The Black Swan author Nassim Taleb recently issued a challenge to economists to debate him on the subject of risk in economics:
"I would love to debate a prominent economist LIVE in front of an audience… Nobody has accepted so far," he wrote on his Facebook page a few days ago. He singled out the New York Times' Paul Krugman as someone he might challenge to a debate: "I am looking for an economist… I could challenge him publicly. Krugman?"
Taleb has long been an intellectual hero of mine. I have been an avid reader of his writing on finance, statistics, risk, and probability for the last decade, and I would recommend all of his books — Fooled by Randomness, The Black Swan, The Bed of Procrustes, and Antifragile — in a heartbeat. Some of the ideas that his books introduced me to — the Ludic fallacy, black swan events, survivorship bias, hindsight bias, prospect theory, antifragility, iatrogenesis, skin in the game — have provided me with much of the mental landscape that I use to think about probability and risk.
Now, I am not the academic economist that Taleb is looking to debate. But nonetheless, I accidentally found myself drawn into a debate with him on Twitter. Why? Because in 2010, he made some very bad predictions on interest rates and inflation, two extremely important subjects in economics.
At the start of 2010, Taleb argued that betting against government treasuries is a "no brainer" due to the high U.S. deficit and what he perceived as the high risk of inflation. His view — if I understand it properly — was that the government's and Federal Reserve's attempts to stimulate the depressed economy were dangerous, ill-conceived, and likely to lead to negative side effects like high inflation and soaring interest rates. He quipped: "So long as you see the picture of Larry Summers going to Davos, you have to stay short U.S. Treasuries for another year. It means they [the Obama administration] don't know what's going on."
In fact, in a 2009 Financial Times op-ed, Taleb warned that stimulus policies and government deficits were dangerous, and that central bank money creation would lead to hyperinflation:
We believe that stimulus packages, in all their forms, make the same mistakes that got us here. They will lead to extreme overshooting or extreme undershooting. They lead to more borrowing, by socializing private debt. But running a government deficit is dangerous, as it is vulnerable to errors in projections of economic growth. These errors will be larger in the future, so central bank money creation will lead not to inflation but to hyper-inflation, as the system is set for bigger deviations than ever before.
In reality the price of Treasuries soared after Taleb made his prediction, and the price remains higher today than it was when he made the prediction. Inflation also remained low and contained. And countries with relatively larger stimulus packages — like the U.S. — have seen faster-falling unemployment, and stronger growth than countries like the U.K., which rejected (or were forced to reject) stimulus. Taleb wants economists to throw out the vast majority of their mathematical models, but mainstream economists using mathematical models, like Paul Krugman, got all of this very right.
So I pointed out that any economist who debated Taleb would likely raise these off-target warnings. Taleb's comeback was to accuse me of cherry-picking one statement to criticize him. Why?
To Taleb's trading strategy, a few bad bets mean nothing. Humans in markets misprice risk and routinely underestimate the likelihood of unexpected large-impact events, which Taleb calls black swans. This creates the opportunity to profit from a trading strategy that makes lots of small bets on events the market considers unlikely. You only need to be right occasionally, as each time you are right, you collect a massive payoff. As Taleb pointed out to me on Twitter: "I did 700,000 trades in career, was "wrong" on between 650,000 and 695,000."
Of course, not everyone can adopt such a strategy. Every bet a trader makes requires a counterparty. If your strategy is to make lots of small bets all with the possibility of a massive payoff, other people in the market have to be prepared to accept those bets, frequently winning small amounts and occasionally losing a massive payoff (or as Taleb puts it, "eating like a chicken and shitting like an elephant").
And here's the rub: In the real world, not everybody is a trader using Taleb's strategy of making many small bets, frequently losing small amounts, and occasionally winning a massive payoff ("eating like an elephant and shitting like a chicken").
On some subjects — like the direction of interest rates and inflation— being wrong once reveals that there are big problems with your understanding of how the world works. And if you're an influential person with a big voice who influences large institutions and governments — as Taleb does — being wrong on an important subject that influences government policy can be extremely problematic.
In the Great Depression, many countries including the United States, Britain, and Germany, bought into the idea that the depression was a symptom of rottenness in the economy, and that businesses had to fail en mass in order to purge the rottenness from the system. They enacted liquidationist policies — try to reduce the deficit, and let the economy work itself out — in pursuit of that goal. Unemployment shot up, leading to massive social unrest and prolonging the depression, as incomes continued to fall and debts were defaulted upon. In many countries, including Germany, voters abandoned mainstream political parties and flocked to extreme parties like the nationalists and the communists, who promised to end unemployment and economic stagnation.
High unemployment is a menace because of its insidious effects on the individual and society. It makes individuals more susceptible to depression, anxiety, obesity, and suicide. It raises the risk of home repossession and homelessness. It leads to the erosion of skills. And the children of the unemployed are more likely to become unemployed themselves. And the higher the unemployment rate rises, the more crime occurs. If we're going to talk about risk in economics, mass involuntary unemployment is the place to start.
By encouraging worry about the potential future danger of deficits and high inflation at a time when inflation is low, and government borrowing costs are very low, deficit scaremongers are encouraging governments and central banks to not fight the real and present menace of unemployment. This risks replaying the depression of the 1930s. Indeed, Britain — to whose government Taleb is an adviser — prioritized deficit reduction over fighting unemployment and has experienced very weak growth — a weaker recovery even than Britain's very slow recovery from the Great Depression.
Taleb may deride myself and other journalists for lacking skin in the game — being insulated from the consequences of our actions — but what skin in the game do wealthy government advisers issuing flawed advice really have? Taleb does not even live in the country whose government he advises, and his pre-existing wealth from his successful career as a trader insulates him from the danger of experiencing hardship as a result of mass unemployment.
Now, lots and lots of people — including many respected economists — publicly warned of high inflation or hyperinflation and soaring interest rates in 2009 and 2010. People are fallible, and predicting the future is hard, so everyone is bound to get things wrong sometimes. The thing I try to do when I make a totally incorrect prediction on a worldview-defining subject like interest rates and inflation is to reassess my beliefs about the world, figure out which part of my model caused me to make the bad predictions, and try to come up with a new model or models consistent with reality.
"Usually when you find the model this far off, you've probably got something wrong with the model, not that the world has changed," he said. "Inflation does not appear to be monetary base driven," he said. [Business Insider]
Taleb's response, on the other hand, has been to call people who called him out on his erroneous warnings "fucking idiots" and to deny that his warnings were off-target.
Now, Taleb actually has lots of worthwhile things to say about topics in economics like Modern Portfolio Theory, the Efficient Markets Hypothesis, and the use of statistical tools in economics. I'd enjoy seeing a critic of economics like Taleb debate a mainstream economist around these topics. But are those subjects really more important than the plight of the unemployed, and the insidious effect that mass unemployment has on society?
Any economist worth his or her salt — and especially Paul Krugman, who understands the dangers of mass involuntary unemployment — would immediately call Taleb out on this, and make it central to the debate.
Taleb, of course, could avoid this by accepting that we should have been worrying about unemployment and not inflation or rising interest rates, and issuing a mea culpa.