Can the sociology of finance prevent the next bubble?

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.