Economics as an Open Physical System

ABSTRACT The present article builds on the definition of economics as an open physical system in contrast to the traditional closed neoclassical approach. The fundamental difference is the principle that all economic activities have physical dimensions, including undertakings related to coordination and regulation. At the same time, economic processes cannot be reduced to physical phenomena. The neoclassical prices can be viewed as second‐level dimensionless numbers defined with respect to the basic physical units. The traditional general equilibrium analysis is at odds with the second law of thermodynamics because it assumes a spontaneous convergence to a low‐entropy state (economic equilibrium) with no cost. In fact, economic systems require a constant inflow of energy and matter from the environment. This circumstance implies a need for centralized feedback via monetary circulation, Central Bank monetary policy and other centralized regulations. This approach allows us to reverse Walras's law: it is not the real sector that determines the equilibrium on the money market; rather, the money market, controlled by the Central Bank, guarantees the equilibrium in the goods and services market, given the gross substitutability principle. Further, we discuss the role of frictions and information processing in the economic systems. The final conclusion is that open economic systems are unstable and need regulation.