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July 7, 2012

Pareto

History of normal distribution and how its extensive usage made economics/finance abnormal

ANDY HALDANE of the Bank of England keeps coming up with one terrific paper after the other. In his latest, Haldane looks at the history of normal distribution, why it was given the name normal, how it moved from sciences to social sciences and finally into economics and finance.

Just like his other papers, this one covers many topics, making it difficult to summarise all the thoughts. At a very broad level his idea is that we should not be blinded by the beauty of the normal distribution curve. In fact, there is very little in economics and finance that resembles normal distribution which has thin tails. Most economics and finance distributions have fat tails. Fat tails implies probability of extreme events is much higher than assumed by normal distributions. Once we start estimating fat tails in say finance, costs of many products and overall costs and capital ratios will be much higher.

Our beliefs in normal distribution remain high and are fooled by randomness whenever there is a crisis. He rightly says: “If public policy treats economic and financial systems as though they behave like a lottery- random, normal- then public policy risks itself becoming a lottery.”

Understanding Bank Runs

RAJKAMAL IYER and MANJU PURI analyse a bank run which occurred because of the failure of a major bank in the State of Gujarat. The authors have collected micro data of each depositor and minute by minute activity of the first bank. This helps them understand several reasons for the bank run.

First surprise finding is that deposit insurance is not effective. The people who have loans as well as deposits are less likely to run. This is perhaps because such people are afraid that the bank will not give them loan in the future. They also happen to be more sticky customers of the bank. The longer bank-depositor relationship leads to lower likelihood of a withdrawal during the crisis.

Social networks also matter- if other people in a depositor’s network run, the depositor is more likely to run. Even timing of the bank runs matter as depositors withdraw during the morning. Those who came via introducers withdraw in the afternoon. The reason is that one gets to know from neighbours of a run first thing in the morning. Whereas, introducers usually tend to be colleagues at office who inform the depositors at the work place. They show most depositors do not come back to redeposit funds. Hence, policymakers could be looking to protect banks from runs.

Photo: Casey Sarin

How India moved from Silver Standard to Gold Standard in 1870s

MARC FLANDREAU and K. OOSTERLINCK in a must read, explain how Indian currency system moved from a bimetallic standard to the gold standard in the 1870s.

There is huge debate about what led to the emergence of the gold standard in 1870s. Before the gold standard, we had bimetallism where both silver and gold were used for minting currency. There are two views on why this switch happened. Older one believes that it was because of supply shock which led to large rises in the supply of silver. The newer view says it was France’s political decisions which led to the switch.

The authors use a natural experiment of India’s bond markets in the 19Th century to understand the reasons. India offered both sterling and silver-based rupee bonds. India’s rupee remained staunchly on the silver standard till 1870s and maintained the free coinage of silver and silver-convertibility of rupees until 1894 (Keynes 1913).

As both bonds were issued by the same government, there was only one major difference- the silver exchange rate risk. The authors go onto show that till 1873 there was no silver premium between the two bonds. Post 1873 investors demanded a silver premium to hold silver based rupee bonds.

Thus the paper shows it was French decision to switch to Gold standard in 1873 which led to the switch to Gold standard.

Why veiling is rising amidst Muslim Women?

JEAN-PAUL CARVALHO looks at the reasons for the rise in veiling amidst Muslim women. Surprisingly it is rising among educated urban women.

As per Carvalho, veiling acts as a commitment mechanism which limits temptation to violate religious norms. Agents who succumb to temptation experience regret and/or social disapproval. This mechanism helps link the new veiling movement to economic and social changes experienced by Muslim women around this time. The most important changes are urbanisation and migration, especially to Europe and the United States. This has led to influx of women into formal education and employment and created tensions.

Exploiting the new economic opportunities meant exposure to more liberal environments which might have been social disapproval. Veiling thus emerged as a strategy to balance these competing concerns, by publicly committing an individual to religious standards of behaviour. Veiling also acted as a strong signal to other communities for not pressurising Muslim women into activities not tolerated by the latter’s religion.

This has policy implications as well. Countries which ban veiling or look to ban veiling could prove counterproductive. It could lead to induce religious types to forego economic opportunities and segregate in their local community as a costly substitute for veiling.


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