Inadequate Equilibria: Part 1

April 16, 2019

The world can be a depressing place if you look at the second-by-second news cycle. If you were to have a hundred year newspaper, it’d probably be mostly good news. Of course, we live in the second by second cycle. Much of life is predicated on living in and interacting with these relatively broken systems. This is something that’s played out throughout history. There have been proposed answers to these things from exit—Thoreau’s Walden and those who choose to live off the grid these days—to the revolutionary—communism and socialism to completely overhaul the system. Inadequate Equilibria is in the same vein as Freud’s Civilization and It’s Discontents.

As a human being, I think it’s critically important to contribute to this project. There are individuals that choose to exit the system. The Airbnb host, or the person that just lives off a 4% drawdown of their existing assets (aka a retiree at any age). Of course, indirectly, you’re slowly allocating capital to the right places, but this could be done much better.

As a startup founder and investor and general human being, much of my time in life is spent on these problems. It’s weaseling our way to find something that makes a big difference in the world. Many of the systems seem so hard to flip/change. While this is something that we know intuitively, In a quick 170 pages, Yudkowsky characterizes this in a clear voice without resorting to throwing up his hands.

Starting from a theoretical basis, he seeks to answer the question, “why are so many aspects of the world not optimized to the limits of human intelligence in the manner of financial prices?"

Depending on your perspective, pouring all of our collective human intellect into optimizing finances over a short-term view could be heartening or disheartening. It can be disheartening to see so much of talent under-allocated to efforts that don’t seem to produce end results. After all, no one likes paperwork. Doubly so, no one likes paper work that doesn’t mean anything. Triply so, no one likes paperwork that was created by “the system” or “the man” and you have to adhere to it or else you won’t be able to eat, but “the man” won’t be able to eat so you can’t even change the system.

The book can loosely be divided into three sections. This post is the first in a series.

  1. Laying out the meta concepts of inefficiency, inexplicability, and inadequacy
  2. Inadequate equilibria in all areas of society (to be published)
  3. Adding inadequate equilibria to your mental toolbox and life (to be published)

Much of technology can be characterized by the attempt to bring adequacy to human endeavors. Once upon a time, markets were so inefficient with respect to information that Ben Graham could make money buying stocks based on the market value being less than book value. Now that markets and systems are inadequate with respect to our wetware and incentives, these can be many stickier and harder to change. Of course, Charlie Munger has also often noted that he’s underestimated the power of incentives.

This book is a master course in rationality, society, and how to act that I think it deserves a separate post for each section. I’ll cover the first here.

“If I had to name the single epistemic feat at which modern human civilization is most adequate, the peak of all human power of estimation, I would unhesitatingly reply, “Short-term relative pricing of liquid financial assets, like the price of S&P 500 stocks relative to other S&P 500 stocks over the next three months.” But why? We’ve often considered financial markets the nervous system of the economy, the best way to relay information.

Allocating capital allows equities to have a lever.

  • Lower cost of capita RoE + RoIC, better capital structure, easier to retain employees because bonuses are worth more, can leverage stock price to acquire new companies.

Elizier introduces the concept of modest epistemology. The later debunked notion that you should trust the expert view most of the time, unless you really have an opinion/have put in the time. Often, this is the most social status oriented view of the world. Last, he introduces his self-treatment of his wife’s SAD (Seasonally Affective Depression) treatment as well as his dandruff problem. With these three examples, he respectively illustrates the notions of inefficient markets, unexploitable markets, and inadequate systems.

Three types of systems/markets

All these classes of markets or systems are adequate with respect to something. Markets are efficient relative to the average individual but not to hedge funds. The average investor isn’t able to find alpha, because changes are not predictable.

The view presented is that markets and systems have predictable movements in prices until they reach some equilibrium point, the so balance of supply and demand. Each individual agent is trying to sop up as much “free money” in the form of predictable price movements as they can. While inefficient markets are systems where the price can be the sole signal of value, inadequate systems are more complicated. Each agent within the system is trying to fulfill their own incentives. Whether that be striving for fame, curing individuals of diseases, their behavior is shaped by incentives. And right now, these incentives are out of whack. The ways in which they get out of whack are collectively known as “Moloch’s Toolbox”. (Sidebar: if you don’t know Moloch, then I don’t know you ;).) Collectively, these are the the tools below:

Principal-agent problem (people who make decisions who don’t benefit)

Information asymmetry

  • Example: Colleges act as a filter for 1) hardworking kids 2) smart kids. But 4 years and $250k is a lot to prove that...
  • Common knowledge -> how to things settle in this point. it’s a signaling/asymmetric information problem

Nash Equilibria of misaligned incentives, and not Pareto Optimal

  • Two-factor markets and signaling equilibria
  • Pareto optimal -> a single move that makes everyone better off.

Using these as a lens with which to view society is pretty powerful. But the real question is how we can break the grip of these equilibrium points? Usually, it’s come in the form of billionaires or those with the requisite skills + luck to reset the systems. Examples of these reset points might be Bitcoin and SpaceX. They both act as a reset for the systems that they are compared against, centralized banking systems and traditional contract-based space agencies.

While Moloch’s Toolbox is extremely simple, there are different counterarguments against it. On one hand, you can say that everyone is self interested and things won’t change because of that, a “cynical economist” view. Or, you can refer to the view that systems are bad because people are bad, and people are just bad at coordinating, a more nihilistic view. Either way, if you’re a startup founder or trying to change the world for the better, you’re fighting against multiple forces, the “system”, the “haters”, and the “cynics”. The problem is that the combination of those three forces make it quite hard to craft a clever solution. You can’t just build a better mouse trap and hope people will come, instead you need hit some critical mass for different stakeholders to “flip things". That is incredibly hard, but extremely worthwhile.