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PROFESSOR: So what I want to do is continue
talking about risk.
We've already talked about risk quite a bit last time.
And what I want to do partly is sort of emphasize some
specific points and, I think, partly go over some of the
ideas that have to do with a community
sharing its own risk.
So rather than risk through formal insurance markets, talk
about what happens if people try to insure each other.
And what that does is it creates a nice context for
thinking about institutions in general and the fact that
people live together, how that might actually change their--
I think it's the display settings.
I think we need to move to--
SPEAKER 1: [INAUDIBLE].
PROFESSOR: OK.
So how the fact that people live together in one place and
have to deal with each other on a long run basis, how that
affects the ways in which they can structure their economic
lives to help each other.
So it gets into a question which is beyond, I think,
moving us beyond what we'd usually be talking about,
which is individual decision making, towards a more
collective action kind of perspective.
So we want to slowly move towards not just what happens
at the level of the individual, by why doesn't the
collectivity together generate good outcomes?
And this is a good in to that question.
So we're going to talk.
So I'll give you a set of examples of collective action,
and we'll start talking a bit about the collective efforts
to improve things.
I'm not sure what's happening.
But we'll figure this out.
So the first, just to remind you, we were talking about
risk and, in particular, the fact that poor people face
extremely high levels of risk.
I said that yesterday, and today I'll show you some
numbers on that just to get us on to that.
Just to summarize where we were last time, what we talked
about primarily were sort of both that the poor face a lot
of risk and that they do a lot of things to mitigate risk,
but those things are not necessarily good for them.
So the examples we talked about or, for example, going
to work when your income goes down.
But when you go to work when your income goes down,
typically that's when everybody else's
income also went down.
So they also all go to work.
That drives wages down and makes everybody
potentially worse off.
And the second example--
what's another example of a costly thing you could do to
mitigate risk?
Yep.
AUDIENCE: Farm separate pieces of land that are far apart
from each other.
PROFESSOR: Right.
Farm separate pieces of land far apart so that they don't
have the same risk profile.
AUDIENCE: You could choose not to take a crop that might be
more successful because you're worried that if you spend
money to buy new seeds and it doesn't turn to be as
successful then you loose more money than if you just used
your seeds from the previous crop.
PROFESSOR: Any other?
AUDIENCE: Choosing a bunch of different jobs instead of
specializing in one.
PROFESSOR: Yep.
Choosing a bunch of different jobs rather than doing one.
Why do you want to specialize?
AUDIENCE: It allows you to become more
productive, more skilled.
PROFESSOR: So you give up--
sorry?
AUDIENCE: I was just going to say efficiency.
PROFESSOR: Efficiency, exactly.
You just get better at a job if you do it more with more
[INAUDIBLE].
Yeah.
AUDIENCE: [INAUDIBLE].
PROFESSOR: Yeah.
AUDIENCE: [INAUDIBLE]
Like, if you were doing 15 classes [INAUDIBLE].
PROFESSOR: 15 is a high number.
[LAUGHTER]
PROFESSOR: OK.
So I think you can see the logic of this.
So the question is we already talked a bit about kind of the
market for insurance.
What we didn't talk as much about is why don't people help
each other?
One solution to this problem is just helping each other.
So the logic of helping each other is very, very simple.
We each get maybe independent shocks and so it's quite
likely that, you know, when somebody else gets a shock, I
don't and vice versa.
So we can kind of split the shock.
So if anything bad happens, we don't bear all of it.
We can pass on a part of it to somebody else.
That seems straightforward.
So why doesn't that solve most problems?
That's sort of the question that we're going to spend some
time thinking about.
It's a very simple idea, right?
We don't need to go to an insurance company.
We can just pool together our own risk.
AUDIENCE: [INAUDIBLE]
like, the cost of living [INAUDIBLE] cost?
Like, how many people are you going to pool
together for that?
And sometimes people think that they shouldn't have to
pay for someone else's--
PROFESSOR: How many people should we pool together?
AUDIENCE: As many as possible.
PROFESSOR: Why as many as possible?
AUDIENCE: Because then it's more diversified.
PROFESSOR: Right.
So if we think that--
so you have the example, the probability, here, let's say
they have independent probabilities.
Two people, they have a probability of a quarter that
they both end up with a bad shock, right?
What's that probability if there were n people?
AUDIENCE: 1/n squared?
PROFESSOR: N squared.
Think about what were the probability.
The probability is half that--
I think you meant the other.
You just inverted the exponents.
It's 1 over 2 to the power n.
I think you're writing it in--
it's 1 over 2 to the power n.
So as n goes to infinity, the number of people who get
shocks together is going to 0.
So that's sort of a very simple idea.
So the question is why doesn't it happen?
And that's sort of what we're going to spend our time
talking about.
So it does happen.
The first answer is it does happen.
So here's a nice, nice example.
And it says something about--
actually, it's an interesting example.
So it turns out that the way to work in Nigeria, I don't
actually give you money.
I don't actually give you money when something bad
happens to you.
What do I do?
I loan you money and in particular if you're expected
to pay me back, I ask for less payback.
If I'm expected to pay you back, I pay you more than what
I was supposed to owe you.
So usually interest contracts tend to be completely
inflexible.
You know, my mortgage is quarter of 5.4%.
I pay 5.4% every year until the market is paid.
That's not what credit looks like in Nigeria.
In these villages you found that the interest rate itself
is very flexible.
