Negative Feedback Loop?

I’m a little puzzled by one of the statements in David Hackett Fischer‘s conclusion to his The Great Wave: Price Revolutions and the Rhythm of History. On p. 249, he writes,

In a free market, individual responses to inflation commonly cause more inflation. Individual defenses against economic instability cause an economy to become more unstable.

This process might be called the irrationality of the market. It is so in the sense that it converts rational individual choices into collective results that are profoundly irrational. Far from being a benign or beneficent force, the market when left to itself is an unstable system that has repeatedly caused the disruption of social and economic systems in the past eight hundred years.

In a heavily footnoted text, this statement has no supporting citation, so it must be part of the common wisdom. But I must have missed that part of Econ 101.

Is this statement supportable? Is there evidence that this is the case? Or has every instance of “market instability” resulted in an over-correction by forces “outside” (or dominant players inside) the market?

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One Response to Negative Feedback Loop?

  1. pat says:

    Irving Fisher’s “Debt-Deflation Theory of Great Depressions” ( http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf ) is really good on the propensity for economic instability to feed upon itself and exacerbate instability.

    As for inflation leading to more inflation, I think it goes something like: People have some amount of money and see inflation occurring (or expect it to increase in the future). With inflation, they’ll see that money losing value in the future, so they’ll be less likely to save it and more likely to spend it now because it’s purchasing power is expected to be greater now than in the future. Since they’re spending more money, on a relatively limited amount of goods, they bid up the prices of those goods, so the inflation gets worse. Now, if interest rates increase enough, this process may be averted and inflation stopped, but probably at the cost of economic hardship (look at early 80s US Fed policy).

    Asset price speculation might operate similarly. People see house prices going up, and expect them to continue rising, so they purchase houses. If enough people purchase houses, this becomes a self-fulfilling prophecy, and prices do increase, which seems to vindicate the previous optimism, and another round of speculative purchases might occur: The process feeds upon itself. Eventually, though, this probably ends–at some point, people are unwilling to bid prices up further, and people begin to realize the houses were not as valuable as they thought, and a panic sets in. If the speculation was fueled by debt, then the debt-deflation process described by Fisher begins. Just like in the previous paragraph, the end of inflation (in this case, of house prices) brings with it a great deal of economic hardship.

    I could be wrong on the second paragraph, or missing some key points, but I think it’s at least partly right.

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