“Knowledge of the message is not enough…
…for the message to be successful, each person must not only know about it, each person must know that each other person knows about it.
In fact, each person must know that each other person knows that each other person knows about it, and so on; that is, the message must be common knowledge.”
– Michael Chwe, Rational Ritual
In newspapers of the 1930s, the most unusual of beauty contests took place.
In traditional contests, the competitors are beauty figures. A prize is awarded to whoever a panel of judges decided was most beautiful.
But in these contests, the competitors were everyday newspaper readers. And the prize was awarded to whoever was able to pick out the six most beautiful faces based on what other newspaper picked as most beautiful.
So a contestant (newspaper reader) was not picking the six most beautiful faces in their eyes. Which faces do I think are most beautiful?
Nor were they picking who they thought most other readers would view as most beautiful. Which faces do I think others will think are most beautiful?
Rather, they were picking the faces based on what they think others would think what others would think were most beautiful. Which faces do I think others will think what others will think are most beautiful?
They were betting on the average opinion of the average opinion.
This is common knowledge. What the crowd believes what the crowd believes.
John Maynard Keynes, one of the most influential economists of the 20th century, understood this:
“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs…
…the prize being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point view.
It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.
We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
– John Maynard Keynes, The General Theory of Employment, Interest, and Money (1935)
This post has 4 parts.
First, we’ll wrap our heads around ‘common knowledge’, go through an example, and take a deeper dive into the mechanics from a game theory lens.
Second, we’ll talk about common knowledge in mass media and why I stopped avoiding mass media. (You read that correct, stopped avoiding, rather than start avoiding.)
Third, we’ll touch on the Common Knowledge Game in financial markets.
Fourth, I’ll share how my understanding of common knowledge has practically changed the way I think and live.
1. Common Knowledge?
In an age of information abundance, wisdom becomes less about how much you know, but rather your ability to distinguish truth from narrative.
Thankfully, there seems to be increasing awareness of the cognitive biases: survivor bias, confirmation bias, correlation is not causation etc. (Although we could all benefit from continual reminders, myself included).
But what most people don’t seem to comprehend is that a narrative, even if completely fictious, is a fact in itself. A second-order truth of sorts.
Common knowledge is basically a metanarrative.
Common knowledge is information that everyone believes is shared by everyone else.
This is different to a consensus view (what everyone is thinking).
It’s the consensus view of the consensus view (what everyone thinks what everyone is thinking). A second-order consensus.
It’s not what the crowd believes. It’s what the crowd believes what the crowd believes.
The effect of common knowledge on human behaviour has long been understood. By political leaders and dictators, marketers and propagandists, business pioneers to religious cult leaders.
“It’s not enough for everybody to know a fact. Rather, everybody must know that everybody else knows that fact.
Certain beliefs are only helpful if everybody in a community commits to them. The need to not only transmit information but create common knowledge explains why public rituals, rallies, and ceremonies are consistent across cultures.
They don’t just transmit information. Rather, by making a shared set of beliefs explicit, they serve as an ethical blueprint for the community.”
– David Perell, News in the Age of Abundance
1.2. Island of Green-Eyed Tribe Example
On the island of the green-eyed tribe, blues eyes are taboo. Those with blue eyes need to get on a canoe and leave the island the next morning.
But there are no mirrors or reflective surfaces on the island. So no one knows their own eye colour.
It is also taboo to talk about eye colour.
So if you see a fellow tribesman with blue eyes, you can’t say anything. This means that no one knows they have blue eyes and therefore no one has ever left the island before.
One day, a foreign missionary comes to the island and announces “at least one of you have blue eyes.” The missionary is telling the truth and everyone believes him. What happens next?
If there was only 1 blue-eyed person, they go thorugh this thought process:
“I see everyone here has green eyes. I thought I had green eyes too. But the missionary said at least one of us has blue eyes. Oh no, that means that person must be me.” The blue-eyed person leaves the island the next morning.
If there were 2 blue-eyed people, each of them would go through this thought process:
“I see everyone has green eyes except that guy. He must be the blue-eyed person the missionary is talking about.”
Since they both think they themselves don’t have blue eyes, neither of them leave the island the next morning.
The next day they’re both surprised to see each other still on the island.
