Many of the ideas I express in this blog are strictly my own, but when it comes to networks and power laws, many of the ideas come from others. As an introduction to some of these thoughts I recommend the following books:
Ubiquity by Buchanan - this is the best introduction to the universality of networks and power law concepts
Linked by Barabasi - this is a good discussion of network growth and structure
Why Stock Markets Crash by Sornette - this is a quantitative discussion on network simulation of markets
Fooled by Randomness and The Black Swan by Taleb - Not for the timid but I recommend anything by Taleb - more than anything, these are works of philosophy and epistemology
The Misbehavior of Markets by Mandelbrot - an attack on traditional market analysis by one of the greats of chaos theory
The Tipping Point by Gladwell - This was done before much of the current theory was thought about - but it explores the same phenomenon as Linked
Showing posts with label Power laws. Show all posts
Showing posts with label Power laws. Show all posts
Thursday, December 16, 2010
Anger Management
Anger is a natural reaction. Heck - I'm angry about it. I have particular people in mind when I think of attitudes that "led" to this - and when I think of them, I get angry. Unfortunately, I think my own anger gets mixed into my blog post - but in a weird way - I'm angry at my own anger.
Intellectually, I think the search for causes and villains is in at least some sense unfounded. What happened in the markets is like an earthquake, or avalanche, or like a panic in a crowded room. It is a natural byproduct of the physical and social structure which developed so successfully over the last 40 years. As we drove our economy to more efficiency, less redundancy, and fired anyone who didn't produce immediate results, we created a very successful economy, but also one that was reaching criticality. Was it inevitable that it would happen when it did and in that particular way - no. But it was inevitable it would happen sometime and in some way and when it did - it was inevitable that we would all be angry.
There was a massive inflow of liquidity/financing made available over the last 30 years and it was this liquidity flow which ultimately stopped. But it was also this massive liquidity flow which led to the stock market and real estate rally over the same time. [And at least in part, these financial innovations were a response to the establishment of ERISA and pension plans in the 80's. Pension plans needed something new to invest in, and our capitalist system created it.] The same phenomenon that led to the economic success of which we are so proud as a nation was both the cause of and result of the processes and practices that blew up.
I am proposing that this crash - and all such crashes - are natural and inevitable byproducts of dynamic "living" systems. If you look hard enough, you may be able to find a triggering event of such a crash, but most likely, every major event was itself caused by a series of smaller and smaller inconspicuous triggering events. Pareto theorized that diverse systems of society and economies can result in a particular and relatively stable pattern of wealth distributions. I'm saying the same thing about how such systems behave over time.
I also believe that a good paradigm for thinking of such a living system is that of a dynamic network.
We see networks everywhere - in a wide range of natural and man made phenomenon. Networks occur naturally - simply as a response to things interacting with with their environment. We see these networks when look out the window at our ecosystem, when we have peaceful relationships with our neighbors, when we see our stocks rally and fall, when we turn on the power to our home. They can lead to amazingly successful growth (Google for example) and equally devastating failures. When things go our way - we think of them as natural and normal. When capitalism "worked" it was because of its inherent superiority and the work ethic of the American people. When it fails - lets find the culprit and string him up.
I also believe that networks display a signature - or fingerprint in their behavior. This signature is the power law distribution, such as the Pareto distribution.
So it is in this context I find the crisis so absolutely fascinating - so cool! But at the same time - Yes - those b____s on Wall Street are getting huge bonuses because We bailed them out. I just wish I weren't so angry about it.
