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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