“Hang on, if he didn’t leave that means he saw someone else with blue eyes. I see that everyone else has green eyes, so that must mean… ah shit… it means we both have blue eyes.”
So on the morning after, both blue-eyed tribesmen leave the island simultaneously.
If there were 3 blue-eyed people, a similar situation as above would occur. Except all 3 would leave simultaneously on the 3rd morning.
We can generalize to a case where there are n blue-eyed people. The generalized solution is that for any n number of blue-eyed tribesmen, they all leave simultaneously on the nth morning after the missionary’s statement.
1.3. Mechanics through game theory lens
To understand how common knowledge affects group behaviour, we take a deeper dive into its mechanics.
Consider the typical elements in game theory (PARTS): players, added value, rules, tactics, scope.
Using the green-eyed island tribe example, the players are the tribesmen.
The added value was the new piece of information introduced by the missionary.
The rules of the game were embedded in the tribe’s informational structure. No blue-eyes allowed. No talk of eye colour allowed.
The tactics of all players were assumed to be purely 100% cooperative, rational, and optimizing for efficiency.
The scope assumed a closed system confined to the green-eyed tribe island, with each game theory ‘move‘ time period being one day.
Key to understanding the mechanics is understanding that common knowledge is usually a subset of public knowledge, but it doesn’t have to be. It could be private knowledge too.
Let’s break this down.
In the above example, the equilibrium state before the missionary’s arrival was perfect private information.
Everyone knew everyone else’s eye colour (except their own). But this knowledge was siloed inside each individual’s head and not made public.
The missionary did not transform private information into public information. He never pointed who has blue eyes.
However, his announcement (“at least one of you has blue eyes”) was a new piece of information.
And this new information caused the tribesmen (players in game theory terms) to change their behaviour to move to a new equilibrium state (blue-eyed people gone).
By introducing new public information into the informational structure, the missionary did transform private information into common knowledge. Remember, common knowledge can be public or private, so long as everyone believes its shared by everyone else. In this case it’s having blue eyes.
The behaviour change only took place after public or private knowledge (in this case, private) became common knowledge.
“Even if everyone in the world believes a certain piece of private information, so long as it stays private — or even if it becomes public information — no one will alter their behavior.
Behavior changes ONLY when we believe that everyone else believes the information.
THAT’S what changes behavior. And when that transition to common knowledge happens, behavior changes fast.”
This is the power of the crowd being able to see the crowd. From business to politics to religion, understanding this has been pivotal to those that have been able to influence so many. For both good and bad.
1.4. Pluralistic ignorance
Another subtlety of common knowledge is that it has nothing to do with one’s individual opinion on whether the consensus view is factually correct or incorrect.
Common knowledge comes in 2 flavours:
(i) everyone believes, and everyone believes that everyone believes
(ii) no one believes, but everyone believes that everyone believes
Pluralistic ignorance is the latter. Common knowledge based on false beliefs.
Example 1: Insecure teenagers trying to be cool. A bunch of 13 year olds try beer for the first time. Everyone it’s bitter. No one actually likes it. But everyone pretends to like it to be “cool.” No one dares to admit or express their true opinion of beer. And so, everyone thinks everyone else likes it. And takinig this one step further, each individual individual believes that everyone thinks everyone likes it. This is common knowledge built on a foundation of false belief. Pluralistic ignorance.
Example 2: COVID panic buying. The toilet paper hysteria in early 2020 was not due to inability to replenish supplies (at least in Australia, that is). Most people knew that Australia manufactures its own toilet paper. But despite knowing this, everyone thought that everyone else would panic buy. So the panic buying become a self-reinforcing, self-fulfilling prophecy. Based on the consensus metafear of people’s fear that they can’t wipe their own ass. Late 2021/early 2022, we repeat this cycle with rapid antigen tests.
Example 3: Emperor’s New Clothes, the classic folktale. Some fraudulent tailors convince an emperor that they can create the most marvelous outfit. The caveat being the outfit can only be seen by those who are not stupid. The emperor makes the purchase and receives the “clothes” (nothing). Protecting his pride, the emperor pretends that he can see the clothes: “Oh how marvellous!” All of his servants ignore the nakedness of the emperor, and also pretend to see for the same reason. No one wants to admit they can’t see the clothes.
