The Wall Street Journal (WSJ) recently published a headline article titled “Hedge Funds’ Pack Behaviors Magnifies Market Swings”. While it is not unusual to see the WSJ write on hedge funds and market swings, this article is unusual because it emphasizes the social ties linking investors. It reflects a sea change in the way that the public and the media view financial markets – and an opportunity for the social studies of finance (SSF) to reach a broader audience.

For the past decade, the quant metaphor has dominated public perceptions of financial markets. Institutional investors – particularly hedge funds – were seen as “quants” that used sophisticated computer models to analyze market trends. This idea went hand-in-hand with the view that markets were efficient – fueled by reliable, public data, proceed through sophisticated, rational algorithms, and powered by intelligent computer systems instead of mistake-prone humans.

Of course, the recent financial crisis has dislodged such beliefs. Instead of mathematical geniuses finding hidden patterns in public data, quants were revealed as Wizards of Oz – mere human beings capable of making mistakes. Their tools – computerized systems – went from being the enforcers of an efficient market to a worrying source of market instability. As stories about flash trading and inexplicable volatility popped up, the public even began to ask whether the quants were trying to defraud the public.

If institutional investors are mere humans instead of quantitative demigods, shouldn’t they also act like humans? And – shouldn’t their social natures affect the way they make investment decisions? The mainstream media is finally confronting such questions – which SSF has long raised. This particular WSJ article parallels a widely-circulated working paper by Jan Simon, Yuval Millo and their collaborators, as well as my own work under review at ASR.

The world is finally catching up with SSF. Will we finally be heard? It is our responsibility to reach out to the public and the media.

Still with the on-going Goldman Sachs story: yesterday, during one of the hearings of the American Senate Governmental Affairs subcommittee we had one of these rare chances where worldviews collide ‘on air’. In yesterday’s hearing, Senator Carl Levin was questioning former Goldman Sachs Mortgages Department head Daniel Sparks about matters related to selling of structured mortgage-based financial products known as Timberwolf, during 2007. The full transcript is not available (you can see the video here), but a few lines can give us a gist of the dialogue that took place. When Levin asks Sparks why Goldman Sachs hid from the customers their opinion of the value of Timberwolf (a product that an internal GS memo described as a ‘shitty deal’), Sparks answers that ‘there are prices in the market that people want to invest in things’. On another occasion exchange, when asked what volume of the Timberwolf contract was sold, Sparks answered: ‘I don’t know, but the price would have reflected levels that they [buyers] would have wanted to invest at that time’.

This reveals the incompatibility in its naked form. While Levin focused on the discrepancy between the opinions among Goldman Sachs’ employees about the value of the product and between the prices paid for these financial contracts, Sparks placed ‘the market’ as the final arbiter about matters of value. That is, according to this order of worth it does not matter what one thinks or knows about the value of assets, it only matters what price is agreed on in the market. Both Levin and Sparks agree that not all information was available to all market actors. However, while this is a matter for moral concern according to Levin’s order of worth, it is merely a temporary inefficiency according to Sparks’ view.

Moreover, the fact that this dialogue took place in a highly-visible political arena, a televised Congressional hearing, entrenches the ‘ideal type’ roles that Levin and Sparks play. Sparks, no doubt at the advice of his lawyers, played the role of the reflexive Homo economicus, claiming, in effect, that markets are the only device of distributional justice to which he should refer. Levin, in contrast, played the role of the tribune of the people, calling for inter-personal norms and practices of decency. These two ideal type worldviews, as Boltanski and Thevenot show, cannot be reconciled. What we call ‘the economy’, then, is oftentimes the chronology of the struggle between these orders of worth

The Problem with Economics

January 26, 2010

Blog readers interested in an ANT-ish refreshment on the infamous topic of the “performativity of economics” may find this little contribution amusing (PDF here).