[Note that the 80/20 rule is an example of a Pareto distribution - there can be any number of actual parameters - and the Pareto Distribution is just an example of a power law distribution - so when I say networks exhibit power law distributions - I don't mean they all have 80/20 Pareto distributions. Its just that the 80/20 rule is known and hopefully illustrates the point]
Friday, December 10, 2010
Capitalism at the Brink
Recent data released by the Federal Reserve sheds more light as to just how bad things really were in late 2008 - and arguably even today. This Washington Post article summarizes some of it: http://www.washingtonpost.com/wp-dyn/content/article/2010/12/01/AR2010120104658.html?sid=ST2010120106876. As we all should know at this point, the Fed was helping a lot more than was admitted to. I looked at what I think was the raw data behind this article (http://www.federalreserve.gov/newsevents/reform_cpff.htm ) and I looked at just the first 3 months of the data. Between the end of October 2008 and January 2009, the Federal Reserve purchased from securities dealers, banks and finance companies over $380 billion worth of commercial paper. Commercial paper is (was) typically considered to be the highest quality, most liquid type of capital market security. The fact that the Fed had to buy this paper means 2 things: 1) the banks, dealers and finance companies would probably not have been able to raise money (by selling these short-term investments they owned) without the Fed help (and therefore may have defaulted themselves). 2) The issuers of this commercial paper were most likely unable to borrow though the capital markets themselves, and thus may have also defaulted. The issuers (ultimate borrowers) of the paper included "good" companies like GE, Caterpiller, Toyota and Harley Davidson. So in effect, by being willing to buy commercial paper issued by these companies, the Federal Reserve was telling the shell-shocked capital markets to "Please calm down! - Look! We will buy assets from you if you get in a liquidity pinch yourself. So don't worry about buying commercial paper, because if you need to sell it you will always be able to look to us." This was just one small part of what was the implicit government guarantee of the financial system. It also is an indication of how quickly a financial crisis was going to translate into "real America". Defaults of major US companies were imminent and would escalate rapidly.
By the way, I spoke to a couple of people recently who claim that they received no benefit from the bailout. I contend that while we can look at some evil individuals who unfairly benfited by this disastor, the biggest aggregate group of beneficiaries are : anyone with a bank account, retirement plan, money market account, stocks, real estate and anyone who owns or works for a business who borrows money from anyone or who has customers with any of those assets. In fact, I would go so far as to say anyone who relies on a functioning civilization was a beneficiary.
I am amazed at the number of people who have, say, a retirement income and bank accounts, and think they are insulated from this issue. Just look at the balance sheet of a retirement fund or of a bank. You will not find your cash anywhere! Instead you will find things like stocks, real estate, business loans, commercial paper and deposits in other banks.
By the way, I spoke to a couple of people recently who claim that they received no benefit from the bailout. I contend that while we can look at some evil individuals who unfairly benfited by this disastor, the biggest aggregate group of beneficiaries are : anyone with a bank account, retirement plan, money market account, stocks, real estate and anyone who owns or works for a business who borrows money from anyone or who has customers with any of those assets. In fact, I would go so far as to say anyone who relies on a functioning civilization was a beneficiary.
I am amazed at the number of people who have, say, a retirement income and bank accounts, and think they are insulated from this issue. Just look at the balance sheet of a retirement fund or of a bank. You will not find your cash anywhere! Instead you will find things like stocks, real estate, business loans, commercial paper and deposits in other banks.
The Inequality Formula
As a follow-up to my discussion on the Pareto Distribution and the distribution of wealth in society, I note a recent article in Bloomberg Businessweek magazine from October 25, 2010. ( http://www.businessweek.com/magazine/content/10_44/b4201008238184.htm ) This article "The Inequality Delusion" by Drake Bennet discusses an upcoming study by two psychologists [Dan Ariely from Duke and Michael Norton from Harvard Business School] on how wealth in the US is actually distributed and how starkly this distribution differs from most peoples' expectation. For example, when people in a large survey were asked what percentage of the nation's wealth was controlled by the richest 20%, the average response was 59%. When asked what they believed would be an ideal percentage, the average response was that the richest 20% of the people should control just 32% of the nation's wealth. The "actual" percentage of the nation's wealth controlled by the richest 20% is...... 84%! Shocking! Well, maybe not too shocking since this is essentially what Pareto found in his initial studies of the same phenomenon through history. It is essentially the 80/20 rule as described by the Pareto Distribution.
I'll admit I was a little surprised by this article. First, do people on average really believe that the richest 20% of the people should control just 32% of the nation's wealth? Wow! Second, while my guess on the survey question would have been 80% because that is roughly what Pareto found, I am still surprised at how close it was to that number. As big a fan as I am about this whole concept, I feel there has got to be a tremendous data problem - specifically: "how do you measure wealth?" I would think that the variability of wealth measurement methods and quality of data would significantly shift the results from study to study. Also, socialist or communist societies have a whole different conception of wealth and ownership. My feeling is that in a communist society the same 80/20 rule may still hold, but only if you change the concept of wealth ownership to "ability to control resources" such as through political power. My understanding is that Pareto himself was socialist/communist earlier in his life but became disillusioned when he saw the politically powerful in these economic systems displaying the same wealth/power grabbing behavior as their non-socialist counterparts.
