The Incentive Standard

Central banks publish forecasts. Read their payoff matrix instead. It leads through Washington, ends in Tokyo — and explains why the most incentive-literate institutions on earth keep buying gold.

A personal note before we begin. This essay was dictated rather than typed. A few weeks ago, a mountain bike trail in the Austrian hills disagreed with my line choice, and I performed what witnesses have generously described as an involuntary somersault — landing on head and shoulder. The invoice: a broken collarbone, a broken rib, and a bruised cervical spine. The helmet, I should add, earned its keep several times over.

The author, shortly after rediscovering the concept of asymmetric risk.

Convalescence has its compensations. I have been reading more than I have in years, re-watching Papillon — a man locked up for years who never stops thinking about escape, and no, I cannot imagine why that film resonated with me just now — and, above all, I have been forced to slow down. Forced deceleration, it turns out, is a condition highly conducive to thinking about incentives. One-handed and full of painkillers, you stop watching what people say. You start watching what they are paid to do.

Which brings us directly to our topic.

I. The Emperor and the Railway

Emperor Franz I of Austria was, by the standards of his age, no fool. When engineers petitioned him in the 1830s to build steam railways across his empire, he refused — not because he misunderstood the technology, but because he understood it perfectly. Railways would move people, ideas, and unrest faster than his police could follow. Nicholas I of Russia reached the same conclusion by a different route: his empire’s entire social order rested on serfs staying on the land, so he throttled the banking system, banned industrial exhibitions, and restricted construction. Neither monarch was ignorant. Both read their payoff matrices with complete accuracy.

They owned nothing that industrialization would have made more valuable — so they suppressed it.

Contrast England. The Luddites who smashed textile machinery between 1811 and 1816 were not fools either; they were highly skilled workers who understood precisely what was happening to them. They lost anyway — because the English aristocracy owned the mineral rights beneath their estates, and coal was becoming the fuel of the industrial age. The gentry stood to profit, so the machines were protected with the full force of the state: twelve thousand soldiers garrisoned in the affected counties, machine-breaking elevated to a capital crime, seventeen men on the gallows. The technology did not win because it was good. It won because the powerful were paid to let it win.

The price of choosing the Austrian path is well surveyed. Economist Diego Comin has shown that the speed with which a country adopts new technologies explains at least a quarter of today’s wealth differences between nations. The Ottomans, after all, did eventually get the printing press. Just a few centuries late.

Charlie Munger compressed this entire literature into eleven words: “Show me the incentive and I will show you the outcome.” The aphorism is usually deployed to explain corporate misbehavior. We would argue it is the single most useful analytical instrument in monetary economics today. Central banks publish dot plots, forecasts, and carefully lawyered statements. But if you want to know where policy is ultimately headed, do not read the speeches. Read the payoff matrix.

Below, we apply Munger’s test twice: first to the Federal Reserve under its new chairman, then to Japan — the country where every incentive described in this essay has already reached its logical conclusion.

II. The Great Pretender’s Payoff Matrix

Kevin Warsh arrived at the Fed talking like a young Paul Volcker. “We’ve missed for five years, and we’re going to fix that,” he declared of the inflation target at his very first press conference, batting away any suggestion of raising the 2% goal with the dry observation that the “two” stands to the left of the decimal point. Markets briefly believed him: in the nine days to July 24, the CME FedWatch probability of a rate hike jumped from roughly 11% to 38%. At the July meeting, three FOMC members dissented — only the sixth time in three decades that so many broke ranks at once. Dario Perkins of TS Lombard rendered his verdict after the press conference with admirable economy: talking, so far, appears to be the chairman’s greatest talent.

We share the skepticism — and not because we doubt the rhetoric. We have simply read the incentives. Three of them, to be precise.