March 3, 2002

Is the world babysitting the US?

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Henry Kissinger (a man who knows a thing or two about negotiating with the Chinese) in his latest excellent book, Does America need a Foreign Policy?, sums up the difference by saying that the Chinese regard the solution-seeking Americans as “erratic and somewhat frivolous”.

Such erraticism and frivolity is very evident in the American coverage of the economy. Nowhere is the search for instant answers more evident than in the media scrum to interpret single economic numbers minutes after they are published.

Thus we get the “recession is over” call from one brigade as a result of one number or the “recession never started” from another shower. The point is that a bit of perspective is needed to tease out what exactly is going on in the world economy.

If America is emerging quickly from its recession, we need to rethink a certain number of our basic ground rules.

A few months ago this column was very taken by the way the American economist Paul Krugman looked at recessions and his analogy that economies operated like babysitting co-ops in the US. It is worth revisiting this approach.

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-op 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 a 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.

Our modern economy works in a very 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. So despite all the complicated mathematical models that economists use to forecast the economy, the message is pretty simple. The babysitting model tells us why recessions happen, but also what can be done to get out of them.

In the original babysitting crisis, the lawyers and teachers among the couples thought that the answer to the recession was to compel couples to babysit on certain nights. But this did not work. Eventually, it was seen that 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 recession 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.

Back in the real world, Alan Greenspan understood the babysitting model and responded to the recession in the US in early 2001 by printing money. This week he appears confident that his tactic is working and the US is emerging from recession. Although he remains cautious, his mood is positive as he believes that the recession is over and recent economic data backs him up.

(There is a lot of anecdotal evidence here from leading indicators, such as advertising revenues, that the worst is over here as well.)

Does that mean we are out of the woods? What would the Chinese say? The typical US interpretation on the 2000-2001 recession is: “It is over, problem solved, let’s get started with the recovery.”

In contrast, the Chinese might argue that another stage is over and we are into the next stage. The Chinese might contend that the extent to which the US can print money is dependent on either the US rate of savings or the rest of the world’s willingness to finance American spending. Let’s address these two issues.

US savings have been falling for the last decade. The savings ratio in the US is now negative and there does not appear to be any immediate prospect of the US consumer saving considerably more over the coming years.

If those shoppers turned to savers today, the economy would reverse into recession overnight, so it is in nobody’s interest for the US to get all parsimonious all of a sudden.

Therefore, we must assume that the Yanks will continue to borrow from the rest of the world to finance their shopping.

The current account measures how much the US is borrowing and here the figures begin to get scary. The US is borrowing close to $2 billion a day from the rest of the world to finance itself.

A recent Financial Times article revealed that the US is getting into debt so rapidly now that by 2006, this debt will amount to 45 per cent of GDP and by 2010, 64 per cent of GDP.

So at some stage, the US’s ability to print money to keep it from going back into recession will be constrained by the fact that every time an American buys a new 4×4 the US slips further into the red.

Many argue that this will not matter because the US borrows in dollars and the world is keen to lend. Yet the obvious implication of the US having no risk in borrowing is that the lender incurs huge risk in lending. The fault line is the dollar. The more they borrow, the more vulnerable the currency becomes.

By printing money last year, the US might have just gobbled down a “free lunch”. Time will tell whether the rest of the world is willing to pay the bill.

David McWilliams presents Agenda on TV3 today at noon. The programme is repeated at 6pm.

When Mao was asked in the 1950s what were the lessons of the French Revolution he responded that it was “far too early to tell”. Such perspective has characterised Chinese thinking for centuries. Whereas we in the West want instantaneous answers and foolproof solutions to all our questions, the Chinese appear to look at problems in a series of stages to be understood and not necessarily with solutions.