Thursday, June 10, 2010
"Too Big to Fail" a book by Andrew Ross Sorkin - A Review and Comments
I just finished Too Big to Fail and found it enjoyable, but not so much that I would definitely recommend it. I think I enjoyed it more than many people would because I was in the financial industry, did business with all of the firms mentioned in the book and I was familiar with a few of the people.
The book covers the financial crisis from the failure of Bear Stearns in early 2008 through the failure of Lehman and AIG and it ends with the introduction of the TARP program in late 2008. There is a little back story on the career of a few of the major people such as Bernanke, Paulson, Geithner and Fuld (at Lehman) but most of the book is structured as sequential snapshots of conversations and meetings. The pacing of these snapshots is leasurely at first but by the end is frenetic as the book switches back and forth in minute to minute conversations as people desperately try to stop a immanent economic catastrophe. I found this pacing annoying because I had a hard time following the timeline. Early on, there could be months between snapshots but by the end they were minute to minute - and it wasn’t clear just when things were happening. But this escalating pacing did provide what little sense of story the book had.
This book is a documentary - not a story. It covers a lot conversations among a long list of people most of us have never heard of and in whom we probably have no interest. And it covers events which, if viewed in isolation, without proper context, have little meaning. So while I say this book is a documentary - it is arguably not a good documentary because a good documentary should give the reader a sense of context as to what led up to the events, what sort of environment they took place in and why they were important.
That said, I found the book interesting - but I have a painfully intimate knowledge of the institutional money flows that keep businesses afloat and the economy running. So I already had a sense of context. I imagine that most people who follow the markets will also have enough sense of context to enjoy the book - but perhaps may not understand the sense of imminent catastrophe that drove the actors.
I have a few takeaways:
1) People were amazingly naive for an amazingly long time. Keep in mind that the institutional money markets had the equivalent of a heart attack in the late summer of 2007 and never recovered. This was more than 6 months before Bear Stearns fell and more than a year before Lehman failed. The institutional money market is like the blood flowing through the body of the economy. It is taken for granted, but if it stops flowing, it isn’t long before the major organs fail. The body in this case had enough money in its system to last 6 months, then the organs started to fail. Concentrating on poor asset quality and the mortgage market is like a Doctor concentrating on a broken arm or perhaps even cancer. Bad, but certainly not immediately fatal. The immediate problem was that patient was dying from lack of blood flowing through the body.
2) People were so fixated on hedge funds selling short financial stocks and fraud in the mortgage industry that they seem to have ignored the far more important fact that money - the blood of the system, had stopped flowing. As evidence of this, the book relays many conversations where CEOs are ranting about short sellers driving down their stock price and as though that was the real problem. And yet none of the companies were at risk of collapse because their stock was going down. The companies were collapsing because they were running out of money - as in cash. And even while they were trying to sell any and every asset in the company to pay off the next bill coming due, they ranted about short sellers. Financial companies always have big bills coming due - they are 70% to 99% financed by debt. They don’t need to pay off the stockholders. They need to pay off their debt coming due.
3) It seems that Goldman Sachs alumni are everywhere. The book never pointed to this being a real problem, but I can sure see that when it looked like “even Goldman Sachs” would fail within the week, then the line in the sand was drawn right then and there. No one could imagine a world without Goldman Sachs.
4) Senior executives didn’t seem to understand their own business. [no surprise] This was particularly clear at AIG when they woke up to the fact one day that Securities Lending was going to cost them a boatload of money and it sounded like they didn’t even know what Securities Lending was. The whole “short-sellers” controversy that CEO’s ranted about was just an indication they didn’t realize the real issue. The regulators weren’t any better. They ignored the fact that AIG was insolvent for months before it finally fell. They were looking at Lehman when “surprise surprise” AIG collapses. All of these events followed a fairly clear trajectory and the regulators should have been able to connect the dots.
