Wednesday, March 13, 2013

More on Manias, Panics and Crashes

I continue to read Manias, Panics and Crashes: A History of Financial Crises by Charles P. Kindleberger and Robert Z. Aliber. (See "A thought about the housing bubble" and "A thought about investing".)

The book is fundamentally about times when things in the economy go out of control. We would like the growth of the GDP to be continuous and predictable but there are recessions and depressions. We would like the stock market to behave predictably, but there are bubbles and crashes.

Engineers and mathematicians have developed control theory to enable the description of dynamic systems and thus the ability to design systems that achieve their purposes with stability.

Perhaps the central fact recognized by control theory is that positive feedback in a dynamic system has the potential to make that system unstable. Kindleberger and Aliber point out that there is positive feedback in markets subject to bubbles and crashes -- people buy more because they see prices increasing (and opportunities for profits) but increased demand leads to further price increases; people sell more when they see prices decreasing (to prevent losses) but increased supply leads to further price decreases.

Using control theory, engineers design stable systems by adding damping so that tendencies to overshoot desired levels of output are damped out. Perhaps more important they add negative feedback. Regulation can add damping to economic systems, and government fiscal and monetary policy can provide negative feedback.

The stock market, real property markets and economies are extremely complex systems. Kindleberger and Aliber focus on events that spread among several countries. Thus they focus on economic events that occur in the linked financial or economic systems of several countries, maximizing the complexity of the systems of concern. It is perhaps not surprising that they are hard to control and sometimes become unstable.

Indeed economists like the idea of "the economic efficiency of markets", their instantaneous adjustment to new information. However, Kindleberger and Aliber point to lags in market responses as common in the systems that the study.

Control theorists are not surprised to see jitter in systems built for rapid response to changes in conditions, but are at pains to see that jitter is contained and does not lead to crashes. So too, control theorists see that rapid response is sometimes achieved by designing systems that overshoot in their response to a new signal but then correct to achieve the desired path. One wonders if there are insights from these aspects of control theory that can be applied to improving economic stability.

It is decades since I took my engineering courses in control theory and I never used the tools of control theory in my professional work. However, I think I developed a little intuition that remains, giving me a different way to understand the phenomena described in this book.

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