realists, constructionists, and lemmings oh my! (part I)

Here is an exchange from Friday’s News Hour with Jim Lehrer :

David Brooks: People took out these loans. People assumed house prices were going up. It’s a contagion all across the world in highly regulated economies in Europe, less regulated economies here. And to me, it’s this social contagion that has sort of transcended all the other barriers.

Jim Lehrer: Well, as Alice Rivlin said on this program the other night, what nobody counted on was the possibility even that home prices wouldn’t always go up, they would eventually go down. Nobody considered that as a possibility.

Mark Shields: Twenty-six years we had — from 1982 forward, we had low unemployment, low inflation, and pretty good economic times. A lot of people were hurting, but, you know, so there was that reason, that expectation that things were going to get better.

Jim Lehrer: And home values were always going up.

Mark Shields: Yes.

 And here is what former Fed governor Rivlin had said:

We were victims, the whole country, of a collective delusion that housing prices would keep on going up. And I think we lost control of our common sense.

Many people who bought mortgage-backed securities, who bought other securities that were related to them, didn’t ask one simple question, which was, what happens to the value of these securities when housing prices go down, as they eventually would?

I find this kind of talk to be fascinating.  For at least two reasons.  First, these are smart people, but they are saying silly things.  Were you deluded into thinking that housing prices were always going to go up?  Did you lose control of your common sense?  Personally, I had long thought that it was moronic to believe  that housing prices were always going to go up, and I was convinced that they had become insanely overvalued.  And I’m positive that that is true for many of you.  I’m even reasonably sure that this is true for the talking heads quoted above.  At least, I’m sure they thought there was a significant possibility that we were in a housing bubble.  And I’m certain that they participated in numerous discussions since 2000 and even before about such a possibility.  Like many of us, I’m sure that they were aware of the work of Robert Shiller–and maybe even got sent this fun video [based on these data])  If you have any doubts that the idea that we were in a housing bubble of unprecedented proportions was widely discussed, here is the number of articles in U.S. publications mentioning the words “housing bubble” by year (courtesy of Factiva):

Year Mentions
1999 4
2000 1
2001 20
2002 827
2003 539
2004 641
2005 2973
2006 1921

So, while there certainly were many dissenters with the view that we were in a housing bubble (please don’t all raise your hands at once!), it is clearly wrong to say that we are were all deluded, jumping lemming-like (metaphorically, not literally– turns out lemmings were given a bad rap by our friends at Disney) to our financial ruin.  The possibility that we were in a bubble was widely discussed and believed by many.

The second reason I find this interesting is that it is a useful route in to a set of related questions concerning how we should think about market prices and how they relate to “fundamentals,” an issue I promised in my last post that I’d address, and this issue relates more broadly to the perennial divide between realism and constructionism, with implications far beyond financial markets and including, in particular, the truth-value of scientific theories.  (Sorry for that awful sentence) In my next post, I’ll try and stake out an intermediate position that both incorporates the wisdom in each perspective and tries to deal with their problems.  In this post, I’ll lay the groundwork, by showing how pure constructionism and pure realism ironically lead to roughly the same (uncomfortable) place.

To begin to see how these seemingly opposing perspectives lead to the same place, note that adherents of both a pure constructionist perspective and a pure realist perspective should start sweating at the idea that we were in a housing bubble.   Why?  Well, the answer is obvious when you take the realist point of view– the notion of a bubble implies that prices are not (always) constrained by fundamental values.  But what about the pure constructionists?  At first blush, you might think they would take a perverse pleasure in the bubble in that it shows that prices really are constructed and not anchored in fundamental values.  However: (a) Acceptance of the claim that we were in a bubble implies acceptance of the claim that prices can be, and were, wrong [which is a four-letter word in constructionist land]; (b) Acceptance of the idea that the bubble popped implies acceptance of the idea that prices ultimately are constrained by fundamentals, even if such constraints are looser than realists typically suppose.  So there is a sense in which it is more comfortable from a pure constructionist perspective to say that in fact there was no bubble and that, as always, prices are just social constructions with any price being possible. 

Note that this implication can be seen in the politics of realism and constructionism.  Greenspan’s Congressional testimony on Thursday is case in point for why it is idiotic to have a pure realist as a chief regulator.  Why did he not do something about the mispricing of risk by banks?  In short, he gave the same answer as James Cox, as quoted two posts ago:

Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.

