Thursday, February 11, 2010

Business Cycle

Systems with feedback loops can have complicated, difficult to predict behavior. However, there are three basic varieties of simple feedback loop, and understanding these three types can lend insight into the behavior of more complicated loops.

The first type is positive reinforcing. These loops runaway in one direction forever, until something in the system changes and the dynamic is allowed to breakdown. The classic example is the runaway population growth of bacteria in a petri dish.

The second type is balancing. This kind of loop is characterized by equilibrium among opposing forces. It takes effort to push these systems away from their natural equilibrium point, and they tend to fall back again once the effort stops. However, they can be complicated by having multiple points of equilibrium.

The third type of feedback loop is oscillating. This is essentially a special version of the balancing type of feedback loop. As with the balancing type there is a force and an opposing force, but in this case the opposing force has a delayed response. As a result the system swings from one extreme to another, like a pendulum, as the system is dominated first by one force and then by the other. Aviators may refer to this behavior as PIO - Pilot Induced Oscillation. If there is a delay between when the pilot gives an input to the control surfaces and when the aircraft responds then the pilot will tend to give too much input and then over-correct, sending the plane into a potentially fatal oscillation. In a way, the PIO acronym puts too much blame on the pilot as this problem is really a result of the system dynamics.

I think the business cycle is the result of an oscillating feedback loop in the economy. Not much of an insight really, except that it implies that there is something structurally wrong with the economic system. Left to its own devices, the system will keep exhibiting this behavior.

The story I was taught in high school economics was that the Fed had been established to interrupt this oscillating behavior, by anticipating it and correcting for it. I was told that the Fed had been enormously successful in that role. I'm not sure that was true.

Can there be a market solution for bubbles and the Business Cycle?


  1. It's called "free banking."

  2. Lee,

    Thanks for your comment! I'm sure the free banking/private currency angle is something that's been covered over at Think Markets or elsewhere. Can you give me a pointer to a good discussion of it? Particularly how free banking might solve cyclic behavior?

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