So I pay more than what I owed, in some sense, when you
are doing badly and I pay less than what I owed when you're
doing well.
That's a way to provide insurance, but it goes through
this cover of a loan.
AUDIENCE: How do they determine if someone has an
adverse [INAUDIBLE]?
You know, like, through word of mouth?
PROFESSOR: Perfectly good question.
We'll come back.
Let's come back to that.
I want to spend a minute, before we get to that
question, on a more basic question, which is why do you
think they do this?
Why do you think that they go through this loan mechanism?
So then what they seem to be doing is paying you more on
your loan when you do badly and paying you less on your
loan when the payer is doing badly.
Why does that make any sense?
What could be driving that structure?
Yep.
AUDIENCE: Because they know that later on when they'll
probably be doing badly that they'll get a break and that
it'll help them out.
PROFESSOR: But why don't they just give them money?
Why through the loan?
The question here I'm asking is why is it that I give you a
discount on your loan rather than just
handing you some cash?
What is that pointing to?
AUDIENCE: Desire to not to feel like
you're giving a handout.
PROFESSOR: So one possibility is that you it's sort of a
cover, right?
That's an interesting idea.
It's a cover for I'm giving you the money.
But it's not so much that people are not seeing that I'm
handing you some cash.
They're seeing that I'm actually paying you some money
back for a loan.
So in that sense it's a cover.
Maybe everybody else also knows that you are poor.
It's not so clear that it's so hard, you know.
You had a comment?
AUDIENCE: They don't want them to think that, become
dependent on things like that being free or, like, kind of
expect that they're going to get handouts all the time?
PROFESSOR: Well, why would that be any different?
I could always say that I'm doing badly, and you'll pay me
more on the loan I gave you.
Why would that be any different to loan?
AUDIENCE: Maybe because it creates some sort of
dependence relationship between the two people.
So if you have to agree to it beforehand, the other one can
just say, well, [INAUDIBLE].
PROFESSOR: I will come back to that.
Yeah.
AUDIENCE: I was just going to say that it sort of sets up a
contractual agreement where when I'm not doing well, you
help me out and when you're not doing
well, I help you out.
PROFESSOR: Right.
Yeah.
AUDIENCE: You could also say that if someone just gives you
money that's kind of expected to get some of the money,
something non zero benefits, a loan that you have to repay,
there isn't really a guarantee how much of a discount you're
going to get.
You can't really take that into account as well.
PROFESSOR: So what you're saying is related to what
they're saying, which is that one thing about a loan is
using the loan suggests that this is making use of a
preexisting financial relationship, so an ongoing
relationship.
The difference between my giving you money seems to be
mostly that in a sense these are people who already had a
financial relationship.
So it's the case that a lot of these people, one owes the
other one money already.
And adjusting the terms of that suggests that it's not so
much-- so in other words, it's not clear that what this isn't
telling us is simply that the people who have these
transactions are already people who've had a stock
against each other.
So it's not the case that--
so it's, you know, you keep count and say it's not clear.
So instead of thinking of the loan as being a separate
financial product, one way to think about it is
that we keep accounts.
And I've done you five favors.
You've done me three favors.
And the net is two favors.
And the loan amount really reflects our netting out of
those favors.
So in other words, what is nice about a loan is it's a
net I owe you or you owe me.
It's a net accounting device for keeping track of who's
done who how many favors.
So by thinking of it in long terms, it creates a natural
framework for thinking about this as kind of a social
accounting device.
How do I keep track of--
like, maybe people also say, well, I did you seven favors
and you've not done me one.
I have heard people say things like that, so the same
psychology.
It's a good way to keep track.
Thinking of it in terms of a loan makes it clear that what
you're trying to do is keep track of an ongoing
relationship.
It's a stock.
I gave you 100.
You paid me back 50.
Then I give you 30.
Then you give me 200.
And when I add those up, every stage, what I really care
about is not how many times what happened but the net
amount you owe me.
And that's a good way to account for the relationship
so we can keep track of am I someone who owes you or are
you someone who owes me by sort of counting that amount.
And that way we don't need to keep track of all these other
numbers, whether it was 20 ones and 15 another time.
It's just one number which kind of measures our
collective obligation.
And the reason that we would like-- why would we like to
keep track of the collective obligation?
Why does it matter that we keep track of the collective
obligation?
AUDIENCE: I mean, it promises them security, right?
PROFESSOR: Security for who?
AUDIENCE: I would say that in the community because one
person who was taking thousands of dollars from
someone else, I'd know that if that person asks me for money,
I wouldn't loan the person [INAUDIBLE].
PROFESSOR: So one advantage of that might be that it kind of
summarizes my status in the collective system.
So it may be that everybody knows I owe you 50.
And then nobody will want to lend me much more because it
looks like I'm just somebody who takes money from everybody
and never gives them.
So it's a good way to keep track of whether there's
someone who sort of tried to beat the system.
But there's another even simpler reason why.
AUDIENCE: I guess [INAUDIBLE], which is
basically the same thing.
PROFESSOR: Speak up.
AUDIENCE: Just to be a way to avoid moral hazard, which is
essentially basically the same thing.
PROFESSOR: Why would they avoid moral hazard?
AUDIENCE: Because it's an accountability system.
So, like, everyone in the community is kind of aware of
it's a way of keeping track of it on a smaller scale at a
larger company.
For example, like, in the city couldn't do it.
