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Engineering models could hold the key to economic recovery

Our economy is simply a vast collection of people trading with other people, so it feels logical and straightforward to think of it as a sort of giant amorphous blob with fundamentally human qualities. Words such as confidence, for example, are used to express market sentiment, which we might imagine as the aggregated balance of all our positive and negative thoughts about the future direction of the economy.

But there is another school of thought that suggests the opposite – that our human qualities play second fiddle to our real, primary role as dumb cogs in a giant economic machine. In this view, the current state of the economy was caused by the prevailing structure of the market, independent of the intelligence or stupidity of the people working within it.

Confidence, far from being the sum of human feeling, is what engineers call an ‘emergent property’ – the range of patterns that arise from a range of relatively simple interactions – as chaotic as the weather. And like bacteria spreading across a petri dish, the market cannot help but inhabit whatever niches appear that can support a profit, irrespective of their underlying wisdom. This theory might well explain the bundling up of subprime mortgages into mis-rated financial products bought by institutions whose decisions came from a far more base or instinctive location than well-informed logic.

Google “zero-intelligence trading” and you will find more on this idea. There are researchers who have demonstrated that completely random trading actually leads to the same pricing patterns observed on stock exchanges. Meanwhile, it is well established that humans, in some circumstances, behave with the intelligence of motes of smoke.

The flow of a crowd leaving a football stadium will exhibit set patterns, even though every individual makes their own decision about where to walk. Similarly, road traffic can be modelled accurately despite each vehicle being driven by a human being in their own individual style. Timid, distracted, aggressive or even lunatic driving all averages out on a large enough scale.

Another anthropomorphic word used with respect to the economy is recovery. Recovery might elicit thoughts of a welcome return to rude health, but to an engineer it means the automatic response to some disturbance, strain or impact. Recovery in these mechanical terms depends not on decisive action, but on two basic material qualities: springiness and damping.

The science bit
Traders and financial analysts use similar concepts to model the way markets might move. But, to an engineer, recovery is a dynamic process that fits into one of
three states: under-damped, over-damped, or well-damped. The three conditions
are divided not only by their speed of response, but in how they continue to change after the initial reaction.

In an under-damped system, springiness dominates. This means that forces opposing disturbance are stronger than all others. In the way that a swing door oscillates before returning to its resting state in the door frame, the strength of an under-damped reaction will send a system rushing back to the centre so quickly that it will overshoot again and again until the energy of the disturbance has dissipated. This phenomenon is called ringing – or W-shaped recovery.

In an over-damped system, forces countering movement in any direction dominate. The initial disturbance is strongly resisted, but so too is the return to normality, meaning that balance is reached more slowly than necessary. In economic terms, this is the U- or L-shaped recession, depending on your level of pessimism.

But between these two lies the “Goldilocks state” that has joined the recession vernacular, in which springing and damping tendencies are evenly balanced. The well-damped system returns to normal without overshooting and without excessive delay – economists know it as the V-shaped recovery.

It is worth noting that there is an infinity of under-damped and over-damped conditions, from ringing that never stops to a recovery that never actually arrives. There are relatively few outcomes in the centre that resemble a prompt and smooth recovery.

Alas, it is impossible to assess all the market forces that provide damping or springing effects within our economy because the machine is too big and too complicated. Economic forecasts often seem as reliable as weather forecasts and they go awry for similar reasons – the underlying forces may be simple, but their interplay is subtle. However, it is reasonable to suggest that the intervention of governments tends to represent a reduction in damping and an increase in springiness: lack of credit, for example, is a damping force, as is a high interest rate.

The question is, how likely is it that the adjustments to the economic machine made by governments will bring about a well-damped recovery, after the biggest financial disturbance in living memory? And if we are simply following the rules of physics – damped, springy or otherwise – does anyone have any modicum of control over our chances of recovery?

Lem Bingley is editor-in-chief of Financial Director. He originally trained as an engineer.

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