In my previous post, I already discussed the basic flaw in this line of thinking.  In short, while individuals act in their own self-interest, this very pursuit of self-interest can lead them away from fundamental values when they are; (a) acting as agents rather than principals: and (b) speculators rather than income or enterprise investors. For the moment though, what is crucial is to recognize is how idiotic it is to have a regulator who thinks that the self-interest of the targets of regulation is enough to ensure the desired behavior– in this case, that they will price loans (and secondarily, home values, upon which the value of those loans depended) correctly.  Essentially, the prices must be right because market participants have such a strong incentive to get them right.  And then the job of the regulator is…?

But just as it is silly to have a Chicago-type economist as your chief regulator, it would be just as silly to replace him with a constructionist.  To paraphrase Abbott in The Chaos of Disciplines (sorry– I don’t have the book in front of me and so don’t have the exact quote or page number), “the problem with constructionism is that it has no politics.”  Constructionism can never tell you what should be; it can only tell you that there is little basis for what is.  In particular, if there is no such thing as a right price or a wrong price, would Greenspan’s constructionist doppelganger have any more basis for questioning banks’ lending practices than did the Greenspan-the-realist?  No. 

As I said, parallel issues come up in the science wars, especially as they pertain to the “performative” properties of economic theory.  Consider in particular how orgtheory’s own Teppo Felin and his coauthor Nicolai Foss respond, in their forthcoming article, to a paper by a 2005 AMR paper by Ferraro, Pfeffer, and Sutton.  FPS argue that the self-fulfilling nature of social scientific theories (and especially high-status ones coming from economics) imply that even a false theory can become true if practitioners adopt that theory and enact its principles.  F&F argue that a focus on such positive feedback-loops ignores various negative feedback loops that prevent the acceptance of economic theories that are unconstrained by objective reality and human nature.  

As with the debate concerning the basis for financial market prices, this debate is between a constructionist position (FPS) that says that the success of a theory is a function of what people are ready and willing to believe, and a realist position (F&F) that insists that the theory must be valid for people to believe it.  And note again that while these positions oppose one another, they lead to the same place– neither them of them can account for the widespread acceptance of a wrong theory!  For FPS (and the performativity movement with which it is allied), this would be problematic because it means that the self-fulfilling properties of economics are not so powerful after all.  And for F&F (and the realist position that it develops), the widespread acceptance of a wrong theory is problematic because it implies that the truth does not constrain (economic) theories very much.  In sum, while the performativity folks suggest that “economists make markets” and the realists think that economists just provide insight into markets, neither of them can account for when wrong economic theories prevail for long periods of time.  Perhaps this doesn’t matter because there are no, widely-adopted, but wrong economic theories.  But then what about the efficient markets theory espoused by Greenspan, and his Chicago-type allies?!  This was certainly not a case of economists being right about markets, as F&F would lead us to expect.  And it was not a case of  economists making markets, as FPS and their performativity cousins would lead us to expect.  In fact, this was a case of economists breaking markets!

In sum, we need an intermediate position– one that reconciles:

(a) The idea that prices (or the relative success of different theories) reflect subjective valuations and these valuations are governed, in the first instance, by (the anticipation of) others’ subjective valuations; with

(b) The idea that such valuations are constrained by fundamental and objective values. 

Moreover, such a position should hopefully be able to explain why those constraints operate so loosely for periods and then tighten up.  And this question is particularly vexing since we clearly have a case where there was a massive bubble but there was not, contrary to the talking heads quoted above, a mass delusion.  What did people believe then, and what changed?

I’ll try to develop such an intermediate position (basically, just a summary of views that I’ve already expressed in my articles on stock market valuation) in my next post.

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Written by ezrazuckerman

October 26, 2008 at 6:24 am

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34 Responses

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  1. Ezra: A few quick comments:

    “…realists think that economists just provide insight into markets…”

    Not necessarily — economists may TRY to provide insights into markets, but of course may be wrong in some of their key assertions (being wrong certainly does not obviate realism); often they are wrong (partly because models are abstractions, but they also are wrong with some key assertions). But, that indeed points out a problem with performativity and the argument that false (or “arbitrary:” dependent on the socio-political-technical machinery/tools, and importantly, the models shape reality INDEPENDENT of the correctness of the models themselves) economic theories strongly determine reality: why, then, do only SOME “false” assumptions/models (Black-Scholes) become reality while others do not (agent omniscience)? So, from the aforementioned paper:

