Dr. John Rutledge
Summary: Welcome to Asset-First Economics. In this episode, we discuss two ideas from my published papers. The first is that all economic activities are energy transformations and all economic change is driven by the Second Law of Thermodynamics. The second is that the market economy is a far-from-equilibrium, Complex Adaptive System with an Achilles Heel--the temporary, abrupt, and violent phase transitions that we call financial crises.
Investors who understand these ideas have a real advantage over those who don’t.
I created the audio file using Notebook LM to produce a simple summary of the main ideas. You can download the original source article from the Review of Financial Economics by clicking the following link. A transcript of the audio file is below. You can find more information on our Asset-First Economics podcast and video series at www.safanad.com. An archive of my written work is available at drjohnrutledge.substack.com.
As always, I welcome your questions and comments.
Dr. John
You can listen to the article here or download the original article in the Review of Financial Economics by clicking this link.
Transcription of the Audio File
Welcome to the Deep Dive. We are going straight into the deep end today, synthesizing a truly fascinating stack of articles by Dr. John Rutledge. Quite a stack. We have decades of economic history, complex systems theory, and even physics, specifically thermodynamics, all coming together to explain something very concrete.
The really erratic relationship between inflation, interest rates and financial crises. It sounds like a wild jump from physics to finance. But that’s really our mission here. We’re taking these traditional economic concepts and looking at them through this powerful if a bit counterintuitive lens of a far from equilibrium framework, and why do we need to do that.
The standard models that assume the economy just chugs along your smooth, gentle equilibrium. They just completely fail when the real world gets hit by massive sudden shocks, and that failure is huge. I saw one of the sources put the global economies balance sheet, so the value of all assets, stocks, real estate at $566 trillion at the end of 2024.
Yeah, $566 trillion and the actual economic flow, the GDP, is only about $30 trillion, so the standard models are focused on the small flow, but they completely ignore the massive reservoir that can have these violent, unpredictable swings. We need a map for those swings. We need a framework that treats catastrophic events like 2008 or the inflation of the seventies as well.
Normal outcomes of a complex system, not as some gentle temporary shock that you can just model away. Okay, so to get to the root of this, we have to go back in time. Let’s start with the early 1980s? Economists back then were really grappling with this brutal persistent inflation, and the main idea was all about price stability and how people, you know, structured their wealth.
This gets us back to something called the portfolio balance Theory. The core idea was actually pretty simple. It said interest rates are basically two things. The real interest rate. So the return you get after inflation, plus whatever you expect inflation to be. But the real driver, the mechanism behind it all was the collective portfolio decisions of households.
That’s the key. It was all about what people chose to own. So interest rates weren’t just a lever the Fed pulled, they were a reflection of what the average person was buying and selling. So walk us through that asset market whiplash of the seventies and eighties when inflation started raging.
What did people do to protect their money? It was a massive capital migration, just a huge shift. People abandoned financial assets, stocks, corporate bonds, you name it. Because their value was just getting eaten away. Eroded by inflation. So instead, they move their capital into tangible assets, things you could physically touch, like housing, gold, and farmland. That’s trillions of dollars moving out of traditional credit markets.
Okay, wait. Connect the dots for me. How does me buying a house for some gold directly push up interest rates? Because that capital is no longer available to lend. If you’re buying land, Instead of buying bonds, you’re effectively shrinking the supply of credit available to borrowers.
Ah, and with less credit supply, assuming demand stays the same, the price of that credit, the interest rate, has to go up dramatically. And I assume the reversal was just as dramatic when disinflation kicked in during the eighties? Precisely. As soon as Paul Volcker showed he was serious about fighting inflation, expectations flipped direction. Financial assets looked safe again, not just safe but profitable. So capital reverses course, flooding back into bonds and stocks. That surge in demand for financial assets made bond prices rise and by definition interest rates fell sharply in 1982.
That’s what economists call arbitrage. Okay, so let’s use that concept of arbitrage, the relentless flow of capital, as our bridge to physics. We’re moving from supply and demand curves to energy gradients. This is where it gets really interesting.
Yeah. This is the leap. What happens when we view that whole economic process, even that 1980s portfolio shift as a system governed by the laws of thermodynamics?
The first concept to grasp is that all economic activities are just energy transformations. The ultimate source of all wealth is solar energy, either current, like a solar panel or vintage stored energy that could be fossil fuels. But it’s also the complexity stored in our infrastructure, in technology, and in human knowledge.
So if the economy is an energy transformer, then we have to distinguish between useful output and waste. Just like a power plant. Exactly. Thermodynamics, separates organized, useful work from waste, which is heat. Economic work is coherent energy transformed by production or innovation, and economic waste in the form of heat.
That’s incoherent energy, wasted effort, bureaucracy conflict. Good policy from this perspective is just anything that encourages coherent work and minimizes waste, heat. That analogy clicks immediately. We’ve all seen effort turn into heat instead of work. So how does the second law of thermodynamics, the rule that energy has to disperse, how does that drive the system?
In physics, energy flows down a gradient. Hot to cold. In economics, we call that arbitrage. So arbitrage is just the second law at work in our world. It is, it’s driven by these energy gradients. These are just differences in prices, wages, or going back to our 1980s example, in the expected returns between tangible and financial assets.
The steeper the gradient, the faster the flow. And that flow, in turn, flattens the gradient a little bit.
Arbitrage is this universal force just relentlessly exploiting those differences. And technology has just turbocharged this whole process. Optical fiber and high speed communications have dramatically lowered friction. Moving capital used to be slow and expensive. Now it flows at the speed of light.
And while that makes markets incredibly efficient, reducing the heat from transaction costs, there’s a downside, a huge one. The increased speed also massively increases volatility in the systems. Well, it’s susceptibility to crisis. It’s like speeding up a river. It gets where it’s going faster, but the rapids are way more violent.
