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Sitting in forgotten library corners, books about business cycles have gathered decades of dust. However, the idea of feedback that is present in most of them remains a key idea in economics. Indeed, many of the disputes in macroeconomics center on the importance of various feedback loops.

Recall that dampening feedback is stabilizing. If market economies did not have strong dampening feedback, they would spin out of control. The way in which prices provide dampening feedback in markets is explored elsewhere.

Amplifying or positive feedback is destabilizing and leads to extremes. For example, consider the notion of a self-fulfilling prophecy. Years ago a rumor started in one part of the United States that toilet paper would be in short supply. People reacted by running to the store to stock up, which emptied the shelves. The rumor turned out to be true only because it caused itself. Can you see the pattern of amplifying feedback here?

An amplifying feedback loop is at the center of Keynesian economic theory, the subject of the next chapter. As income goes up, people spend more. However, one person's spending is another person's income, so more spending causes more income, which causes more spending, and so on. Given the amplifying feedback loop at its center, it is no surprise that Keynesian economics sees the economy as unstable when left to itself.

Expectations are often part of a feedback loop. Expectations are formed based on how people see the world. People then base decisions on these expectations, so that these expectations influence the world. An important example of expectations that economic forecasters watch is consumer confidence. When the economy is prospering, people become more optimistic. As they become more optimistic, consumers spend more and businesses invest and hire more. This causes prosperity to continue. This interaction also acts in reverse. When economic performance is poor, people become pessimistic. Consumers spend less and businesses invest and hire less, which tends to make the economy continue to sputter.

Several decades ago the most popular theory of inflation among non-economists was the theory of the wage-price spiral. This explanation of inflation suggested that higher prices caused unions and workers to demand higher wages. Higher wages then drove up costs, which businesses passed on with higher prices. (A problem with this theory is that unless total spending rises, higher wages and prices will result in recession, which will stop the spiral. However, little details such as this only seem to bother economists, not editorial writers.)

Good macroeconomic policy is stabilizing, which means that it contains dampening feedback. Human judgment can provide this dampening feedback, or it can be automatic or built in. Macroeconomic disaster strikes when policy causes or allows amplifying feedback cycles to develop.

In the German hyperinflation of the 1920s, the bankers of the Reichsbank did not understand what was causing inflation, but they were confident that they were not causing it. They saw the amount of money was growing less rapidly than prices, and they believed that their duty was to provide more money to keep up with prices.1 Can you see that a policy that responds to inflation by printing more money sets up a disastrous feedback loop?

An amplifying feedback loop involving money also developed during the Great Depression. As the economy worsened in the 1930s, the amount of money in circulation fell, and the Federal Reserve did not see this as inappropriate. Much of the fall was a result of runs on banks. When people converted their deposits into currency, the total amount of money fell because in a fractional reserve system, which we have, a dollar of reserves supports several dollars of checking-account money. When that dollar of reserves is withdrawn as currency, it supports only itself. As money stock fell, the economy worsened. The worsening economy set up conditions that led people to lose faith in banks and withdraw funds, causing a further reduction in money stock. The Federal Reserve did not cause this loop, but they did not act to block it, and most economists today believe that they should have.

The idea of feedback is very much alive in economics and will pop up in a variety of places as you read further. In contrast, few economists read any of the old business-cycle books. However, some of the ideas in that literature survive, and a look at them provides a transition from the quantity theory to the Keynesian theory of the next chapter.

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1In more technical terms, they saw that real money stock, which is money stock divided by the price level, had fallen. They believed that because real money stock had fallen, money could not be the cause of the inflation. They did not realize that a decline in real money is a normal reaction to a hyperinflation. As money becomes a poor way of holding wealth, people try to minimize cash holdings.

Copyright Robert Schenk