I've been reading a bit lately about the field of Econophysics, which I think is pretty cool. At heart, it doesn't really seem to apply "physics" to economics, so much as bring some uber-robust statistical methods physicists have crafted to inform the (comparatively) simpler (but still hard) methods of financial economists. A critical view would be it's just a bunch of physics geeks who, disillusioned by the barriers of their field, sold out to peddle their quantitative wares to Wall Street. Either way, it got me thinking about how analogy between seemingly unrelated fields is a basis for our most interesting inter-disciplinary scholarship. Hence, this experimental, yoga-stretch of a post and its motivating question. What can physics teach us about corporate governance and financial regulation?
To begin, consider Heisenberg's Uncertainty Principle. Our layman's take-home: one cannot measure a phenomenon without affecting it. The Uncertainty Principle requires that when the position of an atom is measured with a photon, the reflected photon will change the momentum of the atom by an uncertain amount inversely proportional to the accuracy of the position measurement. In other words, in order to view something, one needs to shoot a photon particle at it, but at the quantum level that photon changes the momentum of the particle you are trying to measure. This is similar to how one cannot, some believe, regulate financial activity without affecting the design of the financial system. Lawyers and bankers counseling issuers will help their clients design their activity to either comply or evade the regulatory apparatus (a.k.a. regulatory arbitrage). Thus, regulation designed to affect a financial system that is informed only by the system design pre-regulation will be outmoded before it even goes into effect.
Let us also think for a moment about how waves (e.g. sound waves) transmit energy. We subdivide our observation of this energy transference into two boxes: amplitude (the disparity between the baseline and the wave's peaks and troughs) and wavelength (the distance between distinct waves). This may be a useful dichotomy to inform our understanding of related dualities in our business such as (i) the debate over principles-based regulation vs. rules-based regulation in financial accounting [or, complicate it a bit, analogize it instead to the related distinction between amplitude modulation and frequency modulation used to regulate airwaves] or (ii) the disparity between quantitative and qualitative materiality in federal securities law so aptly identified in the last junior scholar paper. Two distinct qualities to the very same phenomenon, and easily confused by the non-specialist. In both of the analogous fields, my understanding is that we are measuring two distinct phenomena that are at heart related on one dimension we can understand and measure, but unrelated on another dimension we can understand and measure. The same challenge we see in the acoustics problems that the physics nerds specializing in wave theory contend with. Spooky. But hopefully a thought useful to someone out there.
I know nothing more of quantum physics that what I learned from Stephen Hawking's two books that, from his perspective, politely omit "For Dummies" in the title. (Still, to me they seemed more difficult to digest than tamales from a street cart at a Texas border town.) Check them out, they're awesome. Now let's consider the wave/particle duality of matter and energy. Matter and energy, to the quantum physicist, are two sides of the same coin, but they need the distinction; without it, their theories don't make sense. It is a useful fiction helpful to understand and to manipulate even though the description remains beyond complete human understanding (except for the realm of pure math). This is similar to the notions of market efficiency we use in justifying the fraud on the market theory, merely useful fictions for our models. Then again, should we scrap that in favor of a chaos theory approach, incorporating what we would otherwise describe as "trading noise" into models of market efficiency itself? Analogous on some ways to what the behavioral people have been trying to do?
Now, let's switch gears, and talk about the Laws of Thermodynamics. At heart, one cannot escape the entropy (eventual escape) of heat from a dynamic system. Agency Costs can be analogized to energy entropy in these models. Let's compare these laws and the notion that using financial intermediaries to overcome the agency problem creates a new agency problem. In both cases, we're really just talking about leakage from the system, and refining the system to limit this leakage of valued energy. I'm not saying that law schools should start hiring JD/PhD chem people as the next corporate law scholars (especially since had to look it up to spell Mendeleev). But agency costs and energy displacement are, ultimately, a perfectly analogous form of entropy from a dynamic system, and it can't hurt for chemical engineers and corporate law scholars to try to talk to each other and compare notes.
The Basel II Accords use capital adequacy requirements that take into account noise in systems, but also leave room for additional subjective judgments. Is this supported by conclusions of the bad boys of mathematics, the chaos theorists? Mandelbrot described both the "Noah effect" (in which sudden discontinuous changes can occur) and the "Joseph effect" (in which persistence of a value can occur for a while, and then rapidly change). Our minds resist the principles of chaos theory, just like the mathematicians do, because notions that we cannot predict the world aren't helpful. In other words, if there is no predictability to the future we want at least the comfort of the myth of predictability. But chaos theory is more sophisticated. Simply put, it can help to predict when systems will become completely unpredictable, or at least cement the need for a cushion against predictability when regulatory or investor bias causes the whole system to run off the rails. In short...cut the SEC Enforcement budget in half, and give that money over to the SEC Office of Risk Assessment...and have them hire some econophysicists!!!
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1. Posted by Jeff Lipshaw on August 26, 2008 @ 6:20 | Permalink
All very interesting and provocative. I got hung up for about six months on analogies of "axiomatic" and "deductive" formal systems to law, and spent hours working my way through Godel's proof which holds that complex formal systems like arithmetic are incomplete in that there are true statements that are undecidable - they cannot be proved or disproved within the system. In a nutshell, the arithmetic equivalent of cannot be proved).
A wise person cautioned me about the application of analogies from systems of logic. I think the jury is still out, but it's good advice to be cautious - and certainly a blog post is a fine place to float a trial balloon.
I have four suggestions:
1. On the question of analogical reasoning at all, see a series of essays edited by David H. Helman, Analogical Reasoning.
2. On the question whether there are scientific analogies to the process of judgment, [self-promotion alert]! see my Law's Illusion: Scientific Jurisprudence and the Struggle with Judgment.
3. On the question whether explanatory causation in the physical sciences is helpful as a matter of attributive causation in the human arena, see my Models and Games.
4. What is old is new. The book sitting in my backpack (a few pages at a time on the T) is Hart and Honore, Causation in the Law.
2. Posted by Jeff Lipshaw on August 26, 2008 @ 6:24 | Permalink
Something got messed up at the end of the first paragraph of that comment. Godel showed that the arithmetic equivalent of the phrase "cannot be proved" could not be proved. So it was the arithmetic equivalent of the Liar's Paradox, since the equivalent of "cannot be proved" was indeed a true statement built up within the formal logic of the arithmetic system.
3. Posted by David on August 26, 2008 @ 8:44 | Permalink
Sounds kinda trendy and so on ... but evocative. I can't quite figure out how chaos theory is different from risk assessment, though.
And what is it with you Mason people? You always want to cut the budget for everything in half!
4. Posted by Matt Bodie on August 26, 2008 @ 12:49 | Permalink
My concern with theorizing like this is that it takes an interesting idea too far. Sure, there are parallels between the phenomena you discuss. But to say: "agency costs and energy displacement are, ultimately, a perfectly analogous form of entropy from a dynamic system"? Perfectly analogous?
Ultimately, there will always be weaknesses whenever you use methodologies from the sciences to examine human behavior. There's a big difference between electrons and people -- people have free will. Sure, people may act in predictable ways. But an electron follows the laws of physics. People, on the other hand, can do things like default on their loans in unpredictable amounts, or commit fraud.
One last thought -- I would draw a different analogy to the Heisenberg uncertainty principle. Regulators are trying to regulate; they are not just trying to observe. Social scientists, on the other hand, are just trying to observe. I think the principle has more to say to academics than it does to policymakers.
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