Thursday, March 6, 2008

Snake Eyes, You Lose

Imagine you run this little test, adapted from Nicholas Taleb's The Black Swan (see book recommendation on the right):

On one side is Ben, a wing-tipped bearded ex-professor of economics who now works at the Fed. He became famous because of his precise econometric modeling of the Great Depression.

On the other is Moe, a wizened veteran of Wall Street who has been bloodied in many a battle with sharpies, conmen, penny stock pushers and assorted manipulators. He is not famous and doesn't want to be. But he is quite rich.

You hold up a pair of dice and assure Ben and Moe that they are not loaded. You then start throwing the dice and after twenty consecutive throws of snake-eyes you ask both of them what's the most probable outcome of the next throw. Ben, being who he is, naturally says "seven". Moe laughs and says "snake-eyes". Ben protests that he was assured the dice were not loaded. Hearing this, Moe laughs even harder and calls Ben a schmuck. Who do you want as an investment adviser?

The moral of the story is, if you expect the economy to respond strongly to deep interest rate cuts - like it did so many times before - you better check beforehand that this time the game hasn't been "loaded".


9 comments:

  1. Re: The moral of the story.

    Hmm. That's a curious statement to make. I'm trying to figure out how that translates to real life. It's not that I would question the interpretation (I might even be inclined to agree with you), but I am just wondering what that enigmatic story means.

    Who would I want as an investment adviser? Even if Ben is wrong, I certainly wouldn't want Moe (who relies on loaded dice) to be my investment adviser. Because soon enough they will load the dice against me, too. In that case, it may just be better to stay out of the game altogether.

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  2. Okie,

    The moral is (I think) not that Moe has personally rigged the game; rather he recognizes a rigged game when he sees one. Even after 20 snake-eyes in a row, Bernanke naively believes in an efficient market governed by the laws of probability rather than a rigged market hopeless skewed by avarice and greed.

    My money is on (and with) Moe.

    Cheers!

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  3. One of the two is a Mo(e)ron and the other's just Moe. A long while ago, on my blog, I offered that Ben Bernanke and The Fed would do exactly what he they are doing because it was the only thing he and they could do.

    I amend that statement now by saying he is doing what he is programmed to do, namely use the utterly outdated and now disastrous Greenspan approach.

    Mr. Fed Chairman: Here's what you must do immediately.

    REVERSE COURSE!!! RAISE RATES. THAT'S RIGHT, RAISE THEM! THIS WILL HAVE THE OPPOSITE EFFECT ON THE LONG BOND THAT YOUR DISASTROUS PANIC EASINGS HAVE HAD TO DATE. THE BANKS ARE INSOLVENT. RAISING RATES WILL ACCELERATE THE INEVITABLE BANKING COLLAPSE.
    YOU CAN BE HISTORY'S HERO OR ITS GOAT! WHICH WILL IT BE?

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  4. The dice were loaded by the person doing the test; it is all about assumptions vs. evidence.

    Regards

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  5. They're Ben's dice.

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  6. Yes, they're Ben's dice. Which makes him twice as stupid to not realize that someone swapped out the good ones and replaced them with the loaded pair.

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