The current financial crisis and the will to measure

The current crisis is certainly not a simple phenomenon, but a mix of different dynamics and problems. The first ‘dimension’ concerns the creation of the bubble in the American real estate market. With interest rates low, and steadily growing house prices, the market for subprime mortgages and alt-A mortgages (mortgages issued with lower standards) grew rapidly.Footnote ¹⁶ Already in 2006, Alt-A and subprime mortgages accounted for 50 per cent of the entire mortgage market. Two key dynamics seem to have fostered this growth: (a) the securitisation of credit which allowed banks to sell outstanding claims to global markets and thereby reduce their risk expose; (b) the changing landscape of the mortgage market itself. While in 2003 24 per cent of new mortgages were underwritten by private banks and 76 per cent by government-sponsored housing enterprises (GSE) like Fannie Mae and Freddie Mac, the proportion of private issuers rose to above 50 per cent in 2006.Footnote ¹⁷ With this privatisation, the standards for underwriting mortgages were reduced. While GSE issued only prime mortgages, private banks fostered the growth of the Subprime market.

The securitisation of credit by transforming mortgages into Collaterlised Debt Obligations (CDO) and the privatisation of the mortgage market linked the American market tightly to global financial structures: the slicing and dicing of subprime mortgages into tradable assets was made possible by modern financial instruments like derivates, modern practices like securitisation, new actors like Credit Rating Agencies (who provided first class ratings and thereby suggested false security in the context of a market downturn), and Hedge Funds (generating the demand for those assets).Footnote ¹⁸

The privatisation of the mortgage market brings us to the second dimension: the ‘embeddedness’ of the American economy into global finance – or better: how Global Finance is part of the American economy.Footnote ¹⁹ Through these markets, surpluses from China and other countries re-entered the Amercian economy and financed consumption. The American real estate market was not simply a market, but a very strategic market in the recycling of surpluses. Third, with those assets sold world-wide, the crisis spread globally quickly. The global transmission of the crisis triggered world-wide bank runs and several bankruptcies of major institutions (like Northern Rock, Sächsische Landesbank, and of course Lehman Brothers). While at the onset it was believed that we were dealing with an ‘American’ crisis (consider the first reaction by the Chinese and Russian governments), it quickly became clear that we were facing a truly global malaise. Again, and quite similar to the financial contagion literature in the context of the Asian Crisis, the contagion of turmoil was driven by credit channels: in particular Hedge Funds and banks whose investments were leveraged in order to maximise potential profit. When the crisis unfolded, these credit channels worsened the situation as banks simply refused to lend money to each other.Footnote ²⁰ The inter-bank lending system almost collapsed and even guarantees by governments could not restore the necessary trust. This was partly due to the fact that the shadow banking system is actually larger than the ‘official’ part. As a consequence, we witnessed a ‘flight to quality’ from emerging market assets into the US Dollar, leading to very substantial falls in the Russian stock market in particular, amongst others.

Fourth, the collapse of the inter-bank lending system soon captured other sectors of the economy through which the financial turmoil was translated into a global recession.Footnote ²¹ The Global Recession emanated from a number of causes: from a collapse of demand due to the burst of the real estate bubble to the loss of confidence by companies who postponed investments. Last but not least, we witness a discursive change on the national level: The classical crisis management mechanisms, like a concerted interventions by major central banks, could not avoid the full manifestation of the crisis and the independence of Central Banks today is increasingly questioned.Footnote ²² Instead, countries fell back on fiscal policies and saved banks with rescue packages of unprecedented proportions, including the nationalisation of vulnerable banks. The consequences of these measures, which ‘socialised’ the losses and increased public debt, are today widely felt in Europe. Today we have to ask ourselves whether we actually have adequate policy responses for a financialised economy?

