Economic Feedback

OPEC - The Organisation of Oil Producing States - has just announced they are dropping oil production with the intention of increasing the price of oil. At a time when economies world wide are entering a recession there is a great danger of putting the brakes on slowing economies and accelerating the decline. OPEC is now meeting much more frequently and are attempting to anticipate demand and prices so they can make better judgments in this area.

In order to understand this, and how it affects many aspects of economics, it is useful to understand the engineering concept of feedback.

Feedback can be positive (technically, in phase), or negative (out of phase). An example of positive feedback is when you bring a microphone next to a loudspeaker. At first nothing may happen but then if you make a noise, such as by knocking the microphone, you get a very loud noise. What happens is that the sound is amplified and comes out the loudspeaker where it is picked up by the microphone, amplified again and so on until the initial sound has turned into a load screech limited only by the maximum sound of the amplifying system. The feedback is positive: an initial sound is boosted and then boosted again and so on.

For an example of negative feedback imagine you are driving down an straight, undulating road and you are concerned about breaking the speed limit. You accelerate up to the speed limit, say 100 K/h, and keep an eye on the speedo. As you drop below this speed you put your foot on the accelerator, as you speed up you take your foot off. So as you get to a hill the car slows down and you apply more power. When you get to the top of the hill and start going down the car speeds up and you take your foot off.

This is negative feedback in action and serves to stabilise the speed of the car. It is what the cruise control of a car does. Negative feedback is used across a wide range of applications in order to make them more stable.

Now imagine we are driving the car as above but the engine is slow to respond to changes. So when we put our foot down the engine doesnÕt respond for 10 or so seconds, and similarly when we take our foot off the engine continues as it was for a similar time.

Now when we get to a hill we apply more power in order to speed up but the car will continue to slow down well below our desired speed until finally the power kicks in and the car accelerates. When we get to the top of the hill and the car starts accelerating we take our foot off, but power is still being applied for 10 or so seconds and it will continue to speed up. In fact, the adjustments we are making serves to make the speed changes worse then they would be if we applied the same power continuously. We are no longer applying negative feedback but positive feedback.

There is a way round this however. If we know that there is a 10 second lag and we can see that we approaching the top or bottom of a hill we can anticipate and apply or reduce power beforehand.

In economics feedback is used as well. When the oil price gets too low OPEC increases supply, and when it rises they reduce supply. However, like the car with the delayed reaction the changes donÕt affect the price immediately, there is a lag. Thus the OPEC decision to meet more frequently is in order to anticipate the demand and effects of the change in production, and prevent the changes having the wrong effect.

Now, the Federal Reserve Bank of Australia (and the US for that matter) doesnÕt have this attitude. They look at figures from the previous quarter and use these to change policy (reduce or increase interest rates) and apply a brake or accelerator to the economy. This is worse than having a delay. ItÕs more like looking back to see if we have just gone up or down a hill and using this to decide whether to apply a brake or accelerate. Sometimes, by chance, it may work out and if the economy is on a steady rise then looking back will be pretty good estimate of whatÕs in front. If the situation changes, however, it simply is not going to work.

Another factor when dealing with economic issues is that there are a number of factors that can influence the economy. Going back to our example of driving the car, imagine that there is an intermittent strong head wind. If the car responds quickly when we depress the accelerator there is not too much of a problem. When the wind blows and we slow down we apply power; when it drops off we decrease power. There is a slight delay after the wind starts up until we realise we have slowed down, and similarly there is a sudden burst when the wind dies down until we decrease the power. However, if we are driving the car with a delay then applying or decreasing power in response to wind changes is worse than useless. By the time the power comes in the wind may have dropped off. It may even be going in the opposite direction. The best course of action in this instance is to do nothing and weather the storm. This is all very well if we are driving a car but if we are driving a bus with passengers complaining of going too fast or too slow we may have difficulty staying focussed. So it is with government policies. The opposition will use the fluctuating fortunes as an opportunity to criticise the government, but in reality it is outside of the governmentÕs control. They should stick to their guns.