Ever since I’ve been ill I’ve been amazed at what an incredibly complicated and effective system the human body is.
Things have gone wrong that I’ve previously taken for granted and I’ve been forced to learn how the different control systems keep everything working together.
The economy is the same.
It is made up of the many different decisions that the billions of people make.
It is best understood by learning a little about systems thinking.
An Introduction To Systems Thinking
First, there are two different types of issues involved with quantity that we are naturally concerned with:
- Stocks – the balance at a particular time of an asset or liability
- Flows – the movement within a time period.
As individuals we think about income as flows and wealth as stocks and I urge you to start thinking more in causes and effects, in flows and stocks.
It will be a habit that will serve you well.
People say:
- “My salary is £50,000 per year” (flow)
- “I saved £4,000 last year.” (flow)
- “My house is worth £280,000 at the moment. When I bought it three years ago I paid £250,000.” (stock)
- “Last night there was £9,748 in my main bank account.” (stock)
Stocks are therefore affected by flows and any revaluations of the underlying assets or liabilities.
If you prefer to get away from money for a while, you can think of a bath partially filled with water. That quantity is the stock. If you turn on the tap, you get a positive flow that increases the quantity. If you pull the plug out, you get a negative flow that reduces the quantity.
This movement is a small system of cause and effect.
There are two types of system:
- A positive feedback loop that means the stock keeps increasing or decreasing. This is the virtuous circle (if it’s getting better) or vicious circle (if it’s getting worse).
- A balancing feedback loop that means the stock changes up to a target value and then a control action kicks in to keep the value at the target. The commonly quoted example is a thermostat in a central heating system. You set a target and the heating fires up and then stops when the temperature is reached. If the temperature then falls, the heating fires again.
A bathtub with water flowing in is a positive feedback loop system as the water gets higher and higher unless a large enough overflow pipe is fitted in which case it has a balancing feedback loop.
Your body has positive feedback loops – your hair will keep growing – and balancing feedback loops – your kidneys keep your body chemistry under control.
The economy also has both.
Compounding Feedback
Money earning compound interest gets bigger and bigger as the interest paid in previous years starts to earn interest. This is a positive feedback loop system. It has adverse effects if you’re on the other side and have to borrow money and pay compound interest. People who build up credit card debts struggle to clear the balances when interest rates are 25% p.a.. Things get much worse when people resort to pay-day loans with interest rates of 300% per annum or more.
The Rule of 72 is an easy way to understand compounding rates. Divide the annual interest rate into 72 and you’ll have a close approximate of the number of years it takes for the value to double.
Money earning interest at 10% will double in just over seven years. If interest is 25%, the money doubles in less than 3 years. If it earns 2%, it will take about 36 years.
The workings of supply and demand mean that markets are usually balancing feedback loop systems. They will find an equilibrium.
If a business invents a new wonder product that receives massive public relations and marketing, demand is high while supply is low. Prices and profits are high.
The firm who invented it has every incentive to increase production to a level where it can maximise profit. However, unless there are barriers that create a monopoly, other suppliers are going to be attracted by the opportunity to earn profit. They will start producing and prices will carry on reducing.
Eventually a level will be reached where no firm can increase profit by selling another unit. Demand equals supply and the market has found the equilibrium price.
In the real world, supply often increases too far, prices fall too low and the least profitable firms are forced out of business before the market price settles down.
The same type of balancing feedback loop happens with national economies and its foreign exchange rate. If exports are higher than imports, the demand for the currency is higher than supply and the exchange rate will rise. This will make exports more expensive and imports cheaper.
The cause and effect feedback relationship is complicated by delays. Imagine the difficulty of having a shower if the water was too cold and you added more hot water and had to wait a minute for something to happen. You’d probably give the hot tap another tweak and then find the water was too hot.
This relationship is complicated even more if there is a variable time delay since it makes it harder to see the relationships.
Why It Is Sometimes Necessary To Interfere In The Market
The problem with the workings of the market happen when people and governments interfere because they don’t like the results they see.
This introduces instability and causes unpredictable results and unintended consequences.
Unfortunately there is a catch 22.
Markets don’t work all the time and action needs to be taken to correct market failures.
In particular, there are three big reasons why governments have to intervene:
- Public goods – there are some things that society wants but individuals making rational decisions on their own won’t provide. That’s because there is the chance to get a free ride – to benefit while someone else pays the cost. A classic example is national defence. You may have strong pacifist beliefs and not want to pay for the armed forces but you enjoy the freedom from persecution from an oppressor. There are also public bads like health epidemics that can benefit from government assistance in the form of preventative inoculations. The more people who can be protected, the less chance the disease has to become a major destructive force.
http://en.wikipedia.org/wiki/Public_good
- Externalities – transactions can impose costs on third parties to the transaction. A great example is pollution from industrial processes.
http://en.wikipedia.org/wiki/Externalities - Markets aren’t efficient – the efficient market hypothesis says that the price represents the complete knowledge about something and is based on making rational decisions. If you’ve ever bought a second hand car or been scammed in any way, you’ll know that isn’t true.
http://en.wikipedia.org/wiki/Efficient-market_hypothesis
Interfering causes problems but not interfering also has problems.
Interfering to correct a market inefficiency which doesn’t create good outcomes is sensible and beneficial to the economy. This naturally encourages governments and regulators to want to interfere more and they drift into areas where the market functions effectively, even when it creates short term pain.
As we go forward, we will see plenty of these strains where the natural market has been prevented from working as it should.
Politicians may mean well. They see a problem like high unemployment and they want to do something about it. Indeed they may be elected to do something about it.
We will see that interference can postpone a problem, and then it’s much more difficult to correct it.
Past Articles In This Series
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