"Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step-by-step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day-by-day, and at the end of the day – if you live long enough – like most people, you will get out of life what you deserve.” – Charlie Munger (Trades, Portfolio)

[Ed Wexler, Poor Charlie’s Almanack]

Charlie Munger (Trades, Portfolio) is a brilliant man and I cannot believe how neglected he is in the shadow of Buffett and Berkshire. Charlie gave an insightful lecture titled Academic Economics: Strengths and Faults after Considering Interdisciplinary Needs and gave it on Oct. 3rd, 2003 to the Herb Kay Undergraduates at the University of Santa Barbara Economics Department.

It is the 9th talk in the (Must Read) book, Poor Charlie’s Almanack. Charlie gives much deserved praise to Adam Smith, John Maynard Keynes, Riccardo and Paul Krugman in the beginning of the lecture, although he clearly favored Smith.

Adam Smith was so good a thinker and so good a writer that, in his own time, Emmanuel Kant, then the greatest intellectual in Germany, simply announced there was nobody in Germany to equal Adam Smith. Well, Voltaire, being an even pithier speaker than Kant, immediately said, Oh well, France does not have anybody who can even be compared to Adam Smith.

As Charlie always does, he leaves the apprentice to reach for the answer, explanation, reasoning and judgment. [Hint: Read Wealth of Nations, The Principles of Political Economy and Taxation, and General Theory of Employment, Interest and Money.

• He explains he has this tendency of leaving questions unanswered because of the way his father taught him, leaving analogies open to interpretation and attribution.

So What’s Wrong with Economics?

Charlie puts forth nine simple ideas to help the economics discipline progress in the years to come and obtain a multidisciplinary attitude along the way.

1) Fatal Un-Connectedness, Leading To “Man With A Hammer Syndrome,” Often Causing Overweighing What Can Be Counted

Simply stated, Overweighing what can be counted, an excessive reliance on quantitative measures leads to and causes fallability.

As Einstein once said famously “All that can be counted, does not count.”

And Charlie added . . .

[Humans] (1) overweigh the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important.

One of the most important factors in business cannot be counted. Culture.

Sure you could make up some asinine balanced scorecard, fitting the model to the mood, or you could use your multidisciplinary knowledge in history, biology and psychology to develop an intrinsic model of what has worked and why.

What makes a strong culture? What kind of culture does your dream job entail? Why?

Who do you not want to work for? Why? What makes a weak culture? Why?

2) Failure To Follow The Fundamental Full Attribution Ethos of Hard Science

“What’s wrong with the way Mankiw does economics is that he grabs from other disciplines without attribution. He doesn’t label the grabbed items as physics or biology or psychology, or game theory, or whatever they really are, fully attributing the concept to the basic knowledge from which it came. If you don’t do that, it’s like running a business with a sloppy filing system. It reduces your power to be as good as you can be.”

Attribution helps memory retention through structural recognition of the problem and relates to ones own experience and knowledge for better understanding.

3) Physics Envy

The envy of physics can be simplified into mistaking soft science for hard science and attempting to oversimplify what is dynamically complex. Everything should be made as simple as possible, but no more simple.

Charlie illustrates the point with Washington Post. Washington Post in the early 70s was trading at “a fifth of what an orangutan could figure was the plain value per share by just counting up values and dividing” but because some partner at McKinsey had been educated in capital asset pricing model, beta, efficient market theory and even worse, believed what he was taught, a stock buyback program was neglected.

At the time it was conventional wisdom that companies should not buyback shares on the premise that the market is efficient. This means there is no advantage in buying shares. Luckily for Washington Post shareholders, Warren Buffett (Trades, Portfolio) came along and convinced the board to buy 50% of outstanding shares, creating over a billion dollars in value in the process. The rest is history.

The moral of the story being soft sciences are not governed by laws but rather plausible rules or heuristics that are easily broken. The second example of physics envy is of a rustic legislator that attempted to have a law passed to round Pi to 3.2, allowing school children to make computations easier. Luckily the law did not pass, as architects and quantum physics will agree.

4) Too Much Emphasis on Macroeconomics

“There’s too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It’s like trying to master medicine without knowing anatomy and chemistry.”

Charlie gives us a problem to solve to illustrate the lesson at hand.

Business: Tire Chain, Les Schwab

Sales: Hundreds of Millions from zero in 50 years

Founder: No formal education and is now age 80.

How did he do it?

Well, let’s think about it with some microeconomic fluency.

Is there some wave that Schwab could have caught?

The minute you ask the question, the answer pops in. The Japanese had a zero position in tires and they grew rapidly. So this guy must have ridden that wave some in the early times. Then the slow following success has to have some other causes.

“He must have a very clever incentive structure driving his people. And a clever personnel selection system, etc. And he must be pretty good at advertising. Which he is. He is an artist.”

Charlie explains extreme success is likely to be caused by some combination of the following factors, surfing the wave being the most important:

A) Extreme maximization or minimization of one or two variables.

B) Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.

C) An extreme of good performance over many factors.

D) Catching and riding some sort of big wave.

Microeconomics and smaller subconscious cause and effect relationships are the governors of macroeconomics, much like quantum physics governing macrophysics, macrophysics meaning visible and measurable to the naked eye.

5) Too Little Synthesis in Economics

This section can quickly be explained by a problem that Charlie had proposed in combination with the Riccardo comparative advantage and Smiths pin factory observation.

• Comparative advantage states, it is beneficial for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than others.
  
• Adam Smiths pin factory is an observation he made and detailed in the wealth of nations. Smith found that ten workers were able to produce 48,000 pins per day because of the divided and specialized labor. If each worker handled all the steps required to make a pin, he could only make twenty per day. It pays to embrace specialized labor.

Charlie provides an example of a delinquent hotel property, in a bad neighborhood, that had caused nothing but problems and losses in the past. The previous owner (like most of us) encountered the problem of functional fixedness, a problem solving inhibitor. It took a new chap with very little conventional knowledge to turn the ship around. Of all things he needed the hotel as a hub, to store elderly travelers overnight. A shuttle bus picked them up and dropped them off (at Disneyland) so there was no need for the parking lot.

Breaking the functional fixedness of a typical hotel revenue model and turning the parking lot into a putting green solved the problem. Specialization and comparative advantage at its finest.

6) Extreme and Counterproductive Psychological Ignorance

Here I want to give you a very simple problem. I specialize in simple problems.

You own a small casino in Las Vegas. It has fifty standard slot machines. Identical in appearance, they’re identical in the function.

They have exactly the same payout ratios.

The things that cause the payouts are exactly the same.

They occur in the same percentages. But there’s one machine in this group of slot machines that, no matter where you put it among the fifty, in fairly short order, when you go to the machines at the end of the day, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy winning machine?

Male: More people play it.

Charles Munger: No, no, I want to know why more people play it. What’s different about that machine is people have used modern electronics to give a higher ratio of near misses. That machine is going bar, bar, lemon. Bar, bar, grapefruit, way more often than normal machines, and that will cause heavier play. How do you get an answer like that? Easy. Obviously, there’s a psychological cause: That machine is doing something to trigger some basic psychological response.

7) Too Little Attention to Second and Higher Order Effects

This fallability is quite understandable, because the consequences have consequences, and the consequences of the consequences have consequences, and so on. It gets very complicated, very quickly.

Higher order effects can attributed to cause and effect relationships as well as posterior probabilities. Thinking about the 2nd and 3rd level order effects in a "fish bone" style is a great way to train.

- New incentives cause expected behavior to deviate because it is based on past incentives (Medicare exuberantly underestimated by over 1000%)

- Investing in textile looms. How much of the proceeds from capital investments will stay at home (in the owners pockets) versus the consumers pocket (in the form of lower prices).

Game theory or dynamical systems are also a great place to start to understand higher order effects.

8) Not Enough Attention to the Concept of Febezzlement

If you have embezzlement that is not known to the embezzled, it has a wonderful Keynesian stimulating effect on the economy because the guy who’s been embezzled thinks he is rich as he always was and spends accordingly, and the guy that has stolen the money gets new purchasing power.

Although anyone with background knowledge in algebra will understand this effect is quickly cancelled out upon discovery of the embezzlement. Essentially a legal, yet unethical, juiced up wealth effect.

Febezzlement = the functional equivalent of embezzlement.

9) Not Enough Attention to Virtue and Vice Effects

The last point Charlie made is best taught with the story he used regarding the differences in attitude, integrity, culture and how social proofing/envy take hold in his speech to Stanford University Law School Address.

“I have a friend who made an industrial product at a plant in Texas not far from the border. He was in a low-margin, tough business. He got massive fraud in the works compensation system – to the point that his premiums reached double-digit percentage of payroll. And it was not that dangerous to produce his product. It’s not like he was a demolition contractor or something.

[The friend wasn’t able to convince the workers to stop the fraud]

So my friend closed his plant and moved the work to Utah among a community of believing Mormons. Well, the Mormons aren’t into workers’ compensation fraud – at least they aren’t in my friend’s plant. And guess what his workers compensation expense is today? It’s two percent of payroll – down from double digits.

Letting the slop run causes this sort of tragedy. You must stop slop early. It’s very hard to stop slop and moral failure if you let it run a while.”

The last point can be distilled or simplified into four main points.

• Trust, Virtue, Honesty and Integrity.

Keynes once said: “It’s not bringing in the new ideas that’s so hard. It’s getting rid of the old ones.” And Einstein said it better, attributing his success to “curiosity, concentration, perseverance and self-criticism.”

By self-criticism he meant becoming good at destroying your own best-loved and hardest-won ideas. If you can get really good at destroying your own wrong ideas, that is a great gift.

Always look for disconfirming evidence.