PROFESSOR: Right.
That's basically the same thing.
But in some ways I think there's an even simpler reason
why you may want to keep track of it, which is simply it may
well be that I just knew vis-a-vis someone else, he may
want to know, how many times has this guy taken from me?
And I may want to just put a limit to that because I know
that at some level I'm going to die
in 20 years or something.
And so I'm going to say, look, you know, if it's reciprocity,
so that the reason I'm giving him is x, that he will pay me
back eventually, then I want to know whether it's
reasonable to expect that I'll get enough back from him.
So if I think that basically the reason why I'm giving him
the money is because he will eventually give me back the
money when I need it.
Well, if my future is 20 years and I've given him $5 million
dollars, I'm unlikely to get that much back.
So I want to know roughly where I am in that transaction
because that's the only way that I can kind of make a
rational decision about whether it's worth continuing.
If my reason for being in the relationship is that I also
think that I'm going to get some favors from him then
knowing how much he already owes me is a way to keep track
of how much can I reasonably expect to get back from him.
If that number's already way past anything then I don't
need to give him extra favor to get more back.
At some level I'm just not going to be able to collect.
So if there's some kind of a rational--
so I might want to limit my exposure to him because in
some sense I know that it is never going to pay off to
invest so much in a particular person.
So it might be a useful accounting device.
So I think that Chris Udry, who did this study, his
interpretation very much was this.
They're keeping track of how much they owe each other, that
everybody knows roughly I owe this guy this much, which is
within reasonable limits.
It's not too much.
And, therefore, I can expect to get it back eventually.
So this is a table from Chris's paper.
And it's just a very simple point, but it's worth looking
at the paper.
It's sort of striking.
So it's the monthly interest rate.
These are huge numbers.
That's why it's worth looking at.
The monthly interest rate, when the borrower gets no
shock, he pays four percentage points less per month.
That's a lot, right?
Four percentage points.
What's four percentage per month compounded?
What's the compounded?
AUDIENCE: [INAUDIBLE].
PROFESSOR: Close to 50%.
So that's like 50% off.
So you're getting, like, 4% per month less.
Now take a look at the number.
When the lender, he has a bad shock, no shock, he charges
basically 10 percentage points less per month than when he
has a shock.
Difference would be minus 7.5 and 2.6, is basically 10
percentage points.
But when he has a shock, he charges 10
percentage points more.
So these are massive numbers.
I mean, those are, like, huge.
The interest rates just move enormously suggesting that
there is actually substantial resource transfer
that's going on.
Yeah.
AUDIENCE: So is this like he actually charges or the person
just chooses to pay more?
PROFESSOR: He chooses.
So we don't know that.
All we observe is that the person pays that much more
when the lender gets a shock.
But the difference, just to get the order of magnitude,
these are very, very large numbers.
So these are substantial transfers going on in both
directions.
On the other hand, there's still 10% of a loan.
So it's like, you know, the stock is much bigger.
So these people have an ongoing
ledger with each other.
And then they change that number by changing the
interest rate by a lot.
Now, what's that also telling us?
It's also telling us something about the scope of this
relationship, right?
So if the way I'm going to get my insurance is by getting
even a 10 percentage point reduction in
the interest rate--
so let's say the interest rate is 15%.
And I get 10 percentage points off, but I owe you $100.
How much do I save?
I save $5.00, right?
I was going to pay you $15, and I now pay $5.
The main point is that the amount of insurance that you
can get through this system is still very limited by the
amount of loan there is because, you know, if I'm
giving you a discount on a loan then that depends on the
loan amount I had.
So if the loan amount was $1 million then a discount on
that is worth a lot.
If these are poor people and their net loan amount is $10
then the fact that I'm getting a discount from the loan is
not giving me that much insurance.
So the downside of thinking about it in loan terms and in
principle, this could be relatively small number.
So I think these interest rates are high.
But they're not high enough to turn a small number into a
small number.
So that's sort of one thing to keep in mind.
We'll come back to this because I want to talk a
little bit more about other forms of insurance.
So one form of insurance we observe is this loan.
And that has its advantages, and it's a
nice accounting device.
I can keep track of what's going on.
It has the disadvantage that if I haven't given you a loan
then I can't help you.
It sort of goes through this loan.
So if you only owe me $5 then it's not going to be a big
transfer because you can, at most, let off the
interest on the $5.
But the interest on $5 is $0.50.
And that's not going to make a big difference to me.
So in general that limits the scope of the system.
And what I want to talk about is a bit of stuff from
Thailand, which is different because our colleague, Robert
Townsend, has been studying these villages
for many, many years.
And I'll show you some data from what he's collected.
And then we'll see that the way insurance is offered in
Thailand is very different in principle.
And so institutional form--
in Nigeria it's a loan.
In Thailand we'll see what it is.
So first here's a nice table.
It's sort of a fact that I've been saying many times.
It just says how much risk do people bear?
So what this table is, each row is a farmer.
They don't have data for every farmer.
But two things to note.
One is look at the best year and the worst
year for these farmers.
They're somewhat correlated but not perfectly, right?
The best year for some farmers was '85.
The worst year for some farmers was '85.
The best year for some farmers was '88.
The worst year for some farmers was '88.
Why am I emphasizing the correlation?
These are all within the same village, within one village.
Why am I emphasizing the correlation?
AUDIENCE: To emphasize that the shocks are independent.
