Latticework of Mental Models: Gresham’s Law

This article is the fifth of this weekly series called Latticework of Mental Models, which will be authored by my friend and partner in writing the Value Investing Almanack, Anshul Khare. Anshul will write on various mental models – big ideas from various disciplines – which can help you think more rationally while analyzing businesses and making your stock investment decisions.

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Few weeks back, we discussed the mental model of Storytelling. I am going to use the same model to start this post. Let me start with a true story, and take you back to medieval India.

Between the years 1324 to 1351, Delhi was ruled by an emperor named Mohammad-bin-Tughluq from the Tughluq dynasty. He had a scholastic background and spoke multiple languages. In spite of good intentions, some of the policies that he enforced during his rule backfired which made him infamous as an eccentric ruler. One such failed idea was about an experiment that he did with the local currency.

Tughluq noticed that India had very few silver coins and a comparatively larger number of bronze and copper coins. He decided to promote bronze or copper coins by passing a royal order that bronze and copper coins are to be accorded the same value (i.e., same purchasing power) as silver coins. In other words, he wanted the markets to mentally consider bronze and copper as silver itself so that 1 gram coin of bronze can buy the same goods as 1 gram of silver. It looked like a neat idea however the emperor failed to consider the law of unintended consequences.

The loophole in this strategy was that copper and bronze coins were very easy to forge. As a result the silver coins completely disappeared from markets and this led to a tremendous increase in the circulation of bronze and copper in the market because people started minting their own coins. Consequently, this led to a rise in the prices of essential commodities and a hyper-inflation like scenario. Eventually, Tughlaq had to withdraw this order and bronze and copper returned to their nominal value i.e., their value fixed by the free market. (Source: Wikipedia)

This phenomena is known as Gresham’s Law, named after Sir Thomas Gresham, an English financier who formalized this observation as a law of economics. Before moving ahead, let’s look at the formal definition of Gresham’s Law.

Gresham’s Law is a monetary principle stating that “bad money drives out good.” In currency valuation, Gresham’s Law states that if a new coin (bad money) is assigned the same face value as an older coin containing a higher amount of precious metal (good money), then the new coin will be used in circulation while the old coin will be hoarded and will disappear from circulation. (Source: Wikipedia)

I think discussion of Gresham’s Law would be incomplete without mentioning the apocryphal account of India’s most celebrated capitalist Mr. Dhirubhai Ambani’s businesses acumen. During his days in Yemen when Dhirubhai used to work as a manager in a filling station, he observed that the Yemini Rial was made of silver coins and was very much in demand in London Bullion exchange. He would collect the silver coins and melt them into pure silver to sell them into the market. Perhaps Dhirubhai was familiar with Tughluq’s adventures.

I am sure Mr. Gresham would have felt vindicated.

In the world we live today, Gresham’s Law in its original form may not find much utility. In his speech given at Harvard-Westlake school in California in January 2010, Charlie Munger said –

In economics textbooks they teach you Gresham’s Law: Bad money drives out good. But we don’t have any bad money that amounts to anything. We don’t have any coins that are worth a lot, that have precious metals that you can melt down. Nobody cares what the melt-down value of the quarter is in relationship to the dime, so Gresham’s Law is a non-starter in the modern world. Bad money drives out good.

But the new form of Gresham’s Law is ungodly important. The new form of Gresham’s Law is brought into play – in economic thought, anyway – in the savings and loans crisis, when it was perfectly obvious that bad lending drives out good. Think of how powerful that model is. Think of the disaster that it creates for everybody.

What do you do when the world’s greatest multidisciplinary thinker tells that Gresham’s Law holds tremendous insights? Well you want to explore this mental model in other fields of human endeavours. Don’t you? Let’s find out.

In Learning
In yesteryears, the sources of information were acutely limited for most people. But the story is remarkably different in the modern world where the quantum of information that an average person consumes in a week is more than what an earlier generation was exposed to in a lifetime. Although accessibility to wide array of information brings with it the advantage of better efficiency in our affairs, but can you guess what kind of risk this introduces?

It is said that an intelligent way to answer a question is to pose another question. And Gresham’s Law asks us the fundamental question: Is bad information driving out good information?

Unlike a currency whose value is easy to measure, the quality of information is not. In spite of having a strong bullshit filter, which mental models help you construct, it’s still a complex issue to separate a bad information from real knowledge. Why is it so?

Majority of the content we consume these days doesn’t cost us anything. With no money at stake, the primary criteria for choosing something to read is the attractiveness of the content. This brings us to the next question. What makes a content attractive?

Evolution has programmed us to be attentive to psychologically arousing content i.e., content that is gross, violent, or gossip which is humiliating, embarrassing, or offensive. Sadly, this isn’t really knowledge. It’s an illusion and mostly a waste of time.