Just when you think you’d had enough with hearing about the end of Wall Street and financial markets as we know them, there comes a story by Michael Lewis. It’s a very nice piece and well worth the read. But there are some points that call for clarification. One of them is the wrong impression that people may have about retail finance. Large part of the complex network of activities, technologies and institutions that is known collectively as Well Street is retail. That is, people and companies who sell financial products. In fact, for most of the public, this is the only side of Wall Street with which they ever get in direct touch. Now, when someone buys a car or TV, they know that the salesperson selling them the product has little knowledge about the intricacies of the technology driving the TV or the car. The same type of realisation about the division of labour does not seem to hold when it comes to financial products. The products there, having very little visible material, technological, footprint (at least to customer), somehow give off the impression that they are ‘made’ by the people who sell them, or, at the most, by a one level up the hierarchy of the retail finance company. The truth, as anyone now knows, is that Wall Street retailers did not know more about their products than your average cars or electronics sales people know about cameras or washing machines they sell. As one of Lewis’ interviewees tells him: “What I learned from that experience was that Wall Street didn’t give a shit what it sold”. Sure, they were some who knew more, but that’s typically because they had more background than necessary to do their job. Of course, “Old” Wall Street encouraged the establishment of indifference, and frequently let immoral and even deceptive practices to take root, but it would be incorrect to single out and demonize retail finance. It is not any better or any worse than any other retail business: it is based on distributed ignorance about the products sold.   

The discussion about the performativity of economics in OrgTheory is continuing . This new chapter includes Ezra Zuckerman, myself and the introduction of a time travelling machine! In other words, what would have Black, Scholes and Merton said if they were able to see, in 1973, the future of their model. I’m biased, of course, but I think that this is a fun and thought-provoking little piece.



Ezra Z:

Yuval, I’m not sure it is so productive to get into an extended discussion about the use of BSM as a canonical case by which to push on the idea that economic theories are performative. I’m pretty sure that we are not going to agree on this. Here is a quick summary of my view (and that of a financial economist friend of mine, who gave me some feedback on this):

Let’s say that we traveled by time machine to 1973, and we reported to Black, Scholes, and Merton that: (a) their model was an inaccurate predictor of prices in 1973; (b) that it would become highly accurate by 1980; and (c) it would become less accurate by 1987. Here is how I think they would respond:

1. We know it’s not accurate today. This doesn’t surprise us since it’s a *new* model of what the option price *should be*. It is not a model of what prices are. Moreover, it’s a very good thing it is inaccurate today! This means that you, my friend, can make a lot of money by using it! That is, it is a valuation *tool.* If you use it, you will become rich! And *those profits* vindicate our model! (Of course, we don’t rule out the possibility that there are better models, which would be even more profitable. We know that our model is based on highly restrictive assumptions. But it’s still a much better model of what prices should be than any other model we currently have).
2. Of course, once word gets out that this is the right way to value options, everyone will adopt it and then use of our model will no longer provide profit opportunities. So, the fact that you tell me that it will become accurate by 1980 is yet another *vindication* of our tool!
3. You then tell us that, after 1987, it will become less accurate. Ok, well that could concern me. But let me ask you. Is it also true that:

(a) The models of the future are all built on our basic foundation [with its key insight, which is that option prices are driven by the volatility of the underlying asset], but just relax our highly restrictive assumptions [which we already know are too restrictive but hey, we have to start somewhere!]?
(b) That our model would still be the convention because none of its descendants had won out to replace it as the convention? and
(c) That people will be assessing the state of the financial system with a volatility index whose logic derives from our model?

What? These things will also be true? Wow. That is the ultimate vindication. After all, we know that our model will be improved upon. What would worry us would be if our basic foundation were undermined, and it sounds like that has not happened. Moreover, we recognize that point 2 above need not be a vindication of our model. Rather, the fact that a valuation tool becomes more and more accurate could just reflect the fact that it has become widely adopted (in fact, we have been told that in the future, some finance scholars will find out that this is true even for models that have nothing to do with fundamentals! [see$%20F&F88.pdf. But the fact that our model is still basically accurate and that all future models are built on its foundation indicates that our model was not just a self-fulfilling fad, but was actually a great model. (We hear that this basic point will be made in a paper by Felin and Foss.)

Yuval M:

Ezra, this is a fascinating discussion! Also, I love the time machine metaphor!
But, before I answer to the hypothetical future-aware B, S & M I would like to say that I agree with you about not turning the Black-Scholes-Merton model into a ‘canonical case’ of performativity. While it is an interesting case, because of the natural experiment setting, there are other, equally promising cases out there (e.g. target costing, fair value in accounting, balance scorecards).