PROFESSOR: Yeah.
So that there is scope for insurance.
I can insure you only if we don't both get into trouble at
the same time.
So the worst year for one farmer is not the worst year
for the other farmer.
The second thing is look at the magnitudes.
That last column is the percentage.
If you look at the harvest amounts, the best year and the
worst year, the differences are massive.
It's just the amounts.
I just want you to look the amounts.
The amounts are impressive because think about you got an
income of 50 one year and 115 the next year.
Those are big differences.
Anything else that strikes you?
Now, this may be difficult to see.
But one thing that's interesting is that if you
look at the--
it's not that the people who have average less harvest, the
risk seems to be independent of that.
So richer people seem to have roughly the same risk as
poorer people.
So everybody seems to be exposed to risk.
It's not that the rich people have less risk.
AUDIENCE: How do you define richness?
PROFESSOR: Take the maximum amount of harvest, the maximum
harvest, the people with the biggest maximum harvest
[INAUDIBLE].
This table is nice too.
It goes back to answering the implied question.
What's going on?
What's the source of risk?
AUDIENCE: These are all the same households?
PROFESSOR: Sorry?
AUDIENCE: These are all the same households?
PROFESSOR: No.
Yeah.
These are the same households as the previous table, same
numbers, B35, 36.
These are the same households.
They all live in the same village.
And this is asking why did you face risk?
And, again, mostly it has to do with weather.
Though, for some people, there's one person who says
that insects is the biggest source of risk.
Yeah.
AUDIENCE: I don't fully understand how someone's best
year was also someone's worst year, how rain
could be the problem--
PROFESSOR: Yeah.
Someone else want to suggest the answer?
AUDIENCE: I mean, I think it indicates that--
I think there's two potential answers.
One, rain could be the answer.
Maybe some of these fields are irrigated.
But judging by the variation on even the wealthiest fields,
which presumably would have the greatest chance of
irrigation, the fact that it's still pretty big fluctuations,
that's probably not the answer.
I mean, I think it's indicative that there's other
factors at work other than rainfall.
PROFESSOR: But they're saying that it's rain.
AUDIENCE: Sure.
I mean, maybe because they don't realize.
I mean, I think if they realize what the other farmer
was doing that [INAUDIBLE]
more successful, they'd probably try to do it.
So maybe they didn't realize that fertilizer-- and maybe
that they got unlucky and got hit with a disease they
weren't able to recognize.
PROFESSOR: They didn't realize.
That could be.
Go ahead.
AUDIENCE: It could be different crops.
PROFESSOR: Yeah.
So most of this explanation is that some of them are doing
very different crops.
So it might be some crops hate water and
others really like it.
Like, rice really adores water.
But cotton or chilies hate water.
So there are crops which you get too much rain, you get
lower output and crops which output is always
increasing in rain.
And so one possible explanation is that they were
planting different crops.
So we both planted the same time.
I'm planting a crop which will hurt if the rain is bad and
will do well when the rain is good and the other way around.
So that's one possibility.
The other possibility is that they're just micro climates,
that the rain is sort of--
after all, what matters is not so much rain as such but rain
at the right time.
So I plant on a particular day.
My saplings have just come out of the ground.
That's when I need rain, when the plant is young.
And so it may well be that the rain on those five
days was very good.
But then the guy who planted later, he thought the rains
would be better in five days.
And then the rains were really not better.
They were really bad.
So it may very well be that there is either geographical
variation in rainfall within a local area or just over time.
So I planted on a particular day.
I needed the rain 10 days after that when the
saplings came out.
I got the rain.
You didn't get the rain.
So I think both of those are plausible.
So I just wanted you to look at this because I
keep talking of risk.
But this is sort of a much better way to look at it.
You just see the magnitudes of it and the sources of it.
So I thought these tables were very nice.
And what he goes on to do in this paper is asking how do
people deal with risk?
And so he's describing three villages very close to each
other, to the point where one of the villages, people
actually use the financial institutions
in the other villages.
So they're very close to each other.
They're exactly in this area where the
rainfall was measured.
So the risk is roughly what you saw.
So we got a sense of the risk.
And in Nigeria we saw that people respond by borrowing
from each other.
Here, in this particular village, there are five
different funds.
So there's a village savings fund.
And the village savings fund is actually an equity fund.
These guys actually pay you a different rate of return
depending on what the borrowers were willing to pay.
So I put in money into this fund.
And then you come and borrow.
You're willing to pay 20%.
Then that money gets rolled back to me.
So it's a fund which has a variable interest which
depends on the village demand levels.
What do you think should happen to the interest rate in
that fund when the rainfall is good or bad?
How would it pay?
Will it go up when the rainfall is good or down?
AUDIENCE: Won't it go up because people are willing pay
more [INAUDIBLE]?
PROFESSOR: So one possibility it will go up because when the
rainfall is good, productivity is high.
People are willing to buy more inputs to produce.
Is that good for insurance or bad for insurance?
Yeah?
AUDIENCE: [INAUDIBLE]
PROFESSOR: That's good for insurance because the people
who are getting high
productivity shocks are borrowing.
But you would imagine the opposite, which is a fund with
a variable interest rate where we only borrow from it when
we're desperate.
Then you might see the demand for those funds being
particularly high when rainfall is bad because we're
all trying to borrow from that to survive.
And at that point, very few people are going to lend.
The interest rate is going to go up.
