Can the sociology of finance prevent the next bubble?

February 4, 2011

As chance would have it, I lived in New York during the early 2000s, and then again in second half of the decade. This gave me front-row view to the two fin-de-siecle capitalist crises. I was a young PhD student at NYU during the dot-com boom, and strove to “participate” by studying securities analysts and financial valuation. And I was a junior faculty at Columbia Business School during the credit crisis, and was at dinner with an official of the Fed on the night it bailed out AIG (“makes me sick in the stomach” was his reaction to the email, at around 8 pm.)

For this reason, give a lot of thought to the question of what these crises have in common. And if there is one combined message coming out them, I believe it is this: we live in a bubble-prone economy. Every nine years or so our financial markets accord an excessive level of value to a certain asset class. Once it happens, it looks irrational and avoidable. And then it happens again.

Ex-post, economists have found a broad range of explanations for bubbles. Both credit- and dot-com crises can retrospectively be blamed on incentive problems –- on securities analysts that peddled worthless stocks, or on bankers that packaged gilded toxic assets. Other explanations such as the Black Swan or behavioral biases can also account for the ways in which crisis damage is magnified. But these mechanisms are really aggravators rather than the genuine source of trouble.

So what’s special about bubbles? There is nothing worse that bubbles, I believe. The price mechanism stops working in their presence. Prices start promoting the wrong form of economic activities — be it investment in unnecessary fiber optic, or overconstruction of macmansions. And no matter how much incentives are subsequently realigned, once a bubble forms, the game is over. Capital will be misallocated, even with the best of intentions. The reckless pioneers will be rewarded. The late-entering masses will loose their savings. And the banks that lent to the party promoters will need to be bailed out. Again.

Given this, bubbles should play a key agenda within the social studies of finance in the next years. Is there an organization of financial activity that could help banks avoid bubbles?

In a recent piece, David Stark and I examine this problem. What can banks do to prevent jumping on the next foolish bandwagon? Our piece draws on our fieldwork on International Securities, and considers two different cases. We look at how traders interact inside the firm, and at how the firm interacts with others. The key element that is common to both is an attention to dissonance. Difference, diversity, friction… is the key resource that our bank cultivated to find an original voice and avoiding the herd. Dissonance warns the organization about the mismatch between its own representation of the environment, and the environment itself.

How can dissonance be exploited? Internally, we observed a form of organization that my coauthor has described elsewhere as “heterarchy.” That is, firms that celebrate disagreement and debate, and are therefore able to pick up on discordant cues. Externally, we found a mechanism that we labelled “reflexive modeling.” This amounts to the use of financial models to translate prices into a numerical measurement of what rivals believe, and thus question one’s own views. Our piece, titled “Seeing Through the Eyes of Others,” is forthcoming in the HANDBOOK OF THE SOCIOLOGY OF FINANCE, K. Knorr-Cetina & A. Preda, Oxford University Press, 2011.

11 Responses to “Can the sociology of finance prevent the next bubble?”

  1. […] post: Can the sociology of finance prevent the next bubble? [socializing finance] This entry was posted in 1. Bookmark the permalink. ← Michael Lewis [NONSENSE] on […]

  2. Yuval Says:

    Daniel, the piece sounds very interesting and the reader sounds like a must-buy for SSF folks. I have an issue, though, with the concept of market bubbles: how do we know that one period is a ‘bubble’ and the another one is ‘normal’? How do we know when to trust that markets price according to fundamentals and when not to trust them? Of course, I am aware of the out-of-market contexts according to which market-based prices can be benchmarked and bubbles can be evaluated But, given that the interesting things during bubbles happen outside the market, I am wondering if bubbles worth particular sociological attention. I ready to be persuaded about it…

  3. danielbeunza Says:

    Hi Yuval — I have found Keynes’ rule of thumb for determining a bubble pretty useful: when your porter recommends that you buy, it’s time to sell.

    Aside from the awful classism connotations of this dictum, I saw just that as I returned from NYC to Spain for my first faculty job back in 2003. While sitting on the underground in Valencia, a group of senior homemakers got into the train in one of Valencia’s poorest areas. And they began to gossip about the capital gains that this acquaintance or that friend had been making by buying and selling apartments. We are, I concluded, in a real estate bubble.

  4. yuvalmillo Says:

    Yes, I agree completely: market behaviour cannot be explained, probably, by markets themselves but by out-of-market phenomena.

  5. Eric Titus Says:

    Just found this blog after starting the paper and am looking forward to more insights. But it seems to me that banks are not necessarily the ones who want to prevent bubbles. In fact they are often the main beneficiaries because they can time entry and exits better than other investors. It is not just a question of enabling banks to recognize bubbles, but of incentivizing early exits.

    Consider that even at a place like Lehman Brothers, you would have been better off riding the bubble than encouraging prudence. The best way to benefit from the bubble would be to buy in to the bubble on the way up, stay closely involved in the market making process, and start hedging your exposure once you see signs of weakness. Although as a future economic sociology PhD I think it would be great for sociology to be involved in these sort of discussions, I think its contributions can be made in other areas. Organizational change in the banks won’t change until the institutional landscape shifts. And maybe heterogeneity at the federal reserve and various agencies would improve regulation. This piece is certainly interesting, but I don’t think organizational sociology can prevent the next bubble until it is in the banks best interest.

