Quick links

June 30, 2008

A new blog about the connection between STS and ontology, focusing on the workshop Daniel described.

http://stsontology.wordpress.com/

Tom Wolfe is thinking that it’s the ‘end of capitalism as we know it’. The story is a bit confused, but so are financial markets these days.

http://www.nytimes.com/2008/06/24/business/24sorkin.html?_r=1&adxnnl=1&oref=slogin&ref=business&adxnnlx=1214821262-Ht2eAktdvL0YMp2w1eB/KQ

I was looking through the programme of the next 4S conference (Society for the Social Studies of Science) and there were a lot of financial market-related papers. Many of them, as expected, will be given by people who are close to, or part of, SSF, but not exclusively:

  • Assembling the hybrid client: making banking markets by matching profile with person (Zsuzsanna Vargha, Columbia University)
  • Marketization of climate change: contesting the performativity of Economics (Anders Blok, Copenhagen University)

[at the same session Rita Samiolo will also be presenting. I know the paper and I think that it’s a very good ANT story – although Rita may not agree with this definition – so, it’s highly recommended]

  • Markets as Simulations: Economic Theory and Market Design in the Restructured Electricity Industry (Daniel Breslau, Virginia Tech)
  • Towards a Material Sociology of Markets (Organized by Juan Pablo Pardo-Guerra, Donald Mackenzie and Anita Engles)
  • Dealing with emission allowances: How companies learn the fundamentals of the EU Emissions Trading Scheme (Anita Engels, University of Hamburg)
  • Making Things the Same: Gases, Emission Rights and the Politics of Carbon Markets (Donald MacKenzie, University of Edinburgh)
  • A market of EPIC proportions: finance (re)configured in the London Stock Exchange (Juan Pablo Pardo-Guerra, University of Edinburgh)
  • Weather matters: thermometers, equations and models in weather derivatives trading (Samuel Randalls, University College London)
  • The awkward materiality of housing markets (Susan J Smith, University of Durham)
  • From New Deal Institutions to Capital Markets: Commercial consumer risk scores and the making of the U.S. subprime mortgage market (Martha Poon, University of California San Diego – yes, the very same one!)

After last evening’s raucous discussion about the price of bananas and its implicit politics, today there is a notice of a closed workshop to be held in Toulouse.

Hat tip to Teppo Felin at orgtheory.net.

Radical uncertainty

June 21, 2008

For a recent discussion of Austrian and neoclassical approaches to uncertainty, read Tyler Cowen’s post and follow the links.

Can economists make markets out of anything? How much knowledge do you need to to build a calculative device? Do you need Bayesian priors to create trade? Or can you create markets de novo?

Arnold Kling says:

I think that we will not see contingent claims markets emerge in the case of unknown unknowns, because the bets are too hard to define. If you can define a bet, then you have created a known unknown. If you cannot define a bet, you have an unknown unknown.

Do economists transform untradable unknown unknowns into tradable known unknowns?

It makes me go “Hmmm”.

On Friday, crude oil prices jumped in a new all-time high: the benchmark futures contract of light sweet crude was traded at US$139.54 in New York.

This new record was attributed to a comment by Iranian-born Israeli deputy prime minister, Shaul Mofaz, who said that: “If Iran continues its nuclear weapons program, we will attack it. Other options are disappearing. The sanctions are not effective. There will be no alternative but to attack Iran in order to stop the Iranian nuclear program.”

The news stories did mention that the context for this comments is the primaries in Kadima, PM Olmert’s party, where Mofaz is a contender and that it is likely that the comments were made for ‘domestic consumption’. The reaction to the statement shows that in today’s highly connected markets distinction between the local and the global cannot be made easily. Mofaz’s Israeli political bravado injected volatility to global oil markets. Such effect, in itself is dangerous enough, of course, but the other ‘leg’ of the reflexivity circle is potentially even riskier. In fact, this side of the phenomenon may feed a social loop that can place Iran and Israel on a sure collision course.

How so? Mofaz is now aware of the impact that his words have on markets. However, if anyone may think that this would serve as a lesson and that future comments would be less vehement, then they do not know the Israeli political discourse. Mofaz will now celebrate his influence on global oil markets and will use last week’s price rise as leverage for creating more political capital. Moreover, the reaction to this comment will motivate Mofaz and other Israeli politicians to outdo it and to have even more impact. So, as long as the scandal-ridden Olmert government is haemorrhaging support we should expect increasingly more flamboyant statements from Israeli politicians about Iran, more volatile markets and a steady progress to the brink of a (possibly, nuclear) war in the middle east.