That's going to be bad for insurance.
So it depends very much.
Rather a fixed interest fund, a variable interest fund can
be either good or bad for insurance.
Then there is a fund for purchase of pigs.
Here, the interest rate is fixed.
But there's a rollover provision.
Rollover provision is if you are in trouble and you can't
pay, I can let you keep the loan for longer.
You pay more, but you don't have to pay back now.
Is that good for insurance or bad?
AUDIENCE: Well, it depends on the person
that they're insuring.
If the person [INAUDIBLE]
they can keep rolling it over and eventually drop out.
But it could be good if the person is experiencing some
transitory shock [INAUDIBLE].
PROFESSOR: Assuming that the person is going to pay it
back, it's good for insurance.
Rollovers are good for insurance.
There's a fund for purchase of fertilizer.
So each of these is almost like a proper financial
institution at the village level.
So in this village, the leader has
organized a bunch of funds.
And you can save money to buy pigs in this fund.
And right now if I've saved money and you want to buy
pigs, you can borrow from this fund.
And, likewise, there's money in a fund for buying
fertilizer, a rice bank where the rice I grow I can store.
And when I need rice, I can take rice from it.
And there's a health care fund where we each put in money.
And if somebody gets sick, he gets to spend it.
So this is a village which is rich with financial
institutions.
These are not loans.
In particular, the health care fund or the rollover is
something where I'm making a direct transfer to the people
who are hurting.
But it's not bilateral loans.
These are kind of financing from a financial institution.
So the main point I'm making here is that here you see a
very different sort of insurance.
This is organized through collective action.
Everybody's getting together and lending to everybody else.
Now, he goes down a few more miles from May Wak to a
village called Sop Wak.
And what does he see?
Well, on paper it looks very similar.
But here's the problem.
All the loans are in default.
Not all, but a lot of loans are in default.
Is this good or bad for insurance?
Anybody else?
Why is a default bad for insurance?
AUDIENCE: Because then the people who are putting in the
money won't get any money.
PROFESSOR: But maybe the person who is defaulting is
the one who needs to not pay.
It's so clear that default is bad for insurance.
The problem is with this default then nobody will put
money into the bank.
So default is, in a sense, a form of insurance, right?
I allow you to not pay when you can't pay.
But if there's a lot of default and I think that's
mollified then I may not put money into the bank.
So, again, it's not clear which way it goes.
But he interprets this as saying that these places,
these banks, nobody's putting money into them.
So these banks are kind of defunct.
Yeah.
AUDIENCE: How could it default and not repay?
PROFESSOR: Oh, we could imagine a world where that's
exactly how we provide insurance.
So we each imagine that the rule is.
Year one, if you have a shock this year, you borrow.
Even year two, if you again have a shock then you default.
We write it off, happens in one time out of 10 or
one time out of 20.
But, you know, it can happen to any of us.
And when it's really bad and I've had two shocks in a row,
it's better for me to not have to pay back than you to give
me yet another loan.
There's no particular reason why default would be bad for
insurance if we could make sure that
the default is limited.
AUDIENCE: Doesn't the insurance company just loose
all that money though?
PROFESSOR: Yeah.
But it counts into its--
the insurance company is losing that money.
But remember, when an insurance company makes a
payment, it also loses money.
So just think of it as a form of payment.
Default could just be a form of insurance because I could
be paying people in the form of default.
You don't have to pay.
Fine.
You don't have any money, you don't have to pay.
That's a perfectly legitimate form of insurance.
Just the question is whether it's deliberate, in which case
there will be too much of it.
And in that case the system won't work.
Yep.
AUDIENCE: That may be the case when there's an insurance
company or a government which is writing off the loan.
But the latest census [INAUDIBLE].
PROFESSOR: I guess a lot is relative to what they're
willing and what they were planning for.
There's nothing else about a lot of default.
It's just what you're planning for.
I could plan for, you know, one loan out of five will be
defaulted, and the others will just absorb that loss.
It might me fine.
It may be a form of insurance.
Default is a natural form of insurance.
That's a way of understanding.
There is nothing obviously bad about default if it's
completely just I have no choice.
I default.
That's a perfectly good way to insure myself because then I
don't need to pay when I'm in really bad shape.
It's when I start using as an excuse to not pay that it
makes a difference.
Yeah.
AUDIENCE: I think I'm getting tripped up because usually
default is when the intent is for you to get that paid back.
So if you're using default as a form of insurance, to me,
it's no longer default then.
It's just a form of insurance.
PROFESSOR: OK.
I kind of agree with that.
I mean, that seems like we're arguing over words.
So I think default just means I don't pay the loan.
And when I don't pay the loan, that might
very well be desirable.
Now, as you see, their view is a bit that it's not actually
necessarily a good idea to collect because they're taking
the view that these people are defaulting because they need
to default.
So it's not clear what default means here.
And that's worth understanding.
Then he walks down to a third village.
The third village is a few miles down.
And none of these funds exist.
So one village, all the funds are working well.
In the second village, there's lot of default.
The funds are still there.
Third village, no funds except one.
And you are in the Nigerian mode where you're just
borrowing from each other.
So what's the advantage of a fund over
borrowing from each other?
Let me see if someone else wants to answer.
What's the advantage of a fund over
borrowing from each other?
AUDIENCE: They have more resources for you to borrow?
PROFESSOR: Why?
AUDIENCE: One individual has a limited constraint, whereas if
people pool their money together.