These five ‘problems’ show the diversity and multiplicity of the problems, dynamics, and forces currently at play: apart from questions related to economic bubbles, we deal with questions of financialisation and a continuously changing ‘network’ of financial actors; the politics of financial innovation, the institutionalisation of derivatives and structured financial products, the adequacy of ratings and the politics of creditworthiness, disintermediation and banking, public debt, the shadow banking system, questions of credit channels vs. money, and face a deteriorating role of the state in contemporary capitalism up to a point where we can already see how the crisis leads to a the radicalisation of political discourses. When it comes to the question of how financial markets are to be reformed, this complexity is rarely taken into account.

Instead these dimensions are lumped together under the rubric of some ‘market or government failure’. Already in 2008, publications by the BIS, IMF, and FSBFootnote ²³ fostered the idea that an exogenous shock had hit Wall Street. The report produced by the FSB and the IMF on ‘the Financial Crisis and Information Gaps’ talks about ‘vulnerability through shocks’;Footnote ²⁴ as does the FSB reports on ‘Improving Financial Regulation’ in 2009 and 2008.Footnote ²⁵ The chapter on systemic risks in the IMF Global Financial Stability Report from April 2009 states that systemic risks result from asymmetric information and uncertainty, with the task to identify information gaps and measures that help to reduce them.Footnote ²⁶ The FSF comes to the conclusion that the crisis can be attributed to unsound disclosure requirements:

According to this view, the breath-taking rise of Collateralised Debt Obligations (CDO) and complex financial instruments has led to a situation where individual actors simply had to lose sight of their risk expose. In other words: the complexity of the five dimensions of the crisis, including the interplay between new actors, instruments and practices, is reduced to a problem of information asymmetry. Thereby the social character of the crisis, including the collapse of evaluating, pricing, and trading AAA-assets that now have turned into poisoned papers, is reduced to questions of data disclosure and standardisation.

This interpretation essentially externalises the source of financial turmoil. The reason why financial markets are inefficient and turbulent from time to time is not associated with the internal operation of financial practices itself, but with insufficient regulation: the source of instability is not endogenous but exogenous, as the FSF confirms: ‘Public authorities recognised some of the underlying vulnerabilities in the financial sector but failed to take effective countervailing action, partly because they may have overestimated the strength and resilience of the financial system.’Footnote ²⁸ Without externalities caused by regulatory bodies, there would be no problem of asymmetric information.

This externalisation of financial turmoil helps to uphold the myth of the efficient market hypothesis. It is assumed that financial markets could be stable if only the regulatory infrastructure set the right incentives.Footnote ²⁹ The reduction of turmoil to some lack of information in other words introduces a conceptual hierarchy insofar as it is assumed that financial markets could work if only the regulatory infrastructure were sound. In other words, crises result from some ‘failure’. Regardless of whether we have to deal with a market failure or a government or regulation failure – it's the failure of regulatory bodies that causes financial turmoil. It is this interpretation that sets the boundaries of the reform debate and at the same time defines the relationship between politics and finance in a specific way: politics is reduced to the task of providing the necessary infrastructure. When it comes to understanding the crisis, however, it is not politics but economic expertise that tells us what is a good idea, what failure led to the crisis, and what reforms should look like. As long as it is assumed that financial markets adhere to their own laws and logic, it is also assumed that regulations have to take this internal rationality seriously and cannot work ‘against the market’. This is an assumption that is almost cynical given that at the heart of the crisis is not the FED or SEC or any other financial authority, but the current assemblage (including the Special Investment Vehicles, CDOs or CDS) of actors, instruments and mathematical models. The crisis is the result of practices that were deeply embedded in modern finance. Without the innovation of specific financial instruments, without the ratings, without high leverages, the crisis would not have been possible.

