Financial Regulation and Thermoeconomics
By Richard Goldwater and Arthur Jonath
© 2009 - Goldwater and Jonath
No theory has yet emerged to explain our recent financial collapse. Public discussion focuses on economic theories of Adam Smith from 1776, and of John Maynard Keynes from 1936. We propose a scientific update of economics that we call thermoeconomics that looks at financial regulation in a whole, new way.
Smith and Keynes consciously or not relied upon Isaac Newton’s 17th century laws of motion. These described a universe of balanced, “action-and-reaction” that Smith turned into economic “supply-and-demand”. Smith believed that competition and an “invisible hand” would keep profits in line, and guide an economy toward an ideal balance. Keynes sought to balance full employment against inflation or deflation, and argued that government spending should function to maintain the balance.
The problem is, Newton’s laws can describe only perfect, perpetual motion. A cycling economy is more like an engine than like a pendulum or a gyroscope. Once things wobble, Newtonian balance no longer rules; only the use of fuel can put things back on track.
Thermodynamics, the 19th century science of heat and fuel, explains nature more completely than Newton’s laws do. Thermodynamics describes imbalance. Heat released from fuel flows from hot to cold, not the reverse, and spreads toward an equilibrium with the environment from which it can never return or be recycled. Flowing heat may accomplish work like powering a car, but always leaves behind a waste exhaust product called “entropy” that represents energy lost to equilibrium. Everything that happens uses up fuel to release energy, so increasing entropy is a sign of anything happening.. Eventually, the entire universe will run out of fuel as it expands toward the equilibrium-oblivion known as “heat death”.
No other quantity in nature must increase irreversibly as time does. Because successful economic transactions require that profit and money supply increase overall, these behave mathematically as increasing entropy. Profit is thermoeconomic entropy. Because entropy is waste, one can hardly consider profit as anything useful, or maximally to accumulate profit as a goal.
The thermoeconomic function of business is like that of a farm, to recycle profit as though it were waste. Combining profit with new energy, materials, and ideas to generate new value reduces local, economic entropy. Many financiers prefer to generate profits from profits without recycling them. These ”no-value profits” do not harness labor and energy, but instead grow by feeding on themselves. Without recycling, these bloated profits represent rapidly increasing economic entropy, leading to equilibrium crises such as we continue to experience.
Lately, algorithmic super-computation facilitates instantaneous trading that skims profits, and creates the computer equivalent of insider trading. Only an economy expanding dangerously into bubbles can temporarily cover up the theft of profit from value production. When will these gamblers’ bubbles burst? At least in Las Vegas, one can reliably calculate the odds.
Many called our recent “credit crunch” a “perfect storm”. We worry that this was merely a major storm. We might better compare our financial defenses to the levees around New Orleans that Army engineers knew all along had a 25% chance to fail at any time.
Only extraordinary, collective action limited the recent catastrophe. Even obstinate libertarians might concede that some government intervention was necessary. Might we not act to prevent another such battering? New regulations must severely tax financial maneuvers that cause bubbles, rather than rely on after-the-effect remedies. They must also promote the production of goods and services, and reward the value-creating, entrepreneur-innovator with profit.
Adam Smith wrote this about financial regulation: “To restrain private people… from receiving in payment the promissory notes of a banker… when they themselves are willing to receive them; or, to restrain a banker from issuing such notes…… may, no doubt, be considered … a violation of natural liberty. But …exercising the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical”.
Society regulates when competition fails to balance, and has done so at least since the Sherman Anti-trust Act of 1890. Regulations today affect many industries, as well as the activities of traders on exchange floors. Now, we must regulate finance by taxing valueless profit production. Defeating coherent regulatory change will only permit a truly final, perfect storm.