PROFESSOR: Right.
It's a way to pool many more people in.
So that's the advantage of a fund.
So what do you think is going on?
Why do these villages, which are very similar, have same
kind of risk next to each other, have
very different patterns?
Think about what it takes for such an institution to exist.
AUDIENCE: They need the trust of the [INAUDIBLE].
PROFESSOR: Right.
So the way one of these funds works is by saying that I'm
going to put money into it now because I can get money into
it in the future.
What does that assume?
Yeah.
AUDIENCE: It's going to exist in the future.
PROFESSOR: That there is a future.
So in other words, if I think that everybody else is going
to default today, I should default as well because there
will be no fund in the future.
So this is a classic kind of problem of anything that's
sort of sustained by the future.
It depends on there being a future.
So this is the problem that right now a lot of microcredit
organizations are facing.
Microcredit organizations promise you a loan if you pay
back your loan.
Now, suppose you think that nobody else will pay back
their loan.
What's going to happen to the microcredit organization?
It's going to go bankrupt.
If it goes bankrupt, what's going to happen
to your future loan?
AUDIENCE: It doesn't exist.
PROFESSOR: It doesn't exist.
So basically if everybody expects people to default in
the future then I should default now.
So if everybody else is expected to default, it is
rational for me to default.
If everybody expected to pay back in the future then it's
rational for me to pay back because then the fund will be
there for a long time.
So I think this is sort of the reason why funds--
so all of these kind of informal institutions are
fragile because they rely on this kind of coordination.
I only want to repay if everybody else wants to repay
or at least as long as enough people want to repay that the
fund will be going.
If I expect that lots of people will default in the
future, I should default now because the fund is going to
go out of business.
I'm not going to get anything out of it in the future.
So I might as well just stop having anything to do with it.
So it totally depends on trust.
If I believe that everybody else is going to behave well
then I should behave well.
If I think that everybody else is going to behave badly then
it's over in some sense.
That's one central weakness of these kinds of informal
institutions.
They rely on the expectation that I'm going to behave well
in the future.
Yeah.
AUDIENCE: Well, if everyone else is going to pay back in
the future, wouldn't it still be better for you to default
now if you were being selfish because the fund's still going
to exist whether or not--
PROFESSOR: No.
But then you can't borrow again.
Then they can say, look, you defaulted.
You didn't pay the money when you needed to.
You were supposed to pay money into the fund.
You didn't pay.
Now you're out.
But if you come and ask me to put money into the fund and I
know that everybody else is planning to default, I'm never
going to do it.
And if I ever get a loan out of it, I'm going to default as
soon as I can because I know everybody else
is planning to default.
So in these kinds of institutions, default is
entirely sort of self-fulfilling.
So if I expect default, I'll have default.
If I expect people to behave well, we'll probably all
behave well.
So probably the reason why these villages are so
different is because of this expectation mechanism which is
very important to understand.
And it's true of lots of financial institutions.
They rely on our future compliance to work.
And that's why, for example, even banks to some extent--
if I decide that I'm going to withdraw my money from the
bank, everybody is going to withdraw money from the bank
tomorrow, what should I do today?
AUDIENCE: [INAUDIBLE].
PROFESSOR: I should withdraw today.
That's a bank run.
So a lot of financial institutions have
exactly this feature.
And that's why it's not so surprising to see that some
villages have very good institutions, rich set of
institutions, others don't.
The fact that some villages have default,
it's the same reasoning.
Once people start defaulting, everybody's going to start
defaulting.
Yeah.
AUDIENCE: Could it be possible that in one village a default
is costlier than in another village?
Maybe, like, socially you'll be ostracized or something
like that, and that will help support the program where
everyone pays into the fund?
PROFESSOR: Sure.
So it could very well be that another thing that this tells
us is that, for example, a leader matters.
So if the leader is someone who can enforce punishments in
the village so if I default--
suppose I'm supposed to pay back, and I know I can pay
back but, you know, I just refuse to do it.
If the leader can basically have me ostracized then, in
some sense, I'm not going to do it.
And then given that I'm not going to do it, everybody else
is willing to pay into the fund.
So it's going to be huge leverage from effective
leadership.
That's the other actually conclusion of this paper is
that there's a good leader in the first village, and he was
very important in setting up these institutions.
He made them work.
Yeah.
AUDIENCE: I was actually going to ask that.
It seems that you have to someone who's a good leader in
order to make these things work.
But what was that guy or girl doing to keep people confident
of the performance?
PROFESSOR: I can't tell you.
It said that the leader was very energetic, et cetera.
There's a description of the leader, but it doesn't tell me
what he was doing so much.
OK, so we already talked about moral hazard--
other limits of insurance.
But I wanted to emphasize that because I wanted to emphasize
that this is not just a limit of insurance.
It's a limit of any institution that is not
enforced by legal punishments.
Anything that's not enforced by legal punishments is
fragile always.
It will work if it works.
It doesn't work, it doesn't work.
That's sort of the main point of that example.
If we all stop paying money into the fund then
the fund will die.
So I might as well take my money and run.
That's true of not just insurance but of any other
kind of institution.
Now, moral hazard, we've talked about.
I'm going to skip moral hazard.
Here's another problem with informal insurance.
This is all what we've been talking about a bit.
So we've been sort of talking about implicitly default.