As a summary then, we can see that the FSF as well as the IMF conceptualise the question of (in)stability of global financial markets as an information problem that can be solved by ‘more data’. It is believed that as long as every actor has access to the same data, the stability problem is solved. For example the FSF emphasises that ‘[e]nhanced disclosure … could help to avoid a recurrence of market uncertainties about the strength of banks’ balance sheets in the event of a future episode of market turmoil’.Footnote ³⁰

However, what this crisis shows, maybe more than ever before, is that the basic problem is not the lack of raw data, but a change in their meaning, which inevitably refers back to social relations. CDOs with AAA-ratings turned into poisoned paper, ratings were invalidated, assets turned into ticking bombs. The entire process of value and price determination within financial markets broke down.Footnote ³¹ The problem is not just ‘data’, but that a financial crisis disconnects existing data from stories, myths, and narratives that stabilised their meaning in the first place. During a crisis, data is redefined and linked to new stories and narratives where the same numbers now mean something completely different. A crisis shows processes and dynamics that are beyond ‘rational’ adjustment along with new data, but points to the generative power of interpretation. Data does not have an inherent information particle that flows from actor to actor. Rather, the meaning of data is the result of an assemblage of a constellation of actors and organisations, the practical use of economic models, and institutionalisation of financial instruments. However, to focus on these social processes of price formation, valuation, and ‘intersubjective expectations’ invalidates the story of the ‘exogenous shock’ that has hit financial markets like a meteorite hits planet earth. Rather, the question of ‘the social’ in finance highlights that the crisis is endogenously produced – and is irremediably linked to questions of economic expertise, authorities in markets, and economic models.

At the same time, however, the strategic use of asymmetric information in official reports perpetuates a naturalised understanding of financial relations, perpetuates monetarist ideas of stability, and thus to silences more ‘radical’ ideas of how to reform finance. Every argument that does not takes asymmetric information seriously falls out of the accepted (and by economics constructed) and acceptable limits of reform. More radical calls for a new financial order are thereby delegitimised and do not acquire the same ‘scientific’ status as more moderate reforms.Footnote ³² The question to be asked now is thus: how can we conceptualise crises as a result of financial practices themselves? How can we challenge the story of asymmetric information being told so far and thereby highlight not only its limits, but also its political consequences? The next section suggests that Hayek's later social thought could provide such an avenue.

Friedrich Hayek's social theory

Hayek is without doubt one of the most influential and controversial economists of the twentieth century. Although his work had experienced something of a revival after the disintegration of the communist bloc, the revival focused predominantly on his writing on socialism, without further interest in his social theory.Footnote ³³ However, there is more to Hayek's thought than those aspects emphasised by conservative free-market wingers.Footnote ³⁴ This section intends to highlight a dimension of Hayek's thought that could advance the current endeavour to construct a ‘constructivist SPE’. His concepts of uncertainty, rules, and institutions can shed a different light on the three tenets of uncertainty, intersubjectivity, and institutions that were emphasised in current constructivist contributions in IPE.Footnote ³⁵

Before I discuss these three concepts in some detail, it is useful to put Hayek in the context of Austrian economics.Footnote ³⁶ Austrian economics provides an alternative approach to economic processes. The founder of Austrian economics, Carl Menger, rejected Smith's division of labour as an explanation for the source of the wealth of nations and measure for human progress as being too materialistic. The inherent materialism of Smith and Walras led to too prominent a role of formal reasoning in economics, limiting our understanding of economic phenomena. To counter this materialism, Menger argued that development, evolution, and wealth of societies cannot be attributed to the division of labour per se, but derives from the prior division of knowledge. This division of knowledge provides a different ‘foundation’ for economics. From here, Menger developed a subjective theory of value and inquired into the ‘origins’ of social institutions like the market or money.Footnote ³⁷ For example, Menger observed that if prices would describe an objective equilibrium, every transaction would be easily reversible: in equilibrium, every actor would be indifferent between specific food baskets. Yet this is exactly what we do not observe: every contract, every trade, every decision comes with a time asymmetry: a reversal is not that easy. The seller sells only if he makes some imaginable profit. The buyer buys only if he thinks the goods are worth the money. Ultimately, there would be no transaction as every seller would reject any higher price. In terms of rational expectations: if prices would indicate the quality or ‘intrinsic value’ of a good, every seller should update his expectations as soon as a potential buyer would be willing to pay a higher price – and trade could not be motivated. The mistake made by Walras was that prices would not reflect ‘equivalent’ values and thus would not ‘equalise’ demand and supply. The entire concept of equilibrium or steady-state is thus rather strange. Instead, the economic sphere is an ongoing process of transactions and communications.