Incentives of the modern media is aligned to supply us the stories we want to read — not the ones we should read. Please note that there is nothing bad about the notion of reading for entertainment, but the thin line between knowledge and entertainment is getting blurred. Most of us consume information under the illusion that our knowledge is increasing, not realizing that our precious time is getting spent in reading for entertainment.

And this is how the high quality information is driven out by cheap low cost content.

You have to brace yourself from becoming a victim of Gresham’s Law. This means that information you should ingest doesn’t always have to be interesting initially. It also means that an effort is required on your side to resist the seductive content and focus on something which may be difficult to digest.

Some of the most valuable sources of information (including books) may not consistently give you interesting information but if you keep at it, over a long term, you will end up becoming more knowledgeable and better decision maker.

Mr. Gresham would be never have imagined that his ideas will find application in information age.

In Business and Investing
In a raging bull market, where a lot of poor quality businesses become center of attraction for majority of investors, nobody talks about business fundamentals. So, in a way, the sound practices of identifying a business are ousted by greed and envy driven shortcuts.

One of the common practices among investors is selling the winners and holding on to the losers (because of sunk cost fallacy). A natural outcome is that they are left with a portfolio consisting of losers only. Gresham’s Law of investing – bad stocks driving out the good stocks from the portfolio.

Talking about culture of bad accounting practices, Warren Buffett wrote in his 1999 letter to investors –

…managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don’t produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired ‘earnings’ or set the stage for them in the future.

Rationalizing this behaviour, these managers often say that their shareholders will be hurt if their currency for doing deals – that is, their stock – is not fully priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish. Call this behaviour Son of Gresham: Bad account drives out good.

Charlie Munger, in his 1984 Letter to Wesco Shareholders, expressed his concerns about Gresham’s Law affecting the loan practices. He pointed out how bold (bad) loan practices were driving out the conservative (good) loan practices which could lead to widespread insolvencies in the banking industry.

The concept also applies to morals. William Ophuls writes –

As with Gresham’s Law in economics, bad values drive out good, so moral currency is continuously debased.

Unethical behavior is contagious. If you find that it’s easy to cheat and steal in an organization, it’s just a matter of time before majority of the people in that system start exhibiting dishonest and unethical behaviour. Even if everybody was absolutely honest to begin with, social proof makes it increasingly hard for any individual to behave in a good way. Watching those around you succeed for wrong reasons isn’t easy to handle. Envy is hard to counter. Such is the human behaviour.

If you closely observe, you would realize that ‘incentive bias’ and ‘social Proof’ together create the lollapalooza of Gresham’s Law. This proves how interplay of multiple behavioural biases result in extreme irrational outcomes.

In politics also, bad behavior tends to drive out higher moral values and principles. It’s not very uncommon to see young people with good intentions get into politics only to get sucked in by dark forces of so called “dirty politics”.

Conclusion
So the central idea here is that Gresham’s Law explains a lot of happenings in the world around us. Let me take the risk of sounding like a broken tape and tell you again that no mental model explains everything completely. Similarly, Gresham’s Law needs few pre-conditions to take shape i.e., a positive feedback loop reinforcing the bad behavior/practice/value etc.

Worldly wisdom requires the use of multiple mental models to understand the real life experiences. It’s said that there is nothing more dangerous than a man with an idea especially if it’s the only idea he has. So instead of swinging your single hammer in every direction, you should learn to rely on your toolbox (latticework) containing multiple instruments (metal models).

I think what Abraham Lincoln said is a great metaphor for life long learning. He said –

Give me six hours to chop down a tree and I will spend the first four sharpening the axe.

Learning multi-disciplinary ideas and building a latticework of mental models is akin to sharpening your axe. Axe sharpening doesn’t necessarily mean that you have to build a super smart brain or develop an IQ of 180. You just have to devote some time in learning the ideas that matter – the true wisdom. Wisdom that can help you cut through the crap and directly see the core.

Charlie Munger says –

I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.

According to Mr. Munger, there are about 100 or so models across the disciplines of microeconomics, physiology, psychology, elementary mathematics, hard science and engineering. And, of course, it’s not possible to learn all of them in day or a week or even in a single year. It’s a long term course and will require some efforts. But when you’ve committed yourself to a lifelong journey for seeking worldly wisdom, it’s a small price to pay. Are you ready to pay that price?

Did you just say “Yes”? I think I heard that.

I sincerely hope that you are finding some value in this Latticework series. As I said earlier, my primary motive here is to develop a better grip on these ideas myself. In an attempt to explain these ideas to you, the concepts get distilled further in my own head.

Like happiness, wisdom also increases with sharing. So carve out few minutes in your routine for sharing these ideas with your buddies.

Take care and keep learning.