Feedback
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.
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
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