Analog Designer and control engineer Bob Pease and I have had a discussion or two via e-mail about control theory and control engineering. So when I came across a bit by him in a back issue of Electronic Design on how control control theory relates to how the Federal Reserve ought to control the money supply, I was interested. Here is what Bob had to say about the Fed:
FINANCIAL FLOOBYDUST * Switching gears, Alan Greenspan has admitted that he screwed up and had a bad model for the economy. He claims he misunderstood what was going to happen. What did Spice suggest for him to do? I coulda told you that Greenspan was not doing a good job on his PID controller.
He waited too long to start decreasing the interest rates, and then he decreased them too slowly. I noticed that at the time! Then, by leaving the interest rate at 1% for too long, he got the ARMs to start out too low. And then when the rates went up, the subprime mortgage holders got whip-sawed.
This is exactly how you make a limit-cycle oscillator! In other words, Mr. Greenspan did not have enough D (derivative) term in his controller, and he failed to anticipate new problems. And he had too much gain in the I (integral) path. I can do this any day, on my bench, but I don't destroy a nation's economy.
No, I don't want to take over Greenspan's job. I don't want that job. But I could still do it less badly.
Notes: SPICE is an electronic circuit simulator. And you might like a general overview of PID controllers. For reasons I'm not going to go into here this is my favorite mathematical model of a PID controller.
In private conversations with friends who are interested in economics I have maintained for years that economists are ignorant of control theory, treat all economics problems as if they are a calculus problem that can be solved in the limit, and ignore the short term dynamics of our economic plant. Which is to say they are looking for equilibriums rather than dynamisms. I read an economics paper once that said that if you follow the right path - not too much of this or too little of that - you will get optimum results. Assuming of course that the right path can be known in advance. But what if you don't know the right path in advance? Well then you are in need of a control system tuned to the economy that will tell you when and how much to correct your inputs to give a close enough approximation to the ideal path. And if your control system is not properly tuned? Well it will wreck the economy.
We do have a control system and it is not properly tuned. Welcome to the current wreck.
You can read more of my thoughts about control theory and economics at this posts: Economics Made Simple
Here are a few pages of books on Control Theory and Economics.So it is not as if there has been no thought about the problem before. The problem in my estimation is that these books have not influenced practicing economists much. Pity. For all of us.
What your friend is missing in his musings about control theory and the Federal Reserve is that the very act of intruding in the economy causes a myriad of secondary effects that are impossible to anticipate and cause great noise in the feedback loop, most of which is delayed by various amounts.
In fact, since several federal agencies and GSE's like Fannie and Freddie are busy expanding credit apart from the Fed, attempting to measure the Fed's tampering is so full of errors it is like trying to measure the height of the waves from the stern of a speed boat circling in its own wake.
Austrian economists call this the "knowledge problem" and indeed it is exactly why socialist intrusion by government in an otherwise free economy simply cannot be successful.
theBuckWheat · July 15, 2010 5:41 PM
That is the best criticism of this post that I have read so far (I'm having a discussion at Power and Control).
BTW I like this one by Hayek on the knowledge problem:
Are we simply in the situation of the 19th century where every bank is issuing its own currency? Such that control by a single controller is hard or impossible? Then how can the Fed make decisions? I know, I know. With great difficulty.
Of course the plant is somewhat intractable because the plant "constants" are variables. Sometimes fast changing variables. And that is just on the macro level.
The best thing we could do is shorten the reaction time of the plant to inputs. i.e. just in time mfg. etc. However, for major inputs like oil supply it is relatively inelastic in the short term. i.e. it takes about 10 years to make a find and produce from it. If we could do it in 6 months we would have a more stability.
Long lags + high gain = oscillator.
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Any way I think the knowledge is valuable. Even if only to define the limits of the possible.
FIRST, we have to have a rational feedback mechanism, a proper thermostat, so to speak.
Only THEN do we worry about damping and such.
The Fed is supposed to protect the currency, in lieu of gold backing. But politicos have added saving employment, and stimulating growth, and being the watch dog as well.
And beyond that, the entire mechanism is askew. Right now, we have an irrational regulatory system.
What is irrational feedback> Imagine if my home thermostat was built by Congress. Instead of turning on the furnace when it gets cold, the Congressional thermostat would open the blinds, turn on music and start mixing drinks. The theory? Neighbors, thinking there was a party, come over and their body heat warms the house.
If boards and shareholders had in fact had set up rational feedback mechanisms and enforced sound risk management, then firms would not have gone so far off the rails.
The real issue in capital markets is the Rube Goldberg apparatus that passes for regulation. Whatever else history records, the current financial contretemps did not result from lack of regulation. Rather, it arose from human weakness on both sides–government AND industry. The amorality of industry is widely discussed. What is too often ignored is the human weakness in government.
Consider the specifics:
• Congress delegates to SEC, which delegates to PCAOB/FASB to set rules for accountants, who then compel GAAP and SarbOx reporting to shareholders, in the vain hope that they will in turn force directors to rein in managements. (.)
o Perverse outcome 1 – Auditors deny blame for fraud, and get rewarded with more work under SarbOx.
o Perverse outcome 2 – Rating agencies in epic fail, and get rewarded with more work under TARP.
• Coming along after the fact, shareholder suits are too blunt a corrective. They create uncertainty, and raise D&O premiums, but have no effect on management and emphatically do not discipline boards.
• Meanwhile SEC also allows SROs and exchanges to set their own rules. As does CFTC.
• Then Labor, by way of ERISA, tries to define prudent investing, which means delegating authority (but not responsibility!) to rating agencies, who are paid to say “yes.”
• Beyond this general corporate regulation, there is special banking oversight, including the Fed, OCC, FDIC, and OTS. On top of that come the state banking regulators.
All of that ignores the fact that the sole proper role of the Fed is to make sure the Treasury does NOT cheapen the dollar and thereby rob investors by inflationary default. (cf. Bagehot vs. Hankey.)
With so many moving parts involved, no specific party can ever be called to account. No one gets blamed for failure. Being mortal, bureaucrats love power just as much as private enterprise loves money.
Even worse, it is far more profitable to game the rules than to enforce them. So the best minds are squandered on games. Witness the over-reaction of SarbOx, the waste of money on useless reporting, and the ease with which companies avoided real change.
Such a scheme is far worse than nothing at all, for it deludes us into thinking that Someone, Somewhere, is Responsible.
Free markets are great, but that’s not quite what we have now.
So it is not as if there has been no thought about the problem before. The problem in my estimation is that these books have not influenced practicing economists much. Pity. For all of us.
The Anti-Idiotarian Rottweiler
Don?t bang your head!
What your friend is missing in his musings about control theory and the Federal Reserve is that the very act of intruding in the economy causes a myriad of secondary effects that are impossible to anticipate and cause great noise in the feedback loop, most of which is delayed by various amounts.
In fact, since several federal agencies and GSE's like Fannie and Freddie are busy expanding credit apart from the Fed, attempting to measure the Fed's tampering is so full of errors it is like trying to measure the height of the waves from the stern of a speed boat circling in its own wake.
Austrian economists call this the "knowledge problem" and indeed it is exactly why socialist intrusion by government in an otherwise free economy simply cannot be successful.