Economic Engineering

Human knowledge is the assimilation of a vast range of experiences. The incorporation of new ideas from other disciplines allows scholars to incrementally expand the frontier of knowledge. Otherwise, we become trapped in an obsolete paradigm, like the medieval scholars who argued incessantly about how many angels could dance on a pinhead. The adoption of mathematical techniques, for example, allowed economists to model and test new ideas. Likewise, the use of engineering principals can provide interesting insights into cyclical properties. The oscillation of objects creates sinusoidal patterns, with defined amplitudes and frequencies. This phenomenon is repeated throughout nature. Scientists, during the 19th century, established the basic laws of thermodynamics, which today provide the basis for many modern machines—including air conditioners, steam turbines and jet engines. The foundation rests with the thermodynamic cycle, whereby heat chases cold. The way an air conditioner works is by pumping a cooled gas through metal coils, drawing in the room’s warm air and expelling it out again. As the warm air passes over the coils, the heat is absorbed into the gas and the colder air is pumped back into the room. However, as the warmed gas is re-cooled, the energy must flow into another zone that is relatively cooler. That is why the back of an air conditioner is always blowing hot air. An air conditioner is actually a heat exchanger that moves energy from one place to another. Nevertheless, every engineer knows that the differential in temperature is what makes the process works. The allowance of only one phase of the sinusoidal progression stalls the operation. By applying this concept to economics, it can be inferred that there can be no expansion without contraction.

The inherent qualities of human beings largely define their behaviour. The frailties of the human body help explain herd tendencies. There is safety in crowds. This is one of the characteristics exploited by marketers and fashion designers. They create brands to attend these insecurities by generating a common sense of identity. The same goes with finance. Fear of the unknown and fear of failure produce crowded trades. Several years ago, for example, emerging markets were only for the strong at heart. They were reserved for a small band of exotic investors, who had local knowledge and skills. Emerging market corporate bonds were a subset of emerging market instruments left for a narrower band of experts. Yet, they are now main stream. Fund managers from across the planet are rushing headlong into corporate bond deals. As a result, valuations are becoming misaligned. Since the rush started, little has changed in most of these emerging market countries. They still tend to be mono-product exporters, with weak institutions and rampant corruption. Yet, they are now the most sought after assets in the financial world. This crowding of trades is what creates manias and bubbles. It is what leads to over-investment in sectors, such as technology, housing and tulips. It is also what triggers the oscillation between booms and busts.

However, policymakers fail to understand that by dampening the amplitude of the most unsavoury part of the business cycle, they are preventing the formation of the expansion phase. Just as in thermodynamics, where energy cannot flow unless there is a differential in temperature, there can be no recovery unless there is a recession. The Obama Administration’s rapid move to limit the effects of the 2008 credit collapse is the reason why the economy is not getting any traction. The banks are walking zombies, loaded with trillions of dollars in bad loans, mortgages and properties. Households are swimming with their heads deep underwater. Therefore, all of the quantitative easing (QE2) in the world will not solve anything. The financial system will take the additional money and push it back into the securities markets to lock in a quick profit. Except for a handful of bankers and traders, QE2 will not generate any new employment. However, a massive restructuring of bank and household balance sheets would allow the financial system to create the space to start anew. Otherwise, we are headed into a prolonged Japanese-styled downturn. As the amplitude of the sinusoidal curve decreases, it morphs into a flat line. Moreover, the sinusoidal curve is naturally symmetrical. Altering the shape of the phases only destabilizes the cycle. Therefore, in the same way that its namesake lies rusting at some Arabian pier, QE2 will not be anything new. Had the Obama Administration allowed the economic cycle to run its course, the U.S. economy would have been in the midst of a powerful rebound by the start of his re-election campaign. However, it is now moribund in an obsolete paradigm, and President Obama is on his way to becoming another one-term wonder. As in the words of a famous Spanish film director, there can be no pleasure without sorrow. The same goes with economics. There is no gain without pain.

5 Responses to "Economic Engineering"

  1. Dr. John Cardillo   September 29, 2010 at 6:49 am

    An Engineer’s perspective.When I saw the title of this article I was excited. I thought that finally, someone was analyzing the financial system from an engineering perspective. I was disappointed though that the article used engineering analogies to defend volatility and no controls.As an Engineer, I’ve often viewed the financial system as a classic control system problem. Much like a suspension system on a car is designed to keep the ride running as smooth as possible despite the bumps and pot holes along the way; I thought the financial system should be designed to keep economies running smooth despite the occasional blip such as wars, natural disasters, etc …In classic control system theory, the financial system is “out of control”. A system goes out of control when positive feedback is under dampened. In a car, if you remove the shocks, the car will bounce or oscillate incessantly. In the financial system, the herd tendencies described by Mr. Molano represent positive feedback. The lack of controls or dampening of this behavior has lead to the volatility that we are experiencing today.In classic control system theory, a system is at risk of destroying itself if positive feedback is amplified. Think of what happens when you place a microphone in front of a speaker. In the financial system, highly leveraged financial products have amplified the volatility and produced a train of bubbles that burst each time the limits of the system are breached.This volatility may be good for those in the industry that make there living on how fast things change. But for the average citizen, the ride is killing them.I’m not an economist, so I am ill equipped to suggest ways to get this system under control. I will say this though. As an engineer, it would be unethical and irresponsible to design control systems that behave like the current financial system.

    • Will Richardson   September 30, 2010 at 2:25 pm

      That’s a good point John.The controls in modern economies are the fiscal automatic stabilisers. For the private sector to net save without an inventory driven contraction, the government sector has to step into the spending gap to balance demand and supply and maintain growth. If the public deficit is too small, demand and income contract and the economy is dragged below full potential growth.A logical extension of automatic fiscal stabilisers is to give all un/der-employed people a Job Guarantee at a living minimum wage, much as has happened in Norway except for those unemployed up to 26 weeks. This provides a floor for demand and powerfully effects private sector expectations, savings and investment and propels the economy onto a higher sustainable growth path.This is known as Modern Monetary Theory and the Job Guarantee.If the government underfunds net private saving especially if it tries to have arbitrary budget surpluses or 3% deficit self-limiting rules, this takes money out of the system and provides the pressure or nudge for private actors to get into debt to maintain saving, and this eventually hits the limit of what interest payments can be sustained out of private incomes…ie the Great Credit Crunch of the last few years…this is before you even get into the unbalancing effects of poor/weak financial regulation, the over-saving when wealth and income becomes to concentrated and unequal.

    • Frank   January 31, 2013 at 5:20 am

      Very good John, I am an engineer too and I completely agree on the need to control markets.