British Academy: The UK's National Academy for the Humanities and Social Sciences
Enquiry, Evidence and Facts: An Interdisciplinary Conference
The Collapse of Fact: Financial Markets, Knowledge and Crisis
Professor Donald MacKenzie
School of Social and Political Science, University of Edinburgh,
Adam Ferguson Building, George Square, Edinburgh EH8 9LL
A paper presented to the conference
‘Enquiry, Evidence and Facts: An Interdisciplinary conference’
at the British Academy, London, on 13 December 2007
Biography
Donald MacKenzie works in the sociology of science and technology and on the sociology of markets. He holds a personal chair in sociology at the University of Edinburgh, where he has taught since 1975. His first book was Statistics in Britain, 1865-1930: The Social Construction of Scientific Knowledge (Edinburgh: Edinburgh University Press, 1981). His most recent are An Engine, not a Camera: How Financial Models shape Markets (Cambridge, MA: MIT Press, 2006) and Do Economists Make Markets: On the Performativity of Economics (Princeton, NJ: Princeton University Press, 2007), co- edited with Fabian Muniesa and Lucia Siu.
Abstract
A crucial, underappreciated aspect of financial markets is that they are sites of the production of public as well as of private facts. Private facts (for example, a price or an interest rate quoted by one person or firm to another, and/or agreed between them) may suffice to permit bilateral transactions, especially if sustained ultimately by legal sanctions.
For many purposes, however, private facts are inadequate. Even purely bilateral transactions are often facilitated if there is a credible, public ‘market price’ or ‘market interest rate’ that can be consulted to check whether a quoted price or rate is fair. Trustworthy public estimates of borrowers’ credit-worthiness make debt markets far more liquid than they would be if determining creditworthiness required extensive ad hoc investigation. In some cases, indeed, public facts are essential. Cash-settled derivatives contracts (such as ‘futures’ or interest-rate ‘swaps’) based upon an index level, price or rate are possible only if the level, price or rate is seen as not subject to manipulation by the parties to the contract.
Conversely, if the credibility of public facts is called into question, crisis can ensure. Financial-market actors become reluctant to buy from each other or lend to each other. Subclasses of actors – such as hedge funds – that depend upon market liquidity then become financially distressed, and if the extent of their consequent forced sales of assets is unknown, uncertainty is increased. The valuation of assets and liabilities on balance sheets is cast into doubt, and trust thus drains from assessments of creditworthiness.
Examples of mechanisms for the production of credible, public facts include:
- ‘Fixings’, such as LIBOR (London Interbank Offered Rate), which is the basis of derivative contracts totalling over $170 trillion (around $26,000 for every single human being on Earth).
- Models, such as the single-factor Gaussian copula used in the credit derivatives market.
- Ratings of creditworthiness, such as those produced by Standard & Poor’s, Moody’s and Fitch.
- Corporate financial reporting, especially balance sheets.
The crisis to be discussed is that of summer and early autumn 2007, in which an increasing risk of default on ‘subprime’ mortgages in the US had worldwide consequences, causing paralysis of key markets – and e.g. the ‘run’ on Northern Rock. What is striking about the crisis is that the ‘subprime’ problem, though serious and large in absolute terms is limited in relative terms. The US Federal Reserve’s estimate of subprime losses is $50-100bn, but the world’s outstanding debt securities (private and government) total around $40 trillion. So even if the Federal Reserve is wrong, and losses are $200bn, they would amount to only 0.5 percent of the world’s debt securities (Giles, Tett and Davies 2007).
How did a limited problem come to paralyse global markets? The paper will argue that the mechanism was a collapse of fact. Ratings came to be distrusted, and as the models used to value complex debt securities were called into question (they had never been much trusted by insiders) balance-sheet and off-balance-sheet valuations of those securities came to be seen as dubious. Even LIBOR – previously a remarkably solid fact – was dismissed by some as a fiction.
‘Liquidity’, write Carruthers and Stinchcombe (1999, p. 28), ‘is among other things, an issue in the sociology of knowledge’. Liquidity in modern financial markets requires solid facts, and when facts collapse so does liquidity. Those who depend on liquidity – not just hedge funds, but banks such as Northern Rock – are then in great danger. The conditions are in place for the most primal of all threats to a financial market: bank runs.
References
Carruthers, Bruce G., and Arthur L. Stinchcombe. 1999. "The Social Structure of Liquidity: Flexibility, Markets, and States." Theory and Society 28:353-382.
Giles, Chris, Gillian Tett and Paul J. Davies, 2007. “Parallel Worlds?”, Financial Times, 17 August, p. 9.