    “To further illustrate how objective reality puts a boundary on the self-fulfilling nature of theories; consider the question of why some assumptions of economic theories have NOT fulfilled themselves, while others have. Specifically, while FPS focus on the self-fulfilling nature of the assumption of self-interest, neoclassical economics has traditionally also made strong assumptions of agent omniscience or hyper-rationality. The assumption of hyper-rationality means that agents have full knowledge of (their own and other agents’) preferences and choices and the consequences of associated actions; hence for example the assumption of fully efficient markets (cf. Friedman 1953). However, it is quite clear that DESPITE the dominance and power of economics in the social sciences (FPS), the theoretical assumption of agent omniscience has not fulfilled itself. This raises the question, why do some aspects of economic theory (or other theories for that matter) appear to be self-fulfilling (such as self-interest), while others are not (such as hyper-rationality)?”

    OK, so, there’s much much more here that needs vetting…I’ll craft a post to highlight some of the key issues.

    Overall, its very hard to make a clean sweep and argue that constructionists are truly engaged in explaining (ironically, in the realist sense) what economists are doing; while the economists are engaged in a language game (construction) of sorts that has nothing to do with explanation and understanding (or science).


    October 26, 2008 at 7:58 am

  2. I don’t have time (ahem) to digest this in detail, but —

    However: (a) Acceptance of the claim that we were in a bubble implies acceptance of the claim that prices can be, and were, wrong [which is a four-letter word in constructionist land]; (b) Acceptance of the idea that the bubble popped implies acceptance of the idea that prices ultimately are constrained by fundamentals, even if such constraints are looser than realists typically suppose.

    No, this doesn’t follow. If you’re a “pure constructionist” (I’m not sure what that is, though) I think you can just believe (a) that there’s a self-reinforcing cycle of beliefs and actions regarding the prospects of some asset and (b) that eventually this cycle exhausts itself and people change their minds (or panic). This can be a completely endogenous process, like the dynamics of fads and fashion, popularity amongst teenagers, religious charisma or what have you.

    I’m not saying that you can’t adduce evidence against strong constructivism, or that I believe it myself. But there’s no logical gotcha here, with constructivists unwittingly and ironically committed to a premise they nominally reject.


    October 26, 2008 at 2:26 pm

  3. On the theory-social reality related issues (matters related to F&F and FPS) — Fabrizio Ferraro will be guest blogging here at orgtheory in the near future and we’ll have a forum/dialogue to systematically vet these matters.


    October 26, 2008 at 8:20 pm

  4. Teppo:
    a. On the relationship between realism and theories being wrong: I did not (intend to) say that a realistic perspective on science says that all theories are right. What I said was that realism is made uncomfortable by the idea that an incorrect theory would be widely accepted. A more precise way of saying this would be that the theories that outcompete others over time will be those that better at capture reality. (Better still would be to say that the theories that win are those that provide the best balance of realism against parsimony). This is roughly parallel to, but considerably weaker claim than the efficient-markets-hypothesis that market prices are the best available estimates of value, given available information. The reason I say it is weaker is that no serious realist would actually maintain that the ‘science market’ is so efficient that we can say that it is always in equilibrium. Of course, this is not true of the stock market either, but it is at least somewhat plausible in the latter setting.
    b. Black-Scholes is a very tricky example. First, it is not really relevant due to point a—i.e,. the question at hand is which theories become widely adopted rather than whether any particular theory is right or wrong at a particular point in time. Second, I think it is incorrect (!) to characterize it as a descriptive theory, at the time of its writing. Black, Scholes, and Merton were well aware that the market for options did not behave according to their model. Rather, it was a piece of financial engineering (i.e., intended from the outset to be an engine rather than a camera). No engineer is surprised that her wonderful design is not widely adopted before it has first been implemented—otherwise, what is the point of the design? And she is hopeful that it becomes widely adopted thereafter, thus validating her genius. This is the story of BSM, as far as I’m concerned. I think it is quite in line with your argument (that it diffused because it was a good model) but it cannot be used as an example of a widely-adopted wrong theory. A better example, IMHO, is the efficient markets hypothesis.

    Perhaps I should have been clearer with my definition of a “bubble.” From the literature and even from common parlance, I think the term implies that the prices are unjustifiably high. But such a claim cannot be made unless one has a sense of what would be a justifiable price. Sure, one can always say that prices are just going up and down due to internal dynamics, as in the case of fashion (e.g., as modeled by Lieberson in A Matter of Taste). But that is not an account that uses the term bubble in a meaningful way– or at least in the way I had in mind. More generally, and putting aside semantics, the point is that a pure constructionist account (which I am defining as one that understands prevailing valuations as driven solely dynamics that are internal to the evaluators and is unconstrained by objective features of the things that are evaluated) cannot say that prices were too high before and that they are more reasonable (or too low) now. They must in fact hold on for dear-life to something like the fashion model you described.