  6. Taylor Spears Says:

    Very interesting post, Daniel. You say that: “bubbles should play a key agenda within the social studies of finance in the next years.”

    I like this idea, but the question becomes — how do we go about understanding how financial activities might be organized to prevent bubbles?

    I think the answer is, ironically, to not focus research exclusively on bubbles; that is, cases where evaluation practices fail.

    Instead, one should examine the processes of evaluation symmetrically by studying both cases of success and failure, and providing a common set of sociological explanations for both. Over time, SSF could build a repertoire of cases and draw comparisons between successful and unsuccessful evaluation practices — ones that fail and degenerate into bubbles, and ones that work successfully and value assets “correctly.”

    You and Stark, of course, both mention the usefulness of symmetric accounts of evaluation in your papers, but given that it seems to be one of the core “value propositions” of SSF, I thought I’d explicitly make mention of it in the discussion here.

  7. danielbeunza Says:

    Eric — point well taken, but I partly disagree.

    True: any organizational reform in banks needs to be in the bank’s own self-interest.

    However, I don’t think that shareholders in Lehman were better off because the bank pursued credit derivatives. Not even Dick Fuld (the CEO) was better off: his personal wealth was all tied up in Lehman stock, so he lost almost all of it.

  8. danielbeunza Says:

    Taylor — I could not agree more that symmetry is needed. It’s one key flaw in behavioural finance studies, which set out from the outset to study “biases”. However, I think that symmetry needs to take place directly in each study, as opposed to having it at the level of the literature. In other words, one study of succcess and one study of failure does not make up for a single study that was undertaken before it was known whether it was a success or a failure.

    One excellent example of that is the NYSE. It’s not secret that Yuval and I have been doing research on it for three years. With the current sale to Deustche Boerse, it is not clear that the company was not leading its industry. It can be seen by some people as a case of partial failure. But, crucially, we did not approach the NYSE with an eye to study failure. For that reason, the mechanisms we became interested in are not only those that don’t work. In fact, there were a ton of initiatives that were incredibly efficient at the NYSE. It remains to be seen how those combined into the overall outcome that we now know.

  9. tcspears Says:

    I think you’re right that where possible, it’s best to get successes and failures within a single study. I just wonder if that’s possible most of the time, and that we’d be restricting the scope of inquiry to limit ourselves to cases where success and failure are both prominent. For instance, my own current research is on evaluation practices in the interest rate derivatives market, which seems to be a market where widespread failures on the order of arbitrage disasters or the CDO bubble are quite rare. In many ways, it seems to be the antithesis of the CDO market: there’s tremendous heterogeneity in modelling practices, and calculation isn’t “outsourced” to institutions like ratings agencies as it was in the CDO market. Then again, I might encounter lesser-known failures from which a symmetric account could be built when I actually start my fieldwork.

  10. Rajeeva Sinha Says:

    If my attribution is correct Bertrand Russell wrote somewhere that if you leave your front door unlocked decent people will not enter your house uninvited it will just increase the temptations for poor characters to enter your house. Thieves like Madoff will get in anyway. You have to worry when your (financial) community looks the other way when your house is being robbed.
    What has increased the frequency and size of asset bubble? Short answer: The huge increase in the supply of investible funds and lack of investible opportunities caused by a global governance deficit.
    Factors that have increased the global supply of investible funds are retirement savings and longevity amongst OECD countries; redirection of global capital flows to resource rich and emerging markets like China and India with high personal savings rates; and growing global income inequality and concentration of wealth amongst the top 1% of the population.
    The IMF estimates that savings in fixed income assets alone doubled in six years from 200 – 2006 and is growing, the financial crisis notwithstanding.
    So what can this excessive liquidity do? Surely it cannot sit idle. There are very few markets it can go to with assurance of respect for property rights. Paradoxically the people who do not like to pay taxes like societies that respect property and civil rights. Amongst the top lenders to the US governments are Caribbean banks.
    This global governance deficit also has the effect of increasing the irresponsibility of OECD governments. The US can borrow till this day at near zero rates and issue mega IOUs to itself. European governments also cashed in their governance dividends though some of them are in trouble now.
    So the problem is not social norms and customs or networks. There is serious lack of investment opportunities that will lead to cash flows from increased supply of goods and services. At the same time paradoxically, more than half the humanity has no future because of lack of access to credit.
    Regulation and monitoring of financial markets is needed. You need to lock the front door of your house. However, till institutional mechanisms are created for the huge liquidity to flow to investible opportunities that will increase global access to finance and the flow of goods and services (and there is a pressing environmental, social and now political need for it as ongoing developments in the middle east suggest) asset markets will repeat with increasing frequency and scale.
    Microfinance and social enterprises are not clichés even if Michael Porter and the HBS would like to consider these as ways to rethink capitalism. Unless we resolve the global governance deficit and expand the breadth and depth of the market where entrepreneurs globally can connect with suppliers of finance we will continue to have bankers continue to reward themselves with mega bonuses as their talent is needed to make bets (derivatives) whose market is 10 -12 times more than the size of the stock market of publicly listed companies.

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