If you stand outside and stop the first person you see walking on the street and ask them: “What do you think about the economy today?” – the answer will almost certainly be – “The economy is in a recession. Don’t you know that?” – and most will follow up with – “What hole have you been living in? Don’t you know that the entire world is in the grip of a severe recession?” – and the person will probably walk away disgusted and angry with you. It does not matter if the person is man or woman, old or young, the answer will always be the same. Make no mistake, as of January of 2009, most of the world is in the grip of a severe recession. Most major stock markets are at all time lows and a large number of jobs have been lost across the world.

I have often wondered and the question has been asked to me by so many friends and acquaintances – We know what a recession is, but what causes it? What is the solution to a recession? The truthful answer is: I didn’t know either. Of course, I knew what a recession was and it’s deadly effects. But I had no idea about what caused it and how to get rid of the problem. That is till I read an amazing book titled The Return of Depression Economics – and the  crisis of 2008 by Paul Krugman – Winner of the Nobel Prize in Economics. I was deeply impressed by the author’s ideas and explanations. I haven’t finished the book yet, but when I am done, I will try and do a review of the book as well.

But on to recessions – what are they? To understand this, let’s consider the example given by Paul Krugman from his book. Krugman talks about a Baby-Sitting Cooperative, an association of young couples with kids who were willing to baby sit each others children.

This co-op was large with about 150 couples, so there were plenty of couples ready to baby-sit and managing the association was a non-trivial task.

Like many such associations, the co-op issued it’s own scrip or currency -  a coupon. Each coupon entitled the holder to one hour of baby-sitting. In other words, when a couple went out for the evening, they would leave their baby to be sat with another couple and for each hour, the sitter would receive one coupon from the baby’s parents for this service. The system was shirk-proof: it automatically ensured that over time, if a couple wanted to use the baby-sitting service, they would have to also contribute and baby-sit other babies to earn their coupons.

However, the system was not as simple as this sounds – for smooth running of the system, there was a need for a sufficiently large number of coupons to always be in circulation. Couples who had several free evenings would attempt to “hoard” coupons by trying to baby sit as many babies as they could and build up a “saving” of coupons. Obviously, this hoarding was matched by a depletion in the savings of other couples.

This kept on happening till one fine day, there were relatively too few coupons in circulation. The cause is not very important, but the effect is.

Couples who felt that their “savings” of coupons were insufficient became anxious to babysit other couples babies. However,  one couple’s decision to go out was another couple’s opportunity to earn a coupon, so opportunities to baby-sit became harder to find. This made couples even more reluctant to go out and to use their “reserves” except on special occasions, which made baby-sitting opportunities even more scarce, which made couples even more reluctant to use their “reserves” and so on and on it went until…

The Baby Sitters Co-Op went into a recession. No couple was ready to go out and spend their hoarded coupons and consequently, no one was available to baby-sit a baby because of the total lack of demand.

If you are with me so far, then let’s go ahead. If you are feeling a little lost, go back and read the paragraphs again. I had to read them more than once to grasp the complete concept – but when you have done so, you’ll realize that it is really a brilliant example.

Now, let’s conduct our own analysis and try to visualize the effects of the same. Let’s assume that to counter the recession, the co-op managers forced a mandate that each couple would need to go out twice a month and have their child baby-sat by others. In other words, there would be some artificial demand created by this and there would be more babies being sat and consequently, more baby sitters. Do you think this will work? If yes, how and if not, why not?

Let’s continue this discussion next week.

Credits: The complete credit for this example goes to Paul Krugman and his book – The return of Depression Economics – and the Crisis of 2008 from W. W. Norton. I strongly recommend reading it, if you can.