    October 26, 2008 at 9:40 pm

  5. From the literature and even from common parlance, I think the term implies that the prices are unjustifiably high. But such a claim cannot be made unless one has a sense of what would be a justifiable price.

    You can’t just help yourself to the premise that a bubble is, by hypothesis, a situation in which prices are unjustifiably high and that “unjustifiable” must refer to some objective measure of value independent of the assessments of any agents in the market. On our hypothetical PC (pure constructivist) view, the “justifiable price” is given endogenously by the balance of assessments of agents in the relevant market or field. Certainly if a larger and larger number of credible agents come to believe and insist that a price is unjustifiable then eventually some belief-threshold will be reached, there’ll be a crash and — after the fact — most people will agree that yeah, it “really was” a bubble all along.

    Sure, one can always say that prices are just going up and down due to internal dynamics, as in the case of fashion (e.g., as modeled by Lieberson in A Matter of Taste). But that is not an account that uses the term bubble in a meaningful way– or at least in the way I had in mind.

    By “meaningful” or “the way I had in mind” you just seem to mean “an account that uses the term ‘bubble’ as though bubbles must involve departures from some external measure of value” — but this is what is at issue from a PC point of view.

    More generally, and putting aside semantics

    It’s not a matter of semantics — it’s a question of defining what needs to be explained. A PC theorist will say “It’s all very well if the common-sense definition of ‘bubble’ involves a story about departure from some objective measure of value, but my account of this process is no more committed to accepting this definition than a theory of fashion or popularity is committed to believing in the existence of some quality of fashionability or popularity that exists independently of the views of the members of some social field or other.”

    the point is that a pure constructionist account (which I am defining as one that understands prevailing valuations as driven solely dynamics that are internal to the evaluators and is unconstrained by objective features of the things that are evaluated) cannot say that prices were too high before and that they are more reasonable (or too low) now.

    Of course it can. Our PC theorist just has to avoid sloppiness and speak, for example, in terms of the structure of opinion amongst market agents at a particular time in the past versus the structure of opinion amongst them now. It’s trivially true that a consistent PC account cannot suddenly start talking as though the “true prices” of goods are revealed by a crash — if they were to do so, it wouldn’t count as much of a PC account. But it’s not true to say that PC theories are unable to talk about sudden drops in value, crashes, market corrections or bubbles in a consistently constructivist manner. In particular, a PC account is well able to encompass a divergence between the views of the bulk of the market and a minority of naysayers and bears (at time t), and the subsequent reversal of fortunes when the market as a whole comes to accept (at time t+1) that the bears were “objectively right all along”.


    October 26, 2008 at 10:23 pm

  6. Kieran:

    All I’m saying is that it seems useful to be able to distinguish between two different assertions:

    1. The reason that prices fell was because that they had gotten so high relative to their true underlying values that they could not be sustained.
    2. The reason that prices fell was because people came to believe that they had gotten so high relative to their true underlying values that they could not be sustained.

    If you want to use the term “bubble” in both accounts, then I say uncle. What I’d like though is to be able to distinguish the two accounts. Because while similar, the two accounts are quite different (the second sees prices as driven purely by internal factors; the first gives a role to external, ‘objective’ [i.e., intrinsic to the thing being evaluated] factors) and as I said in my post, they have enormously different implications for policy/action. For the second, there is never a basis for intervention. The first says that there sometimes is such a basis. It is someone who subscribes to the first that I want as my regulator and managing my 401k.


    October 26, 2008 at 11:22 pm

  7. If you want to use the term “bubble” in both accounts, then I say uncle. What I’d like though is to be able to distinguish the two accounts.

    I’m saying that these are (potentially) two different explanations or characterizations of the same phenomenon — the two accounts are indeed very different, but the question is not the semantic one of whether one should properly be called a bubble and the other not, but rather the empirical one of which account best explains things that conventionally are called bubbles.

    I said in my post, they have enormously different implications for policy/action. For the second, there is never a basis for intervention. The first says that there sometimes is such a basis. It is someone who subscribes to the first that I want as my regulator and managing my 401k.

