What do central banks really do? Why do central banks even exist? Do we really need them?
A babysitting economy gets a central bank
Here’s a story.
A story of why the world has central banks rather than not.
Paul Krugman cited the story as the model for understanding what central banks can and can’t do.
In the early 1970s, a gaggle of Capitol Hill insiders set up a babysitting co-operative. They were busy couples. And nobody wanted to drag infants to restaurants and parties.
Despite the Cold War, the co-op sprung from communitarian principles. Members would babysit for one another.
The problem was one communist regimes denounced in Capitol Hill were familiar with — central planning.
Nearly 200 families participated in the co-op. How to decide who owed babysitting services to whom and when?
Babysitting scrip.
Families were issued 40 pieces of scrip upon joining. Each scrip was worth half an hour of child-minding. 15 minutes in peak times (preceding Uber’s surge pricing by decades).
So new members started with 20 hours of off-peak babysitting, or 10 hours of peak babysitting.
Couples then traded these scrips with each other to ‘purchase’ babysitting services.
But the co-op struggled.
Families realised their scrip endowment was modest. A night out could cost a couple over 10 scrips — 25% of their ‘savings’!
So couples began hoarding. They wanted enough scrip reserves before they felt comfortable going out.
But soon everyone was offering to babysit and no one was going out. Nobody was spending; hence nobody was earning.
The co-op entered a babysitting recession.
Too many members were chasing too few scrips. The issue was money supply.
The co-op’s committee, stuffed with Washington lawyers, tried legalistic interventions.
Like mandating members go out at least once every six months.
(Imagine our government, in a recession, legislating that we purchase $5,000 worth of goods every quarter).
We know about this Capitol Hill co-op because one member was an economist who couldn’t believe his professional luck.
Richard Sweeney and his wife wrote of the community’s travails in a brief article for a leading economics journal.
Paul Krugman later popularised the story in Peddling Prosperity…what he chose to emphasise was strange, though. More on that later.
Anyway, Sweeney wrote things got so bad, the lawyers on the co-op committee resorted to shaming:
‘The thinking was that some members were shirking, not going out enough, displaying the antisocial ways and bad morals that were destroying the co-op. Hence the bylaws to correct morals.’
Out of ideas, the lawyers finally absconded to the economists. And the economists suggested an easy fix.
Everyone gets more scrip.
Print more money.
The babysitting recession ended. Sweeney recalled:
‘There shortly arrived a balance between those who wanted to go out and those who wanted to sit. A golden age, on a minor scale.’
Krugman buries the lede
Krugman thought the co-op was a fable of immense value.
It changed his life:
‘Twenty years ago I read a story that changed my life. I think about that story often; it helps me to stay calm in the face of crisis, to remain hopeful in times of depression, and to resist the pull of fatalism and pessimism…’
The co-op was a model of the actual economy. And the model showed central banks can resolve intractable problems.
But Krugman glazed over something.
Injecting more scrips into the babysitting economy helped.
For a few years.
Then the co-op’s central bank erred by issuing too much scrip. As Sweeney recalled:
‘The golden age lasted only a couple of years. Maybe morals deteriorated – or perhaps the scrip was again out of whack. Now the problem was that more people wanted to go out than to sit.’
Krugman admitted this twist to the tale, but only as a quick aside:
‘Too little money is a bad thing; but while GBP [gross baby-sitting-co-op product] could be expanded up to a point by printing more coupons, this process could only go so far. Indeed, issuing too many coupons actually hurt the co-op: an excessively expansionary monetary policy is counterproductive.’
Counterproductive is one way to describe it. More on that next.
Krugman also omitted entirely another solution to the co-op’s problem.
Let prices fall.
In the co-op, one scrip always equalled either 30 minutes of off-peak babysitting or 15 minutes of peak babysitting.
The committee imposed price controls. Price controls hardly ever work.
Fluctuating prices could also have brought supply of babysitters and party-goers into balance.
Economist David R. Henderson raised this very critique when Krugman’s book first came out:
‘Nowhere does Krugman mention that another way to solve a problem of excess supply is to let prices fall. It’s not surprising that Krugman left this out. He seems to be biased in favour of having government step in rather than letting markets work things out.’
But central banks ‘stepping in’ doesn’t always solve problems. Sometimes central banks cause them.
Does the world need central banks?
The babysitting co-op’s central bank got it out of a recession. But it later stoked inflation.
So what’s the moral of the story? Do economies need central banks?
In a 1993 address, Milton Friedman questioned the very purpose of central banks, asking:
‘Does the world need to have any central bank? Can we conceive the world in which no country has a central bank?’
It seems a bizarre question.
Most major economies have a central bank.
Decisions by the Fed, the European Central Bank, the Bank of England, the Bank of Japan, and even our RBA make headlines.
But central banks were not always ascendant.
Charles Goodhart’s oft-cited Evolution of Central Banking began like this:
‘Although Central Banks would appear to be firmly established in all major countries, academic economists have been far from convinced that these institutions are necessary, or even desirable in an optimal state of affairs.’
I’m not calling to do away with central banks (like Friedman did in his speech). Clearly, the existence of so many implies some usefulness.
I am only saying central banks are fallible. Economic problems have multiple solutions, of which central banks are but one.
Take the babysitting co-op.
Printing more scrips worked. But letting prices fall would have worked, too.
And sometimes, central banks’ solutions lead to their own problems.
A 2022 edition of a popular textbook from recent Nobel Laureate Ben Bernanke says this:
‘Basically, inflation occurs when the aggregate quantity of goods demanded at any particular price level rises faster than the aggregate quantity of goods supplied at that price level.
‘In general, the only factor that can create sustained rises in aggregate demand, and thus ongoing inflation, is a high rate of money growth.’
And since central banks decide the rate of money growth, the thing that can lead to ongoing inflation is …central banks.
Regards,
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Kiryll Prakapenka,
Editor, Fat Tail Daily
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