As usual, Peter Levin’s comments are illuminating and thought provoking, and this one is not different. So, I thought that it would be better to put it here as new post (with my reaction), rather than just as a comment

Peter Levin on the ‘Performativity: will any theory do?’ post

Interesting post, addressing a concern I think about all the time. But might I suggest that there are alternatives as well. You note that if the theory ‘fails’, or if it has no ‘public experiment’ available to it, there is no possibility that it will be performative – at least in the sense you mean.

I was thinking about the cases where the theory remains, despite evidence to the contrary. My art specialists are as likely to speak of a price as ‘not yet achieving’ its market price, or that its market price is not yet in line with its cultural value, or something like that. In other words, out-of-line prices are explained not by a failure of theory (in this case, theory is that mess of valuation done by specialists), but by a failure or anomaly in the marketplace.

A second case recalls to mind that someplace (I can’t seem to recall it now) I remember a study asking whether economists were judged based on their predictive abilities. This is interesting because of economics’ claim to at least aim for prediction. I recall, though, that prediction was less important than providing ‘interesting explanation’ or somesuch. I read this, again, as some kind of bending of the world to match what theorists do, rather than the reverse.

I realize these are not exact counter-factuals, but I’m interested in your thinking about how wide a range of possibilities there might be. The idea that there is a reality out there, and that theories ‘work’ or ‘don’t work’ in explaining-then-shaping those realities, seems a bit constraining.

My reaction

About situations of ‘price not achieved yet’. Yes, we see such situations frequently in markets, when the public experiment is not delivering the results one expects them to deliver. In these cases the burden of proof is transferred elsewhere. That is, in the case of the art specialists they will need to explain why it is that the price they predict for that piece is not achieved in the market. Another example, where such burden of proof is really pressing, is the example of convergence arbitrage. There, a trader’s position is dependent on asset prices in two markets to converge, but they may diverge. In such cases, it is not uncommon for the trader to ‘defend the position’, either successfully or unsuccessfully, against his/her manager who may want to unwind it There is a very good paper about this by two finance scholars (“The Limits of Arbitrage” by Andrei Schleifer & Robert W. Vishny. The Journal of Finance, 1997). So, you are right, a one-time discrepancy between prediction and market would not fail the theory, but gradually, if such incidents mount and if these incidents cannot be defended successfully, then we should expect the performativity circle to be broken in some way.

About the second case: economists who simply produce ‘interesting explanations’. In the cases where experts do not take part in the prediction-performativity game then no public experiment (at least in the restrictive sense I am suggesting here) exist. But, of course, the claim you mention is interesting with regard to expanding the concept of the public experiment to the (relevant) realms of aesthetics of theories, their appeal to policy and so on.

About ‘reality out there’: the public experiment concept is agnostic about the existence of external reality. We follow the agents here. As long as the agents find the predictions useful in their interventions, the theory will be supported.

I was asked the question above, in different variations, many times during the workshop we did in NY in April. ‘what if, instead of Black-Scholes, the traders would have used some less-useful prediction mechanism (for example, astrology) would you then expect a performative effect to take place?’ or (the flip side of the previous question) ‘if Black-Scholes was not accurate to begin with and only became so as a result of traders using it, then why would anyone use a theoretical pricing model that was not producing accurate results?’

An answer, specific to the Black-Scholes case and how it became popular in spite of its inaccuracy during time of financial stress, can be found in this paper, that’s now making its way through a journal review process. However, the concept of performativity of expert knowledge in organisations alludes implicitly to a more general mechanism through which the process unfolds. As I did very briefly in the workshop and, as I now develop a paper version, I would like to offer here an initial set of theoretical definitions that describe the conditions necessary for performativity to take place.

To generalise performativity of predictive expertise, it is necessary to refer to reflexivity. Naturally, actors’ reflexivity is at the core of performativity: actors’ reactions to the ‘predictive content’ of a theory are the engine of performativity. What then, affects actors’ reactions to the theory?

First, given that actors are aware of the content of a theory, the actors’ ability to intervene in the field for which the prediction is made determines how effective would be the efforts to act in accordance with the theory. For example, we may have accurate theories about the rate at which the universe is expanding, but we are virtually helpless when it comes to intervening in this field. In this case, our reflexivity (after all, we are part of the universe) cannot be translated to intervention. In contrast, the public nature of financial markets makes them a field that is open to theory-driven intervention. In fact, such interventions – ‘taking positions in the market’ – are the lifeblood of the financial system.