As will be discussed in more detail below, in contrast to a mechanistic, clockwork-like concept of institutions, Menger argued that institutions escape the single logic of ‘a general will’ or some design, but have to be understood as ‘organic’ entities.Footnote ³⁸ Although institutions result from human action, they are not just some simple mechanism and cannot be reduced to individual cost/benefit calculus. They are inherently social and – in our parlance complex – phenomena. Indeed, many thoughts of Menger are close to what later became sociology. Menger developed an economic theory interested in the most basic social institutions based on ideas of a subjective theory of value, time-irreversibiltiy of economic transactions, and organic change of economic institutions.Footnote ³⁹

Hayek returned to these ideas again in his later writings when he increasingly moved away from ‘mainstream’ economics. He criticised economic thought for misunderstanding the very problem of economic phenomena: the reduction of institutions to individual cost/benefit motives ultimately fails to grasp their complexity. Institutions bring different individuals into contact where each actor has its own history, self-understanding, and set of expectations.

To discuss this intuition in more detail, I will first introduce the concepts of uncertainty, rules, and institutions. This takes us to the question how and what kind of knowledge is discovered, stored, and distributed in communication. The primary assumption is that within the economy, communication is shaped and formed by prices. With prices, we associate a certain set of social relations, we associate a certain temporality and range of possible objects that are considered to be ‘economic’. This specific role of prices as media of communication is further explored in the third section where it is argued that financial and real markets differ in the way prices operate. This is then the first step towards a concept of economic crises that puts communication linkages, prices and knowledge at the centre.

Rules

The last section showed that from the 1960s onwards, Hayek's work was increasingly concerned with examining the importance of the ‘tacit’ knowledge that is found in norms, cultural traditions, and institutions. This tacit knowledge precedes the knowledge we analyse in proposition or with common propositional logic. Rather, it is a kind of pre-predicative knowledge, that is, stuff we know already before we engage in transactions but usually not aware of. Pre-predicative knowledge is, for example, not interested in the theoretical knowledge we acquire by asking other actors, but in practical knowledge we already have while asking, promising, threatening, etc.Footnote ⁵⁰

To grasp this relationship between ‘reason’ and ‘rules’, Hayek differentiated three kinds of rules: first, there are positive rules that exist as sentences in language. These are the kind of rules we know from science and its propositional logic. Then there are rules that can be expressed in words but only express what was known already. These rules ‘translate’ tacitly known knowledge in knowable knowledge. Ultimately, there are also rules that cannot be expressed in words at all, like the ‘feeling’ we have for a language or appropriate behaviour in certain situations. Those rules are often applied and used, yet they remain hidden from what we know. These kind of rules also encompass the rules of our mind, the ways by which we are able to speak a language and refer to things. These abstract and for our thought most basic rules (in our parlance we'd say constitutive rules) escape rational thought, as Hayek notes: ‘we are not in fact able to state all the rules which govern our perceptions and actions … much that we successfully do depends on presuppositions which are outside the range of what we can either state or reflect upon’.Footnote ⁵¹ Yet these rules govern our practical life:Footnote ⁵²

Rules guide our cognitive processes, the use of categories, and thereby the very way we think and experience the world.Footnote ⁵⁴ As the conditions of their possibility precede the formulation of interests and preferences, they cannot be ‘discovered’ by simply going around and ‘interviewing’ actors, nor is it possible to capture their relevance in rule utilitarian terms in order to save some rational approach to science – or the dogma of empirical social science. Rather, the primacy of the abstract is equal to acknowledging the theory dependence of observations. These rules oppose the error of constructivism and its pretence of knowledge, that is, the image that humans could via reason step beyond the conditions of their culture to see society with a view from nowhere. Such an idea – even conceptually or introduced as an ‘as if’ hypothesis, is an illusion and potentially dangerous and it makes us over-confident in the scientific method and natural images.

