Monday, October 11, 2010

Economics in Real Life: How (Basic) Recessions and Stimulus Work

Another in a series of "Real Life Economics" examples I've been putting together for people interested in economics, or taking introductory economics, for how economics actually affects the real world.
Credit for this one goes to Paul Krugman, pre-intellectual suicide, and Greg Mankiw.
First, Krugman:
This is the "most basic" scenario of how a recession happens, laid out by Krugman. The link also introduces things like interest rates to complicate this basic outline
"The Sweeneys tell the story of--you guessed it--a baby-sitting co-op, one to which they belonged in the early 1970s. Such co-ops are quite common: A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share. 
       The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong? 
Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve--then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation. 
       Now what happened in the Sweeneys' co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further. 
In short, the co-op had fallen into a recession. 
       Since most of the co-op's members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems ... 
If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year's worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op's story, to play with it and draw out its implications, it will change the way you think about the world....
...Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking. And so, as I said, the co-op's story helps me to resist the pull of fatalism and pessimism."
And secondly, Mankiw. You'll notice that this "babysitting economy" requires two sides - it requires both someone willing to work (babysit) and someone willing to consume. Imagine that some people had accumulated lots of babysitting coupons and others had accumulated very few - in other words, there is "poverty" and "wealth" in the economy. Imagine that each year, the 10% with the most coupons had to give 20% of their coupons above the average amount to the 10% with the least coupons. How does this affect willingness to work for everyone involved? (For Graham this question is not optional).***see stars below for one answer***
Which brings us to Mankiw's column today, already cited earlier in my blog:
"HERE'S the bottom line: Without any taxes, accepting that editor's assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family's marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?
By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working. "
***This is not to say that we shouldn't help out people who need babysitting, but it does very much skew the incentives to work - those with few coupons don't need to work as hard because they'll get coupons (and the more they work, the less they'll be given), and those with lots of coupons don't want to work as hard because for each "coupon" they earn, they're actually only earning .8 coupons. The Mankiw article indicates that for many, they're actually only earning .1 coupons... which should make everyone very worried about the babysitting equilibrium put forth by Krugman...

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