Second, to serve as a basis for performativity, the connections between the field and the theory have to form a ‘well-designed’ public experiment. By ‘well-designed public experiment’ I mean that it is necessary for the predictive theory to provide items of information that could be confirmed or refuted unambiguously by items of information coming from the field. Again, the Black-Scholes pricing model and the early options exchange provided a nice public experiment. The model predicted a numerical item referring to a future market price and the market produced the actual price. In comparison, astrology can also be used a market-predictive methodology, but it is not likely to create to a good public experiment, as astrological predictions are very difficult to confirm or refute unambiguously.

Let us go back now to question about the predictive quality of the theory. That is, what would happen if the theory produces inaccurate predictions: is it possible that performativity would take place? Note that the two conditions above do not refer to an a priori validity of theories; they simply refer to the mechanisms through which performativity of such theories may evolve. Thus, ‘false’ theories can be performed; and that is because the second half of the mechanism described above, the public experiment, is exactly the process by which the validity of such theories is tested. Theories that produce predictions about the social, and especially ones that refer to intervention-prone areas in society, are not examined in isolated laboratories, but in public experiments.

However, a simple counter-argument can be presented here: maybe what we witness are the actions of the actors that simply activate a theory that had been correct? Such an argument, of course, does not take into account the full meaning of a predictive theory. Predictions that derive from theories do not provide arbitrary predictions of the future, but refer to a causal mechanism that stands at the basis of the predictions. So, when a theory does not incorporate the effect that its own prediction have on actors that can (and do) intervene in the predicted field, the predictive ability of that theory is reduced significantly. Of course, it is possible that such a ‘deaf’ theory would work, even for a considerable period of time, but when the actors (both human and non-human, as it were) would stop ‘supporting’ it, the theory would no longer produce accurate predictions. A good example, of course is, this is what happened (with some simplifications) to the Black-Scholes pricing model after the 1987 crash.

If we take this argument to its logical extreme then we could hypothesise situations whereby any theory could be performed, just as long as actors find its predictions useful and act in accordance with these predictions. However, the notion of usefulness underlying this argument is, in essence, a pragmatist one. That is, we know that the usefulness of a theory does not equate with its accuracy (the same way a public experiment is different from a classic laboratory experiment) and yes, we can hypothesise such a situation. But, it would be safe to assume that it is unlikely that actors would find theory that consistently produces grossly inaccurate predictions useful and thus, it is unlikely that such theory would be performative.

There’s an interesting video on FT today (John Authers, the Short View) reporting on some research which posses an empirically supported challenge the random walk hypothesis from efficient market theory.  Historical research done by London Business School shows that there has been, in practice, a momentum effect during the 20th century in the way the market has moved.  According to the study, the effect can be traced across several markets with the exception of the U.S.  (See synopsis or press release.)  Authers concludes that “maybe there’s something to be said for trading heavily and just looking at who’s hot…”

Any guesses or predictions as to what the potential performative effect of a piece of research like this might be?

(In passing, I was puzzed as to what ‘big mo’ might mean.  Turns out it has some rather naughty uses which I’ll leave the reader to look up on their own.)

Comment on ‘Last year’s model: stricken US homeowners confound predictionsBy Krishna Guha and Gillian Tett The Financial Times, Comments and Analysis, January 31, 2008 19:01

Story The Financial Times raised an interesting question this week about changes in consumer repayment behavior, and the failure of mathematical models to keep up to these changes in relation to the subprime mortgage mess. It would seem that a statistically visible number of consumer have been opting to continue repaying their credit card bills and car loans even while defaulting on their mortgages. This contradicts conventional wisdom which suggests that rather than risk foreclosure, households would prioritize the home over small debts, paying mortgage payments first and foremost when in financial trouble.

Malcolm Knight, head of the Bank of International Settlements, summed up this new pattern of repayment as follows (quoted by Guha and Tett):

“Now what seems to be happening is that people who have outstanding mortgages that are greater than the value of the house, or have negative amortization mortgages, keep paying off their credit card balances but hand in the keys to their house… these reactions to financial stress are not taken into account in the credit scoring models that are used to value residential mortgage-backed securities.”

