The austerity versus spending debate is an ongoing phenomena and has opened a deep chasm between differing ideologies in the spheres of politics and economics. Unfortunately, the debate tends to be coloured more by ideological biases than a focus on evidence based economic experience. It is therefore helpful to understand the issues at hand via a simple real life example – and with that aim in mind I summarise below a note by Paul Krugman on the "Baby-Sitting Co-op" written in 1998 in the context of the Asian Financial crisis, but also very relevant to the current crisis. The note illustrates how economies can fall into recessions and the process by which government stimulus can help the economy recover from them.

-The original story was told in an academic article published in 1978 about the experiences of the two authors (husband and wife) who were part of a baby-sitting co-op in the early 1970s in the Washington area. The story had a big influence on Krugman's economic thinking.

-A group of 150 couples agree to baby-sit for each other, thereby removing the need to hire baby sitters for cash. The arrangement was mutually beneficial as baby-sitting more children in addition to your own was not much of an additional burden, particularly given that you would receive the same service some other evening.

-To ensure that every couple did their fair share, the co-op issued scrip-pieces of paper equivalent to one hour of baby-sitting time. The relevant amount of coupons were exchanged at the end of each baby-sitting session and the system was self-reinforcing – over time each couple would do an equal amount of baby-sitting as it received in return.

-However, technical problem developed as couples (during periods of low social activity) would baby-sit more often to build a reserve of coupons to be used when social activity increased at a later date. Normally this demand would average out over time as one couple staying at home would be offset by another couple going out. But since many couples held reserves, the co-op needed to ensure a large amount of scrips in circulation.

-This particular co-op, however, experienced a sharp drop in circulating coupons (for complicated reasons involving the payment and collection of dues which were paid in scrip). This shortage led to more couples trying to build reserves and were reluctant to go out. But this tendency deprived other couples to earn coupons, further reducing baby-sitting opportunities with couples only going out on special occasions. The co-op experienced a recession.

-A debate began between two groups in the co-op – the lawyers (who wanted to legislate a recovery by passing a rule requiring couples to go out more often) and the economists who wanted to issue more coupons. The economists finally won, more coupons were issued and couples started going out more often. Eventually (of course) the co-op issued too much scrip leading to different problems....

-This simple story illustrates how an economy can fall into a recession (because consumer demand falls – i.e. co-op members go out less often) and how central banks can act to resolve the situation (by monetary easing - i.e. issuing more scrip). 

-The story also has an important lesson- that recessions are not a punishment for our sins which we are fated to suffer or because its members are bad and inefficient baby-sitters, nor because of a flaw in their values. They happen because there are too many people chasing too few scrips.

-The story could be extended further – there could be situations where co-op members could find themselves out of coupons because they went out several times in a row, and therefore could not get baby-sitters, even though they were able and willing to do more baby-sitting in the future. To resolve this problem, they could borrow more coupons from the co-op, with a penalty in terms of more coupons to be repaid later. 

-Under this system, couples would hold less reserves than before knowing that they could always borrow more if necessary. The co-op could also vary the penalty depending on whether there were an abundant supply of baby-sitters (lower the penalty to encourage more people to go out) or a shortage of baby-sitters (increase the penalty to encourage people to go out less).

-The above co-op would thus have a central bank which stimulates, or cools down, an economy by reducing or increasing the interest rate.

-How do "liquidity traps" occur in this co-op? There could be a seasonality to the demand and supply for baby-sitting – with people preferring to stay at home during dark and cold winter months (to build coupon reserves for more summer social activity). The co-op could even out the seasonality by lower rates in the winter and higher rates in the summer – but this seasonality could become so strong that even at zero interest rates people are more willing to baby-sit than go out leading to (via a self-reinforcing cycle) fewer and fewer baby-sitting opportunities in the winter and a recession.

-"The story of the baby-sitting co-op is not mere amusement – if only people could take it seriously and try to understand the great economic issues at stake, whimsical parables are not a waste of time but the key to enlightenment - it is a story which can save the world".

While this article appeared in 1998, in response to the Asian crisis, it has very relevant applications to the challenges we face today – i.e. a liquidity trap where consumer demand remains anaemic despite zero interest rates. So rather than focussing on practical and tested measures to lift developed world economies out of the liquidity trap, the focus has unfortunately shifted to an expression of ideological biases against "big government" and "debt" and the solution being espoused is even more "austerity" – which has prolonged and deepened the slump. It is also clear that the US Fed, led by Bernanke (who probably understands the implications of the above story well by being a leading scholar of the Great Depression!), is taking steps in the right direction (though arguably not aggressively enough as it is constrained by the political dead-lock in the US) while the ECB remains mired in a morass of ineffective decision making and being held hostage to an irrelevant episode of history (the "Weimar Hyperinflation"). 

The next few weeks are likely to be critical for global markets– with the EU summit on December 9th and the Fed policy meeting on December 13th. The market is expecting an announcement on a plan for fiscal union for the Eurozone, to be followed by more active intervention by the ECB (and the IMF) to support the government bond markets. This would likely lead to a massive year-end rally which may extend to the early part of next year, but as we have seen innumerable times before, this is also likely to be followed by disappointment with a lack of details and unforeseen problems with the plan. Meanwhile, the Fed seems to be laying the groundwork for a QE (with statements in favour by several governors) , with a focus on the housing market, and there is a high possibility they announce this on December 13th. 

I have attached below charts which illustrate the year-to-date performances of the major global equity markets and other asset classes. Assuming we get stimulative policy actions across the globe (and there are clear signs that this is beginning to happen with the coordinated central bank actions last week), the markets which are likely to out-perform are the ones which lagged last year- namely: Europe, India, Hong Kong & China, Brazil, Japan and commodities. Sometimes a simplistic approach to investing works far better than complicated analysis!