Josh Dowlut's  Instablog

Imagine you were LOST on a desert island with about 100 people.  Economics is much easier to understand now.  After solving your most pressing basic needs such as food, water, and shelter, such a group would develop an economy of sorts if given enough time.  A specialization of labor, and an exchange of what is produced by that labor would evolve.

Imagine our island economy.  We might have John the hunter, Jin the fisherman, Jack the doctor, Michael the builder, Kate the dressmaker, Sawyer the bookseller, Hurley the chef, and Ben the central banker whose task it is to keep the island economy humming along smoothly.  Ben issues the currency that the island economy uses as a medium of exchange.   

Now, imagine that economic activity starts to slow down on the island.  John is selling less boar, nobody’s buying Kate’s dresses, people start cooking for themselves instead of paying Hugo to cook for them.  Let’s think through the two different policy options Ben the banker has:

1. Ben can increase the money supply to try to encourage people to purchase what they otherwise would not. 
2. Ben can do nothing and allow the various producers in the economy to adjust their offerings to something that more people are willing and able to buy.

The first option will “grease the wheels” so to speak by making people feel temporarily wealthier.  You might not buy Jin’s fish at $10 when your island income is $100/week, but you may very well buy it when your island income is $200/week. 

There are a few problems with this method though.  First, it only “works” temporarily.  Eventually Jin will raise his price of fish, consumption of it will fall to the previous level, and you’ll be right where you started.  If Ben tries to keep it up by continuing to expand the money supply, eventually people will come to expect the higher prices, and it will lose even its temporary effect.  The only hope of maintaining even the temporary effect would be to keep consumers guessing about when he was going to increase the money supply by resorting to erratic, unpredictable changes in the money supply, and that would have all kinds off ill effects on long-term planning. 

 Secondly, it assumes that there is no structural reason why consumers aren’t buying his fish.  What if people just don’t like the fish Jin is catching, or the dresses Kate is making?  What if buying less is a way of signaling that Jin and Kate need to produce something else?  What if it is saying people would rather sit on the beach and work less?  Should Ben still try to override this?  In the long-run, won't such a policy deny the island of being able to buy the things they really want to buy and work the hours they really want to work?

The Paul Krugman babysitting co-op and downwardly flexible prices. 

Paul Krugman ran this same thought experiment on the Capital Hill baby-sitting co-op 14 years ago and reached a very different conclusion.  Krugman saw a baby-sitting exchange co-op as a case study on the need for an active central bank with an elastic currency.  The co-op had an exchange system where one hour of sitting service provided entitled the sitter to a claim check to receive one hour of sitting service.  The co-op quickly developed a cash hoarding problem that Krugman saw as justification for an activist central bank.  Parents would try to save up claim checks for summer weekends and drinking holidays, which lead to an imbalance between those who were willing to buy sitting service and those who were willing to sell sitting service.  The market fell far out of equilibrium.

So what is the best method to get it back to equilibrium?  Krugman said there should have been a central bank that could issue more claim checks.  I say they should have allowed the price of sitting service to float.  Everyone knows an hour of sitting service on an average Wednesday evening is not worth the same as an hour of sitting service on New Year’s Eve, but that’s exactly what their system tried to enforce.  Their system essentially created a price ceiling for sitting service.  A better system would have still used an internal script, but would have allowed buyer and seller to negotiate the price.  This way someone will sit for New Year’s, because they know it will buy them a week’s worth of regular sitting.  The lesson is that price ceilings don’t work, not that markets can’t function without a central bank.  It’s really the difference between screwing in a light bulb by twisting the bulb, vs. holding the bulb still and turning the house around it.