This is the story of the transformations that have taken place in both the theory of finance and in financial markets since the 1960s. The crucial development was probably the work of Franco Modigliani and Merton Miller on financial markets. The ruling theory of finance offered explanations of the optimal level of debt a firm should incur, and how it should determine the dividends it paid its shareholders. Modigliani and Miller overturned such arguments through showing that, given assumptions about financial markets that were consistent with assumptions conventionally made in economic theory, neither gearing nor dividend policy should affect the return to shareholders. They were irrelevant. For example, if a firm issued too much debt, causing returns to shareholders to be too risky, shareholders could offset this by holding a mixture of debt and equity.
In the 1960s and 1970s, three strands of the finance literature came together: the theory of corporate finance, dominated by the Modigliani–Miller theorems; the theory of portfolio selection, that stemmed from work by Harry Markowitz in the early 1950s; and the theory of efficient markets, which sought to make sense of movements in stock prices. What these ideas had in common was arbitrage: buying or selling combinations of assets (selling them short if necessary) so as to mimic the income stream that would be obtained from holding another asset. If the prices of two assets (or combinations of assets) differ, even though they yield the same income stream, profits can be made by selling the more expensive one and buying the cheaper one, without affecting one's income. Such reasoning also led to the theory of option pricing, associated with Fischer Black and Myron Scholes, again based on an arbitrage argument. The argument here was that a stock option (which gives the right to buy or sell a unit of stock for a predetermined price) should be worth exactly the same as an appropriately chosen portfolio comprising the stock itself and a risk-free asset: if not, there is an opportunity for arbitrage.
A key concept in this literature is the idea of an efficient market. This has two characteristics: that there are no opportunities for profitable arbitrage and that prices must take account of all available information. These are related in that known arbitrage opportunities would violate the condition that prices reflect all information. If markets are efficient, then it can be argued that prices should follow something like a random walk, for they must reflect new information, which cannot, by definition, be predictable (it cannot be a pure random walk because prices cannot become negative). This explains the phenomenon, known at least since the 1930s, that professional investors cannot perform better than the market, except by chance. The implications of this for practitioners were radical. Unless financial analysts can unearth information about company performance not generally available to the market, the best that they can do is to keep pace with the market.
These ideas led to the transformation of financial markets. The existence of a formula for pricing options led to the establishment of markets for options on financial assets which were significant because they opened up the possibility of portfolio insurance (ensuring that the value of a portfolio did not fall below some lower limit), and institutions such as hedge funds. This entire industry was based on the idea of arbitrage with increasingly complex combinations of asset holdings being developed. Fortunes were made, the most visible being those made by those behind the hedge fund, Long Term Capital Management (LTCM), established by a team including Robert Merton and Myron Scholes, two economists who won the Nobel Memorial Prize for their work on finance. Programmed trading, a feature of portfolio insurance, was blamed for the stock market crash of 19 October 1987, whilst the financial crisis of 1998 was marked by the near-failure of LTCM.
This account gives no more than the gist of the complex story told by MacKenzie. In particular, it leaves out many of the points that are crucial to his account, which is based on interviews with around 60 participants and wide reading in what is by now a very large literature. He approaches it as a sociologist concerned to identify the social interactions underlying these events, from which I pick out some of the most important.
The first is the relationship between academics and practitioners. The theory of finance was developed largely, though not exclusively, by economists located in business schools who had strong links with practitioners. More significantly, the theories were developed by people working in financial institutions, sometimes developing ideas that their institution would put into practice, and sometimes by academics. The latter might engage in consultancy for financial institutions or, in several cases, set up companies that sold advice or engaged in buying and selling on their own behalf or for clients. The Nobel prize-winners involved with LTCM were in no way unusual in this respect.
Another theme is the complexity of the human interactions that lie behind markets that economists analyse in much simpler terms. The establishment of the crucial futures trading markets involved overcoming legal barriers that were linked to perceptions of whether transactions in derivatives constituted gambling rather than legitimate trading activity. A futures contract on the Dow Jones index had been considered illegal, on the grounds that because it could be concluded only through a cash payment, not through delivery of any physical good or company shares, it was no more than a vehicle for gambling. It also involved key players behaving in ways that MacKenzie represents as going beyond pure self-interest. Derivatives markets might have foundered through lack of business had Leo Melamed, at the Chicago Mercantile Exchange, not had contacts whom he could persuade to engage in trading. Milton Friedman's reputation with the Secretary of the Treasury was crucial in getting approval of futures markets for Treasury Bills in 1976. Furthermore, though intensely competitive in one sense, the markets where trading took place exhibited very clear social structures, without which their operation could not be understood.
