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3 depressions and financial crises. Failing to recognise those tail events – being fooled by randomness – riskscatastrophic policy error.So is economics and finance being fooled by randomness? And if so, how did that happen? That requires alittle history.
A Short History of Normality
(a) Normality in Physical Systems
Statistical normality had its origin in a set of physical experiments in the 17
century. Galileo discoveredmany of its fundamental properties when studying the measurement of distances to the stars. He found thatrandom errors were inevitable in instrumental observations. But these errors exhibited a distinctive pattern, astatistical regularity: small errors were more likely than large and were symmetric around the true value.This “reversion to the mean” was formalised in 1713 by Jacob Bernoulli based on a hypothetical experimentinvolving drawing coloured pebbles from a jam-jar.
The larger the number of drawings, the greater thechance that the observed number of coloured balls approximated its true average value. Although the gamewas simple, its implications were far-reaching. By simply taking repeat samplings, the workings of anuncertain and mysterious world could seemingly be uncovered.The date when the normal distribution was formally introduced is known with precision. OnNovember 12, 1733, the second edition of
The Doctrine of Chances
by Abraham de Moivre first plotted thebell curve. This was based on the probability distribution of another repeat game of chance – the number of"heads" which appeared when a fair coin was tossed. Such was the beauty of the distribution uncovered bythis experiment, de Moivre “ascribed it to the Almighty”.
Understanding of the normal curve was advanced in the early 19
century by two mathematicians,Carl Friedrich Gauss and Pierre Simon de Laplace. Gauss, a maths genius, was using the curvature of theEarth to improve the accuracy of geographic measurements in the Bavarian hills. He observed that thedistribution of estimates varied widely, but tended to cluster around a mean with symmetry either side.Gauss also forged a link between the normal curve and a particular approach to statistical inference – the“least squares” method. He pioneered the least squares method to locate the dwarf planet
,minimising random errors from astronomical observations earlier provided by Italian monk Piazzi. This linkbetween normality and least squares has continued to this day.