Feedback Economics

Ideas from systems science show that governments must manage the market

June 21, 2010

Reductionism is a concept used throughout science. The idea is that, if you know the parts of a system, you can understand the whole through the interactions between its parts. This doesn’t mean that the properties of the whole are a simple multiple of the parts. Instead, complex emergent properties arise that were not present in any individual component. Hurricanes, for example, can be explained through the interactions of molecules in the air, but an individual molecule in isolation can’t form a hurricane. Nevertheless, systems do nothing that can’t be traced back to their parts.

In many systems, the interaction of parts takes the form of a network. In this, individual elements affect some of their neighbours in specific ways, while being affected by other neighbours in other ways, and, though every element is not directly linked to every other, they are all linked in some indirect fashion. The economy is clearly like this, with individuals, organisations and the natural environment being the component parts. Some elements have direct linkages like flows of goods, services, cash, financial instruments, commands and other things. Others do not have direct linkages to one another, but everything is still linked indirectly in a global network.

A crucial feature of such systems is the phenomenon of feedback. In a dense network, especially one that has grown organically, it will always happen that some variable is affected, probably via several indirect steps, by another variable that it itself affected some time earlier. For example, a rise in the price of, say, shoes may lead to an excess of volume supplied over demand and this may cause retailers to cut prices again – a rise in the variable we call price causes oversupply and this, in turn, causes a fall in price. Alternatively, an increase in the price of some asset, say houses, may attract yet more buyers into the market and cause another increase in price. The former is an example of negative feedback, a process where a given change tends to reverse itself, while the latter is positive feedback, a process where a change tends to feed on itself, leading to runaway change.

Most events in the economy can be explained, simply and elegantly, through positive and negative feedback. In some cases, positive feedback can only operate easily in one direction – being able, say, to cause a self-reinforcing increase in some variable, but not a self-reinforcing decrease. We see sustained trends as a result. Long-run economic growth is like this, with new technology leading to more economic output and this leading to more new technology; usually with no reverse process that causes technical know-how to disappear and output to decline. Something similar happens to inequality in economies with little or no redistribution: advantage in wealth leads to advantage in the marketplace and this, in turn, leads to further advantage in wealth, with no converse process arising naturally from the market to cause the gap to narrow.

In other settings, positive feedback can operate in either direction, causing either a self-reinforcing increase or a self-reinforcing decrease. In share and house prices, extravagant bubbles arise when people expect price rises to continue and dramatic busts occur when they expect price falls to continue. These phases, each driven by positive feedback, alternate with one another over time, with the other kind of feedback – negative feedback – usually being responsible for the turning points. This latter occurs, for example, when enough investors realise that price increases have gotten out of hand and begin selling, causing the market to turn.

Similar dynamics drive the ups and downs of unemployment and the alternating phases of inflation and deflation that are observed in market economies.

Feedback economics fits perfectly with the emerging discipline of behavioural economics, which seeks to explain economic actions in terms of human psychology, not the abstruse theorems of classical economics. In essence, behavioural approaches explain the properties and interactions of actors in the economy, while feedback explains the emergent properties that arise from these interactions.

Both disciplines also fit with the founding principle of science that, whether we are studying basic physics or human society, observation of reality must be the only road to truth. Behaviours are identified by observation, generic feedback mechanisms that are observed in all kinds of systems are applied to these to produce hypotheses for how the system overall will behave, and these hypotheses are tested by further observation. There is a role for mathematics, especially the mathematical statistics used to validate observations and theories, but there is little need for the extravagant mathematics of classical economics.

On policy, feedback economics points to a mixed economic system in which the state plays a large role. If GDP growth is dependent on a feedback loop of ever-improving technological ability, and if companies do not have adequate incentive to fund the long-term scientific research and the twelve to twenty years of education per person needed to support this; then the state must clearly take a role. Likewise, if markets are prone to wild swings in asset prices, credit, general price levels, jobs, GDP and other key variables; then governments must regulate the behaviour of key actors (especially financial institutions) to mitigate this tendency, and must move the money supply and their own budget deficits or surpluses in a way that counterbalances whatever cyclicality remains – an insight that can be traced at least to Keynes’ General Theory in the 1930s. Finally, if there is a tendency to produce far more inequality than basic incentives require, then there must be redistribution to counterbalance this.

But we know from history that communist central planning, however well-intentioned, leads to inefficiency and oppression. So the state cannot take over entirely either. The only answer is a mixed economy.

Classical economics is very different in its thinking. It assumes that behaviour is relentlessly rational – putting it flagrantly at odds with known psychology – and that individual rationality leads to collective rationality. For example, rational people would always be willing to work for a wage that leaves some profit for the employer and it should therefore always be possible to arrange a beneficial exchange of work for money, ensuring that the economy never strays from an equilibrium where the only unemployed are those who are moving jobs. If there is, transiently, some unemployment, it must be because real wages are so high that firms cannot offer additional jobs without running a loss. Rational people understand this (including complications relating to inflation or deflation) and quickly respond by accepting lower wages, bringing the economy back to equilibrium.

Classical equilibrium theory, in essence, emphasises only negative feedback, neglecting that, in every case, there is also positive feedback. On unemployment, for example, significant job losses lead to reduced spending, harming additional firms, causing more job losses and causing prices to fall in a way that makes those who still have an income hold back on spending because they expect things to be even cheaper in future. A positive feedback loop is thus established that drags the economy towards collapse unless the state intervenes to stop it. Classical economics concludes that all such interventions are unnecessary, and that pure free markets are almost always ideal, simply because it focuses on negative feedback and neglects positive feedback, ignoring half of how the economy actually works.

If economists want to be more like scientists – which they clearly do, borrowing all the maths of physics along with terms like “equilibrium” and “elasticity” – then they should give a central role to the simple concept of feedback.

Sean Harkin is a financial risk consultant. He previously worked in the field of cell and molecular biology. His book, The 21st-Century Case for a Managed Economy was published by Harriman House