    But this isn’t true at all. Let’s say I have a really well worked-out PC theory of the dynamics of self-fulfilling bubble-like processes in markets. I think I’d do at least as well in managing a 401k as someone who was an out-and-out fundamentalist. Take the example of Keynes, who characterized the business of playing the stock market as a beauty-contest phenomenon where the goal was not to accurately assess fundamental facts about any underlying “beauty” (or value) of stocks, but rather to accurately assess what “average opinion about average opinion would be” about that underlying value, and act on that basis. That’s a pretty thoroughgoing PC view, and based on the job he did for Cambridge, I’d be happy to have Keynes manage my 401k. Which isn’t to say that you wouldn’t do just fine with, say, Warren Buffett in charge of yours.


    October 26, 2008 at 11:59 pm

  8. Kieran:

    This is a lot of fun. Unfortunately, I have to sign off for the rest of the evening. For now, I’d say:

    On the bubble business: I thought I already said uncle to this (and clarified that I was uninterested in the semantic point) but only in distinguishing those two accounts.

    On your last paragraph: I’m not sure which part of what I wrote you think is a matter of truth/falsehood (I love the irony of being accused of making false statements by someone defending the coherence of pure constructionism!!!). Surely you don’t disagree that the two positions have very different implications for action. And if you meant my statement of preference for a fund manager or regulator who believes in fundamental value, this was stated as a matter of opinion (“I want”), not an assertion of fact. Yes, it’s possible for a PC-based fund manager to do well. (It is unclear to me actually though whether that is the approach that Keynes actually employed at Cambridge, but perhaps it it is). Personally though, I’d take a good value-investor (a la Buffett or Bill Gross) over the long term, but I grant you that the former can do well, especially in the short-term.

    And you could even have a pure constructionist as the fed chairman. It’s kind of funny/scary to contemplate. Let’s call our PC fed chairman Mr. Ponzi.

    Congressman: “There is concern among some observers that asset prices have become dangerously overvalued. What do you plan on doing about it?”
    Chairman Ponzi: “There is no such thing as “overvalued.” How quaintly positivistic of you! All that is necessary is to persuade a lot of influential people to buy more assets, and prices will continue to rise!”

    Again, this is possible. All I’m saying is that it’s different and that I want no part of it.


    October 27, 2008 at 12:45 am

  9. (I love the irony of being accused of making false statements by someone defending the coherence of pure constructionism!!!)

    It isn’t at all inconsistent to say you can make true or false statements about what happens (or can happen) in systems that are purely socially constructed.

    I should elaborate but right now I, too, have other pumpkins to carve. Oddly, even though Halloween is nothing but a complete social construction, a self-fulfilling fabrication from beginning to end, its facticity is such that any efforts by me to insist it doesn’t come until next month, or some other time more convenient to me, will, unaccountably, be aggressively rejected as untrue by my kids — my immense local patriarchal authority notwithstanding. Chairman Ponzi should perhaps take note.


    October 27, 2008 at 1:10 am

  10. Interesting example, Halloween. As is the case for most traditional Jews, Halloween is not celebrated in my family. This was not a problem when I was growing up because it had not yet become so huge (and so saccharine– there was a time when it had a real edge to it, at least in my neighborhood). But today, it is always very awkward to answer the perennial question of what my kids did for Halloween. It seems inconceivable to most other Americans that someone might opt out of Halloween. Same is true, to a lesser degree, for (St.) Valentine’s Day. And I personally hate Mother’s Day and Father’s Day for the same general reason is that it is imposed on me rather than chosen. I think Swidler discusses the latter examples in Talk of Love. (And if you didn’t think I was Scrooge already, I also hate the whole cult of birthdays. Though I kinda like Thanksgiving…). So yes, social constructions can exert a lot of pressure, and Chairman Ponzi should take note. But that is exactly what he is counting on. There is nothing out there to threaten the Halloween bubble and a lot of commercial interests to stoke it further.


    October 27, 2008 at 2:57 am

  11. Ezra, for someone who has been so good about opting out of one unhelpful dichotomy (who is right, economists or sociologists?), it’s odd to see you plopping yourself down into another unhelpful dichotomy (who is right, realists or constructionists?).

    I come at this with the same sensibility of a postmodern feminist. It’s not that gender is either natural or socially constructed. But gender is based on agreed-upon biological differences (yes to reproductive organs, no to number of bones in the hands and feet). And it is not such a performance that you can just decide one day to perform a different gender – it is deeply structured. Wanting to tag people as dismissing biology or dismissing culture does not make terribly much sense. Only zealots for biology believe it’s all biology, just as zealots for sociology may believe it’s all culture. Both are wrong.