As the emperor shows off his new ‘clothes’ in public, the crowd watches in shock and silence. Everyone’s thinking the same thing: “why is he naked?” But no one dares to speak up. Everyone thinks everyone else sees the clothes.
Then a young boy yells and points out that the emperor is naked. The crowd joins in and laughs at him. The emperor’s embarrassment shows that he admits that he cannot see the clothes either. (Young boy is the ‘missionary’ here.)
There’s no shortage of naked emperors today.
2. Common knowledge in mass media
2.1. Why I stopped avoiding mass media
You read that correctly. Not stopped consuming, but stopped avoiding,
I used to avoid the likes of popular broadsheets and evening news like the plague. I was convinced that such pseudo-news actually makes you more stupid, fearful, and ignorant. Thinking you know is even more dangerous than not knowing. “Add sex and stir.” “Broadcast emotions rather than truth.” “Manufacture consent.”
But here’s something that I realized rather recently. If I’m so determined to seek truth, whatever message is broadcast to everyone is a truth in itself. A second-order truth. If everyone is being fed some information, then the fact that everyone is being fed that information is itself truth, regardless of whether that information is true or not. It’s meta-news: news about the news.
So there’s actually tangible value to be derived from watching the likes of Fox News. It’s important to know what everyone else is thinking about what everyone else is thinking. So long as you view it through a skeptical filter. Instead of “omg I can’t believe that’s what’s happening in the world”, you view it as “this is what most people are being fed and conditioned to believe.”
2.2. Advertisers are willing to pay for a common knowledge premium
Advertising value obtained is non-linear to the advertising cost.
Super Bowl ads are notoriously expensive. Around $6m for a single 30-second TV ad. This is not only because it’s the biggest event of the year in the US. It’s also because every viewer knows that millions of other people are seeing the same ad. And advertises are happy to pay for this common knowledge premium.
“So for an ad to work by cultural imprinting, it’s not enough for it to be seen by a single person, or even by many people individually. It has to be broadcast publicly, in front of a large audience. I have to see the ad, but I also have to know (or suspect) that most of my friends have seen the ad too.” – Ads Don’t Work That Way
Consider this public health message for instance.
Rather than letting someone view this add privately e.g. via internet, it’s much more effective to display this in a prominent place. Everyone sees the ad, and they also know that others have seen the ad. So next time they’re drinking a sugary drink in public, they’re more likely to feel peer pressure.
This phenomenon has also been understood and leveraged by the fashion and music industries. Rather than designing clothes that you think teenagers would like, you design clothes that teenagers think what their peers would like.
2.3. Why I stopped underestimating celebrity soft power
Alongside mass media, I also used to avoid celebrity gossip, opinions, and ‘news’. Someone got divorced. Seriously. Who cares? If it appeared on the morning news that my parents would watch over breakfast, I would put deliberate effort into not letting that information enter my system at all. I was convinced that celebrity opinions are way over-priced – they receive so much more weight than deserved.
I still think they’re over-priced, but certainly not as over-priced as I thought. Because now I realize how naive I was. I didn’t understand the emergent effect of common knowledge. It doesn’t matter if a celebrity’s opinion on something was actually true or not. It also doesn’t matter if most people think it’s true or not. So long as most people think that most others think it’s true, then that in itself gives it power.
A parallel to this is underestimating the strength of soft power in geopolitics. K-pop is more than just entertainment. If it materially influences South East Asia consumer behaviour, it’s a significant business and economics factor. This is also why I give sociology a lot more weighting in understanding the biggest factors that drive change in the world.
3. Common knowledge in financial markets
3.1. Prices reveal common knowledge around market’s expectations of future events
The common knowledge phenomenon is indeed well understood in finance. The market’s expectations on the probability of future events is baked into price. It doesn’t necessarily mean the market’s right. But it does mean that everyone agrees that this is what the majority of the market believes.
3.2. Meta-games in financial markets
There’s mass media for everyday ‘news’. Then there’s media that all business and finance people read. The sources of the “rumour” in the saying “buy the rumour, sell the news.” It’s the big 4 US finance journals, plus every country/region has additional sources that people follow. For Aussies, it’s the AFR of course.
How do we “see” a crowd in financial markets? Through the financial media outlets that are ubiquitous throughout every professional investment operation in the world — the Wall Street Journal, the Financial Times, CNBC, and Bloomberg.
