Out of Control: Recognizing Instability

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This graph1
shows the ratio of the Dow Jones Industrial Average (DJIA) index
to the price of gold.  While the DJIA is rightly criticized
as an imperfect indicator of economic activity, it does represent
claims on wealth produced by the largest and most successful firms
in the US economy. In a free market, one would expect the ratio
to trend upwards, as the market creates new wealth while the amount
of gold remains nearly fixed. From 1900 until about 1920 this is
exactly what happened, with relatively small excursions around a
slight upward trend. Beginning around 1920 the trend is replaced
by ever-growing gyrations representing the creation and destruction
of wealth, enterprises, and livelihoods. Engineers familiar with
control theory will recognize the growing oscillations as the onset
of instability. 

Engineers have
been studying control
theory
since the 1860s. Keeping any machine operating within
narrow boundaries can be difficult. While the mathematics can be
complex, many of the lessons learned are familiar to anyone who
drives a car.

When driving
a car along a straight and narrow roadway the driver cannot simply
hold the steering wheel fixed; small imperfections in the road and
other perturbations cause the car to depart from the desired path.
When the car drifts to the left, the driver must steer slightly
to the right, and when the car goes right the driver steers left.
The steering corrections are proportional to the deviation; if the
car is drifting slowly, the correction is small, but if the car
is rapidly departing the road, the steering changes must be larger.

This proportional
correction of deviations is called negative
feedback
. The feedback is negative because it is opposite to
the error; steering left when the car veers right.

Positive feedback
occurs when the correction is in the same direction as the error.
If the car veers left, steer left. The car will rapidly leave the
road and crash. Not all positive feedback is bad; used to reinforce
desired behaviors, such as praising a pet or rewarding an employee
for a job well done, positive feedback tends to produce more of
the same. This holds true when positive feedback is applied to undesired
outcomes; the system will produce still more. Positive feedback
acts to amplify the effects of initially small perturbations until
they become very large, or some other limit comes into play. The
Dow/gold graph shows one system that is clearly subject to ever
growing swings.

There are other
ways to destabilize controlled systems, even with negative feedback.
If there is too much delay between deviation and correction, the
deviations tend to grow larger before they are corrected. Drunk
drivers weave back and forth in part because alcohol slows reaction
time, introducing a lag in the driver's control of the car.

Another way
to destabilize a system is with excessive negative feedback. While
the correction remains proportional to the deviation, over-correction
can lead to a loss of control. If the driver makes violent corrections
to small errors, the car will lurch back and forth, eventually spinning
out of control and crashing.

There are examples
of all three destabilizing mechanisms in recent Fed interventions
in the marketplace. Before the creation of the Federal Reserve,
banks that made poor decisions about loans went bankrupt and were
closed. The market reallocated any remaining capital to better and
higher uses. This is negative feedback in action. After creation
of the Fed to support failing banks and particularly after creation
of Federal deposit "insurance" released depositors from
the consequences of patronizing poorly run banks, this negative
feedback was largely eliminated.

Instead, we
now see Bernanke and his co-conspirators furiously creating money
to prop up failing financial firms. This is positive feedback, and
it will certainly produce more failing firms and bad debts. Delay
is also evident, as the crisis was manifest this past July and August,
but the Fed didn’t react until months later.  Jim Cramer's
infamous rant
had one thing right: the Fed had no idea how bad things were. Cramer
started his early August rant by discussing problems at Bear Sterns;
the fed approved a loan to support Bear Sterns in mid-March, over
7 months after the onset of the crisis and too late to save the
firm.

Meanwhile Bush
and Congress lard on more debt for an “economic stimulus package”
when any prudent enterprise would be retrenching and saving. 
Checks are being sent to the same Americans who took on mortgages
and other forms of debt that they cannot afford to repay. This is
more positive feedback; excessive debt and credit caused this panic,
more debt cannot correct it and will make it worse. The “stimulus”
is deliberately targeted to avoid giving money to the most productive
citizens, with no checks for Americans in the top 10% or so of filers
who pay
70% of the income taxes
. The checks won’t be mailed for several
months, so we have positive feedback with delay.

It's hard to
know if the Fed's actions are excessive, but they are certainly
growing rapidly in amplitude. The August injections of a few billion
dollars have now grown to multiple efforts that will each create
hundreds of billions of dollars, and probably trillions in new debt
and credit.

Correcting
a credit crisis caused by excessive debt and profligate spending
requires three kinds of negative feedback: sound money, saving,
and budget cutting. This is the opposite of our present course of
money creation, more debt, and more spending. The instability is
growing because of this positive feedback.

