Incentive-Compatibility is Overrated Yet Inevitable

11-03-2025

Path-dependency protects us from ourselves

The following are examples of laws and economic structures that are not incentive-compatible, yet very few people seem to care.

Florida House Arbitrage

Florida has a state law called the homestead exemption that enables people to declare bankruptcy while keeping their primary residence. Notable people who have leveraged this exemption include OJ Simpson and Bowie Kuhn (former MLB commissioner).

There is a long legal precedence for utilization and makes it attractive for wealthy residents to leverage preceding bankruptcy.

The rules are as follows:

  1. It must be your primary residence
  2. Covers all property contiguously connected
  3. No dollar limit on the homestead exemption value
  4. Must have owned the property for at least 1,215 days before filing. If owned for less, the exemption is capped at ~$200,000

This provides the incentive for people to buy expensive homes while taking on massive personal risk. If you know you’re about to go bankrupt in the next 5-10 years, move to Florida. If there’s even a chance that you’re going to go bankrupt, the rational strategy is to:

  1. Liquidate all your assets
  2. Move to Florida and buy the biggest house you can afford that you can pay off in full
  3. Live there for 1,215 days
  4. Towards the end, take out as much credit as you can: credit cards, personal guarantees, etc. You can probably rack up $250,000 to $500,000 in debt
  5. Declare bankruptcy, keep your house. Liquidate your house after bankruptcy proceedings.

Turn $10 million in exposed assets into $10 million in protected assets, while also extracting six-figures of discharged debt.

And yet neither Florida or Texas are on the top of the list for state bankruptcies.

Credit Card Churning

Churning is the process of applying for new credit cards to farm their sign up bonus. People who participate in churning open and close credit cards multiple times a year, accruing points, miles and cash back in the process. The mark-to-market aggregate value of each sign up bonus ranges from $100 to well over $1,000.

A disciplined churner open the following cards:

  • Chase Sapphire Preferred: $95 annual fee, 60,000 point bonus after $4,000 spend in 3 months (value: $750-$1,200)
  • Capital One Venture X: $395 annual fee, 75,000 mile bonus after $4,000 spend in 6 months (value: $750-$1,350)
  • American Express Gold: $250 annual fee, 60,000 point bonus after $6,000 spend in 6 months (value: $600-$1,200)

Total annual fees: $740

Total required spending: $14,000 over 6 months (achievable through regular expenses)

Total bonus value: $2,100-$3,750

At conservative valuations, the churner’s net profit after fees ranges from $1,360 to $3,010. This is risk-free profit for someone spending $2,500/month on regular expenses anyway. Aggressive churners repeat this process quarterly with different card families, potentially earning $5,000 - $12,000 annually. The most aggressive churners manage 20-30 cards simultaneously, manufacturing spending through various methods to meet requirements.

And yet over 50% of American adults have three or fewer credit cards. Only 40% of people even know what credit card churning is.

COVID Student Loans

During the start of COVID on March 13, 2020, the federal set interest rates on student loans to 0%. This lasted until September 1, 2023. Any student loans during this time were exempt from interest payments, allowing anybody to borrow from the government at a 0% interest rate.

During this time, any enrolled student could have borrowed money from the government and invested it themselves for a risk-free return. A student who took out a $10,000 loan on August 25, 2022 would have made a risk-free $382.12, while also entering themselves in the Biden student loan lottery.

Rates on August 25, 2022:

  • Undergraduate direct loan interest rate = 4.99% (assuming resumption on January 1, 2023)
  • Loan origination fee ~= 1.00%
  • Series I Savings Bonds (rate ending December 31, 2022) = 9.62%

On August 25, 2022, Student A did the following:

  1. Applied for and use FAFSA proceeds, deducting $9,900 from their tuition bill ($10,000 x 0.99)
  2. Took $10,000 from their checking account and bought $10,000 worth of Series I Savings Bonds (minimum lockup = 1 year, lose last 3 months of interest if you withdraw before 5 years)

On August 25, 2023 (1 year later):

  1. Exit Series I Savings Bonds position, netting $661.54 in interest, for a total of $10,661.54

First 6 months: $10,000 * (0.0962 * (6/12)) = $481

Next 6 months: $10,481 * (0.0689 * (3/12)) = $180.54

(The second period is 3/12 because you forfeit the last 3 months due to the early withdrawal penalty)

  1. Jan 1, 2023 - Aug 1, 2023: Monthly payment on student loan = $106.02
  2. Pay back student loan in full ($9,543.30), taking into account the 0% interest rate for the rest of calendar year 2022

Profit = $10,661.54 - ($106.02 * 6) - $9,543.30 - $100 = $382.12

And yet the number and volume of new loans only went up around 10%.

Coda

To be sure, the Florida homestead exemption generates auxiliary fiscal benefits for the state, credit card companies make more money off of people who don’t pay, and COVID policies were implemented during an idiosyncratic point in time.

But in practice, path-dependency matters much more than incentive-compatibility. The Florida homestead exemption should create waves of strategic bankruptcies, credit card companies should be drowning in churners, and the government should have been overwhelmed by students arbitraging zero-percent loans.

The comfortable, first-order explanation is that the opportunity cost is not worth the coordination and social cost. But with information spreading instantly online, automation reducing friction to near-zero, and communities forming around optimization strategies, the barriers are collapsing.

Every day, we stray farther from a high-trust equilibrium. Unlike exploitative arbitrage opportunities, trust doesn’t scale.

This leads to everybody shifting toward more adversarial, antagonistic strategies as they seek to exploit counterparties for maximum short-term gain.

Popularity prediction hash: df89c1f046636a3e01516d8443487d88d0aaa7ae4c2a8f13478dcd53252016c7