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Everything Is Under Control

Can control theory save the economy from going down the tubes?

Brian Hayes

The Great Moderation

With or without control theory, governments and central banks have not given up on attempts to smooth out business cycles. On the contrary, every major recession and inflationary episode in recent years has been met with a “counter-cyclical” response, regardless of the political ideology of those in power.

Feedback principles have probably helped to frame some of those counter-cyclical actions. In 1993 John B. Taylor of Stanford University proposed mathematical rules for setting central-bank interest rates in response to inflation and economic growth—rules that may well have influenced Federal Reserve decisions over the past decade. The Taylor rules constitute a rudimentary feedback mechanism. On the other hand, they do not exploit the full power of modern control theory. In particular, Taylor’s formulas ignore the question of controller-induced instability, and they take no account of the uncertainties that enter into stochastic and robust control methods.

Until recently, the economic strategies of governments and banks seemed to be working rather well. The peaks and troughs of the business cycle have been shallow, with only mild inflation. By 2002, economists were calling our era the Great Moderation.

But confidence in a perpetually purring economy has been swept away by the financial crisis of the past year. Governments have taken extraordinary measures in an effort to stabilize the system. One would like to believe that those interventions were guided by scientific principles of some kind—that the timing and the magnitude of the stimulus plans were calibrated to produce the fastest possible recovery without the kind of overcorrection that might bring oscillations.

Needless to say, the cost of miscalculation is high. Ben S. Bernanke, a student of the Great Depression, has argued that timid and misguided policies of the Federal Reserve were partly to blame for the length and severity of the 1930s depression. Bernanke is now chairman of the Fed, and he has presided over a monetary response that is anything but timid. Since September 2008 the Fed has injected well over a trillion dollars into the U.S. economy.

Not all economists see timidity as the main peril. Athanasios Orphanides of the Federal Reserve has argued that overaggressive corrections in the 1970s contributed to the “stagflation” of that decade. And still another faction questions whether monetary adjustments really have much effect at all. Through an ingenious computer simulation, Christopher A. Sims of Yale imposed the policies of the modern Fed on the economy of the 1930s, and vice versa. Swapping the strategies had little effect on the outcome.

I don’t know what to make of all these seemingly contradictory observations, and I find it unnerving that in a matter of such consequence there is so little consensus on basic principles. If the designers of an airplane disagreed so vehemently about the engineering of the flight-control system, the airplane would not leave the ground until the conflict had been resolved. But grounding the economy is not an option.

It was the economic catastrophe of the 1930s that led Keynes to propose a mechanism for moderating cycles of growth and contraction. Perhaps the current crisis will inspire a further examination of strategies for managing these fluctuations. The precepts of control theory suggest that one useful goal would be to reduce time lags in the feedback loop. On the sensor side, this would mean quicker collection and evaluation of basic business data, such as price levels and employment statistics. Speeding up the actuator side might be more problematic. Although the Fed and other central banks can act promptly on monetary policy, many aspects of fiscal policy are tied to the legislative calendar. The most promising approach may be greater reliance on “safety net” mechanisms such as unemployment compensation, which function automatically, without any need to enact new laws.

Standing in the middle between sensors and actuators are the control algorithms. Finding the optimal control law—and deciding what measure of economic wellbeing should be optimized—is the intellectually difficult and politically contentious part of the process. Maybe the answer is to power up the MONIAC again. We can let the cascade of colored water tell us how far to twist the hot and cold faucets.

©Brian Hayes


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