[This article by Juan RamÃ³n 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:
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.
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.
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.
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?
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).
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).
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.