Physics and Economics

As a student at a liberal arts university, I have developed into a huge proponent of multidisciplinary learning. It’s the way in which we can truly solve problems in the real world, as well as keep our minds open. Although I’ve only been a college student for two years, I’ve had the opportunity to take many classes that I wouldn’t have expected to take at a more degree-oriented university, with topics ranging from ancient philosophy to banking, and pretty much everything in between. One subject that I’ve somehow managed to avoid my entire life is physics. In high school, I opted out of taking physics because it seemed like too intimidating and hard of a topic. Now, in college, I decided against finding time to take a physics class because it seemed irrelevant to what I was studying. Recently, I discovered how absolutely incorrect that sentiment was.

Little did I know up until recently that physics and economics have so much more in common than I thought. In fact, there is an entire branch of economics dedicated to applying theories and methods originally developed by physicists in order to solve problems in economics. Of course, both disciplines are very math oriented, but their similarities extend much further than that. Both subjects are drawn to the actions and reactions between multiple entities and events. Both physicists and economists strive to be able to perfectly foresee causes and predict events, but have ultimately created theories that lean on the fact that doing so is nearly impossible. In economics, there is the efficient market hypothesis, which calculates unpredictability due to the fact that efficient markets are so sensitive that they instantaneously correct for any slight change in the economy. In physics, there is the chaos theory, which I will explain later. Both of these theories are somewhat controversial, but taken for what they are worth, can shine light on how forseeably unpredictable the world around us is.

A couple of weekends ago, I found a little book called Introduction to Chaos Theory in a “Free Books” bin in a Portland coffee shop. Consisting of about 70% illustrations, it is an aesthetically entertaining and understandable explanation of how chaos theory works. To put it simply, chaos theory is an attempt to model the underlying order of complex systems that may appear to be completely random and without order at first glance. It gives light to a concept called the Butterfly Effect, which the idea that some events or objects’ behavior is extremely sensitive to even the smallest changes, meaning that a miniscule change in conditions can lead to huge consequences in the long run. These two topics can be applied to many topics, such as weather patterns, brain states, and even financial markets.

We know that movement in exchange rates during financially turbulent times are essentially unpredictable, but they are definitely not random. Another book called Globaloney by former University of Puget Sound professor Michael Veseth does an excellent job of explaining how exchange markets apply to the chaos theory. He specifically focuses on how it works in a foreign market. Let’s say that there are two traders speculating on a dollar/yen exchange rate. These two traders use different methods to make decisions that affect the same market. The first trader is a fundamentalist—she predicts the exchange rate based on economic fundamentals such as past and present GDP and inflation rates. The second trader buys and sells based on a chartist theory—she uses graphs of price movement patterns, and buys or sells whenever the market differs from her projected trend. This means that as the two speculators buy and sell on different exchange rate theories, the chartist’s action produces a reaction by the fundamentalist that can either assist in keeping the rate in equilibrium, or put the rate in a spiraling upward or downward cycle. This is obviously just one of thousands of transactions that go on in the global market daily, but based on the butterfly effect, these infinitesimally small actions have the potential to create complete instability, as seen by historical failures of market bubbles that lead to global financial crises.

One aspect of economics that originally drew me to major in it is its applicability and relativity to a wide variety of topics. It is always fascinating to personally discover another subject that coincides with economics, even if they seem different on the surface. Of course, I will probably never have the time or the brainpower to truly understand the implications of chaos theory in financial markets, but it is nevertheless a relevant and interesting idea that I had never previously thought about.


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