This analysis of the social structures underlying financial markets carries through into MacKenzie's accounts of the 1987 stock market crash and the 1998 crisis that caused the demise of LTCM, both of which are analysed in considerable detail. The theme is that to understand these events, it is necessary to see them as involving human interactions rather than mechanical forces. This point is illustrated vividly by the incident with which MacKenzie starts the book, the night of 19 October 1987, when the collapse of share prices threatened the ability of the Chicago Mercantile Exchange to reopen the following morning. At the end of each day all transactions on the exchange had to be cleared, those who lost money or had changed their positions paying money to those whom they owed it. It was only through a series of phone calls and a night of arm-twisting and threats (“. . . because if you don't [provide the money], I've got to call Alan Greenspan, and we're going to cause the next depression”, p. 3) that this was completed, with three minutes to spare. MacKenzie implies that if the Chairman of the Continental Illinois Bank had happened not to have walked in while one of his executives was on the phone to Melamed, the exchange would have failed, bringing down the entire US financial system.
MacKenzie is not the first to document the relationships between these various developments. Much is covered by Peter Bernstein's Capital Ideas (Reference Bernstein1992), generously acknowledged by MacKenzie, and by Perry Mehrling's (Reference Mehrling2005) intellectual biography of Fischer Black, which presumably appeared while this book was in press. What is notable about MacKenzie's book is the range of its coverage and the way a complex and technical narrative has been enlivened by material from interviews with so many participants. This material enables him not only to show how things seemed to those involved but also reveals the complexity of the social processes involved. The book is also distinguished from the others by the interpretation MacKenzie has chosen to place on these developments, viewing them through the lens of “performativity”. Given its centrality to the volume, and that it is of philosophical interest, it merits separate discussion.
The idea behind performativity, a word taken from Michel Callon, that the discipline of economics can be “an intrinsic part of economic processes” (16) is hardly new. One has only to think of the remark made by Maynard Keynes, that “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else” (Keynes Reference Keynes1973: 383). More than that, the notion of performativity has been fundamental to beliefs about policy advice. Economists have been searching for theories that will be performative in the sense of changing the world to bring about states of the world described in their theories that they thought desirable. The idea that theories are “engines” is implicit in the idea that the way to test a theory is to implement its recommendations and find out what happens. The notion of performativity can be used to describe the problematic nature of that process. The Keynesians of John Kennedy's Council of Economic Advisers believed that Keynesian economics was performative in what MacKenzie calls the Barnesian sense when an expansion of demand proved able to bring about full employment. Conversely, for James Buchanan, Keynesian economics was counter-performative, undermining the belief that the peacetime budgets must be balanced, generating inflation and thereby bringing into existence a world in which Keynesian theories no longer applied. Economists have always believed that their discipline was an “engine” in the sense in which MacKenzie uses the term.
At the time Markowitz obtained his PhD, much finance was not considered part of economics (an attitude reflected in the position of the American Finance Association, closely tied to the American Economic Association but not part of it). Those who developed the modern theory of finance were largely located in business schools rather than economics departments. MacKenzie notes both of these facts but they merit further attention as they raise questions about the way he uses the example of performativity in the theory of finance to draw conclusions about the performativity of economics. He is clearly aware that finance is special, but how special? Finance is a “virtual” world, of claims (equivalently obligations) that are virtually costless to create by actions that are performative in the sense defined by Austin. There are costs of time, phone calls, paper, computer time, and so on but these are incidental. The significant costs are imposed by legal requirements and social conventions but these can be altered. Though finance clearly has a material dimension – that MacKenzie describes very effectively – and though there is no sharp boundary, there is nonetheless a significant difference between most financial markets and most markets for material products.
This would seem likely to make a significant difference to links between ideas and practice. Because of the nature of the “products” financial markets, despite the complexity of the mathematics, are very simple environments, governed by rules that may be malleable in ways that other economic environments are not. Imagine a Chicago “pit” in which the usual traders could be joined by outsiders, with different educational backgrounds and motives, the rules of their interactions being only loosely defined. Whereas the goal of participants in financial markets is to make money, notwithstanding the examples MacKenzie cites of what should probably be called “enlightened altruism”, agents in the economy at large are more varied in their motives. The point is that changing such a world, where traders cannot be excluded or forced to confirm to what the theory requires, would be significantly different from the changes MacKenzie analyses. Of course, because financial markets have real consequences, not least the transfer of wealth from what have often been called “productive” sectors to the dealers in virtual assets, financial theories are performative in relation to “real” activities (the word real being used in the economist's sense). There seems little reason to believe that the collapse of the US financial system in 1987 would not have had real effects, even if it would not have sent the world into a major depression.
The objection to the concept of performativity is not that MacKenzie's claim about the relationship between economic theories and economic activities is wrong. It is that it is a black box that needs to be opened up. The important question is not performativity but how economic ideas influence the world. It would seem extremely important to distinguish between two possibilities. (1) Believing that x is true will cause x to be true. (2) Believing that x could be true causes people to want x to be true, and so they take actions to change the world so as to make it true. MacKenzie's use of performativity seems to confuse these two very different notions. The emphasis on the social structures of financial markets seems to be implying the second meaning – the world conformed to the theory because people decided that they would create the institutions that would make the theory of finance true. Put in this way, the significance of performativity seems much more limited. Marx's theory that capitalism would eventually give way to socialism was, at least to Lenin and his followers, performative, in that it caused them to take actions to bring about the overthrow of capitalism and its replacement by socialism. Perhaps the performativity of financial market theory is the result of historical contingency: indeed, this would seem to be the import of the social context to which MacKenzie attaches so much attention.