    So too with the economy, markets, prices. To me, it’s not that there is not such a thing as fundamental value, or commodities, or markets. But good grief, markets are simply peculiar and particular kinds of social structures, not somehow outside other kinds of sociological analysis. That the theories that surround them and make them appear super-duper-special and rooted in something more real (hence ‘fundamental’ value, as opposed to ‘conventional value’ or some other term denoted agreed-upon reality) hardly makes me jump up and down. But I would of course say that just because conventional value is a convention doesn’t mean that it can be anything we like. No one says that.

    Now it may be the case that prices in some markets persist at absurdly high conventional values for a long time, and never get understood as bubbles or unreal or whatever. Maybe something like diamonds in the post-1920s contemporary era. But the fact that (common, not really scarce) diamonds rise but never fall in price while tulips do does not mean that the conventional value of diamonds is high the conventional value of tulips is low – ie. a bubble.

    What is interesting to me is the infrastructure of convention – and that’s where my cultural institutionalist organizational tendencies overlap with the performativity crowd.


    October 27, 2008 at 5:29 pm

  12. Ezra,
    Not referring now to the (very interesting) discussion in its entirety and I promise to get back to it (perhaps with the later post that you promised), but I got a few things to say about the references to performativity.

    It’s true that you are referring to the FPS paper, but since FPS have been using performativity the way Donald MacKenzie and I used it (and cite us as the source), and since we were the first to use Callonian performativity in a empirical case, I think that I can say something here without feeling that I’m butting in.

    Ezra, you’re saying that “constructionist position (FPS) that says that the success of a theory is a function of what people are ready and willing to believe, and a realist position (F&F) that insists that the theory must be valid for people to believe it[…] neither them of them can account for the widespread acceptance of a wrong theory!” and “while the performativity folks suggest that “economists make markets” and the realists think that economists just provide insight into markets, neither of them can account for when wrong economic theories prevail for long periods of time.”

    Well, this is incorrect, at least from the constructionist/performative side. MacKenzie and I show in our 2003 paper that the Black-Scholes-Merton model was indeed wrong for a quite a long time – from 1973 until the late 70s – the assumptions of the model did not exist and it produced very inaccurate results (about 205 off). It became accurate as a result of activity in the market. In fact, in a forthcoming paper we explain how and why people and organisations used the model in spite of the fact that it was wrong. Ezra, you don’t even have to take the word of sociologists of science for that. Dan Galai, Myron Schole’s PhD student published papers where he shows that the model was not accurate to begin with, but gradually became so.


    October 27, 2008 at 6:49 pm

  13. just noticed – it’s not “205 off”, but “20% off”.


    October 27, 2008 at 6:50 pm

  14. Yuval: This will be more carefully delineated in a future post (and is also discussed in F&F: e.g., see discussion on Popper and links to both natural and social science) —- the fact that theory affects/changes reality does not provide support for construction and performativity. For example, note that in the natural sciences we cannot say, in similar fashion, that theories strongly construct reality.


    October 27, 2008 at 7:40 pm

  15. Peter: I’m not sure how you read my post and came away with the idea that one needed to choose between realism and constructionism. I said my intention was to stake out an intermediate position. I also did not say that or imply (and my own published papers would imply the opposite) that markets were “outside sociological analysis.”

    I sense though that what’s really bothering you is reflected in these lines: “But I would of course say that just because conventional value is a convention doesn’t mean that it can be anything we like. No one says that.”

    The fact of the matter is that there are indeed such people (off the top of my head, see e.g., And more importantly, the proof of the pudding is in the eating, not the saying. It is insufficient simply to say that yeah, there are objective constraints on conventional valuation. The challenge is to say precisely how such constraints operate. It is hardly a stretch to assert that addressing this challenge is not high on the agenda of most sociologists who study financial markets. And that impoverishes their work. And the flipside is true for financial economists, who tend (with some notable, and perhaps growing, exceptions) to be tone-deaf to the constructionist aspects of how the markets work.

    Yuval: I was not challenging the fact that BSM became more accurate over time; nor that it became more accurate as it became more widely adopted. That makes complete sense. What I was suggesting was that it was a bad example of a wrong theory that became right because of its diffusion. The reason is that it was not wrong in the same way that, say, efficient markets theory is wrong. 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.


    October 27, 2008 at 7:53 pm

  16. The reply I was writing to Ezra became so long and touched on some interesting insights that thought that it should appear as post on SocFinance. But, I am not trying to divert traffic away from you guys on OrgTheory. So, I will continue to discuss this here. Here’s the link:


    October 28, 2008 at 3:53 pm

  17. [...] 28, 2008 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 [...]

