I loved this interview with Elon Musk discussing a wide range of topics. Of particular interest were his comments on first principle thinking. First principle thinking is the formation of fundamental truths from which we can build understandings. Musk has described what he means:
“What reasoning from first principles really means is boiling something down to the fundamental truths, or what appear to be the fundamental truths, and reasoning up from there, and then having a good feedback loop.”
This is essentially how I construct my view of the economy and the financial system. I work from fundamental truths about how things work by looking at operational realities and accounting constructs. So, for instance, when I was saying that QE wouldn’t cause inflation way back in 2009 (when most people thought it came with the risk of high inflation) I was working from a first principle approach. That is, I was going through the basic accounting behind QE and then forming probabilistic outcomes.
The nice thing about the financial system and the economy is that it’s a human construct. And that means we can deconstruct it and understand it through this lens. It is very much like a machine that has various parts we can understand by knowing how they interact. Unfortunately, much of mainstream economics involves largely theoretical concepts (like the money multiplier, NAIRU, the natural rate of interest, etc) that have no first principle basis. Economics can never be as “scientific” as the natural sciences, but a greater use of first principle thinking would be a step in the right direction.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.