There is a further problem. Suppose x is performative. It is significant whether or not theories that are inconsistent with x are also, or could also be, performative. Take naïve versions of Keynesianism and monetarism as an example. It may be that if people believe Keynesian theory, a fiscal stimulus will cause expansion, rendering Keynesian theory performative; it may also be the case that if people believe monetarist theory, a fiscal expansion will simply raise prices, rendering monetarism performative. This could be seen as an example where two conflicting theories can each be performative. This is very different from a case where one theory works and alternative theories are simply erroneous, and are bound to fail.
One reason why this distinction is significant is that if a theory is performative only through making people want to change the world so as to make it true, other objectives are brought in. Why did people want to transform US financial markets? Personal gain is one possibility but even if that motivated many of those involved, others involved presumably believed that the changes would make financial markets more efficient, not simply in the narrow sense used in financial market theory but also in the broader sense of improving the efficiency of the US economy. (One presumes that when these new markets were justified to government and regulators, it was the latter that was emphasized, even if the real aim was personal gain for those proposing the changes.) Suppose the outcome were that the development of derivatives trading enabled some people to make money at the cost of destabilizing the US economy and hence making the US economy less efficient in providing for the welfare of its citizens as a whole. Derivative-pricing theory could then be performative in a narrow sense but the broader theory on which claims to social benefit were based, and which provided at least a partial motivation for implementing the changes, could simultaneously be counter-performative.
These questions can be illustrated with a different example. The events described in the book are also about the theory that destroying the US financial system will end up impoverishing many people, a crucial belief in the 1987 crisis (I treat this as a theory, though it is probably no more than an inductive generalization, backed by loosely formulated beliefs about the economy). This theory was Barnes-performative in that it caused Alan Greenspan to take action to ensure that the Merc did not collapse on 19 October 1987. But is it useful to say this?
A further problem with making any generalizations from the examples discussed in this book to economics more generally is that finance may be unusually simple, depending largely on the notion of arbitrage (conceptually simple, despite the complexity of the many types of arbitrage transaction that MacKenzie recounts). It is not clear that non-financial economics can be reduced to any such simple notion. This creates a problem because it privileges certain types of relations between economic ideas and economic activity. Representations (which are emphatically not photographs, as Friedman made clear) of the economy are diverse and are used in diverse ways (see Backhouse, Reference Backhouse and Boumans2007). The primitive concept of supply and demand not only underpins many formal economic theories but it influences ways of thinking. “Intuition”, a concept on which economists rely heavily in evaluating their theories, is influenced by such ideas. The analysis of the 1997 Asian financial crisis by Joseph Stiglitz (Reference Stiglitz2002) was based on a theory that, because it took into consideration asymmetric information and the risk of bankruptcy, offered an explanation that ran against the policy being pursued by the IMF, challenging notions of supply and demand that many economists found intuitive. The roles of the theories used by the IMF and by Stiglitz are important, but it is not clear that performativity provides the best conceptual framework, for it involves not simply the application of specific theories, but changing deeply held perceptions.
The organization of this review was chosen, in part, for expository reasons, avoiding a simple precis of MacKenzie's argument. However, it was also chosen to make the point that book's discussion of the theory of finance and financial markets can stand independently of the arguments about performativity in which it is wrapped. This discussion forms a highly original account, based on evidence not previously available, that is important for our understanding the way economic ideas have interacted with financial markets and stands alongside earlier work by Bernstein, Mehrling and others. The idea underlying performativity is also important but here, perhaps, greater caution is required. Couple the idea of reflexivity (that social scientists, and hence their theories, are part of the world they analyse) with the social construction of knowledge (even in a weak form) and you come close to performativity. The label “performative” can facilitate the expression of certain ideas but there is the danger that it may become a short-cut. The metaphor of a camera may be better than that of a mirror (in modern cameras images are as much the result of computer software as of light falling on a sensor, making the metaphor of the camera seem problematic) but, attractive as these metaphors are, MacKenzie's title suggests a false dichotomy. The picture is too complex. Performativity typically depends on a range of theories raising problems associated with the Duhem–Quine problem in testing theory, meaning that the conclusions reached can depend on how a theory is defined. It is equally important to explore what lies beneath performativity or its absence: the classification “Barnesian” and “counter” does not get to the heart of the problem.
Perhaps part of the explanation of why MacKenzie takes the view he does, is that economists have accustomed themselves to thinking of their subject as influencing government – they are forever deriving “policy implications”. After Robert Lucas and the new classical macroeconomics, and public choice theory, economists know that policy has (at least in principle) to be considered endogenous, which together with the notion of reflexivity implies that performativity is part of the process whereby theories are assessed. However, because economists have chosen to assume that private activities are generally efficient (driven to it by competition) they do not think of themselves as showing how private activity can be improved by economic theory. Through applying performativity to private economic activities, MacKenzie is reminding economists that relationships they have thought of in relation to government activities actually have much broader implications. How broad those implications might be depends on the extent to which financial markets are unusual. Hence the importance of looking inside the black box of performativity.
