Unexpectedly Intriguing!
June 28, 2005

Are economists finally learning basic physics? Not long ago, Jean-Phillippe Bouchaud and Marc Mezard, both practicioners of a new hybrid field of economics and physics called "econophysics" discovered a connection between the physics of materials and the movements of money. Now, the connection between physics and economics is coming into play again as the Federal Reserve Bank of Cleveland has recently issued its June 2005 report of Economic Trends (available as a 1MB PDF document) in which the Second Law of Thermodynamics plays a starring role in explaining the reactions of financial markets following key events.

First, here are the Laws of Thermodynamics:

  1. Energy can be changed from one form to another, but it cannot be created or destroyed. The total amount of energy and matter in the Universe remains constant, merely changing from one form to another.
  2. Energy tends to flow spontaneously from being concentrated in one place to becoming diffused or dispersed and spread out, unless it is hindered from doing so.
  3. It is impossible to cool a body to absolute zero by any finite process. Although one can approach absolute zero as closely as one desires, one cannot actually reach this limit.

For most people, the Second Law of Thermodynamics makes pretty good intuitive sense. For example, the Second Law is the reason why your hot cup of coffee cools down to room temperature when you leave it sitting out. You can stave off the loss of heat by putting your coffee in an insulated cup, hindering its discharge of energy, but eventually, it will cool down to room temperature.

The writers of the Cleveland Fed's report on economic trends make use of the analogy of the laws of thermodynamics in several ways, all of which appear in the "Economy in Perspective" secton of the report. First, they note the reaction of foreign exchange markets in discharging energy by lowering the rate of exchange between the Euro and the U.S. dollar after the French rejected the proposed EU constitution.

Another example of how the Second Law is used by the Cleveland Fed applies to how financial markets are reacting the the earning potential of U.S. carmakers as they cope with structural disadvantages in costs and productivity with respect to their foreign competition. Here, the Cleveland Fed notes:

The Second Law states that once an obstacle is removed, built-up tensions eventually dissipate. For the U.S. automotive industry, credit rating agencies’ downgrades were what set the adjustments in motion, and the repercussions are being felt all along the supply chain as the industry prepares for various consolidations. Some firms are already leaving the industry, and others are working to reduce costs.

At this point, having already opened Pandora's physics box, the report's authors at the Cleveland Fed begin losing control of the science (being economists after all), by introducing the First Law of Thermodynamics, the Principle of Buoyancy and, oddly enough, kitchen safety:

Thermodynamic forces are also working to convert the potential energy bound up in the Chinese renminbi’s peg to the U.S. dollar into kinetic energy. The question, of course, is in what direction and to what degree the currencies will depart from the present fixed exchange rate, when—and if—the Chinese government alters the peg. Some market observers are convinced that the renminbi is seriously undervalued and would appreciate rapidly in a free float, much like an inflated ball that has been held underwater and then released. Others think that focusing on the exchange rate misses the bigger picture: The thermodynamics of the economic relationship between China and the United States involve far more than the dollar/renminbi exchange rate. The United States is a mature economy and, although it constantly reinvents itself, its pace of change is nowhere near that of China today. The hot frying pan that is China will take a long time to cool, and those of us who want to stay in the kitchen must be careful not to get burned.

Personally, I'm glad they stopped here because I was becoming concerned where they might be going next - Schroedinger's cat had best take note....

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