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.

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:

http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html

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.

We are getting way ahead of ourselves here.

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.

Robert,

Very nice.