The Black Swan: The Impact of the Highly Improbable

I found no formal, Tetlock-like comprehensive study in economics journals. But, suspiciously, I found no paper trumpeting economists’ ability to produce reliable projections. So I reviewed what articles and working papers in economics I could find. They collectively show no convincing evidence that economists as a community have an ability to predict, and, if they have some ability, their predictions are at best just slightly better than random ones—not good enough to help with serious decisions.

The most interesting test of how academic methods fare in the real world was run by Spyros Makridakis, who spent part of his career managing competitions between forecasters who practice a “scientific method” called econometrics—an approach that combines economic theory with statistical measurements. Simply put, he made people forecast in real life and then he judged their accuracy. This led to the series of “M-Competitions” he ran, with assistance from Michele Hibon, of which M3 was the third and most recent one, completed in 1999. Makridakis and Hibon reached the sad conclusion that “statistically sophisticated or complex methods do not necessarily provide more accurate forecasts than simpler ones.”

I had an identical experience in my quant days—the foreign scientist with the throaty accent spending his nights on a computer doing complicated mathematics rarely fares better than a cabdriver using the simplest methods within his reach. The problem is that we focus on the rare occasion when these methods work and almost never on their far more numerous failures. I kept begging anyone who would listen to me: “Hey, I am an uncomplicated, no-nonsense fellow from Amioun, Lebanon, and have trouble understanding why something is considered valuable if it requires running computers overnight but does not enable me to predict better than any other guy from Amioun.” The only reactions I got from these colleagues were related to the geography and history of Amioun rather than a no-nonsense explanation of their business. Here again, you see the narrative fallacy at work, except that in place of journalistic stories you have the more dire situation of the “scientists” with a Russian accent looking in the rearview mirror, narrating with equations, and refusing to look ahead because he may get too dizzy. The econometrician Robert Engel, an otherwise charming gentleman, invented a very complicated statistical method called GARCH and got a Nobel for it. No one tested it to see if it has any validity in real life. Simpler, less sexy methods fare exceedingly better, but they do not take you to Stockholm. You have an expert problem in Stockholm, and I will discuss it in Chapter 17.

This unfitness of complicated methods seems to apply to all methods. Another study effectively tested practitioners of something called game theory, in which the most notorious player is John Nash, the schizophrenic mathematician made famous by the film A Beautiful Mind. Sadly, for all the intellectual appeal of these methods and all the media attention, its practitioners are no better at predicting than university students.

There is another problem, and it is a little more worrisome. Makridakis and Hibon were to find out that the strong empirical evidence of their studies has been ignored by theoretical statisticians. Furthermore, they encountered shocking hostility toward their empirical verifications. “Instead [statisticians] have concentrated their efforts in building more sophisticated models without regard to the ability of such models to more accurately predict real-life data,” Makridakis and Hibon write.

Someone may counter with the following argument: Perhaps economists’ forecasts create feedback that cancels their effect (this is called the Lucas critique, after the economist Robert Lucas). Let’s say economists predict inflation; in response to these expectations the Federal Reserve acts and lowers inflation. So you cannot judge the forecast accuracy in economics as you would with other events. I agree with this point, but I do not believe that it is the cause of the economists’ failure to predict. The world is far too complicated for their discipline.

When an economist fails to predict outliers he often invokes the issue of earthquakes or revolutions, claiming that he is not into geodesies, atmospheric sciences, or political science, instead of incorporating these fields into his studies and accepting that his field does not exist in isolation. Economics is the most insular of fields; it is the one that quotes least from outside itself! Economics is perhaps the subject that currently has the highest number of philistine scholars—scholarship without erudition and natural curiosity can close your mind and lead to the fragmentation of disciplines.

“OTHER THAN THAT,” IT WAS OKAY