But we've also been talking about one thing that an
insurance arrangement demands is that when it's your time to
pay, you pay.
Sometimes you get money from the fund.
Sometimes you pay into the fund.
You have to be willing to pay money into the fund.
That's what keeps it going.
Why do you want to keep putting money in the fund?
We said this already, but just to repeat.
Today I am rich.
I want to put money into the fund so that somebody else can
take it out.
Why would I want to do it?
Why does anyone want to put money into a fund?
AUDIENCE: [INAUDIBLE].
PROFESSOR: Sorry?
AUDIENCE: To get more money back.
PROFESSOR: Yeah.
Eventually you pay me some return on the fund.
But if it has to have an insurance component then it
has to be that the return I get on it is lower than the
market return because otherwise they could have
borrowed from the market.
It doesn't provide any insurance.
So it can't be just because I want to get the money back.
It must be because I expect that I will be able to borrow
from the fund in the future as well.
So I will be willing to put money into a fund which pays
lower than market rate, which is what insurance is.
Insurance is that I'm willing to lend to someone at lower
than market rates so that when he's in bad shape, he doesn't
suffer too much.
That's what's insurance.
AUDIENCE: It's probably also probably the reason why
wealthier people would be less likely to give
into a fund, right?
Because they're already exposed to less risk than they
have already.
PROFESSOR: Exactly.
AUDIENCE: I thought you said that why would a
rich person do it.
Because I was like, I don't know why a rich
person would do it.
PROFESSOR: Well, one reason they may want to do it is that
they feel the same need as--
so what's an insurance fund?
An insurance fund is a fund where I put in money so that
other people can be helped in return for the fact that they
will put in money and I will be helped.
Why would I put in money now?
Because I expect to be helped in the future.
So what are the kinds of people who don't want
to join that fund?
You already gave one answer, which is people who are rich.
They don't expect to get helped.
So that's why you're going to see that if there's a lot of
inequality in the village, you're unlikely to see a fund
because the rich don't really think that they can be helped
by the poor.
If they ever need money, they're going to need, you
know, $100,000.
The poor won't have it.
And, otherwise, they won't need money.
Yeah.
AUDIENCE: I think the chapter also mentioned
timing as one factor.
I mean, if people always postpone, they value future
outcomes less than [INAUDIBLE].
PROFESSOR: Right.
So you need to be forward looking to be willing to
behave well and be forward looking.
If I always think that, well, I'll just not pay now and
whatever happens in the future, that's
not going to work.
You need to be forward looking.
And what's the point around migration?
Why is migration important?
AUDIENCE: Could you say that as you have to expect to be in
that area to benefit?
PROFESSOR: In the villiage, yeah.
You need to be in the village to benefit from the fund.
If I expect to go away, I don't know whether I'm going
to be here to benefit from this fund.
So if there's a lot of mobility in a place then
everything falls apart.
So villages that are closer to the road, to a big city, find
it harder to insure each other.
Why?
Because everybody there has a link to the city.
So they don't know whether they're going to help from the
village or they're going to go to the city
and get a job there.
And so given that I am not committed to being in the
village, it's very hard to give me insurance.
So all of these things.
You need low mobility, low inequality, and forward
looking people.
Yeah.
AUDIENCE: Also we should say there are people who have
access to ways to save their money Right then--
PROFESSOR: That's an excellent point.
What would a bank account do?
A bank account would undermine insurance.
Why?
Because in a bank account I now can get high
return on my savings.
So when I have money, it's more tempting for me to put it
in the bank account rather than put it in this fund,
which is going to pay me a lower return because it's
trying to help out other people.
So any outside options that you provide-- so financial
development might undermine local institutions.
So you might actually see worse institutions where the
financial system is better formally.
Yeah.
AUDIENCE: I misunderstood the whole fund.
You said that the market rate was higher than the fund rate.
PROFESSOR: Yes.
Yes.
AUDIENCE: So even if there was a bank and you experienced
some hardship, you would be more inclined to
borrow money from--
PROFESSOR: Oh, absolutely.
It's the other way around.
The question is who do you borrow money from?
If the bank does it, it makes it too easy for me.
Today, I have money and you need money.
I'm going to put my money in the bank.
That's why you can't get money from the fund.
The fund is a two way street, right?
I need to put in money.
You need to take out money.
As my options of putting money elsewhere get better, it's
going to be harder and harder to force me to put
money into the fund.
AUDIENCE: Even if the rates at the other places are higher
than the rates at the fund.
PROFESSOR: Especially, right?
Let me be clear.
What are we saying?
There's a fund.
What's a fund?
The fund is that I put money into it.
I get lower than market rates.
Why?
Because I want to give that money to someone else who
needs it desperately, providing insurance.
There's also a bank, which pays the market rate.
Now, as the market rate gets higher, it's harder and harder
for the guy who has money today to not feel tempted to
put his money into the bank.
Yeah, you had a comment.
AUDIENCE: But, like, there's a threshold, right?
You have to have a certain amount of money before you can
open a bank account.
PROFESSOR: Sure.
So maybe the bank is not actually available to you.
But if the bank is available to you, that might actually be
bad for insurance.
That's sort of maybe surprising that a bank shows
up and that actually undermines people's ability to
insure each other because it's too easy to now park your
money elsewhere.
Other reasons why informal insurance doesn't work very
well, we've also talked about the
coordination quite a lot already.
If I expect to default on the fund then you
will default too.
That's coordination.