As we are never in the position to construct civilisations from scratch but can only attempt to change society from within society,Footnote ⁵⁵ scientists, as noted above, cannot claim to be in the position of bringing all this knowledge together to calculate some optimal equilibrium point. We can never reduce a system of rules or values in their entirety as to then claim they result from some conscious construction.Footnote ⁵⁶ Therefore, as just discussed, the ‘scientific method’ is highly unscientific if recklessly applied. It is constituted as a particular kind of knowledge framed in the vocabulary of propositions and theories, it not only highlights a very specific part of relevant knowledge for organising economic practices, but it presupposes an objective position that we can never have.

As a summary, at first sight, Hayek's concept of rules is very similar to that of John Keynes as discussed in Widmaier:Footnote ⁵⁷ it makes explicit reference to norms and conventions we follow due to genuine uncertainty. However, Hayek differs in an important aspect: his critique takes seriously the self-referential consequences and includes the observer scientist. The concept of rules denotes simply an inclination or disposition to act or not to act in a certain way.Footnote ⁵⁸ Or as Wittgenstein once mentioned, rules are like a garden path we are used to going along.Footnote ⁵⁹ We do not think about them, we just follow them.

Reconstructing financial crises: economisation, prices, and the quest for financial stability

The previous section argued that for Hayek societies are characterised by the distribution of knowledge and not by the division of labour. He takes on key ideas of Carl Menger and develops them further by turning to complexity theory. Through a necessarily short discussion of his concepts of uncertainty, rules, and institutions that were suppose mirror the constructivist tenets of uncertainty, intersubjectivity, and constitutive rules, it was shown that he challenges not only the ‘scientific’ method, but also develops a process-oriented concept of the economy where prices are understood as media of communication. The focus is thus not on equilibrium conditions or propositions, but pattern recognition and the continuous reproduction of statements, practices, or communication.

To continue this line of thought for a reconstruction of today's problems, a Hayekian reconstruction then highlights that there is no ‘essence’ of finance that could be known. Finance is a specific ‘discourse’ with its own processes of inclusion and exclusion.Footnote ⁷¹ It has its own peculiar semantic net of distinctions; it creates a specific field of knowledge (doxa) and creates a specific set of possible identities. Finance is not a closed system, but inscribes itself on bodies and behaviours; it forms desires and guarantees that there are future needs that need to be satisfied.

This leads us to two further questions that are not fully developed by Hayek himself, but that appear to be necessary for a better understanding of our contemporary conditions: if prices are key for understanding economic relations and serve as communication devices, then the question arises of how prices are linked to processes of economisation, that is, the structuring of reality as economic relations. Sure, the kinds of things, social relations, and temporalities considered to be economic are different from the ones considered with law, politics, science, or the health system.Footnote ⁷² Yet, what is this difference? Also, if prices do play such a prominent role, how can we differentiate financial from real markets and thus move back from the general discussion of economic relations to questions of financial stability. Once we address these questions, we are in a position to address the question of how financial crises constitute a distinct rationality that is linked to the question of order. The next two sections provide tentative answers to these two questions.

Towards a social theory of crises? Communication, endogenous heterogeneity, and construction of prices

From this perspective, and turning to the second question, the idea of ‘exogenous shocks’ or of crises coming from ex nihilo is simply misleading. The tensions and crises of an economic system are always internal to an economic system: what can count as a shock, what actually would have the capacity to cause irritation and resonance, is always already the product of a ‘system’: the discovery of quantum mechanics caused much irritation and resonance in physics, but is of less interest to other systems like law, economy, or politics in so far as the consequences would need to be translated in the language of other systems beforehand: legal claims, market chances, changes of power structures. Crises are internal to systems, regimes and social orders.Footnote ⁷⁹ Systemic risks are not ahistoric givens, but are produced by and change with underlying temporal and spatial conditions of economic practices and thus the dispersion of knowledge and non-knowledge among actors.Footnote ⁸⁰ Central to this approach are not mechanisms of uncertainty absorption or conventions, but the continuing processes of absorption and reproduction of complexity through prices, quantities, graphs, and new instruments and products.

