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CHECK IT OUT: Ronald Coase eschewed blackboard theorizing in favor of empirical evidence. His work inspired economists to examine alleged examples of market failure.

What Ronald Coase’s Work Can Teach Us About Banking

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Why do people use banks and other financial intermediaries? The work of Ronald Coase, a giant of economics who died this past Labor Day at the age of 102, would suggest that banks exist for much the same reason firms of all sorts exist – in short, they add value by saving time and hassle that individuals would otherwise have to incur trading with one another.

Coase helped to transform the discipline of economics in many important ways. Born in London in 1910 and educated at the London School of Economics, Coase was by 1932 on his way to becoming a lawyer. But that development was derailed when an opportunity to study with Arnold Plant presented itself in 1930. Plant's influence made Coase change his mind on both counts and he became an economist.

Plant challenged Coase to empirically examine market phenomena and to avoid, when possible, substituting theory ("blackboard economics") for the behavior of actual economic entities. The genesis of this approach was, for Coase, a visit in 1931 to America to study the industrial organization of American firms. The result was an article in 1937 for Economica titled "The Nature of the Firm."

Coase argued in this article that firms exist because they capture economic efficiencies in production and supply distribution, which leads to lower transactions costs below those available solely to exchanging individuals. In doing this, he sought to explain why price system co-ordination also seems to require the co-ordinating activities of entrepreneurs.

"We have to explain the basis on which, in practice, this choice between alternatives is effected…[T]he main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost to organizing production through the price mechanism is that of discovering what the relevant prices are." This, according to Coase, is what entrepreneurs contribute to a firm's ability to reduce its overall costs.

A possible implication of Coase's arguments concerning firm costs can be applied to financial transactions as well. Financial intermediaries specialize in particular market endeavors and often have better and more relevant information than do individuals transacting in financial markets. A person seeking security for assets, or daily purchasing transactions, or buying orselling real estate will face much higher information and transactions costs if they try and operate without consulting financial intermediaries. Without the market and its evaluation of business reputations, people would have less valuable information upon which to make their decisions. Beyond that, the costs of obtaining the information required in going it alone would far exceed those of making proper use of the vast resources known to financial intermediaries.

Consider a person seeking to invest in a productive asset. People generally are conservative concerning buying into, say, a new equity offering. Entrepreneurs are, by contrast, inherent risk-takers. If entrepreneurs had to negotiate directly with those seeking to invest their savings, costs would be a good deal higher than by using brokers and banks. Indeed, the only thing that explains the fact that people use financial intermediaries is the knowledge that individuals believe those intermediaries possess relative to their own, less informed, knowledge.

Coase had other important insights. In one of the most famous economic articles ever published – "The Problem of Social Cost" – he became one of the founders of what his discipline calls law and economics. Much had been taken for granted prior to this article's publication about the obvious necessity for lots of government regulations and other public actions to mitigate what the economist A. C. Pigou argued were myriad cases of "market failure." Coase's approach again eschewed blackboard theorizing in favor of empirical evidence. He showed in his "The Lighthouse in Economics" that, historically, lighthouses were not provided by governments as Pigouvian analysis suggested must happen, but by the private market. This inspired economists to empirically examine other alleged market failure examples such as the one debunked in Steven N. S. Cheung's "Fable of the Bees." 

Under Coase's editorship from 1964 to 1982, the Journal of Law and Economics, published by the University of Chicago, became one of the field's most influential publications. He received the Nobel Economics Prize in Economic Sciences in 1991, and continued to teach at the University of Chicago. Coase left us with many insights, not the least of which is regulatory failure. The knee-jerk regulations passed in crisis moments can do more harm than good, but all regulation is a static framework applied to an ongoing, dynamic market. The tensions created are inevitable and often costly.

Under his editorship and guidance, some of the most famous critiques of the failures of government regulations were first published. What seemed radical when first examined, e.g. his claim in 1959 in "The Federal Communications Commission," that airwaves should be auctioned to the highest bidder is, today, the standard approach. His claim in the social cost article that, absent significant transactions costs and/or wealth effects, most so-called market externalities (costs and benefits) would be internalized, is a staple of modern economics. Coase has left us a brilliant and significant legacy that will continue to have influence for all time.

Robert Formiani is a former senior economist and public policy advisor at the Federal Reserve Bank of Dallas, an adjunct instructor of economics at Collin College, and the author of "The Myth of Scientific Public Policy."

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Comments (1)
Outstanding article by Mr. Formiani on transactional costs and 'blackboard economics' as well as the legacy of Robert Coase who passed away on Labor Day. He did much to refute the description of economics as the dismal science attributed to British historian Thomas Carlyle.
Posted by tgprice5 | Wednesday, September 11 2013 at 7:51PM ET
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