Now, for Black, Scholes and Merton. Yes, your model is inaccurate now, in 1973, and it cannot be accurate, because the assumptions that underpin it do not exist in the market (no-restriction short selling, free borrowing, continuous trading, etc). And yes, people will use the model (to begin with, your sheets with calculated prices, Fischer Black) and will make nice profits. This, as you say, is a nice vindication of the model.

But, in your second point you start talking sociology, I’m afraid and less financial economics: the fact that people will adopt the model and thereby change prices towards its predictions is a vindication of your theory? Where in your model do we see a description of such mimetic social behaviour? Don’t tell me that Chicago U in the 1970s is a hub of behavioural economists!

Your third point sings your praises, and rightly so, because you guys, transformed financial markets (some would say even capitalism) and virtually invented modern financial risk management. Right again, mainstream risk management models are built on the principles of Black-Scholes-Merton. But, we you start talking about ‘the convention’ I think that you actually refer to more to how the model will be used and how it will become ‘institutionalised’, put into software and rules and regulations, rather than its theoretical basis. The convention that Black-Scholes-Merton is the best model in existence will be built, step by step, by a variety of economic actors: trading firms that used implied volatility as an intra-organisational coordination, the options clearinghouse, the SEC and many other exchanges across the world.

And, yes: you are right to assume a causal connection between adoption and increased accuracy – this process is now called performativity of economics. That is, you will an explosive success (including one very nice surprise in 1997!), but this success should be attributed, in large part, to how your model will affect its environment. Your model, like many other bits of expert knowledge, played a central role in a process of performative institutionalization – it helped to bring about the institutions that performed its accuracy. No doubt – it is a great model – but markets are not detached from the theories describing them and your model will be a vital part of the market.

The NY Times has an interesting op-ed about behavioural approaches to financial markets; specifically mentioning the crucial importance of conceptual frames in decision making. All the usual suspects are there: Tversky & Kahneman, Thaler, Shiller, Ariely and, of course, Taleb. Still, it’s nice to see that behavioural finance is making inroads into the mainstream media. What’s next: economic sociology and institutional approaches to markets on WJS? Well, stranger things have happened…

This post started as a reply to a post on OrgTheory, but it got slightly longer and raised some interesting issues, so I thought that I’d make a post out of it. 

Let me give you the context. The issue here is the question of whether or not a ‘wrong’ economic theory can be performed in such a way that it ‘becomes’ accurate. I claimed that Black-Scholes-Merton is an example (in fact, a very good example) for a wrong, but very successful, economic model. Ezra answered that “The inaccuracy of BSM at the outset was not a surprise to anyone because it was not a descriptive theory, but a prescriptive one- a model for what one *should* do. After all, the options market basically did not exist when the theory was developed, so it could not have been intended as description.”

Below is my answer to Ezra

Ezra, I see what you mean now. However, Black-Scholes-Merton is a good example of a wrong model that ‘became accurate’ and that’s for two reasons: I would call them the ‘weak’ reason and the ‘strong’ reason.

First, the ‘weak’ reason. Yes: an organised options market did not exist when the model was published and the assumptions underpinning the model did not exist in the market even when it was established (i.e. no restriction on short selling, no fees on borrowing, continuous trading). So, from this respect you can say that the model, like many other economic models, was talking about a ‘would be’ or a ‘utopian’ market rather than an existing one. That, of course, does not turn the model into a prescriptive model. No one in the Chicago options’ market or at the SEC used the model with the intention to prove that Black, Scholes and Merton were right. They used the model for a variety of reasons, most of which are related to operational efficiency. As the performativity thesis claims, an economic theory becoming accurate is a result of a networked emergence rather than the outcome of specific agents.

Now, for the ‘strong’ reason. The original, theoretically driven Black-Scholes-Merton model was based on a lognormal distribution of the underlying stock (the theory here goes all the way back to Bachelier, tying the movement of stock prices to Brownian motion, etc). Without this assumption at its basis, the model would be not much more than a fancy card trick run on high power computers. But, guess what… Nowadays, virtually no one uses the plain vanilla (but theoretically justified) lognormal distribution in his or her BSM-based applications. Since the crash of 1987, where the Black-Scholes-Merton was not accurate, the ‘engine’ of the model, if you like, was replaced by a variety of different distributions, none of them justified by the theoretical roots that led to Scholes’ and Merton’s Nobel prize. So, again, for a very long time (at least since the early 1990s) the Black-Scholes-Merton model has been ‘wrong’ theoretically, but useful operationally.