In contrast to mainstream economics, economic stability cannot be defined in static ‘in equilibrium’ but has to be conceptualised in dynamic terms as ongoing processes.Footnote ⁸¹ In this sense, a constructivist SPE reconstructs the constitutive albeit changing conditions of economic stability and its breakdown. The current economic crisis especially shows how relations between financial and the economic system changed in ways beyond what standard economic models envisage: money does not have some kind of supra-neutrality or just short term impact on the real economy. This crisis shows that the emergence of derivates and securitisation as a crucial ingredient to the crisis (and the associated production of contingencies and non-knowledge) altered the risk structure that now feed back on the real economy – from the real estate to the art market.

For example, the horizon of the possible today is structured differently than during Bretton Woods. However, the particular institutional setting of Bretton Woods structured the way in which change could take place via the development of the Eurodollar market. Contingency is linked to the particular form of how practices stabilise and structure interaction and thus to the particular way in which expectations are formed. This creation and destruction of social order is, given its contradictory and conflictual characteristics always unstable and rather improbable. This implies that every attempt to stabilise order creates new contingencies and crises. The result is an ongoing process of stabilisation, crises and restabilisation where attempts to create homogeneity by legal rules creates new heterogeneity by deviant behaviour, where the production of new knowledge creates at the same time via new problems, anomalies, inconsistencies – new non-knowledge.

This holds true for all economic orders: some cause for a crisis is remembered and answered by the transformation or construction of a new order which then provides the space for future crises. The construction of the post-World War II economic order is a case in point. It was a direct answer to the failures of the second Gold Standard regime 1925–31 and in particular the role the great depression played in the emergence of the Nazi Regime. Yet these institutional decisions created their own contradictions, paradoxes, new contingencies and thus paved the way for new crises to emerge: the Bretton Woods system became fragile through the emergence of Eurodollar markets. The specific form of Eurodollar markets was determined by loopholes within the complex web of this post-war financial regulation. Within the political order of the Cold War, these markets served as a means for the Eastern Bloc to hold Dollar beyond the jurisdiction of the USA. Increasingly, specific knowledge of how to work these markets led subsequently to the rise of private short term speculative capital which eventually undermined the spatial and temporal preconditions of the Bretton-Woods system.

What becomes evident at this point is how every regime produces internal distinctions and new norms and thus mechanisms of inclusion and exclusion. Every regime thus produces particular knowledge about its environment which at the same time determines what cannot be known. Indeed, it seems that not only what is known, but also what is not known is socially constructed. And this social nature of non-knowledge is constitutive for the evolutionary dynamics. Certainly, the emergence of regimes like WTO and Basle II were responses to particular perceived crises or a malfunctioning of current state of affairs. But at the same time, those regimes created new knowledge about how to interact with the social world. At the very same time, they produce new blind spots, contingencies, and new non-knowledge which creates the conditions of possibility for new crises and structural changes. Stability and crises are mutually constitutive.

For example, such an interpretation would surely point out how the US current account deficit and the surplus of ‘emerging’ counties were repackaged within the US real estate market. It would point out how derivatives, rating agencies, hedge funds, investment banks but also regulations and governments, provided specific constellations and channels of refinancing surpluses and deficits – and that this assemblage provided the background for valuation processes that then collapsed. When we want to understand the current financial instability, it is simply not good enough to look at state cooperation, rather it is necessary to analyse how the system was reproduced: where were the feedback loops and where were the amplifiers? Indeed, it is even misguided to talk about finance as a stand alone social field. As Hayek pointed out, social spheres are ‘connected’ and the current crisis shows that a solution to the financial crisis will be incomplete as long as an answer is not found as to what to do with trade surpluses. Otherwise, we will witness the emergence of new feedback loops and speculative bubbles where these surpluses are recycled and re-enter the real economy.