Thermoeconomics – Applications in Financial Markets
Thermoeconomics, also known as biophysical economics, is a multidisciplinary field that combines the principles of thermodynamics with economic theory.
This approach seeks to understand economic processes as energy transformations, much like how thermodynamics studies energy exchanges in physical systems.
In recent years, the concepts of thermoeconomics have found applications in financial markets, offering a unique perspective on market dynamics and behaviors.
Key Takeaways – Thermoeconomics
- Understanding Thermoeconomics
- Combines principles of thermodynamics and economic theory.
- Applies concepts of energy conservation and transformation to economic activities.
- Utilizes thermodynamic principles to analyze financial market dynamics, helping in understanding, e.g., market inefficiencies and volatility.
- Energy Neither Created Nor Destroyed (Financial Applications)
- Money doesn’t simply “disappear” during market falls.
- Most capital circulates or shifts between different assets and sectors.
- Investment dollars flow globally, seeking stability or promising opportunities in different assets, asset classes, markets, or currencies.
- Divergence from thermodynamics principles occurs when promises (credits) are not fulfilled, leading to lost value.
- Applications and Critiques
- Adaptation of thermoeconomic tools in financial analysis aids in assessing true cost and value of assets.
- Can help in new ways of thinking about trading and investment strategies, aiding in portfolio diversification and understanding money and credit flows.
- Faces criticisms for potentially oversimplified analogies and concerns over practical real-world applications.
- Ongoing developments in the field are aiming to refine concepts and discover new applications.
The Foundations of Thermoeconomics
Thermoeconomics is rooted in the belief that economic activities are fundamentally energy processes.
It posits that just as energy cannot be created or destroyed, economic value too has its conservation principles.
The second law of thermodynamics, which states that entropy in a closed system always increases, has parallels in economic systems where inefficiencies and dissipations occur.
By viewing economies as energy systems, thermoeconomics provides a framework to analyze resource allocation, production, and consumption.
Financial Markets as Thermodynamic Systems
Financial markets can be seen as closed thermodynamic systems where money, like energy, flows between entities.
Trades, investments, and other financial transactions represent energy transfers, with money being the quantifiable measure of this energy.
Market inefficiencies, much like thermodynamic inefficiencies, lead to dissipations or losses.
Volatility in financial markets can be likened to fluctuations in energy states, with periods of high volatility representing higher energy states.
Does Money Disappear When Markets Fall?
When markets fall, it’s a common misconception that money simply “disappears.”
Like in thermodynamics, when a cup of coffee cools off, the energy in it didn’t disappear; it just went somewhere else.
In reality, the dynamics of financial markets and the broader economy are more intricate.
Here’s an explanation of what happens to money and credit when markets decline:
When the value of an asset (like a stock or real estate) drops, it doesn’t mean the money and credit invested in it has been destroyed.
Instead, it often means that the capital has moved elsewhere.
That said, it someone reneges on a promise, then in that case the credit asset they thought existed doesn’t actually exist.
For example, if a company buys inventory from a supplier on credit (a promise to pay), and the company doesn’t pay, that represents lost value.
So there is some divergence from classical thermodynamics in physical systems.
While there is loss in value in many instances, when markets fall, it’s usually capital circulating rather than being destroyed.
This also makes the argument for prudent diversification rather than concentration in one asset class.
We cover how to do this in other articles.
Movement Between Assets and Asset Classes
Money and credit flow between different assets and asset classes.
This is a form of diversification, a strategy used to manage risk.
Capital is highly mobile in our globalized world.
When markets look less favorable in one country, investors might move their money to another country’s markets that they believe offer better opportunities or more stability.
Similarly, they might convert their money into different currencies that seem more stable or promising.
Conversion to Other Forms of Savings
Not all money invested in the market stays in the market.
Some of it gets converted into other forms of savings.
For instance, an investor might decide to pull money out of the stock market and put it into a savings account, a fixed deposit, or even tangible assets like art, collectibles, among other things.
Some of the money pulled out of markets is spent.
For example, an individual might sell stocks to finance a large purchase, such as a home or car, or to cover living expenses.
When this money is spent, it enters the broader economy, supporting businesses and potentially creating jobs.
In turn, this can support company earnings and support valuations.
Perceived Value vs. Actual Money
It’s essential to differentiate between the perceived value of an asset and actual value.
When a non-public asset’s price falls, its perceived value decreases, but that doesn’t mean the equivalent amount of money has been destroyed.
It’s a paper loss until the asset is sold. If an investor holds onto the asset and its value rises again, the perceived loss can be recovered.
Entropy and Market Efficiency
The concept of entropy in thermodynamics can be applied to financial markets to understand market efficiency.
High entropy states in markets signify high unpredictability and randomness, akin to inefficient markets.
Conversely, low entropy states indicate more predictable and orderly market behaviors, representing efficient markets.
By analyzing the entropy of financial markets, traders/investors can gauge the efficiency of the market and make informed decisions.
Thermoeconomic Tools in Financial Analysis
Several thermoeconomic tools have been adapted for use in financial analysis.
The thermoeconomic concept of emergy, which quantifies the energy used in the production of a good or service, can be used to assess the true cost and value of financial assets.
These tools offer a fresh perspective on financial analysis, emphasizing the energy dynamics underlying market behaviors.
Implications for Trading and Investment Strategies
Understanding financial markets through the lens of thermoeconomics can lead to new investment strategies.
Traders/investors can use thermoeconomic principles to identify assets that are undervalued in terms of their potential or by better understanding money and credit flows between and among assets and asset classes.
Thermoeconomic insights can guide portfolio diversification, ensuring a balance of assets with varying environmental biases that ideally are balanced out to create a quality return-to-risk ratio.
Challenges and Criticisms
While thermoeconomics offers a unique perspective on financial markets, there are challenges and criticisms.
Some economists argue that the analogy between thermodynamics and economics is oversimplified and lacks nuance.
There are also concerns about the practicality of applying thermoeconomic tools in real-world financial scenarios.
Despite these, the field continues to grow and evolve, with researchers exploring new applications and refining existing concepts.
While we didn’t discuss the math associated with thermodynamics in this article, it can provide new ways of modeling financial phenomena.
Thermoeconomics provides a novel lens through which to view and understand economics and financial markets.
By drawing parallels between thermodynamic and economic systems, it offers insights into market dynamics, efficiency, and value.
While still a developing field, the applications of thermoeconomics in financial markets holds promise for creative analysis and investment strategies.