Streetwise Professor

October 29, 2009

An Anniversary Worth Remembering

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 9:23 pm

From The Austrian Economists a timely reminder that this is the 50th anniversary of the second of Coase’s three great papers, on the FCC (which presaged his most important paper on social cost).  (Actually, Coase wrote more than 3 great papers by the standards of the profession, but even by his own high standards three stand out.)

It is gratifying to see a case where a scholar produced his greatest research at around age 50, and then has lived another 50 years (and counting) to observe the transformative effect of that work. (What is it about Chicago and great nonagenarian economists, e.g., Director and Friedman in addition to Coase?)

But perhaps not transformative enough, for much has been written and said on public policy and regulation in the aftermath of the financial shock could have been written or said had Coase never lived.  Which is a shame, and which means that it is highly, highly likely that the legal and regulatory changes that do occur will be pernicious rather than beneficial.

Prior to Coase, it was common for economists to argue that market failures necessitated government corrective.  In particular, those operating in the dominant Pigouvian tradition saw externalities everywhere, and recommended corrective taxes (or other mechanisms) to address them.

Coase asked more basic questions: why do externalities exist? and why, if they are so costly, don’t greedy maximizing individuals do something about them?  This led him to the insight that transactions costs are at the root of any supposed market failure; people do not internalize externalities because the (transactions) costs of doing so exceed the benefits.  This does not eliminate the possibility that government intervention can make things better, because government action may entail lower transactions costs than private alternatives.  But once one recognizes that government policy is not (transactions) costless, the Coasean logic necessarily makes any analysis a comparison between imperfect alternatives, rather than a morality play starring a flawed market and a redeeming government.

This, in turn, necessitates a thorough examination of the sources of transactions costs that make market outcomes less than ideal.  This process of examination frequently identifies underlying conditions, such as information asymmetries, that do not disappear with the passage of a law–and which may in fact be worse in a regulated environment.  In other words, it is often the case that if you are think things are bad now, just think how much worse they’ll be when we fix them!

And that is what is largely missing in the current debate.  In the case of the financial markets, among policymakers and many commentators there has been far too little effort made to answer the question implicit in all of the proposals for a root-and-branch restructuring of the system: why did greedy individuals systematically make such costly choices?  For instance, the proposals to completely restructure–and indeed, largely eliminate–OTC derivatives markets presume that market participants systematically chose the wrong institutional arrangements, at huge cost.  From the Coasean perspective, the greed meme used to justify much government policy actually cuts the other way: greedy individuals have strong incentives to find ways to reduce these costs.

In my view, such an evaluation produces several conclusions which should combine to make those eager for a legislative and regulatory restructuring of the markets far more circumspect.  First, there are strong economic justifications for many of the institutional choices.  Second, by failing to understand better why particular institutional arrangements evolved (i.e., what transactional and transactions cost characteristics affected these arrangements), policymakers run the very serious risk of imposing new institutions that are badly adapted to these fundamental characteristics.  Third, many of the most perverse choices resulted from previous regulations and policies.  (The Calomaris interview that I linked to earlier this week in the Friedman post provides several examples.)

Put differently, things as immense and complex as the OTC derivatives markets are emergent orders, complex systems with rich and inscrutable feedback mechanisms.  These orders have evolved to economize on scarce resources–including to economize on transactions costs.  Intervening to change one part of the system, or several parts of it, will have unfathomable consequences.

Before taking the (often irreversible) step of trying to reshape an emergent order by fiat, it is imperative to understand better why it has taken the shape it has.  Using Coasean, transactions cost concepts is an essential ingredient to achieving such an understanding.  It is also a good antidote to legislative and regulatory hubris.  It is, alas, almost completely lacking in the current policy debate, which bodes ill for the future.

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