explain. I’m trying to come up with criticism for Lora’s criticism of Krugman. It’s not easy, but here goes:
On “investments”:
Investments are possible in this economy. Another “good” in the society is free time, not all of which is of equal value. So a babysitting “investment” might look like this: The Jonses could go to karaoke at the local tavern tonight, but decide against it. Instead, they invest their time babysitting someone else’s kid in the hope of a future payoff. This payoff comes next month, when the Super Bowl comes to town, and they have enough scrip to go see it.
But again, problems arise. Taking a cue from the Peter Schiff lecture recently posted at mises.org:
An infusion of scrip into the economy could influence folks to go out when they otherwise wouldn’t have. They might freeze their butts off in the winter and have a bad time, or they might go to the tavern now, just because they can, and miss the Super Bowl if it happens to come during the next recession. These would be “malinvestments”.
Some economists would say it is a good thing that people are going out and freezing their butts off because it gives other babysitters jobs. But we don’t have jobs just for the sake of having jobs. We have jobs because we want to make and do useful things. If people weren’t going out and freezing their butts off and having a bad time because they have all this extra scrip, they might be doing more productive things at home, like writing novels, or making home-improvements….
I only have a BA in Economics and after reading Krugman’s article I immediately recognized several glaring errors in his analysis. I agree with many of the other comments that the biggest omission is the lack of price signals in the “market.” Thank you Richard Ebeling for teaching me the worthlessness of mainstream, Nobel prize winning “economics.”
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