Edward Quince (EQ): Charlie, Berkshire Hathaway is famous for its decentralized structure. You’ve warned about the "great defect of scale" in organizations. What fundamental flaw emerges when an entity becomes too large?
Charlie Munger (CM): The great defect of scale is bureaucracy. With bureaucracy comes territoriality, which is grounded in human nature. In a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else’s in-basket. This creates big, fat, dumb, unmotivated bureaucracies that are too slow to make decisions, allowing nimbler people to run circles around them.
EQ: This seems tied to misaligned incentives, or what you’ve referred to as the "febezzle"—a pleasant fiction created when rising asset prices or fees mask true value. Can you explain how this happens in finance?
CM: The "febezzle" occurs when an investment manager earns compensation from the rising value of the assets under management during periods of rising asset prices. Both the manager and the investor feel richer, spending from a "wealth effect" that dissipates if asset prices decline. This pleasant fiction can lead to a misallocation of capital to unproductive projects and foolish spending.
EQ: That temporary wealth effect sounds like it applies to broader market euphoria too, masking underlying risk.
CM: It does. When the financial scene starts reminding you of Sodom and Gomorrah, you should fear practical consequences even if you like to participate in what is going on. The danger is that rules in large organizations do not require people to think. How can people deserve trust if first they don’t think?.
EQ: So, success relies on creating a system of deserved trust that encourages critical thinking, rather than relying on strict rules that foster bureaucracy.
CM: We need to build a “seamless web of deserved trust”. The pervasive problem is that many fund managers are led astray by the psychological trap of convincing themselves of the merits of their own case, especially when making public disclosures, effectively pounding into their own head their own conclusions.
The Edward Quince Takeaway
Beware of the corrosive effects of scale and bureaucracy, which slow decision-making and incentivize passing work rather than completing it. Question wealth derived from rising asset prices, as Munger warns these can create a psychological "febezzle" where temporary gains are confused with sustainable, productive income, ultimately leading to misallocation of capital.
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