Negative Feedback

Planet Money is talking about the new Systemic Regulator, and also talking about other theoretical ways of regulating the banks. It occurs to me that one thing that’s missing, and not just a little bit missing, but radically missing, from the current system is negative feedback.

Wouldn’t it be interesting if we could set things up so that before the next bubble starts, the participants in the market can see that as certain stages of the bubble kick in, as measured by certain predetermined checkpoints, then certain economic brakes will be applied. We’d have to be careful not to take away all the control the Fed has, but perhaps you can invent a new set of levers which fall into this category of automatically triggered negative feedback.

Some examples:

  • Increasing the reserve requirement
  • Decreasing tax benefits of mortgage interest
  • Increasing the fees FDIC charges a bank to insure its deposits
  • Federal “encouragement” to states to make a rainy-day fund

The idea is to take “bad ideas”, the things Republicans hate, that they criticize as “friction on the economy” and program them into the financial landscape before they are needed. You’d probably have to choose many more of them, to make sure they provided negative feedback in all segments of the markets. After all, what’s the point of only having a brake on the front right tire?

The triggers would have to be automatically scaled with respect to the natural growth of the economy. Because whether or not there is a bubble, economies grow. And you’d have to find some way to defend them against political meddling. It’s comparatively easy to defend the Fed against pressure as it twiddles its one variable (the Fed funds rate), but it would be something else entirely to work out some kind of system that protected all the other keepers of the negative feedback rules.

One of the negative feedback mechanisms I named above might not be too clear without a description. For better or worse, we have a federal government. That means the states have freedoms that (for example) English counties don’t have. The central government has no right to tell California that it should spend or save it’s money in a certain way. The “solution” has been to setup matching funding mechanisms, then make the federal funds contingent on the state following the advice of the feds. To encourage the states to build up a rainy day fund during economic booms, perhaps all of the matching rules could be parameterized with respect to some sort of “bubble index”. Matching would be 1 for 1 (100%) minus X, where X is calculated with respect to the current “hotness” of the bubble, and how much the state is lagging the federal target for rainy day funds. Smart states would control expenditure to create a big surplus to go into the rainy-day fund, thereby preventing their X from getting above 0, and them losing matching funds.

With all economic things, you’ve got to try (hard as it is) to play the chess game forward a few moves and try to figure out the consequence. The theory of net present value helps decisionmakers take into consideration the future. By warning decisionmakers today that certain economic brakes will kick in tomorrow, they should be more willing to consider options today they wouldn’t have considered otherwise. On the other hand, even if there was certainty that the negative feedback rules were “out there” waiting to trigger, there would still be uncertainty on when the triggers would be reached. And it’s likely that some new and doubly-unstable form of speculation would come into existence.

Though the Planet Money folks have already declared a moratorium on it, I have to say, “the devil would be in the details”.

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