Economics and Organisation

9.             Economics

David Hume was evidently aware of the action of feedback as a self correcting mechanism, although he did not perhaps recognise it as such. In his Political Discourses of 1752, he surmised that if Great Britain were to lose a large part of its money supply, then the price of goods and wages would fall, but it would not take long for this to be corrected because of the impact on the balance of trade with other countries. Likewise, if the country received a quantity of money, this would drive up prices, and imports, which would then send more money to other countries. In fact, Hume compared this mechanism with the balancing of fluids in interconnected chambers

Not long after, Adam Smith, in his Wealth of Nations, explained how social feedback mechanism were involved in the control of wages, population and supply and demand.

For example, when wages fall, then profits rise. This leads to a general rise in wealth of industrialist / capitalists/ share owners, and hence eventually to a rise in wages. Of course, many factors come into play here, such as the rate of unemployment and the strength of labour unions, but the point is that negative feedback will limit runaway trends.

Sometimes, though, that doesn’t happen, and you get runaway hyperinflation as in the Weimar republic, or to a lesser extent in South America, or even Turkey recently. This is a classic case of positive feedback causing a runaway condition. As money loses value, confidence is weakened, and more money is printed, leading to a further decrease in the value of money, and so on.

I remember in Britain in the 1970’s, wage inflation caused a rapid increase in inflation to around 25%, when labour wages and money value chased each other up in a spiral. This process was fuelled by a wage policy that automatically linked wages to the RPI (retail price index), effectively building in a positive feedback loop. One wonders if the then political leaders had ever heard of positive feedback. Of course inflation is not a bad thing for some people. I you own property with a large mortgage, inflation can reduce the value of the mortgage rapidly. But for those with cash savings, it can be disastrous. Inflation effectively redistributes wealth from cash holders to debt owners, often in fact from the (relatively) poor to the better off

The stock market is another place where feedback is evident, both positive and negative. Rising share prices lead people to expect that times are good, and that they will keep on rising, so they buy shares. This leads the price to increase further, and so creates positive feedback. This type of behaviour is known in the trade as momentum buying, and is not something to be recommended. In other words, do not buy shares just because other people are buying them. Why not? Well, eventually someone will decide that the shares have become too expensive, and are overpriced, so they will start selling. Then the price will start to fall, and before you can say ‘crash’, other people will join in and make the price fall further. This is known as momentum selling, or less kindly, behaving like headless chickens. The fall in prices is again positive feedback, but the whole process of changing from rise to fall is negative feedback. And eventually, negative feedback will persuade some people that the shares have once again become cheap, and start buying.

Probably the most extreme example of momentum buying was in Holland around 1636. A fashion for tulip bulbs got rather out of hand, so much so in fact that the price of bulbs went up by 20 times in just one month. At the peak of the madness, one bulb could cost more than a good house in Amsterdamn. This might seem crazy – lets face it, it was crazy, but the point is that people were speculating. They did not intend to keep the bulbs, they were simply buying in the expectation that the price would increase. We are not immune to this kind of thinking even today; not that long ago you could hear some people say that house prices (in the UK anyway) were bound to keep on rising. All sorts of arguments could be used to support this – ever increasing demand, immigrant workers, split families etc. The thing to remember is that when everyone is saying that the price of something must go up, then that is the point of maximum danger, and time to steer well clear.

Some post modern economists have poured cold water on the Tulip Mania theory, though their arguments sound rather like someone trying to persuade you that the Titanic was not exactly sunk. In any event, there have been other notable examples of speculative bubbles such as the South Sea Bubble, and more recently the dot.com bubble.

Wise old investors like Warren Buffet will advise you (amongst other things) to indulge in contrary investing; in other words to do the opposite of what most people are doing. This is worth considering, but don’t overdo it. But here again, the point is that ‘contrary’ behaviour is a form of negative feedback.

Economics is, or course, a tricky business. The old joke that, if you ask five economists a question, you will get six different answers is actually not far from the truth. Look at the end of year predictions for next years GDP, inflation, base rates and currency rates, and you will get a large range of different predictions. The only common factor between all of them is that they will all be wrong. Or if any of them is exactly right, it will be by chance.

The early economic models of balanced supply and demand depend on feedback to keep them in balance. If the market value of something rises too much, people will stop buying and the price will fall. This is classic negative feedback.

In fact, real life is a bit more complex than that. Many factors intervene in ‘perfect’ market pricing. For one thing, naughty companies can indulge in cartels or price fixing which keeps the price higher than it ‘should’ be. For another, modern market complexities can serve to confuse the consumer so much that the optimum decision can be too difficult to take, too time consuming, too costly in itself. Watch a busy shopper in a supermarket, and they will often make more or less random decisions, without much regard to pricing. And the power of global brands can lead consumers to stick to tried and tested names rather than try new ones to see if they offer better value.

In recent times, there has been a rise in applying ideas from Chaos Theory to economics, with the acceptance that such systems are, like much else in life, complex non linear dynamic systems, involving feedback. The trouble is, that this still does not make them any easier to predict. In fact, it tends to bring home the inherent unpredictability.

Feedback in organizations

Organizations come in all shapes and sizes. A small company is one, so is a large company, or a multinational. Villages are too, as are towns and cities. Some living systems are organizations, like ant colonies, or coral reefs. It can be argued that all living things are organizations, in that they are collections of cells organized together.

Let us take city growth as an example. In Field of Dreams, the semi mystic Kevin Costner film, the theme is ‘If you build it, they will come’. There is a lot of truth in that, as anyone who has played Simcity knows. People need somewhere to live, somewhere to work, and somewhere to shop. If you provide all of that, then people will tend to come there. There are a few other factors too, like leisure facilities, policing and crime – all in Simcity as well. There is also a positive feedback effect. If a city grows and attracts more people, then those people create opportunities for yet more people. They need services, hairdressers, decorators, doctors, teachers and so on. Conversely, if a city starts to have inner city problems – violence, graffiti, slums, then people start to move out. As the population falls, the demand for services falls, which leads to further reduction. Of course there are many factors involved here, such as birth and death rates,  which also impact the population levels. The huge growth in third world cities like Mexico City, Sao Paolo, owe as much to high birth rates as to inward migration.

Now let us take a look at companies, which use feedback in all sorts of ways to try and control and improve the company’s growth and share price. The internal accounting system monitors the incoming and outgoing cash, and provides feedback to the directors as to the ongoing situation, and allows them to take steps to correct problems. Likewise, sales forecasts from the sales and marketing department give an indication of the likely income for the near future, and again allows for steps to be taken to increase sales, or cut costs.

Customer surveys and meetings give feedback on how customers view the company, share price monitoring indicates how the stock market is feeling about the company, and staff appraisals give two way feedback between the company and its employees. Running a business involves continuous feedback at all levels, and any company that neglects this even for a short time is in danger of heading downhill fast.