Right + Early II: The Ehrlich/Simon Bet

In the article I mentioned in my last post, the New York Times said Jeremy Grantham was right but early. Jeremy Grantham passed the favor along by saying that Paul Ehrlich was right but early. He referred to a famous 1980 bet between economist Julian Simon and Paul Ehrlich, an entomologist who specializes in being spectacularly wrong about everything.

At the time, Ehrlich was claiming we were running out of commodities and prices would soon soar, destroying global civilization and killing billions of people. Simon challenged him to pick any five commodities and any date more than year away. Ehrlich picked Chrome, Copper, Nickel, Tin and Tungsten and 1990 as the date. A  basket was created with $200 worth each (at 1980 prices) of the five metals. The difference between the inflation-adjusted to 1980 dollars price of the basket in 1990 and $1,000 would be paid by Simon if the basket cost more than $1,000, or to Simon if the basket cost less than $1,000.

All five commodity prices went down, the basket was worth an inflation-adjusted $618 in 1990, so Ehrlich paid $382. Ever since Ehrlich and his fellow travelers have been explaining why he was really right (it’s just those inconvenient facts that got in the way). Now Grantham trumpets that Ehrlich has finally be proven right. I checked the numbers and as of last Friday the inflation-adjusted prices were Chrome ($196.60), Copper ($241.83), Nickel ($200.52), Tin ($126.42) and Tungsten ($205.36) for a total of $970.73.  However Grantham claims Ehrlich still won because three of the five commodities sell for more than $200. Actually what I find most impressive is how little commodity prices have moved over the years in real terms.

Grantham misses the risk intelligence point completely. Ehrlich claimed to be absolutely sure the prices would skyrocket. He was so sure, he pushed for policies that would impoverish or kill more than half the world, and he supported China’s horrendous population control policies (it turned out democracy and economic growth were far more effective in solving population growth). Moreover, he claimed to understand why prices would increase, meaning he should have been able to pick the five commodities most likely to go up in price, and the time interval most likely to prove him right. Being almost right 20 years after the deadline is WRONG!

Simon did not claim the prices would surely and always be below $1,000, just that it was a good bet given a specific deadline. Nevertheless, it is interesting that commodity prices have not declined in real terms. Since the beginning of the industrial revolution the ratio of commodity value to finished good value has fallen, as design and fabrication become more important (an apple is worth its commodity value, a pot is worth more than a lump of clay, a computer chip is worth far more than the sand and other materials it is constructed from).

I think what Simon perhaps underestimated was the tripling of real global GDP from the greatest economic boom in human history that brought billions out of poverty. Commodity consumption remained roughly constant, so commodities have roughly one-third the relative economic importance in 2011 versus 1980. If GDP had grown more slowly, real commodity prices would have declined. But explosive growth offset the long-term trend toward making labor and intangible assets more valuable than physical stuff; therefore real commodity prices stayed about the same.

The big difference between Simon and Ehrlich’s ways of thinking is not that Simon was right and Ehrlich wrong. It’s observing, and learning from observation, versus denying or explaining away all contrary evidence. That’s why Ehrlich is always so certain, even when his story is 180-degrees different from his story last year.

Now, guess which of Simon or Ehrlich’s ideas are shared by more policy experts.

Right + Early = Wrong and in denial

The New York Times had a fawning interview with Jeremy Grantham, describing him as “right but early.” If you tell me it will rain tomorrow, and it doesn’t but it rains next week, you were wrong. If you claim you were just early, you are in denial about being wrong.

It is possible to make a useful prediction when you are uncertain of the timing. I might say, for example, that commodity prices are in a bubble and will decline to half their current values sometime in the next five years. That could be right or wrong. But if I say merely that commodity prices will decline someday, I will either be proven right or the issue will still be open. I cannot be proven wrong, so the prediction has no meaning.

People with poor risk intelligence seize on current trends and extrapolate them to absurd levels. They get a lot of publicity for this. Other people argue against them, pointing to signs that the trend is already slowing, that it generates countervailing forces and that in any case it has to hit some limits.

What happens next? Either the trend does accelerate to cause some disaster, proving the prophet of doom correct. Or the trend slowly and quietly slows and reverses, in which case people never think to credit the skeptic with a victory. If they think about it later, they remember the trend and the guy who postdicted it, and misremember the order of events so they think he was right. The skeptic is remembered as a guy who denies all possibility of disaster and confused with people who either don’t care about disaster or profit from them.

Reputation tends to go to lucky fools and doomsayers who never remember being wrong (and therefore never learn).

Don’t blame uncertainty

I’m tired of commentators blaming rising prices – or falling prices – on uncertainty.  To take just two recent examples, AsiaOne News blamed yesterday’s 0.15% fall in the Nikkei 225 index on “uncertainty over Japan’s post-earthquake nuclear crisis,” while on Tuesday BP and Caltex increased petrol prices, citing uncertainty about supplies from Libya and the recovery of Japan.

If markets really were completely uncertain about the prospects in Japan or Libya, prices wouldn’t move up or down.  Prices only change when information accumulates that tips the balance one way or the other – in other words, when uncertainty decreases.   Let’s be honest, the Nikkei 225 index didn’t fall yesterday because of uncertainty over the nuclear crisis in Japan;  it fell because markets are becoming more certain that the crisis is going to get worse.  And when BP and Caltex decided to increase petrol prices, it wasn’t because they had no idea about what’s going to happen to supplies from Libya;  it was because they are increasingly convinced that supplies will be disrupted.

So, let’s stop using “uncertainty” as a euphemism for “increasing certainty that things are going to get worse.”  Let’s call a spade a spade.

The parable of the talents

In the parable of the talents (Matthew 25:14-30), Jesus praises venture capitalists who make risky investments. But what would the master in the parable have said if one of the slaves had invested the talents in a mezzanine tranche of a collateralized debt obligation backed by subprime collateral which had experienced severe rating downgrades after delinquencies and defaults on the underlying mortgages?