5) Even when the ship is sinking - people still think “will my deck chair be comfortable”. CEO’s cared about short-sellers because they drove down stock prices and that is where the CEO’s had their wealth. Never mind that the company is dying - how is the stock doing. Also, even in the final dying moments of the firms, people still stalled and delayed so they would have a great job in the new company.
6) In the final days before TARP, Geithner ran the show - he was the real deal maker. He sounds like an egomaniac and someone eager to make the “necessary” decision. Paulson sounds like he was in denial but then “woke up” and made TARP happen. In the book, Bernanke sounds like someone always running a few weeks behind events. Cox at the SEC and Fuld at Lehman were punchlines to a bad joke.
7) My interpretation of the events surrounding the BofA / Merrill combination is that Ken Lewis, the CEO of BofA, was an idiot. Merrill Lynch was failing!! It could have been bought from the Government the very next day for free and with probable Government guarantees attached. But Ken Lewis was so wrapped up in his victory dance that he was buying THE Merrill Lynch at a “cheap” price that he completely missed the fact that THE Merrill Lynch was now worthless. And it doesn’t sound like the Government promised him anything. They were hoping BofA was going to buy Lehman. It sounds like the Government wasn’t even that aware that Merrill was about to fail until it almost did.
8) Although the book was full of egomaniacs, jerks, nice guys and idiots, there were no real “bad guys” and no real “good guys” as related to the crisis. Everyone was just caught up in something they had never experienced before and was responding in their own individual way, usually just looking out for themselves or just trying to get through the day. No one plotted to destroy the world.
9) There was a point where the people in the book, well at least most of the people, seemed to have woken up to the problem. It’s like there was a light switch. First it was “we will not support...” and then it was “oh shit...”
When this “oh shit....” realization finally hit, no one really talked about what “oh shit...” meant. It is pretty clear that at a minimum their “oh shit...” meant that all the investments banks would fail. Morgan Stanley was within days of failure and Goldman Sachs would fail “30 seconds” behind that. Then what? Wachovia Bank was already failing and had to be merged, Citi and Bank of America had major issues. Were they next? Other than the unthinkable event of Goldman Sachs failing, the closest the book came to really descibing the full “oh shit...” scenario is that GE would soon fail. But the book never went farther and it implies that the major players kept their mouth shut on just how bad it could be. I believe they kept their mouth shut because they were truly afraid and they didn’t want to voice their real concerns from fear it would accelerate the problem.
So I will give my full version of “oh shit...” If allowed to run unchecked, the small amount of money still flowing through the system would have shut down completely. Investors, due to a combination of prudence, legal requirements and due to their own cash needs would be forced to stop investing in anything that wasn’t Government backed. The investment banks would fail within a week - this meant Morgan Stanley and Goldman Sachs. Citi and BofA would have had major funding crisis within days primarily due to their need to fund massive commercial paper programs. The Government would have been forced to step in at some point - though in this scenario, only small depositors would be covered so there would be trillians of dollars lost to investors and large depositors. All other banks would soon face a funding crisis and would be forced to operate with “negative capital”. GE would have been unable to roll its short term-debt within weeks and would be forced into bankruptcy. (actually most of this was already being talked about) All commercial finance companies would fail along with GE. With the collapse of commercial funding, businesses would be forced to liquidate assets and stop their activities. Even companies who didn’t borrow would see their customers disappear. Layoffs would begin in real earnest.
But then it gets really scary. Municipalities would not be able to issue debt and make payrolls. Basic services would gradually be cut back. Pension funds, foundations, universities, health systems would take massive losses across all asset classes, but worse yet, most their cash is invested in short term debt of financial companies which are no longer paying off. Without cash, pension payments and payrolls are missed. In fact all companies put their payroll and working capital cash in banks and money market funds. These companies can’t make payrolls. The courts would be come clogged. The Government would be forced to call out the military to handle a suddenly impoverished under-policed populace. Foreign governments would begin to default... (Greece, Hungary, Egypt, Spain, Iceland, England, Russia...) Let’s just say it gets a lot worse even from here. The world collapses along the same mechanisms that in better times make it work.
I believe this is what really scared the shit out of Paulson and company. He looked over the edge and saw the abyss. What was unthinkable in our normal world, became the all too possible.
