The Physics of Economics, Part 3

Housing Conditions: Values and Financing
June 19, 2016
SHI Update – June 22, 2016
June 22, 2016

Sir Issac Newton is known as one of the most influential scientists of all time. In the second half of the 17th century (and into the 18th), Newton was one of a number of ‘Natural Philosophers’ who sought to explain natural phenomenon using math and physics (among other things.) His 3 ‘laws of motion’ have become the foundation upon which centuries of classical mechanics (physics) are based…

You may want to revisit the first two BLOGs on this topic before reading on; however, this content is independent.

The Physics of Economics – Part 1

The Physics of Economics, Part 2


Why you should care:   If we can ‘see’ what others cannot, we have an edge.  Newton’s 3 laws of motion explain – and predict – movement of physical bodies all around us.  I believe they also apply to, and can explain, financial market behavior and movements.   And they can help us understand (and predict) both the persistence of large market trends and the concept of unexpected, or ‘unintended,’ consequences.


Taking action: Test these theories. See if they help you gain insight. Perhaps they will help you forecast future economic outcomes that may impact you personally.


THE BLOG:  Once again, let’s quickly review Newton’s 3 laws:

Law 1: “An object traveling at a constant speed, in a constant direction, will continue to do so unless acted upon by another force.”
Law 2: “Force = Mass multiplied by Acceleration” (F=M*A)
Law 3: “For every action there is an equal – yet opposite – reaction.”

Today we focus on Law 3.   Two cars approach an intersection – from opposite directions.   They collide head-on.  The reaction is immediate:  Both stop forward movement, but not before their momentum causes each to collapse like an accordion.

This encounter is easy to visualize.  It’s harder in finance and economics, but just as visceral…and far-reaching.

Take negative interest rates, for example.  This is a popular topic today.   It has attracted tons of media focus.   But very little focus on the implications.   In Newtonian-speak, we need to ask this question:   What might be the ‘opposite‘ reactions (impacts) caused by negative rates?

Consider the impact on insurance companies (IC), university endowments and large pension funds.   Each of these seek relatively safe – or safer – investments.   And each relies completely on return-on-investment (ROI) to fund future capital needs.   If that ROI falls precipitously for a year or so, the reaction isn’t too large.   But what might happen if the ROI decline is protracted, or worse, systemic?

Their reaction is likely to be one of three possible, or a combination:  One, in order to achieve needed yield, they might shift to more risky investment, putting the entity itself at risk of default.   Two, their ROI will be insufficient to funds future capital needs, putting the entity itself at risk of default.   Three, if possible, they may choose to increase other revenue-generating activities:  The IC may choose to increase premiums.  The university may attempt to increase tuition.

In all cases, the unexpected, or unintended consequence, is extremely disruptive.  The longer yields remain low, the greater the potential for default or other problems

And yet, I’ve seen very little in the media on the topic.   Very little.   A.M. Best, a global insurance company rating agency, did make this comment in a recent report:

“Throughout the remainder of 2016, companies will continue to be pressured to generate higher investment yields in the persisting low interest rate environment. It currently remains a daunting challenge to invest new money at higher rates without taking on unwanted levels of increased risk, especially for those companies that have not consistently demonstrated the ability to generate underwriting gains.”

FitchRatings recently commented on the health of the German life insurance industry:

“The German life insurance industry is operating in a difficult environment of low investment yields and earnings pressure. Market interest rates are likely to remain at historical lows for longer and constitute the biggest challenge for the German life insurance industry, in light of significant asset-liability duration mismatches.”

Right in line with this concept, earlier today, Citi Research suggested negative interest rates are a huge systemic problem.   A “seeping poison”  if you will … one that might destabilize global systemically important institutions:

“… For instance, on May 10, 2016, the President of BaFin, Germany’s financial regulator, warned that low interest rates were threatening the viability of German pension funds and insurance companies and were a “seeping poison” for Germany’s banking system.

In this note, we argue that the diagnosis of a threat to German pensions funds and insurance companies is probably correct and that banks too may have their profitability damaged by persistent negative policy rates….

That’s not pretty.   Here is their comment on the impact on pensions and retirees:

“The real victims of low, let alone negative, safe rates are retirees and others unable to return to the labor market. They live off the returns on their savings.  It is not financial viability that is the problem, but a much lower standard of living in retirement than previously expected, and for some outright poverty. Such a situation may of course become socially and politically unsustainable.”

Harsh words.   A harsh reality.  And a truly unintended consequence.

For every action there is an equal – yet opposite – reaction.   The rampant and widespread destruction of yield will have many reactions.   We’ve just begun to see some of them.   Where else will they appear?

  • Terry Liebman

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