With stock markets all over the world tumbling and Irish banks being targeted, the big question is, why do economies go into recession? Why do apparently sound economies turn down? Why is our economy heading south with tax revenues falling and housing prices slumping? Why did Japan go pear-shaped? Did it not produce the finest consumer goods in the world? How come the Asian Tigers — outlandishly praised as late as 1997 by the IMF — experience a meltdown in 1998? Why did Californian land prices plummet in the late 1980s and why is the stock market now worried about a recession in the US?
Surprisingly enough, most economists cannot answer those questions. Many of us are fantastic at telling you what has happened last year or promising more of the same when times are good, but precious few spot the early warning signals that can flash amber well ahead of the tailspin. The fact that every paid analyst in Ireland predicted that house prices would rise above the rate of inflation 2007 evidences this myopia. Maybe it’s because the economy is such an extraordinarily complex beast that nobody can read the tea leaves consistently well.
That said, the simplest way of looking at the economy is usually the best. And last night, when trying to find a babysitter, I remembered the babysitting model of the economy (made famous by the US economist Paul Krugman) which best explains why recessions happen.
Babysitting co-ops are big in the US. Typically, a number of couples form a co-op. The idea is that the Kellys will go out, have a few drinks, get a bit messy and the Murphys will mind the Kelly kids plus their own and so on. The co-op runs on the basis of babysitting coupons. Everyone gets a limited number of coupons when they join. If the Murphys want to go out tonight, they pay the Kellys in coupons. Eventually, if the Murphys are party animals, they will run out of coupons and have to babysit for everyone else to replenish their stock of coupons. In time, they can go out again. In theory, the supply and demand for coupons should always match: there should be enough babysitters and every couple should be able to get a few nights out on the tiles.
In practice, a study of the way a babysitting co-ops works revealed that things turned out differently. Initially, things worked well. People were polite and the coupon system operated smoothly with most couples getting out fairly regularly. But over time, some couples with a few free evenings coming up opted to stay in. Why stay in alone, when you can stay in, babysit and get a few coupons? So they offered to babysit with the view to hoarding coupons for special occasions.
There were two problems with this ‘hoarding for special occasions’ approach. First, trying to accumulate coupons for future occasions was only achieved if someone ran down their reserve of coupons today. Second, every couple wanted to keep a few coupons in store for emergencies. As some couples stayed in, others, believing that their reserve of coupons was slightly low, stayed in more often as well. But as one couple’s opportunity to build its reserves could only be offset by someone else going out, the couples collectively started going out less.
In time, there were fewer and fewer babysitting opportunities. The fewer opportunities to build reserves, the more people panicked about having insufficient reserves for the future, the less they went out and the less babysitting opportunities emerged. This went on and on until the system completely dried up. Nobody went out and nobody babysat. In short, the co-op went into recession.
What has this got to do with post-boom Ireland? Well, our modern economy works in a similar fashion. The recession in the babysitting co-op was real, as real as a recession in any normal economy. Demand dried up and supply remained idle.
Why did the babysitting co-op go into recession? There wasn’t anything wrong with it in principle. The Murphys and Kellys were not bad or inefficient babysitters. Did it lose competitiveness vis-a-vis some other co-op? Not at all. Was there a great, unexpected shock from the outside that jolted the co-op? Hardly. Was there a huge shift in the use of technology, creating a ‘new paradigm’ babysitting co-op elsewhere and our babysitting co-op failed to react and fell behind? No. Did the internet accelerate its downturn? No.
The co-op didn’t stop producing things, demand simply dried up because people chose to hoard the coupons. Similarly, business cycles and their vulnerability have little to do with shocks from abroad, competitiveness or so-called ‘economic fundamentals’. Bad things happen to good economies and it is almost impossible to predict.
When confidence evaporates you know about it pretty quickly. People hoard and spending collapses, precisely in the same way that hoarding of coupons in the babysitting model caused a babysitting recession. Confidence can disappear for no apparent reason. Once people think that they need more of a comfort zone in their bank balance, confidence vaporises.
On the positive side, the lesson of the co-op also reveals what to do in a recession. The only lasting answer was to issue more coupons, which worked a treat. In no time, there were loads of babysitting opportunities, parties and hangovers. Similarly, the answer to a downturn is to print money. Recessions happen because people stop spending cash and they save it instead. Printing money kick-starts spending and, by printing cash, countries can get out of recessions very quickly. In the real world, the coupon issuers are central bankers.
This is what is happening in the US at the moment. The Federal Reserve is printing money, cutting interest rates and causing the dollar to plummet. Unfortunately for us, as confidence evaporates here we will not have the ability to print money because our interest rates are set in Germany. Our exchange rate will be rising and our banks, reeling from the bad property debts on their books, will not be keen to lend.
The ECB runs a big European babysitting co-op, it will have no reason to issue coupons to specifically help the tiny, Irish baby-sitting co-op. At that stage, it will be too late to stomp our feet, scream or throw our toys out of the pram.