In most simple descriptions of the internal combustion engine a critical component is left out: the governor.
The governor is a device that measures the speed of the engine and slows it down more the faster it tries to go. In my lawnmower the crankshaft has blades on it to make a fan - the faster the engine turns the more air the fan produces and the more this pushes a vane that closes down the throttle. Even if I open the throttle full, the wind from the fan closes the throttle back.
Why is such a device necessary? Because without it the engine would get faster and suck in even more air and fuel making it go faster still, and so on. Eventually - or in the case of a lawnmower - very soon, the engine would tear itself to pieces as the internal mechanical strains became too great.
Sounds a bit like what has just happened to the financial system, doesn't it.
Governors (not including Governors of the Bank of England) and similar control systems are well known in engineering and come under the heading negative feedback. Negative feedback is used as a protection mechanism in systems where there is amplification - I open the throttle using a tiny push of my finger and my lawnmower expends thousands of times more energy to go faster and cut more grass. The governor feeds a tiny bit of the increased output back to decrease the input.
How could we engineer negative feedback into the financial system to stop it tearing itself to pieces from time to time?
At the moment, bank rates, the rates which savers and borrowers get are supposed to be controlled by setting a central base rate. Unfortunately the base rate is only loosely related to the cost of money. The lawnmower equivalent of a centrally set base rate would be another control that you had to adjust every few minutes to prevent the engine blowing up or grinding to a halt. You can see why even lawnmowers don't use anything so crude.
Markets without effective feedback loops are like an engine without a governor. Unstable. To get stability, all sorts of complicated ad hoc regulations have to be cooked up, like a base rate mechanism, usually as a knee-jerk reaction to some crisis or previous regulatory failure. This leaves opportunities for human error, dishonesty and manipulation and has to be constantly tweaked. The 'light touch' regulation of the UK authority the FSA (Financial Services Authority) has been woefully ineffective.
Suppose instead we were to tie lending and saving rates to price inflation, what would happen?
For the sake of argument let's say savers get 1 percent more than the rate of inflation and borrowers pay 2 percent more.
Now suppose that house prices start to rise, as they did in the UK up until recently. As prices rise, what buyers have to pay in interest does also as we have tied interest rates to prices. Most existing buyers are not too worried by this as their houses are worth more even though they have to pay more to service the debt. But it does discourage market activity (the opposite of what actually happened) even though house prices are increasing and so prices stop rising and fall back a bit. When prices start falling so also do interest rates, stimulating the market again.
For savers, if prices go up, higher rates of return encourage a shift to saving away from spending. The result is the shops sell less, prices come down and as a result so do interest rates.
These changes are almost imperceptible to the man in the street - just microscopic boom and busts. Just as your lawnmower runs at a constant speed even though the grass is sometimes harder to cut, so the economy runs at a nearly constant rate. An end to boom and bust.
The overall effect is stability, something that is in short supply at the moment.
Of course, it will never happen. Governments amd Governors (the human type) just couldn't bring themselves to relinquish the control they claim to have. There are just too many people with an interest in pretending that it was they who rescued us rather than a simple engineering principle.
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