So that is the real meaning “Too Big to Fail”. If a failure leads to even the possibility of global financial and social meltdown, then its just too big and can’t be allowed to happen.
10) In school, we are taught to think using the paradigm of a “normal” distribution - the traditional bell curve. If you think of the world as following a normal distribution of events, then no natural failure is truly too big. Bad things can happen, but they aren’t really really bad and eventually everything will return to normal. This is the world view of those who say “let them fail - we will recover”. In this pretend world, truly catastrophic failures can’t happen on their own. So if they do happen, they must be caused by someone doing something massively evil. I would say that this is the base-case view of most people, even those who don’t know what a normal distribution is. It is certainly the view pushed by the media and politicians.
But if you think of a world built using networks (such as a financial system) then the distribution of possible events isn’t normal distributed - it follows a Pareto/power-law distribution. And under this paradigm, events can truly become too too big - where a single event can dramatically affect the entire system. - even destroy it. And under this paradigm, catastrophic events can occur naturally. You can always find scapegoats after the fact, but they are not really the cause.
This book is a documentary - not a story. It covers a lot conversations among a long list of people most of us have never heard of and in whom we probably have no interest. And it covers events which, if viewed in isolation, without proper context, have little meaning. So while I say this book is a documentary - it is arguably not a good documentary because a good documentary should give the reader a sense of context as to what led up to the events, what sort of environment they took place in and why they were important.
That said, I found the book interesting - but I have a painfully intimate knowledge of the institutional money flows that keep businesses afloat and the economy running. So I already had a sense of context. I imagine that most people who follow the markets will also have enough sense of context to enjoy the book - but perhaps may not understand the sense of imminent catastrophe that drove the actors.
I have a few takeaways:
1) People were amazingly naive for an amazingly long time. Keep in mind that the institutional money markets had the equivalent of a heart attack in the late summer of 2007 and never recovered. This was more than 6 months before Bear Stearns fell and more than a year before Lehman failed. The institutional money market is like the blood flowing through the body of the economy. It is taken for granted, but if it stops flowing, it isn’t long before the major organs fail. The body in this case had enough money in its system to last 6 months, then the organs started to fail. Concentrating on poor asset quality and the mortgage market is like a Doctor concentrating on a broken arm or perhaps even cancer. Bad, but certainly not immediately fatal. The immediate problem was that patient was dying from lack of blood flowing through the body.
2) People were so fixated on hedge funds selling short financial stocks and fraud in the mortgage industry that they seem to have ignored the far more important fact that money - the blood of the system, had stopped flowing. As evidence of this, the book relays many conversations where CEOs are ranting about short sellers driving down their stock price and as though that was the real problem. And yet none of the companies were at risk of collapse because their stock was going down. The companies were collapsing because they were running out of money - as in cash. And even while they were trying to sell any and every asset in the company to pay off the next bill coming due, they ranted about short sellers. Financial companies always have big bills coming due - they are 70% to 99% financed by debt. They don’t need to pay off the stockholders. They need to pay off their debt coming due.
3) It seems that Goldman Sachs alumni are everywhere. The book never pointed to this being a real problem, but I can sure see that when it looked like “even Goldman Sachs” would fail within the week, then the line in the sand was drawn right then and there. No one could imagine a world without Goldman Sachs.
4) Senior executives didn’t seem to understand their own business. [no surprise] This was particularly clear at AIG when they woke up to the fact one day that Securities Lending was going to cost them a boatload of money and it sounded like they didn’t even know what Securities Lending was. The whole “short-sellers” controversy that CEO’s ranted about was just an indication they didn’t realize the real issue. The regulators weren’t any better. They ignored the fact that AIG was insolvent for months before it finally fell. They were looking at Lehman when “surprise surprise” AIG collapses. All of these events followed a fairly clear trajectory and the regulators should have been able to connect the dots.
5) Even when the ship is sinking - people still think “will my deck chair be comfortable”. CEO’s cared about short-sellers because they drove down stock prices and that is where the CEO’s had their wealth. Never mind that the company is dying - how is the stock doing. Also, even in the final dying moments of the firms, people still stalled and delayed so they would have a great job in the new company.
