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Self-reinforcing loops in the economy are a big problem

August 7th, 2008 · 3 Comments

Classical economics is all about equilibrium restoring mechanisms (we gave you a few examples in a previous post). You tilt something out of balance, and it sets forces in motion that restore it. Unfortunately, reality is just a little bit more complex, there are numerous self-reinforcing mechanisms at work that get us deeper into economic troubles. We describe a few here. 

The most well known self-correcting (equilibrium restoring) mechanism is the price mechanism: when supply is larger than demand, the price falls (usually, in real life it does so with very variable speed depending on which market we’re talking about), lower price stimulates demand and lowers supply until supply and demand are equal again. Equilibrium restored.

The reason economics (until recently) stressed such self-correcting (equilibrium restoring) mechanisms is that it is built on 19 century physics, but we’ll leave that one for another day (perhaps). However, there are also important self-reinforcing mechanisms at work that take us away from equilibrium.

If ‘equilibrium’ sounds too non-descriptive or neutral, try “making an already bad situation worse”. So now you know what we’re talking about, we’ll give some examples.

The current economic problems started in the US, more specifically, in the US housing market. They then moved rapidly to financial markets and started to cause real economic pain. Here’s one self-reinforcing mechanism (or ‘positive feed-back loop’ as economist have it):

1) Credit markets; just when we need more generous credit to get the economy going again, balance sheets have been so badly hammered, that both the demand for, as the supply of credit is going down, reinforcing the economic problems.

Much economic activity is credit financed (especially in the US), so just when banks should expand credit to get the economy going again, they’re tightening conditions. This could get the economy in a negative spiral (but luckily, this is far from the only mechanism working in the economy).

One might say that the Fed could make credit cheaper, and that’s exactly what they’ve done (with considerable abandon). However, the Fed cannot dictate how much banks lend out, or how much consumers and companies borrow. They can only alter the price of credit, not it’s quantity (neither supply nor demand).

Now you might understand why in these kind of conditions, monetary policy has been likened to “pushing on a string”..

2) Even regulatory policy can be countercyclical, that is, reinforce the current economic tendencies (which are downward, needless to say). Banks in trouble need to shore up their balance sheets, according to the regulators. Nothing wrong with that, or so it seems.

So they issue shares and/or sell assets at distressed prices to comply. However, if enough banks do that at the same time, asset prices become even more distressed, pushing other banks over the edge as well, they need to issue shares and/or selling assets at even more distressed prices, etc. etc.. Get the picture?

3) Asset markets are especially prone to positive (self-reinforcing) feedback loops. The US housing market spiralled upwards to dizzying heights because of two self-reinforcing mechanisms:

  • The belief that house prices will always rise (at least in the long-term)
  • The availability of cheap credit.

Both reinforced one-another, until house prices reached such heights, and credit had become so loose, that the process started reversing, at which point they are reinforcing one-another downwards as well

  • credit ever tighter, pushing people over the edge, leading to foreclosures, depressing house prices even more, leading to more banking problems, tightening credit even more, etc. etc..

The house market is far from the only asset market displaying this kind of ‘overshooting’ (and subsequent ‘undershooting’). It’s because, as the late Rudy Dornbusch already showed in 1976, expectations play such an important role. We see these mechanisms played out on the stock exchanges on a daily basis.

4) De-leveraging. Banks (and other big parties operating in the financial markets, like hedge funds) are often highly leveraged (meaning their investments greatly exceed their capital base). When things turn sour, they need to de-leverage, by selling assets (or attracting new capital).

But de-leveraging can easily spread the problems from one financial market to another, selling assets in markets were one can still get a reasonable price depresses those prices, and put other highly leveraged parties in problems, they need to sell, etc. etc.

The disease spreads from one market to another, as leveraged parties sell to shore up their balance sheets, putting others in danger and reinforcing the process.

5) International links. The problems started in the US, but by a variety of mechanisms, they spread to other parts of the world.

For instance, Japan:

  • Japan’s economy probably contracted last quarter, bringing the country to the brink of its first recession in six years, as exports fell and consumers spent less.

Or Europe:

  • European Central Bank President Jean- Claude Trichet said economic growth will be “particularly weak” through the third quarter, suggesting policy makers are wary of raising interest rates again to curb inflation.

One of those mechanisms is the weaker dollar, which eats into Japanese and European exports. But as their economies weaken, they will spend less, which includes spending on American products, so the feedback loop can easily reinforce itself…

Luckily, because prices adjust so rapidly on commodity markets, there is also an equilibrium restoring mechanism at work. As demand falters, economies need less commodities, and these prices will rapidly adjust downwards, as they have done, easing the inflationary threat and giving central banks more leeway to fight the recession.

But numerous positive feedback mechanisms remain a serious threat to the economy.

Tags: The Markets

3 responses so far ↓

  • 1 Stacey Derbinshire // Aug 7, 2008 at 8:30 pm

    Can you tell me who did your layout? I’ve been looking for one kind of like yours. Thank you.

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