In 1995 Charlie Munger, Warren Buffett’s brilliant lieutenant, gave a speech at Harvard titled “The Psychology of Human Misjudgment”. One of the most famous quotes from the speech is “Show me the incentives, and I’ll show you the outcome”.
This is an incredibly valuable framework for predicting outcomes in the world.
One expression of this principle is Clayton Christensen’s “innovator’s dilemma” which describes why very successful incumbents in business often find themselves struggling to fend off competition using disruptive technologies.
I witnessed first hand how Google, one of the greatest businesses of all time, set up internal incentives that make it increasingly difficult for the company to compete and innovate. To be very specific: the incentives at Google are increasingly oriented towards winning internal politics and this clashes increasingly with external outcomes.
We are seeing the beginning of this clash as Google struggles to adjust to competition from challengers in the space of artificial intelligence.
Another area where Munger’s model of incentives applies perfectly is in the area of predicting outcomes where politics interfaces with the private sector. Politicians generally are not incentivized to produce great outcomes for society, they are incentivized to win elections. This is the reason most politicians nowadays are not experienced technocrats but seasoned actors.
As a result, wherever politicians interact with businesses, bad incentives arise (this is the reason libertarians advocate for a small government). One area where incentives and hence outcomes are particularly toxic is in healthcare. Pharmaceutical companies are incentivized to maximize profitability and politicians are incentivized to pursue populist politics.
This inevitably delivers catastrophic outcomes as regulators that are half asleep at the wheel approve harmful drugs and as doctors are incentivized, nay sometimes even forced to prescribe treatments excessively, erratically and irresponsibly.
Munger’s incentive framework has also been helpful to those who have been holding Bitcoin with conviction for years despite its significant volatility. In order to do so one had to understand the context and incentives of a few key players:
- Government: They have to raise money in order to fund their lavish spending as well as interest payments on the nation’s debt. Taxes are unpopular so the better way to do this is to print money.
- Institutional Investors: They are looking for returns to beat and ideally exceed inflation. As valuations relative to earnings reach all-time highs, they have to look for alternative assets to potentially provide a source of return as well as diversification.
- Retail Investors: They are primarily incentivized to not be left behind (FOMO) and ideally to look for opportunities to get rich quickly.
This creates a perfect storm of incentives for an asset like Bitcoin: Increasing liquidity in the system due to the expansion of the money supply, institutional investors desperately seeking yield and retail investors looking to FOMO into the market. It explains both the short term volatility and reflexivity of Bitcoin and the steady longer-term increase in its market capitalization.