  18. Teppo, you are absolutely right: the fact that theory affects/changes reality does not provide support for performativity and the performativity thesis, in its Callonian / MacKenzie&Millo version does not say so. What we do say is that if a theory changes the predicted environment in such a way that increases significantly the predictive power of the theory (the theory ‘becomes’ more accurate) then the theory had a performative effect on the environment. And, you are right, of course, that theories in the natural sciences are not performative in this sense, and that’s because molecules, unlike traders, are not reflexive and are not aware that a theory exists that predicts their behavior.
    (Sorry, just noticed your comment now)


    October 28, 2008 at 6:05 pm

  19. Yuval: The question, then, is to what extent theories are reflexive — can truly even ‘arbitrary’ (e.g., false) conventions realize themselves? In short, there must be boundaries to the self-fulfillment of theories. Does any theory fulfill itself? Why or why not?

    In retrospect we can certainly (somewhat conveniently;) show how models perhaps impacted reality — and label them either performative, or my favorite: counterperformative — but imputing the model itself (or, rather, its arbitrariness and the machinery behind it) requires also highlighting why that particular model was adopted versus another potential model (is the adoption and diffusion of a particular model truly independent of any truth associated with that model — I understand truth is problematic here, as is the question of who is judging that truth; but that’s partly where realism and construction part ways). This comparative approach (of alternative models) also needs to be used when highlighting the potential realization and retrospective ‘wrongness’ of models.


    October 28, 2008 at 9:19 pm

  20. Teppo: Good points. We have two questions here: (1) why do actors choose models (is it related to the models’ validity and accuracy?) and (2) how the models chosen and adopted become performative (or counter-performative)?

    About the first question: actors may choose a model because of reasons that have little to do with the model’s validity. For example, a certain pricing model is likely to produce better annual bonuses for traders in hedge funds than another model, and the latter model was significantly less accurate. Guess which model was chosen… (Real life example, by the way). So, which models/theories would be chosen? The ones that are more useful for the actors involved.

    Second question: models/theories are likely to become performative when they provide a ‘taken for granted’ picture of the environment. That is, it will happen when the practices based on the model are institutionalised to such a degree that they are the de facto standard of operation. That does not mean that the model is the *only* way of doing things, but that it had reached a significant level of dominance that marginalised, in effect, all competitors.


    October 28, 2008 at 10:04 pm

  21. 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%5D. 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.)


    October 29, 2008 at 2:50 am

  22. [...] Bonus visualization: the housing bubble as a roller coaster. (via) [...]

  23. 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.


    October 30, 2008 at 11:40 am

  24. Yuval:

    I think we are at diminishing returns on this conversation becuase I think we are talking past each other. I look forward to opportunities in the future to talk more about this. If you want to post a response to this one, that’s fine. But this will be my last word on this for now. To wit:

    As a teacher of mine used to say, “you do not know what you cannot show.” Two reasons why this is relevant:

    1. You assert that some kind of behavioral/mimetic process was responsible for the spread of BSM. But the logic I referenced had nothing to do with that–i.e., what I said was that it diffused because it was profitable. In general, we should not be surprised that when a tool produces better results, others will come to adopt it as well. I’m sure that you will insist that this is not what happened or that this is only part of the story. But you simply cannot rule it out. And it’s the most straightforward explanation for what happened because it is just the flip-side of a point you have already conceded, which is that BSM provided arbitrage/profit opportunities to its initial users.

    2. While conceding that it was a “great model,” you say that the “success (of BSM) should be attributed, in large part, to how [it] affect[ed] its environment.” But this is bald assertion. You have no evidence that the story is not simply that it was a great model. You simply want to believe that there is more to the story. But at least in this case, simply asserting your your version of reality doesn’t make it so. A certain irony in that….

    A final note: it is not that I don’t think social theories can be self-fulfilling. For instance, the Frankel and Froot paper I referenced in my last comment is a fabulous example of a self-fulfilling theory in a financial market. And it’s a particularly good case because it was not based on fundamentals or written by economists (a la BSM). My problem is: (a) for all the new labels and breathlessness, it simply is not news that social theories have self-fulfilling properties; (b) it is especially not news in financial markets due to their highly self-recursive nature [others' valuations drive your return]; and and (c) it tends to be asserted without trying seriously to rule out alternatives and without seriously taking into account self-defeating aspects of those theories.


