From Thermodynamic Markets to the Thermodynamic Economy

Several years ago I proposed a simple but powerful analogy: financial markets behave like thermodynamic systems. In my original note— Alchemists Sought Philosopher’s Stone, Investors Prefer Philosopher’s Gas—I wrote that:

• price behaves like temperature
• news flow behaves like pressure
• assets behave like volume the classic gas laws (Gay-Lussac, Boyle, Charles) describe classic price moves
  This simple mapping worked surprisingly well:
• More news pressure raises price.
• Strong fundamentals (volume) lift price at constant pressure.
• Higher prices attract more news at constant fundamentals.

I even suggested that:

• work is done when more investors become shareholders (“system expansion”)
• heat is daily liquidity traded
• energy is the stock’s internal liquidity
• entropy is the froth in the price

the second law explains why markets tend to inflate over long periods This model was fun, intuitive, and resonated with many market practitioners who said, “Yes, we really are selling air.” But the more I used this analogy, the more it grew beyond markets. Financial thermodynamics is not only about prices. It is about firms, investors, banks, capital cycles, innovation, and even the origins of the financial sector. This article presents the expanded theory.

When you zoom in, a firm is not a price on a screen.
A firm is a thermodynamic engine.
Capital is the working fluid. - It is the financial equivalent of the water/steam inside a heat engine. It:

• expands (when the firm generates profits),
• contracts (when capital is burned, lost, or paid out),
• carries energy,
• does work,
• and stores state.

If capital rises, the firm has done positive work.
If capital shrinks (due to losses, dividends, capex), negative work is done.

Dividends, interest, wages, taxes—all are heat flows.
They do not change the internal structure of capital;
they simply move money between the firm and the environment.

It rises with profits and efficiency.
It falls with losses or decay.
This gives each firm its own Carnot cycle:

1. Hot isothermal expansion (IPO or hype phase)
2. Adiabatic expansion (price cools, hype fades)
3. Cold isothermal compression (quiet period; capital invested internally)
4. Adiabatic compression (fundamentals improve internally; price warms)
5. This cycle repeats through the firm’s life.

This is the biggest new insight.

In thermodynamics:

• A locomotive steam engine is open cycle. It expels steam and must constantly refill water.
• A submarine reactor engine is closed cycle. The water stays inside and only heat leaves.

The same distinction exists among firms.

Open-cycle firms (Locomotives)

These firms:

• lose capital each cycle,
• must constantly raise external capital,
• burn cash,
• depend heavily on the financial environment to replenish their working fluid,
• create lots of heat (cash flows) that spill into the environment.

Examples include:

• startups,
• airlines,
• shipping companies,
• mines,
• biotech,
• cyclicals,
• almost all early-stage firms.

They are “high-entropy generators.” They produce economic turbulence and create new industries around them.

They require “air-like” external financing: abundant, constant, and inefficient at cooling.

Closed-cycle firms (Submarines)

These firms:

• recycle almost all internal capital,
• generate stable, predictable cash flows,
• do not need external capital for growth,
• release only small heat flows (dividends, modest buybacks),
• accumulate large capital stores.

Examples include:

• Google,
• Microsoft,
• Apple,
• Coca-Cola,
• big telecoms,
• infrastructure firms,
• utilities.

Economically, they are cold, efficient, self-contained engines. They rely on a deep financial system to absorb their heat, but do not depend on it for working fluid.

Open-cycle firms power growth; closed-cycle firms power stability. A healthy economy needs both.

A heat engine cannot operate in a vacuum. It must release heat to an environment.

For locomotives, the surroundings are air—a poor coolant. That’s why locomotives are inefficient and need constant refilling.

For submarines, the surroundings are seawater—a powerful coolant. That’s why submarine reactors sustain a closed cycle indefinitely.

The economy works the same way.

The financial sector is the surroundings.

It:

• absorbs the heat that firms release,
• redistributes it as credit, deposits, savings, speculation, and investment,
• cools overheated sectors,
• warms cold sectors,
• and maintains the temperature gradient needed for engines (firms) to run.

If the surroundings are “air-like” (shallow financial system): firms cannot run closed cycles. They must burn capital and constantly seek new financing. The economy becomes volatile and inefficient.

If the surroundings are “water-like” (deep financial system): firms can run closed cycles, recycle capital, grow smoothly, and innovate. The economy becomes stable and scalable.

Banks are open-cycle engines in the environment. Banks:

• take in deposits,
• push out loans,
• absorb losses,
• require capital injections in crises,
• and depend on constant flows of heat (repayments, interest, deposits).

They are open-cycle processors of environmental heat, just like industrial locomotives.

Now we come to a powerful conclusion:

Capital markets form because industrial firms release heat.

Every firm continually leaks heat:

• dividends,
• wages,
• supplier payments,
• taxes,
• cash flows,
• capex,
• interest,
• and eventually, wealth accumulation.

Just as spilled heat in nature causes air currents, eddies, and vortices, spilled cash flows create financial flows, attracting:

• creditors,
• savers,
• households,
• speculators,
• insurers,
• future competitors,
• seed investors.

And by the conservation of energy, that heat must go somewhere. It must produce:

• new firms,
• new credit networks,
• banks,
• insurance,
• exchanges,
• asset managers,
• pension funds,
• currency systems,
• instruments,
• regulators.

Thus:

Capital markets are the natural thermodynamic response of the economic environment to the heat released by industrial firms.

Markets are not invented. They are condensers, coolers, and heat exchangers.

They arise automatically where enough heat flows exist.

1. Open-cycle firms stimulate economic dynamism.
   They produce the “weather” of capitalism—circulation, storms, innovation, churn.
2. Closed-cycle firms stabilize economies.
   They reduce entropy, accumulate reserves, and provide long-term continuity.
3. Large monopolistic closed-cycle tech firms cool the economy.
   Their efficiency reduces “heat output,” leading to lower startup formation.
4. Banks are inherently open-cycle firms.
   They process heat from industrial firms and need constant rebalancing.
5. Financial crises are thermodynamic imbalances.
   Too much heat accumulated in one place, causing runaway pressures.
6. Financial development is the cooling infrastructure of the economy.
   Deep markets ? efficient cooling ? closed-cycle industrial growth.

Conclusion

What began as an analogy about stocks has grown into a thermodynamic theory of the entire economy:

• Firms are engines
• Capital is working fluid
• Cash flows are heat
• Profits are internal energy
• Markets are heat exchangers
• Banks are open-cycle processors
• Tech giants are closed-cycle condensers
• Economies evolve as coupled heat engines

And capital markets—far from arbitrary constructions— are thermodynamically necessary emergent structures, arising wherever economic heat must be absorbed and redistributed.

This completes the expanded picture that began with talk of stocks, gases, and temperatures.