The article goes on to suggest two possible reasons for the change in behavior that escaped the mortgage default models: first that it may be due to cultural changes that lessen the stigma associated with missing a payment or loosing a home, and second that people may no longer have an incentive to pay mortgages where the loan-to-value ratio has become excessively high with dropping property prices. That is, they’ve decided it’s just not worth it.

Implications Drawn to its logical conclusion, what this piece implies is that on a large scale the American consumer no longer minds having their property taken away from them and might even willingly abandon it once they’ve calculated that it’s too expensive. Hmmm. That sounds kind of… doubtful. Consider the gushing tears and suicidal thoughts of precarious homeowners featured so prominently in Scurlock’s (albeit melodramatic) documentary, Maxed Out. It’s unfortunate that these financial journalists, who appear to live across the pond in London, only had access to macro data. If they had had the chance to come over and investigate the actual practices of American consumers up close, they might have considered dropping culture and economic rationality – two of the falsest friends the social sciences have ever confabulated – and discovered some more plausible reasons to account for this new consumer behavior. Hint – it’s a risk model. FICO® consumer credit bureau scores which receive so much attention in consumer circles – and almost none in the financial press related to the mortgage crisis – are one of the key pieces of information used for matching loan products to consumers in the U.S. In 2001, after pressure from consumer groups started to build in Washington, the scores were released to the public which is now able to purchase access to their scores (see www.myfico.com). So consumers know a thing or two about how the models work, and there is plenty of advice in circulation to tell them how to behave accordingly. What is ironic is that the scores only came to public attention after they were adopted by the Government Sponsored Agencies (GSEs) in 1995 as a sub-component of their automated underwriting programs (Loan Prospector® at Freddie Mac and Desktop Underwriter® at Fannie Mae). From there they worked their way through the mortgage industry into the securities underwriting models (such as S&P’s LEVELS®). Interestingly enough, no mortgage data used to calculate FICO® scores, which were originally designed as risk indicators for small consumer credit, supporting in particular the credit card industry. They were never redesigned to accommodate the mortgage markets because the bureaus have traditionally not had access to mortgage data.

Conclusion Since these scores are the obligatory passage point to further consumer credit and play a role in refinancing – i.e. getting out of a subprime loan, getting another mortgage… and so on – a move to preference credit cards payments over home loans would probably not have much to do with a growing indifference towards foreclosure. Rather it would be a performed consumer response targeted at protecting their precious risk scores. Not convinced? Remember the Paulson Plan released in December? It suggested interest rate freezes on ARMs but would have limited these to cases where the borrower had a FICO® of 660 or more. This means that the category of people the federal government will agree to rescue pay their credit card bills faithfully and on time… even when they can’t afford their mortgages. In this light, paying credit card bills would be a way of waving a white flag that cries out ‘help me (I’m helping my self)’, and not at all a way of bailing out of an overpriced home. If we can consider changing consumer behavior a form of getting it right, then at least one risk model didn’t get it wrong… At least, not this time.

From Bodies to Black-Scholes

A Two-day Workshop on Performativity and the Social Studies of Finance

Organized by Daniel Beunza (Columbia U.) and Yuval Millo (LSE)

Columbia Business School, New York, 28-29 April 2008

The Social Studies of Finance (SSF) is one of the fastest-growing and most intriguing new fields in the social sciences today. Born from the intersection of sociology of science, economic sociology, management and critical accounting, SSF offers a new vantage point for the analysis of financial markets and their dynamics.

This intensive two-day workshop is convened by Daniel Beunza from Columbia Business School and Yuval Millo from the London School of Economics. It is aimed at presenting the field to newcomers, and is directed at research students and early-career researchers in accounting, finance, management, political science and sociology.

To allow effective discussion, the group size is limited to 12 participants. The workshop’s fee is US$ 200. To apply for the workshop, please send by February 29th a CV and a one-page description of your research and how it relates to SSF to y.millo@lse.ac.uk

For more details see: http://personal.lse.ac.uk/millo/SSFworkshop.htm

This is a text that I prepared originally for an exhibition catalog, but I thought that it can also fit nicely with the eclectic spirit of the blog. So, I include it here.

 

We hear many different stories about where the market is to be found and, consequently, what the market should be. Many of these stories, though not all of them, are exclusionary. That is, they tell us: ‘my market is the real market’. When asked where the market is, the trader on the busy New York, Frankfurt or Hong Kong trading will spread his arms and say ‘here’. The day trader, in the basement of her suburban house will point to the computer screen and say ‘right here. This is the market’. The economics professor, surrounded by books and papers in his university office will point to a formula on a white board and explain why this is the market. ‘Well’, the sophisticated art aficionado is now saying, ‘this is not so problematic. The market simply has many representations’. Yes, quite right, but a representation of what, exactly? Where is ‘the market’?