    October 30, 2008 at 10:00 pm

  25. Ezra, I agree that we did talk past each other. It’s partly because of the medium and partly because there are some differences of opinions here about the nature of predictive models and expert knowledge. So, yeah, we should catch an opportunity and discuss it properly.


    October 30, 2008 at 10:47 pm

  26. Ezra,

    I notice in this and similar discussions which touch upon the topic of the performativity of economics that there is a tendency to equate “economics” to “economic theory”. That’s a tendency that only a few STS-oriented “performativistas” would endorse. Economics produces a lot of things (be they performative or otherwise) which are not economic theories (data sets, pricing instruments, trained personnel, allocation algorithms, recommendations, etc.), and when a theory is produced, this does not always look as a predictive, prophecy-like statement.

    Another thing that not all from the science studies faction of the “performativity folks” would endorse is the equivalence between “socially constructed” and “constructed”, the first expression (although highly ambiguous) often referring to collective beliefs, state of minds or cognitive conventions, the second rather being synonymous of “artificial”. From an actor-network viewpoint, for instance, something constructed (say, a bridge, a stock exchange, a price) is pretty real (being real is actually a hard and expensive job).

    These two points are discussed in a recent paper, available here in French (not translated to English).


    October 31, 2008 at 4:16 pm

  27. Hi Fabian: Since you are making a distinction between economics and economic theory, I presume that one or the other then is what performs (and the other, not), or? A problem might emerge when we then post hoc start labeling what performed and what didn’t (and, what is economics versus economic theory) —- the requirement should be to also somehow account for the “best efforts” of these models (and their potential alternatives — and, again, the models after all are trying to capture underlying value); particularly when theories in retrospect of course often turn out to be wrong (though, this also is not evidence for performativity).

    And, now, if we then take something like agent omniscience or hyper-rationality (this comes from above F&F paper), why, then, despite it being very central to the assumptions and models of various neoclassical theories, does that not perform?


    October 31, 2008 at 5:15 pm

  28. [...] a comment » In my last post, I argued that in order to understand systems of valuation, we need to develop an intermediate [...]

  29. Teppo, I just say that “economics” is not only “economic theory” and that the performativity (or not) of the former is not exclusively about the performativity (or not) of the latter (the same applies to any other kind of science). As for what performs more than what, I don’t think there is a rule!


    November 2, 2008 at 6:23 pm

  30. [...] be inevitable? I’m not sure how much of this incredible lack of judgment was the result of pure delusion versus an incorrect theory of value.  Or perhaps delusion was temporarily bolstering an incorrect [...]

  31. FYI, a P.S. on an a trailing thread in this discussion from two years ago. Kieran had suggested that in his role as manager of Cambridge’s portfolio, Keynes had acted like the speculators of his beauty-contest metaphor. I had wondered whether that could be true, and it seems that my doubts were well-founded. I am now reading Justin Fox’s Myth of the Rational Market (quite good, so far; he really understands what he’s writing about and he conveys it simply and clearly– I wish I had that skill!) and he reports that “as an investor, he succeeded by ignoring the daily beauty contests. He struck it rich in the 1930s, after vainly trying to time the market, by holding through thick and thin to stocks he deemed good values.” Fox goes on to quote from a letter in 1938:
    “I feel no shame at being found still owning a share when the bottom of the market comes. I do not think it is the business, far less the duty, of an institutional or any other serious investor to be constantly considering whether he should cut and run on a falling market, or to feel himself open to blame if shares depreciate on his hands… An investor is aiming, or should be aiming primarily at long-period results, and should be solely judged by these.” (Fox, p.338, quoting from p. 38 of Maggridge, ed., The Collected Writings of John Maynard Keynes. CUP. 1983


    November 11, 2010 at 12:34 pm

  32. P.S. The first of the Fox quotes is from p.34 of his book.


    November 11, 2010 at 12:40 pm

  33. FYI, this post got cited by Charles Perrow.


    February 4, 2011 at 2:22 am

  34. Interestingly and encouragingly, there seems to have been progress in the public understanding of the bubble in the 2+ years since this post. See e.g., the contributions here ( suggest much greater acceptance of the idea that there was widespread doubts about housing prices. And I doubt strongly that Brooks, Shields, and Rivlin would now endorse what they were saying back then. Of course, and with all due respect to Chick Perrow and his influence on the world, methinks that neither my posts nor my piece in that Markets on Trial volume had anything to do with this progress.


    February 4, 2011 at 6:38 am

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