Also you would expect that these funds only work because
I know when you really need money and when you don't
because otherwise you could always say I need money.
So you're not letting people who are very isolated--
so people who are not in the village network don't get into
these funds.
They tend to be of people who are relatively well connected
to the village community.
Why?
Because I need to know whether you're lying or not.
And if you live next to me I know that, yes, your cow died
or whatever.
Your pig was eaten up by a tiger or something, whatever
happens to pigs.
But if you live far away, how do I know whether you are in
trouble or not?
So it tends to be that this is concentrated among people who
know each other.
The scope of the insurance is limited.
And, finally, in some sense, this is a very bad mechanism
for dealing with shocks which affect everybody in the
village, obviously.
If there is one blight in the village which affects
everybody, this is not going to help anybody because nobody
can help each other.
So that takes us back to where we were at the end of the last
lecture, which is saying on the other hand, formal
insurance markets are hard to develop.
That's where we ended last time.
We said formal insurance markets are hard to develop.
Why?
Because people are suspicious of these products.
They don't understand them.
They're too complicated.
They have all these exclusions, which you don't
understand.
So you don't like it.
I was telling the story of all of these women who got really
upset because one of their friend's husband died.
But the medical health insurance didn't pay for it.
Health insurance was actually right in not paying for it in
formal terms because their contract said we'll only pay
for people who go to the hospital.
He died at home.
But they thought that, well, something bad happened.
Why aren't you paying for it?
So they basically got very upset.
So insurance is confusing.
Formal insurance has rules, which if you [INAUDIBLE]
you don't understand.
It tends to be quite limited in other ways.
I know a lot about my neighbors.
I know if his cow was eaten up by a tiger, for example.
Insurance company doesn't know anything about my neighbor, so
it can't insure things like that.
But there's a very nice story.
So cow insurance--
I bring up the example because it's a good example.
Insuring cows is a big issue in every developing country
because cows are a major asset.
In some countries, like in Botswana, it's the single
biggest asset other than diamonds, it turns out.
So there only two major assets in Botswana.
They are cows and diamonds.
But most people have cows.
Very few people have diamonds.
So insurance companies have been trying for a long time to
insure cows.
The problem is that you insure cows by saying if the cow
dies, I'll pay you money.
But it's convenient for cows to die because
they turn into steaks.
And steaks, many people like them.
So they create a huge moral hazard problem.
So this company, [INAUDIBLE], had a very clever idea.
They said that if you claim that your cow has died, you're
to bring me the ear of the cow.
Dead cow, you're to cut his ear off and show it to me.
I don't know.
What happened?
AUDIENCE: A lot of earless cows?
AUDIENCE: So everytime my cow died I would start cutting off
ears and creating, like, a black market [INAUDIBLE].
PROFESSOR: Right.
So imagine my cow dies.
I'm not insured.
What do I do?
I cut off his ear and sell it to somebody who's insured.
It created a robust market for cow ears.
Everybody was buying cow ears to go to the
bank and collect insurance.
So that's your primary problem with sort of formal insurance.
They don't know where the cow died.
They have to figure out a way to track that down.
That's not easy to do because of this ear problem.
So basically we're between a rock and a hard place.
People don't understand insurance.
Insurance is incomplete, at best, because you can't really
insure cows because I don't know when
your cow died or not.
On the other hand, if we look at insurance that comes from
the community, the people who have the information, that is
too limited for these other reasons we've discussed.
So we were kind of between a rock and a hard place.
So I think the message of this particular area is that this
is a classic area where a government providing some kind
of insurance that's not expected to break even is much
more efficient.
So rather than thinking of insurance
which is market supplied--
for example, a government scheme which says you can come
to work whenever you need to work and we'll pay you a
minimum wage is very effective because
the wage is low enough.
You're not ever going to take that job if
you have a real job.
You only take it when you're desperate.
So that's a very efficient way to provide insurance.
Now, the problem is that that's not
going to fund itself.
It's a one way payment from the government.
But on the other hand, it makes sure that anybody who is
really desperate can find a job and
therefore it secures them.
So in some terms this is a classic area--
or if you think of insurance where people don't understand
the product, well, they don't want to buy it because they
don't understand the product.
But if you provide it free, they'll take it.
So if the government were to actually subsidize insurance,
that might be a very good way to help poor people because
it's something that they don't understand
that's good for them.
The demand is too low because they don't know how to
interpret it.
On the other hand, they will get the benefits from it.
I think insurance is a very, very natural place for public
intervention.
And I think that's sort of what makes it really
interesting is how to design good insurance products for
poor people which possibly combine some advantage of the
market and some advantages of public funding.
So, for example, instead of the government providing
health care, maybe everybody should have health insurance
with some appropriately designed coverage.
And maybe that should be provided free to people.
If they don't understand the value of it, that's fine.
In the end, sick people are a burden of the government.
So they might as well provide it ex-ante.
Providing a job to everybody--
work fair is the word people use in the US--
to people who want a job is a way to make sure that people,
when they're desperate, there's some way of generating
income and that the wage at that income doesn't go down
because everybody's demanding a job.
So in some sense it's a way to secure people.
And it's a way to do it efficiently, to make sure that
the right people go to it.
You don't want to give them money.
You want to give them a job because a job has the
advantage that you get targeted.
So in some sense it's a good domain to think
about public policy.
I'll stop here.
We might talk a little bit more about it later.