6) In the final days before TARP, Geithner ran the show - he was the real deal maker. He sounds like an egomaniac and someone eager to make the “necessary” decision. Paulson sounds like he was in denial but then “woke up” and made TARP happen. In the book, Bernanke sounds like someone always running a few weeks behind events. Cox at the SEC and Fuld at Lehman were punchlines to a bad joke.
7) My interpretation of the events surrounding the BofA / Merrill combination is that Ken Lewis, the CEO of BofA, was an idiot. Merrill Lynch was failing!! It could have been bought from the Government the very next day for free and with probable Government guarantees attached. But Ken Lewis was so wrapped up in his victory dance that he was buying THE Merrill Lynch at a “cheap” price that he completely missed the fact that THE Merrill Lynch was now worthless. And it doesn’t sound like the Government promised him anything. They were hoping BofA was going to buy Lehman. It sounds like the Government wasn’t even that aware that Merrill was about to fail until it almost did.
8) Although the book was full of egomaniacs, jerks, nice guys and idiots, there were no real “bad guys” and no real “good guys” as related to the crisis. Everyone was just caught up in something they had never experienced before and was responding in their own individual way, usually just looking out for themselves or just trying to get through the day. No one plotted to destroy the world.
9) There was a point where the people in the book, well at least most of the people, seemed to have woken up to the problem. It’s like there was a light switch. First it was “we will not support...” and then it was “oh shit...”
When this “oh shit....” realization finally hit, no one really talked about what “oh shit...” meant. It is pretty clear that at a minimum their “oh shit...” meant that all the investments banks would fail. Morgan Stanley was within days of failure and Goldman Sachs would fail “30 seconds” behind that. Then what? Wachovia Bank was already failing and had to be merged, Citi and Bank of America had major issues. Were they next? Other than the unthinkable event of Goldman Sachs failing, the closest the book came to really descibing the full “oh shit...” scenario is that GE would soon fail. But the book never went farther and it implies that the major players kept their mouth shut on just how bad it could be. I believe they kept their mouth shut because they were truly afraid and they didn’t want to voice their real concerns from fear it would accelerate the problem.
But then it gets really scary. Municipalities would not be able to issue debt and make payrolls. Basic services would gradually be cut back. Pension funds, foundations, universities, health systems would take massive losses across all asset classes, but worse yet, most their cash is invested in short term debt of financial companies which are no longer paying off. Without cash, pension payments and payrolls are missed. In fact all companies put their payroll and working capital cash in banks and money market funds. These companies can’t make payrolls. The courts would be come clogged. The Government would be forced to call out the military to handle a suddenly impoverished under-policed populace. Foreign governments would begin to default... (Greece, Hungary, Egypt, Spain, Iceland, England, Russia...) Let’s just say it gets a lot worse even from here. The world collapses along the same mechanisms that in better times make it work.
I believe this is what really scared the shit out of Paulson and company. He looked over the edge and saw the abyss. What was unthinkable in our normal world, became the all too possible.
So that is the real meaning “Too Big to Fail”. If a failure leads to even the possibility of global financial and social meltdown, then its just too big and can’t be allowed to happen.
10) In school, we are taught to think using the paradigm of a “normal” distribution - the traditional bell curve. If you think of the world as following a normal distribution of events, then no natural failure is truly too big. Bad things can happen, but they aren’t really really bad and eventually everything will return to normal. This is the world view of those who say “let them fail - we will recover”. In this pretend world, truly catastrophic failures can’t happen on their own. So if they do happen, they must be caused by someone doing something massively evil. I would say that this is the base-case view of most people, even those who don’t know what a normal distribution is. It is certainly the view pushed by the media and politicians.
But if you think of a world built using networks (such as a financial system) then the distribution of possible events isn’t normal distributed - it follows a Pareto/power-law distribution. And under this paradigm, events can truly become too too big - where a single event can dramatically affect the entire system. - even destroy it. And under this paradigm, catastrophic events can occur naturally. You can always find scapegoats after the fact, but they are not really the cause.
