I studied physics alongside economics in university. As a result, my approach to theoretical economics has been slightly tempered by this exposure to physics.

Add to it repeated references to physics during the course of my economics study, even finding economics being named “the physics of the social sciences” and that left me with some PTSD (physics trauma stress disorder).

Recently I got into a verbal exchange with someone when I remarked that I did not consider finance a part of economics (not in the current system at least). On being pressed, I further clarified that the calculation of GDP involves adding up the total value created in the production process. I do not think that finance creates new value in the production process. What gives?

Finance today, as practiced in almost all regions of the world, consists of allocating capital (a large part of it lying idle) to productive purposes. In return, the loaner is given an interest payment. There are two costs on carrying out business with such financing. One is the cost of paying the financier for arranging the finance (the fee), the other is the interest payment. Why is the interest payment not counted as a fair return to arranging finance for a business? A business can fail and the interest due from the loan is not always written down. It sticks whether or not the business succeeds or not. The result will be lower profitability as the loan is repaid (assuming the business succeeds).

This kind of financing is all fine (for this essay, consider it fine, if I ever critique this way of financing production, the evaluation of arranging finance this way will be looked into there) as it can actually serve to expand economic capacity by serving to finance expansion of productive capacity. That is not the only purpose that finance is channeled into though. That changed with the rise of neoliberal economic thought and finance taking primacy over production in the functioning of an economy.

A lot of the finance that led to the the Great Recession of 2008 was channeled into speculative activities; activities that don’t really serve to expand production and economic capacity but are used mainly in feeding capital to growing asset bubbles and in making guesses about where a profit (or a loss) can be made, which is no better than gambling. If finance is being used to feed growing asset bubbles and in speculation instead of expanding production capacity, that activity imposes an overhead on the economy instead of increasing efficiency. A detailed look at the accounting used for the entire set of connected processes will make it apparent that most finance imposes a cost on the economy and requires to be written off in the event of debt deflation. Not writing off the financial claims means that future recovery will be absorbed by the financial sector and economic performance will suffer as growth is diverted to paying financial interests and not straight back into the flow of the economy.

Is there any analogous process in physics? A perfect one actually.

The definition of work in physics is given as the vector product of a force acting over a distance. If the force acts parallel to the distance covered by a body, the result is that all that force went into completing the work. However, if the direction of the force and the motion are not parallel, the end result is that the force is not used to do work. The special case is when the direction of motion and the direction the force acts in are perpendicular to each other (at 90°), the work done then is zero. Work done is zero, however, the fact that force was applied means that there some effort invested in the exertion; there was work invested but the output is zero. It is calculated mathematically by vector multiplication.

That is the result that speculative finance produces. There is effort being invested, however, it is not having any effect on the economy’s ability to produce more, which is analogous to the direction of the force and the distance covered being perpendicular to each other. As such financial activities do not serve to expand the economy, the “work done” by such financial activities is zero. There is an important economic effect of such activity though. The effect is transmitted via what is called the “wealth effect”. It is a (mostly) illusory effect of being in possession of more wealth than one actually owns and using that illusion of wealth to leverage existing resources for greater consumption. The problem comes when the illusion comes to an end in what is called an “asset price deflation”. Asset prices that were previously rising (giving the illusion of increasing wealth) start dropping quickly. Modern economies and finance, for all their complexity, are ill-equipped to handle such events as the usual solution, monetary expansion, is questionable in its efficacy.

So finance is a double-edged sword, either it contributes to economic growth by putting capital where actual production can take place or it will be put to use in asset price speculation. It is the second that is cancerous and needs to be (ideally) stopped altogether or heavily regulated.