The sophisticated art lover may revolt now: ‘why do we need a ‘real market’ that would be represented? Why couldn’t we have plurality without an obligatory original? Isn’t the artists’ re-creation of the market just as valid as that of the traders’ or as that of the securities analysts? Haven’t you heard of Walter Benjamin or Baudrillard?’ Yes. There is a faint smell of postmodernism in the air, but I think that this time the sophisticated art-lover may actually do a little better then state that ‘anything goes’.

When we state that any representation of the market is valid because there is now fundamental original that can be represented we implicitly focus on the outputs of markets. For example, the artist may take the voices of traders, graphs representing price movements or an aural translation of prices and embed these into a work of art. This brings us back, sneakily, to the apologetic position where we have to defend our ‘soft’ representations of the market against the ‘hard’ representations that analysts, accountants of finance professor produce. Isn’t there a way out?

Maybe we could shift our focus from the representation itself to the one using it and to the experience of its use. That is, what do people experience when they interact with representations of the market? An initial answer may be that these representations can help people understand where they are vis-à-vis the market and then, they can use this understanding to develop an idea of where to go next. The immediate example is of a map. You are not sure exactly where you are, but a short look at the map and a comparison with the terrain around you, may help you to estimate your location.

But, the alarm bell on our art-lover’s desk is ringing. ‘How can you look at the terrain if there is nothing ‘original’ outside? Didn’t we just say that there are only competing representations of the market?’ Well, let’s be more subtle about our examples, and maybe we will get closer to what market participants experience. You have a map, but you cannot see the terrain right now, as it’s night and it’s raining heavily. You have to rely on the map. But, the art-lover is asking, ‘is there a terrain (market) out there or isn’t there?’ Let us wait a little bit with this question. Remember, we are focusing on the experience, not the market. Let us find out what participants do with the representations.

The geographical map, like a risk map, a graphical representation of past price changes or a printout of mathematical prediction model, to name but a few, is what cultural anthropologists frequently call a ‘summarizing symbol’. Such symbols capture, in a compact informational package, numerous references to related entities. For example, the French flag may represent to a French person the sound of the French language, the beauty of a Parisian boulevard, the taste of regional food and patriotic pride. All these things, and countless others, are ‘compressed’ into a three-coloured rectangular. ‘Yes’, says our art-lover, ‘but these reminiscences are not in the flag; they are simply evoked by the flag, while the map actually includes new information. The French person is ‘smarter’ than the flag, while the market participant is not smarter than the representation of the market’.

This is true. But, the representation of the market, as smart as it may be, does not know what would be the next step that the market participant may take. Granted, the representation and the trader or analyst work together with their representations of the market, but none of them is a-priori superior cognitively to the other. Representations of the market, in their role as summarizing symbols, operate with us (and sometimes, unfortunately, against us), market participants, in our joint person-machine endeavor to make sense of where we are vis-à-vis the market and help us devise our next step.

‘Hold on’, cries the art-lover, almost dropping his espresso, ‘I am returning to the question you didn’t answer before: is there or isn’t there a market that we represent? Now you really contradict yourself. How can a representation of the market, be it a graph, an annual report or a work of art help us to find the market if there is no original market to be found? How can we position ourselves in relation to something if that something does not really exist?’

‘There is no contradiction there’ we should answer. We do not know if there is or there is not a ‘real’ market out there and neither should we care. The floor trader, the on-screen trader and the economics professor we met earlier may or may not care about the authenticity of the market whose representations they interact with. What they do care about is that the representation works. It provides them concise, compact, summarising information that allows them to make sense and make decisions.

The art-lover is now grinning cynically: ‘I like this agnosticism. It’s all very clever, but what has that got to do with aesthetic representation of the market?’ It is related to aesthetic appreciation just as much as it is related to economic, political or social evaluation and decision-making. In fact, when examined carefully, one can find elements of different realms in each market decision. It is not a coincidence that the brain sites that process emotions and logical decision-making are coupled, as recent research indicates. We think and feel at the same time. The different representations of the elusive market are all valid as long as they provide us with a valid experience. Is it interesting, moving, pleasing and insightful? Does it reverberate with your feelings and your intellect? Does it help you to understand or sense things better? If so, this is it. You found the real market.