Monday, June 7, 2010
More on Pareto Distributions
In 1896, Vilfredo Pareto researched the distribution of income and wealth patterns of different countries and in different times. Through this research he found that, across the population of a country, both income and wealth are distributed in a special pattern - one that follows a function: log(N) = log(A) + m log(x) [where N represents the number of people with wealth greater than x, and where A and m are constants]. After fitting the data to this function, Pareto found that about 20% of the people controlled roughly 80% of the wealth in a country - and that this relationship held across the different times and places he studied. This finding was the birth of the "80/20 Rule."
Pareto’s equations didn’t stop there though. They didn’t just predict the data at the 80/20 point and stop. They predicted an entire probability distribution. If you follow the logic of the Pareto Principle:
This type of distribution isn't just limited to income and wealth distributions. We see Pareto and power law distributions in the financial markets, geology, physics, politics, traffic patterns, the internet and biology - just to name a few. For example, you might see the Pareto distribution in the occurrence of forest fires in California. If we applied the same 80/20 pattern here you might find that:
One thing is clear - this new type of distribution is not normal. By that I mean it isn't a “normal” distribution or bell curve you might have studied in college. A "normal" distribution tends to be well behaved in a statistical sense. It describes environment where wild events happen very rarely and when they do, they aren't so wild that they mess up the averages. Pareto distributions (and power law distributions) on the other hand can describe environments where wild events are also rare, but when they do happen they can be very, very wild - far wilder than would be conceivable using a normal distribution. Out of the thousands of earthquakes that occur every year, most are not even felt, but then one occurs which destroys a city. Or after months and months of "normal" financial markets, we get a massive and rapid selloff. These events wouild be typical of power law distributions.
What causes these distributions to show up? We don’t know yet. But one theory is that they all come from types of environments that can be structured as networks. I believe that the Pareto/power law distribution is in fact a signature or fingerprint of a networked environment. Along the same line of thinking, if you are dealing in an environment that operates as a network, you should expect to see this type of distribution to show up. If this theory is true, it provides the answers as to why we see the 80/20 rule so often in business settings. Business environments are all about networks - supply chain networks, computer networks, networks of traders, all sorts of networks but most importantly - social networks.
Pareto’s equations didn’t stop there though. They didn’t just predict the data at the 80/20 point and stop. They predicted an entire probability distribution. If you follow the logic of the Pareto Principle:
- the bottom 80% of the population controls only 20% of a country's wealth = “the poor”
- the top 20% of the population controls 80% of the wealth = “wealthy”
- the top 4% of the population (20% of 20%) controls 64% (80% of 80%) of the total wealth = “very wealthy”
- the top 0.8% of the population controls 51% of the total wealth = “the super wealthy”
This type of distribution isn't just limited to income and wealth distributions. We see Pareto and power law distributions in the financial markets, geology, physics, politics, traffic patterns, the internet and biology - just to name a few. For example, you might see the Pareto distribution in the occurrence of forest fires in California. If we applied the same 80/20 pattern here you might find that:
- the smallest 80% of the fires in California cause only 20% of the damage - most of these fires would not be reported or even noticed.
- the largest 20% of the fires cause 80% of the damage
- the top 4% of the fires cause 64% of the damage
- the top 0.8% of the fires cause 51% of the damage - these are the ones that make the news.
One thing is clear - this new type of distribution is not normal. By that I mean it isn't a “normal” distribution or bell curve you might have studied in college. A "normal" distribution tends to be well behaved in a statistical sense. It describes environment where wild events happen very rarely and when they do, they aren't so wild that they mess up the averages. Pareto distributions (and power law distributions) on the other hand can describe environments where wild events are also rare, but when they do happen they can be very, very wild - far wilder than would be conceivable using a normal distribution. Out of the thousands of earthquakes that occur every year, most are not even felt, but then one occurs which destroys a city. Or after months and months of "normal" financial markets, we get a massive and rapid selloff. These events wouild be typical of power law distributions.
What causes these distributions to show up? We don’t know yet. But one theory is that they all come from types of environments that can be structured as networks. I believe that the Pareto/power law distribution is in fact a signature or fingerprint of a networked environment. Along the same line of thinking, if you are dealing in an environment that operates as a network, you should expect to see this type of distribution to show up. If this theory is true, it provides the answers as to why we see the 80/20 rule so often in business settings. Business environments are all about networks - supply chain networks, computer networks, networks of traders, all sorts of networks but most importantly - social networks.
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