Everything Is Under Control
Can control theory save the economy from going down the tubes?
Economic Sensors and Actuators
To create a control system for an economy, a first step is to identify economic equivalents of engineering concepts such as sensors and actuators. Filling the role of economic sensors are measurements of business activity, such as employment levels, trade balances and statistics on income, savings and spending. The actuators are monetary and fiscal policies. Monetary policy is how a central bank controls the supply of money. (Printing currency is a minor part of this process; the major part is regulating terms of credit.) Fiscal policy has to do with government revenues and expenditures, and especially the balance between these amounts. Because the government is typically the largest single participant in the market, a government surplus or deficit can have a decisive effect on the overall demand for goods and services.
As control tasks go, regulating a national economy looks to be a major challenge. One notable difficulty is the wide range of time scales. Some economic events play out in a matter of hours or days (the 1987 stock market crash, the collapse of Lehman Brothers). At the other end of the spectrum, major trends can last for a decade or more (the Great Depression). Data from stock markets and commodity exchanges flow in minute by minute, but other statistics (retail sales, unemployment, corporate earnings) are calculated on a weekly, monthly or quarterly basis. On the actuator side of the control process, monetary policy is usually revised every month or two, but most aspects of fiscal policy are set annually. Because of all these time lags, regulators can never really know the current state of the economy they are trying to control; they have to act on the basis of measurements made over an interval that extends months into the past, and their actions will not produce their full effects for months into the future.
Another issue is that economic control is a multivariable problem, even though policymakers often speak as if there were a single dial, like a thermostat, that governs the overall pace of business activity. Control actions have different effects on lenders vs. borrowers, workers vs. investors, tenants vs. landowners, importers vs. exporters. A boon to farmers may be a burden to food buyers. The effects on various sectors of the economy cannot be adjusted independently; all the variables interact, much like temperature and pressure in an industrial process.
Still another question is whether governments and central banks actually have the power to tame the business cycle. No algorithm can keep a car up to speed if the engine lacks the oomph to climb a hill. Likewise, agencies trying to correct a severe economic downturn may simply lack the resources to restore prosperity. In the case of monetary policy, it is often pointed out that interest rates are a blade with only one edge: You can raise them as high as you wish, but you cannot lower them below zero. (On the other hand, bailout packages for banks are tantamount to a negative interest rate: The banks are being paid to borrow.)
Among all these impediments to effective control, the most worrisome are the time lags between measuring the state of the economy and applying corrections. Such delays, if combined with overly zealous control actions, bring a risk of controller-induced oscillations—of getting scalded or frozen in the shower. We might still be trying to stimulate a sluggish economy when it is already on the verge of overheating; then in the next phase of the cycle we might overreact in the other direction.
Control theory offers well-defined criteria for deciding whether a system will eventually settle down to a steady state or will enter some runaway regime of exponential growth or unbounded oscillations. Control engineers employ those methods to calculate stability margins—a measure of how closely the system approaches the edge of instability. As far as I know, such stability analyses are not routinely performed for monetary and fiscal controls applied to major economies. Perhaps it is not possible to do so given our imperfect knowledge of the state of the economy; if that’s the case, however, then we also cannot know how the economy will respond to our policies.