That’s a perfect analogy. And this brings us to the core concept, non-equilibrium thermodynamics or NET. Okay. Traditional economics, focuses on systems near equilibrium with smooth, gradual change. But NET argues that the most important events happen when the system is pushed far from equilibrium. So we need NET to analyze these abrupt, discontinuous changes that physicists call phase transitions.
What’s the financial aha moment here? What’s a phase transition in finance? Think about water. You heat it up, it expands smoothly. That’s near-equilibrium change. But then suddenly at a hundred degrees Celsius, it abruptly turns to steam, a completely different state.
That’s a phase transition. In finance, we call them financial crises. Sudden market collapses. The best way to think of them is as temporary network blackouts.
A network blackout. Unpack that for me.
A market is basically an information network. Prices are the signals. In a crisis, trust just evaporates, liquidity vanishes, and prices stop transmitting reliable information.
The system just breaks. It switches from a functioning state A, to a broken dysfunctional state B. It’s a cascading network failure. The whole system’s capacity to transmit information just drops instantly. That makes so much sense. It reminds me of those old fluid dynamics experiments. You increase the velocity of a fluid and at a certain point it just snaps from smooth, predictable flow to chaotic, turbulent flow.
That’s the core realization from the NET framework. We have to accept that the economy can exist in at least two distinct states. And a crisis is just the violent switch between them. And we can actually model this cycle as a round trip
State one is the potential output state full employment where prices are efficiently transmitting information to the people who need it to make decisions.
State two is the failed netwo state where trust is gone and credit is rationed. All right, let’s apply this map to a real event. Let’s use the Subprime Mortgage crisis to walk through the four stages of this round trip.
Okay Stage one. That’s the run-up say 2003 to 2007. The system is near full employment. Profits are strong. Valuations are climbing. But good times, breed complacency, excessive optimism. Credit discipline gets weaker and weaker across the system, and we get closer and closer to that threshold of turbulence, the classic setup for a Minsky Moment.
That’s point A. It triggers stage two, the phase transition itself. The violent collapse. It’s usually short, weeks, maybe months, but incredibly destructive. The system switches from State One to State Two instantly, and this move forces over leveraged investors to sell. They become forced sellers regardless of the quality of what they’re selling.
And during that collapse, what are the only assets that actually do well? Historically, only cash and high quality government bonds. Cash holds its value and bonds rally because of a flight to safety and central banks cutting rates like crazy. Everything else gets hammered. So the destruction is done.
Now we enter State Three, the bottom. This is where find the real pain and the real opportunity. State Three is the recession, and the lenders are forcing fire sales. People who can’t service their debt are forced to liquidate assets at huge discounts, so it’s painful for them. But for an astute, unleveraged investor, it’s the time of extraordinary opportunity.
If you are holding cash, you are now a king. You can buy assets at a price far below their real value. And the sources say this is especially true in real estate. Absolutely. The biggest fortunes in real estate are often made by buying depressed assets during these State Three fire sales. When credit is at its tightest, you’re buying value that the temporarily broken network can’t even see.
And that leads us finally to State Four, regrowth and the journey back to full employment. State Four is the investor’s Paradise. Markets slowly become more accommodating. Credit eases up and the economy starts growing again. Returns in this stage are explosive. Why explosive? Because they’re driven by two things at once, improving performance of the actual assets and the market, re-rating those assets back toward their normal valuations.
You get a double whammy on the way up. You do. Post subprime, for example, hospitality assets climbed 322%. Industrial assets, 272%. Huge gains during that recovery phase. It’s the snapback effect. We’ve used this framework for financial volatility, but in another article, Dr. Rutledge also applies it to something else. The resilience of cities, especially after a shock like the pandemic?
Cities are classic, complex adaptive systems. They have huge network effects. They exhibit something called super linear scaling. Okay. Define that for us. Super linear scaling means that if you double the population of a city, the socioeconomic outputs like wages, GDP, and patents don’t just double, they increase by about 15% more than you’d expect from linear growth. So doubling the inputs gives you more than double the output. That extra 15%, that’s the magic that is the persistent energy gradient. That 15% productivity advantage acts as a massive gravitational force, pulling innovative and ambitious people back no matter what happens.
So, even after a pandemic, people return. History shows they always return to successful urban centers. The network advantage is just too powerful to give up long term. And from an investment strategy perspective, that scaling law is a really powerful predictive tool. The research shows that a city’s relative advantage tends to be preserved for decades.
So investors are wise to focus on top quality assets in places like New York or San Francisco because their underlying network structure pretty much guarantees they’ll recover faster and stronger, and you’ll capture that explosive Stage Four recovery game.
This has been a remarkable journey. We started by looking at inflation in the 1980s forcing a portfolio choice, which then set interest rates. And we ended up realizing those big financial shifts are just manifestations of energy flows, arbitrage driven by return differentials that can push the whole economic system into a completely different state. And that thermodynamic view forces us to confront some uncomfortable truths. It challenges standard financial models because it says there’s no single fixed risk-free rate in a world that can flip between states. When the system shifts, all our assumptions about risk and value have to shift with it.
Which brings us to our final provocative thought for you to consider. Since the economy is prone to those violent stage two phase transitions, cash isn’t just a low yield asset. It’s something more, it functions as a composite security. It embodies a highly valuable, real option.
In a State Two credit crisis liquidity is gone. The cash you’re holding has an extremely high shadow price. (You can think of a shadow price as a black market price.) Holding that cash gives you the option, but not the obligation, to purchase incredible assets at fire sale prices for potentially extraordinary gains when the economy eventually climbs back to State One. So you should consider what premium you are truly willing to place on holding that powerful option today because its value spikes precisely when you need it the most.