We’ve witnessed the Arab Spring, where entire cultures turned on a dime, rose up and overthrew regimes that had ruled for generations. Financial crises start with obscure acronyms and reverberate throughout our society. We appear to be in uncharted territory.
But is that really so or are we just becoming aware of realities that until now we’ve been blissfully ignoring? Before the digital age, we were able to sequester our organizations behind legal and organizational barriers, staving off the tides of evolutionary change. That’s becoming less and less tenable. Our challenge now is to face those forces head on.
The old world
On New Years Day, 1801, Giuseppe Piazzi discovered the dwarf planet Ceres in the winter sky. It was only a fleeting glance and soon disappeared from sight. However, a young math whiz named Carl Friedrich Gauss was able to calculate where it would show up next. A short time later, Ceres reappeared in the sky exactly where the 24 year-old phenom predicted. This miracle was made possible by Gauss’s method of least squares, which fits messy data into a smooth pattern. At the heart of the method is the idea that errors in observation are random and therefore are normally distributed like this:
This concept, encapsulated in the Gauss-Markov theorem, forms the basics of modern statistical analysis. We use it to predict everything from defects in factories to defaults on loans. Mathematical finance, which drives the models that run Wall Street, owes a lot to that little planet.
Chaos
Nearly a century passed when, in 1906, the first flaw was found in the gem of mathematical perfection that Gauss had spawned. It was in that year that Vilfredo Pareto published his famous study on wealth distributions and declared that 20% of societies tend to possess about 80% of the property.
This principle, named after its discoverer, follows a power law distribution that looks like this:
Another half century went by before a young researcher at IBM labs named Benoit Mandelbrot found very similar distributions in signal distortions in communication lines. He didn’t stop there though. Before long, he was finding power laws everywhere, from the flooding of the Nile river to word distributions in texts to financial markets.
More recently, Chris Anderson of Wired magazine noticed that digital technology was bringing power laws to he fore. He argued that improved market mechanisms were making the low volume products that make up 80% of commerce newly profitable. He dubbed this phenomenon The Long Tail.
The inexplicability of interactivity
So why do things like communication lines and markets and word distributions act so different than the celestial bodies that Gauss applied his famous formula to?
For that matter, why is that when we look at people in terms of height or weight or strength or speed they look so much like Gauss’ bell curve, but when we look at how much money people have or how they spend it we get an 80/20 rule?
The answer is feedback. While inert objects simply bounce off of each other, entities in living systems influence one another. The rich really do get richer. While nothing succeeds like success, failure often begets more failure. As Malcolm Gladwell pointed out in his book Outliers, a small advantage can snowball into dominance over time.
It’s important, crucial in fact, to make the distinction between inert systems and ones that feed back on themselves. A key factor in the latest financial crises was that, out of mathematical expediency, the wizards of Wall Street were applying Gaussian models where they clearly didn’t belong. They underestimated volatility and we all paid a price.
Emergence
In the past, we didn’t need to worry about power laws much. The frictions inherent in our old, analog way of doing things acted as safety valves. We were able to adjust to changes before things got out of hand. However, the speed of our new digital reality only tells part of the story. We not only have more interactivity, but more things interacting.
The World Bank estimates that, between 1981 and 2001, 1.5 billion people rose out of poverty. Since the World Trade Organization was established in 1995, 153 countries have joined? We have more consumers and more firms in the global economy who all get votes on what gets produced, who makes it an where.
So what happens when you have lots of people making choices which effect everyone else? Well, as Thomas Schelling explained in his 1978 classic, Micromotives and Macrobehavior, something totally unexpected. One person making a choice is decidedly different than 1 million people making the same choice.
If I decide to sell stock it’s no big deal, but if enough people have the same idea the market crashes, layoffs ensue, commerce sputters and so on. When Justin Bieber’s mother liked his singing, it was a family affair, but when enough people on YouTube agreed, others heard about it and joined the party. In a riot, even the righteous have been known to break windows.
The right side up world
All of this begs the question: Has the world really turned upside down or is if finally going right side up? Through millions of years of natural history, organisms have come to dominate only to be then driven to extinction by forces beyond their control. Why should we be any different? Has the world changed, or just our perception of it.
I would argue the latter. Mandelbrot pointed out the probelems in the models of mathematical finance as early as 1964. Phillip Tetlock, in his 20 year study of political experts, concluded that their analyses were scarcely better than flipping a coin. Look at just about any activity and the vast majority of people consider themselves above average.
The inescapable truth is that in our digitized, networked age we can no longer ignore uncomfortable realities. We can’t take solace in the idea that things will even out or follow the pretty, clean models of statistical analysis. Rather, they can blow out of all proportion or be laid asunder in the blink of an eye. No one is safe.
Our world is messy, as it should be. Anything else would be not only boring, but dishonest.
Greg Satell is a blogger and a consultant at the Americal online media Digital Tonto. You can read his blog entries at http://www.digitaltonto.com