That’s it. These are the only four signal transmission and mediation channels that matter from a financial market Common Knowledge Game perspective because “everyone knows” that we all subscribe to these four channels. If a signal appears prominently in any one of these media outlets (and if it appears prominently in one, it becomes “news” and will appear in all), then every professional investor in the world automatically assumes that every other professional investor in the world heard the signal. So if Famous Investor X appears on CNBC and says that the latest Fed announcement is a great and wonderful thing for equity markets, then the market will go up. It won’t go up because investors agree with Famous Investor X’s assessment of the merits of the Fed announcement. The market will go up because every investor will believe that every other investor heard what Famous Investor X said, and every investor will be forced to update his or her estimation of what every other investor estimates the market will do. It doesn’t matter what the Truth with a capital T is about the Fed. It doesn’t matter what you think about the Fed. It doesn’t matter what everyone thinks about the Fed. What matters is what everyone thinks what everyone thinks about the Fed. That’s how sheep logic, aka the Common Knowledge Game, works in markets. – A Game of Sentiment, Epsilon Theory
3.3. Excessive quantitative easing and market re-evaluation of inflation
Over the past decade we’ve seen the longest ever bull run since WWII.
Some retail investors may attribute this to the rise of tech giants and earnings growth.
But the thing is, the valuation rise has been exceeded the rise in earnings and labor productivity growth is more or less flat.
The US market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Put simply, interest rates and growth.
Most institutional investors would probably agree that the major contributing factors to the bull run stock buybacks on the back of cheap money. If you’re an executive, why would you bother investing and risking new initiatives when you can make shareholders happy by just buying back your stock?
The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? – Gradually and Then Suddenly (Jul17), Epsilon Theory
This is the consequence of excessive quantitative easing and monetary policy on steroids.
What’s the motive behind this? Answer: the US political system is based on the stock market going up. Donald Trump and Steven Mnuchin (US Secretary of the Treasury) look at the indices as their report card. If stocks don’t go up, pension funds and social insurance programs go bust, further amplifying pre-existing inequalities.
The capital markets have already transformed into a political utility. The market knows this.The markets have been living off this narrative. Everyone knows it’s an unsustainable system. But everyone also knows that everyone knows that it’s going to keep on going. Until it can’t.
There are techniques to literally visualize what the crowd is thinking by scraping key words from financial journal articles.
These visualizations reveal the formation of common knowledge around the inflation narrative. Everyone knows that everyone knows that this can’t just go on.
In the Euro zone, there’s a whole another complication. The European Central Bank (ECB) doesn’t have fiscal policy levers. And Germany, which basically controls EU finance, is obsessed with keeping inflation down. When the ECB can increase money supply but not enforce budgets of each European state, the problems are a whole new beast.
3.4. COVID-19 a missionary statement?
Could COVID-19 be considered as a ‘missionary statement?’ Like the missionary that visits the green-eyed tribe island and announces someone has blue eyes. Or the boy that calls out the naked emperor?
Is the market now ripe for a re-evaluation of inflation and its impact on the price of money, and the real return on invested capital?
Despite the short dip in April 2020, market behaviour hasn’t really shifted at all.
But COVID is far from over yet.
We’ll find out over the next couple of years.
4. Wrapping up
Common knowledge is information that everyone believes is shared by everyone else. It’s not what the crowd believes. It’s what the crowd believes what the crowd believes.
It’s an integral part of game theory and critical in understanding how group behaviour changes based on new information. Better understanding common knowledge completely changed the way I consume mass media and view soft power.
The message here is not to declare common knowledge as a trap to avoid. Only a sucker says they’re not a sucker. Rather, it’s a phenomenon that will emerge again and again, so be able to recognize it.
While this concept may not be entirely new, the magnitude of effect of common knowledge is likely under-estimated.
Common knowledge in itself is not good or bad. It just is. Even with pluralistic ignorance, there are cases when this could be good too. Overlaying a moral compass is something separate to common knowledge.
Meanwhile, there are times when we must be the boy that calls out the emperor without clothes.
Dare to be someone that questions sacred cows. Dare to be the 13-year old that kid that is not afraid to declare: “Guys I actually don’t like the taste of beer. Do you?”
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