Three Sigma Bubble? Nonsense!

In his article, “Grantham: Bernanke, Paulson Disgraceful“, Gene J. Koprowski discusses Grantham’s comments to the effect that Bernanke and Paulson should have seen the obvious. Although I agree that their leadership amounted to nothing more than “cheerleading” and shilling the “greed is good” bandwagon, his 3-sigma argument is nonsense. Koprowski quotes Grantham as saying,

“And Bernanke couldn’t even see the house bubble. On our data and Robert Shiller’s, it was a three-sigma, one-in-100-year event. After 100 years of being flat, it soared after 2000. You could not miss it. And right at the peak, October ’06, Bernanke said — quote— ‘The U.S. housing market merely reflects a strong economy’ — unquote,” said Grantham.

The setting of three-sigma limits is accomplished by plotting over time, some data associated from some system of interest. That data is then used to set control limits at approximately 3 standard deviations. The limits set in this manner are used to characterize future data as common or special. Data within three-sigma is to be expected. Data outside of three-sigma is to be regarded as cause for surprise and concern. Grantham argues that the housing bubbles was special and should have been easily spotted by Bernanke.

Grantham’s argument is fallacious. The assumption underlying the use of three-sigma limits is that the system being characterized is in a state of control. This means that the myriad processes making up the system can be viewed as constant. Unfettered free-marketism is the antithesis of a controlled system. Processes and methods are constantly being tampered with by greedy and ambitious actors. The “system” of unfettered free-markets is inherently out of control and therefore, entirely unpredictable.

We have become duped by our own ideology into believing that uncontrolled markets are self-regulating and therefore, in control. But if the system is entirely inconstant—if the game is unbounded, then our perception that it is somehow orderly is an illusion. The only real surprises to be found from data drawn from such a non-system is the illusion of their predictability. Were this not so—were markets actually predictable—you and I and everyone else who understand the nature of variation would soon be rich. (Read “The Drunkard’s Walk” for insights into randomness mistaken for order.)

Unfettered free-marketism is a non-system and is by its very nature, out of control. Its characteristic unpredictability not only makes cunning fools rich and reasonable geniuses poor, it also undermines the foundations of orderly society necessary to solve problems and improve. Poverty amid riches, war, social division, and eventual collapse are the legacy of such practices.

I can sympathize with Grantham’s outrage, but the dereliction of duty of leadership pre-dates Bernanke and Paulson by a long way. A system must be led, but greed and avarice are no system at all. They are the jungle of animal instincts from which man arose. They cannot be led, only shilled by amoral actors seeking advantage over others.

Once again, the predictive power of three-sigma has no application for a system that is out of control. The current administration will fare no better then those who have gone before unless they are willing to tame the beast of free-marketism and create a new economics of social responsibility, carefully reasoned enterprise, and systematic improvement.