It was not
always so. Murray Rothbard's outstanding treatment of The
Panic of 1819
documents striking similarities to the Panic
of 2008. There was speculation in real estate fueled by over-easy
granting of credit, a loss of confidence in banks and financial
institutions, a wave of bankruptcies, and a full-blown credit crisis
with a sudden loss of liquidity. Public land sales dropped over
90%, from $13.6 million in 1818 to $1.3 million in 1821. Those favoring
government intervention proposed various forms of debtor relief,
tighter regulation of banks, inflation of the money supply, and
protective tariffs.

While today's
media, politicians, bankers, and regulators are nearly unanimous
in their calls for more aggressive creation of debt by the Fed coupled
with more regulation and spending by the government, during the
Panic of 1819 nearly the opposite was true. President Monroe largely
ignored the crisis, mentioning the resulting short depression only
in explanation of declining federal revenues. Newspapers and magazines
of the day tended to support a laissez-faire approach. The
New York Evening Post wrote that "Time and the laws
of trade will restore things to an equilibrium, if legislatures
do not rashly interfere to the natural course of events."2

Despite the
many similarities in causes and effects between the two Panics,
opinions in today's "main stream" media are directly opposite
to the wisdom of 1819, although the internet provides a welcome
source of opposing views
for those interested in finding them. Among politicians, Congressman
Ron Paul stands nearly
alone in his staunch support of limited government, less regulation,
drastically reduced government taxation and spending, and a return
to sound money.

The correction
for creating excessive amounts of money out of thin air is automatically
provided by the gold standard, as gold cannot be created and is
mined only with great difficulty and expense. Our nation grew and
prospered under various forms of gold-backed money for 125 years.
In the 37 years since the federal government abandoned any pretense
of gold backing of our currency our standard of living has declined
and our once mighty economy has been reduced to a hollow shell.

The tie between
the dollar and gold was damaged by creation of the fed in 1913 and
progressively weakened thereafter until being abandoned completely
in 1971. The graph shows that the removal of the last tie between
gold and the dollar caused a rapid fall in the Dow/gold ratio as
the price of gold increased. The market had to find the correct
price for gold after decades of a government-fixed price despite
an ever-growing flood of newly created dollars. Once the initial
correction and over-reaction (another common trait in feedback systems)
for the market price of gold had passed, the fed was free to further
inflate the money supply and start the latest and greatest excursion
in the Dow/gold ratio.

Paying down
debts and increasing savings require determination and willpower.
These measures can and should be adopted by individuals, businesses,
and governments. As Jane Austen wrote in Persuasion,
"Your debts are extreme. You must retrench." Cutting spending
for individuals and private business is straightforward; once the
money and credit run out, spending falls automatically if it hasn't
been cut voluntarily. Governments with the power to create unlimited
money and credit can escape these limits, but neither governments
nor their subjects can escape the consequences of such foolish behavior.

It will take
all three of these forms of negative feedback, applied without delay,
to correct the growing instability. The alternative is nearly unthinkable,
but history provides plenty of examples.

Inappropriate feedback and excessive delays have doomed many man-made
systems. The awesome pyramid of debt and credit enabled by the Fed’s
machinations appears to be headed for the same “crash and burn”
fate. The free market produces countless feedback mechanisms
that tend to keep economies growing, creating more wealth and better
living standards for everyone. Apparently Ben Bernanke never took
advantage of the excellent but demanding courses in control systems
engineering offered by MIT while completing his Ph.D. in economics. 
I don’t believe that the market can or should be subject to central
control, but if I were to take the job of controlling the money
supply, I would want a solid background in control theory.

Notes

  1. My graph was inspired by a similar
    plot
    produced by Nick Laird that shows a long period of relatively
    stable growth from 1800–1920. Since the DJIA was first published
    in 1896, Mr. Laird uses a proxy for the DJIA 1800–1896. My
    graph was constructed using monthly average price data provided
    by the Dow
    Jones Indexes
    and Wren
    Research
    . I used government-fixed gold values of $20.67 per
    ounce for the period 1900-1934, and $35 from 1934–1968. Kitco
    provided monthly average prices for December 2007 to March 2008.
    The last point in the graph averages price data from March 1–14,
    2008.
  2. New York
    Evening Post, June 15, 1819, quoted in The Panic of
    1819: Reactions and Policies, Murray N. Rothbard, Ludwig von
    Mises Institute, 2007, pp 31–32.

March
22, 2008

Steve Fairfax
[send him mail] is
owner and president of MTechnology,
Inc.
consulting engineers specializing in power engineering
for the 21st century.

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