For my talk at the UCSD Culture conference, I spoke about market crises, commensuration, and market linkages. The slides are a .pdf of my keynote presentation, available here (the keynote presentation for those who can manage it, is a zip file available here). And this post goes along generally though not perfectly with the slides:
This is a further discussion of the Markets-are-culture/Markets-have-culture dichotomy, with some implications. The MAC-MHC dichotomy is really a shorthand for the troubling phenomenon whereby economic sociologists and fellow travelers either treat the market as the dependent variable (mkts-are-culture) or as an intrinsically economic phenomenon with sociological independent variables (mkts-have-culture). The former are most often associated with the social studies of finance/performativity crowd, but also those looking at, say, the constitution of new commodities, or market agency. The latter is most easily conceptualized as the embeddedness/network crowd – that markets are influenced by their embeddedness in political/cultural institutions.
Where the MAC goes wrong is that it treats markets like a windup toy – the sociological ‘action’ occurs in the creation of the market, but once it is wound up, it tools along as a straight-up economic market. Yes, there is constant maintenance, but the ‘work’ is largely antecedent to the market action. Where the MHC goes wrong is in its implicit assumption that, absent sociological forces, markets work like straight-up economic markets. That is, markets are only sociological to the extent that there are measurable effects of networks, culture, or political institutions on their operation. Otherwise, markets are what markets are.
My issue is two-fold: that this dichotomy is largely an either/or proposition, and that it tends to break along the market phenomena being studied. Unsettled markets, and cultural markets, tend to be analyzed with the MAC approach, while settled markets and more economic-ish markets tend to be analyzed with the MHC approach. It is no accident that MacKenzie and Millo look at the origins of the CBOE, or that Wayne Baker looks at the CBOE a decade later.
Which brings us to the current housing/subprime/credit crisis.
The current market crisis is: 1) a market linkage crisis, made possible via 2) new forms of commensuration (in the form of quantitative finance models and information technologies), resulting in 3) new forms of risk that have not as yet become calculable.
Commensuration and Risk
The derivatives market for mortgage products is typical in its general outline and highly particular with regards the quirks of housing. I’ve gone over some of this before, but the upshot is that the transformation that’s interesting is the securitization of mortgages into collatoralized debt obligations. The alchemy that allows investment banks to transform individual mortgage loans into pooled income streams, into tractable debt instruments, into salable investment units, is the magic here. The commensuration required to achieve this alchemy is impressive, though not particularly unusual (if you can make pollution into a commodity, you can make mortgage payments – at least mortgage payments are already in the form of money streams).
Commensuration is the process of taking two or more qualitative differences, and making them comparable via some third metric. So individual, qualitative distinctions in university applicants can be made comparable via test scores. Cost-benefit analysis is another good example, whereby distinctive potential public works projects can be evaluated according to a ratio and placed hierarchically according to some quantitative metric. This is not new as such – Wendy Espeland turned me on to it as my advisor, and it’s been an old concept made new again through Theodore Porter and others interested in quantification. But what it alerts us to in this case is that risk/return has itself become this kind of commensurative metric.
And further, it has itself become a sort of commodity to buy and sell. To be sure, no exchange sells risk as risk. But financial instruments can be (and are being) reduced to specific kinds of metrics – volatility, return, and historical distribution of gains/losses. This now-bundle of quantities is what I mean when I say that risk is now a commodity. Qualitative distinctions across different financial products (gold, currencies, hogs, equities, mortgages) are made commensurable via a quantitative assessment of their risk.
Ian Domowitz, in 1993, made the argument that the increasing shift towards electronic trading in futures trading (which had hit equities already, but had not yet really had much impact in the commodity futures world) would provide the basis for merger and consolidation in the industry. The argument was that trading platforms would provide a kind of de facto standardization that would increase the possibilities that otherwise incommensurate systems could merge.
Domowitz actually understates what has happened since then. There have indeed been widespread mergers. There have indeed been widespread mergers. A number of European exchanges merged to form EuroNext, which merged with the NYSE to form NYSE Euronext. Deutsche Terminbörse (DTB) combined with the Swiss exchange (SOFFEX) to form EurExchange (Eurex) in 1998. The Chicago Mercantile Exchange and the Board of Trade merged in 2007.
More interestingly, though, is the commensurative effects electronic trading has had on global financial markets. This occurred through the combination of back-end electronic trading and clearing, along with the growth of organizations interested in trading across exchanges and not just within them. Exchanges in this model are not standardized per se, but they are made inter-operable via their electronic back-end systems. It is possible to ‘see’ prices across a wider range of markets now than ever before. It is the difference between having three open telephone lines and a 15-second-delayed to three exchanges trading three different products, and having all three markets on the same screen (and available to be manipulated by mathematical modeling) in real-time.
Combine this new organizational comparability with the commensurative activity I outlined above (a financial technology – some version of Harry Markowitz-type portfolio management) and we have something altogether new: rather than trading individual markets in currencies, real estate, government bonds, or corn futures, trading firms began seeing these things as variations of risk and were able to trade these things as risk.
It is as if the previous market world was a series of silos, each trading their own particular markets, using methods specific to the commodity and moving with the rhythms and cadences of their own particular worries. This new world is a post-silo one – not because shifts in oil are having direct consequences on the price of gold (though they may). But because both of these commodities are translatable into objectified risk.
New forms of Systemic Risk
Historically, the ‘solution’ to the problem of taking on too much risk is to diversify it. That is, to spread risk across a number of uncorrelated markets, so that if something goes wrong in one place, it will be offset by gains in another place. Add to this, in the new post-silo’d environment, the idea that risks are going to be a function of returns and volatilities. Insulation in the financial world, then, should be a matter of reducing vol, while diversifying investments.
But in this new linked environment, the opposite is happening as an effect. Consider, for instance, Amir Khandani and Andrew Lo’s analysis of the August 2007 blow-up among quantitatively-oriented hedge funds (it’s a pdf link). A sudden need on the part of some firms to reduce their positions resulted in a series of days where lots of firms got slammed. As an increasing number of firms had been making similar investments (or rather, using similar investment strategies) in equities hedging, the returns to those investments had declined. As a consequence, to generate good returns, more leverage was required. When a few firms began to unwind positions, a much larger community of connected traders got slammed.
And why did some firms have to unwind positions? Khandani and Lo suggest the following:
the events of August 2007 caught even the most experienced quantitative managers by surprise. But August 2007 is far more significant because it provides the first piece of evidence that problems in one corner of the financial system—possibly the sub-prime mortgage and related credit markets—can spill over so directly to a completely unrelated corner: long/short equity strategies. This is the kind of “shortcut” described in the theory of mathematical networks that generates the “small-world phenomenon” of Watts (1999) in
which a small random shock in one part of the network can rapidly propagate throughout
the entire network.
Brian Hayes, in a provocative talk at the NY Academy of Sciences, made a similar assessment: that we are seeing an increasing number of firms employing multi-dimensional investment strategies – that is, instead of focusing on equities or futures, firms are doing both.
In this new environment, this multi-dimensional strategy has the effect of linking rather than isolating financial crises. The end result is more systemic kinds of market crises – not crises within any particular market, but crises of markets. These are systemic crises, cutting across individual markets. The expression of these crises, as they are now and will likely continue to be for the foreseeable future, things like liquidity events. Liquidity events are generalized market failures caused by a lack of participation, unknown pricing, or an unwillingness to provide a ‘well-ordered market’. In liquidity events, markets don’t fall, they disappear. They fail.