Sunday, July 19, 2009

Boom-Bust: Positive Feedback Economies are Unstable

This is part 1 of my General Economic Theory. It's very complicated and difficult to understand. Ready?
  1. Positive Feedback Systems are Unstable
  2. Economies are Positive Feedback Systems
  3. Economies are Unstable
Got that?

Control Theory is an arbitrarily complex field. I took it for a year in college, and unfortunately forgot most of it. Stability is a formally defined concept within Control Theory. If you can model a system, you can discover if it is stable.

Generally speaking, most stable systems use negative feedback. That is, for any fluctuation there is a corresponding correction. Think of what you do to keep a car going in a straight line - if the car veers, you steer in the opposite direction. Eventually you don't even think about it, and your passengers never notice the infinitesimal corrections you constantly make to keep the car going straight.

One of the simplest and best analyzed forms of negative feedback control systems is the Phase-Locked Loop, which for example is the basis of all modern radio and TV tuners.

Economies are complex, non-linear systems with lots of feedback loops of varying amplifications ("gains") and delays. Most of them are positive feedback, and all of them are difficult to model.

Capitalism is of course positive feedback. Making money gives you more opportunity to invest, where you can make even more. Speculation is an extreme example - you make money on something, and other people want to get in on the action. People become convinced that Tulips are a fantastic investment, and the price of Tulips shoots through the roof .. until the bottom falls out and the last people in lose everything to the first people in (to use a zero-sum oversimplification).

As with other systems, negative feedback provides stability in economic systems. The extreme form of this is Communism ("from each according to his ability, to each according to his need"), in which the lack of incentive for personal gain slows everything to a crawl.

Stagnation is an undesired form of stability.

How do you create a "vibrant" (e.g. unstable) economy, yet avoid economic bubbles? Two words: regulation and taxation. Part 2 of my General Economic Theory comes later.


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