In
1931, Ronald Coase, a 20-year old undergraduate at the London School
of Economics who, because of a childhood weakness in his legs, had
started his education at a school for "physical defectives,"
came to the U.S. to study equally young but increasingly complex companies
like General Motors. He had a revolutionary agenda. Already struggling
to reconcile the socialism of his youth with the free-market sensibility
of his professors, Coase saw big companies as proof that centralizing
activities could work on a grand scale. If he could learn how big
companies did it, Coase imagined, then perhaps the lessons could be
applied to big governments as well. Oddly enough, no one had ever
asked why companies existed, and certainly no one had ever thought
to ask the people who were running them.
What Coase learned made him swear off socialism forever, and led to
the publication of an article that not only changed economic thinking
but also won Coase the Nobel Prize in economics almost sixty years
later. In "The Nature of the Firm", Coase argued that companies
were getting bigger because markets were just too expensive. There
was a price, it turned, out not only to whatever was being bought
or sold, but also to buying or selling it: buyers and sellers had
to find each other, negotiate deals and consummate them - none of
which was especially easy, much less "free."
Coase called the price of doing a deal its "transaction cost"
- and he realized that those costs were the key to why companies were
internalizing more and more activities, especially repeated functions
like buying raw materials and marketing. It was cheaper.
Coase wasn't sure why the "invisible hand" of the market
wasn't working, but he had come to believe that government intervention,
without a clear understanding of the source of market failures, was
just as likely to do harm as good. Instead of tinkering with forces
they didn't understand, Coase believed economists should turn their
attention to the practical problem of uncovering transaction costs
wherever they occurred and stamping them out.
It's amazing what can happen if you actually look at the evidence.
Which makes it all the more surprising that in the seventy years that
have passed since Coase's discovery, economists have learned almost
nothing about transaction costs. They refuse to look at them. And
their reluctance to follow Coase's example has led to a dangerous
chasm between how we think about markets and how they really work.
What makes the new economy new is largely the way information technology
is wiping out transaction costs at an accelerating pace. From global
price comparisons to agent-based searching to low-cost auctions for
anything and everything, the cost of doing a deal is plummeting. The
free flow of information is decreasing the friction caused by transaction
costs. But we know little about that decrease because economists,
for the most part, have done little to identify the source and scale
of transaction costs in the first place. Indeed, most articles in
economics journals begin by asking readers to "assume a frictionless
economy," and then carry on with the old wealth-maximizing, rational
actor theorizing, dressed up old ideas with dizzying mathematical
formula which prove, in such a world, that doing X instead of Y would
be the better course of action.
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In
short, economic theory is stale, and getting moldier by the minute.
In the absence of any real data, economics has gone through few
of the paradigm shifts that are a regular feature of healthy sciences.
Its basic structure has changed little since 1776, when Adam Smith
famously argued for open markets, consumer choice and a healthy
skepticism for government intervention. It is certainly an exaggeration,
but only a slight one, when Coase derides everything that has happened
since then as "little more than a vast mopping-up operation
in which economists have filled in the gaps, corrected the errors
and refined the analysis of the Wealth of Nations."
Classical economics was revised in the late nineteenth century,
in what has been described as the "neo-classical revolution,"
but rather than reject Smith, the neo-classicists simply applied
differential calculus to behavior at the margins of corporate and
individual choice. The neo-classicists argued that the maximization
of personal wealth and corporate profit was in fact the optimization
of society's overall welfare as well. (Greed, in other words, really
is good.) Rather than prove this startling assertion, however, with
experiments or analysis of actual behavior, most economists have
been content to tinker with the formula.
The Fateful Dinner Party
At a famous dinner party in 1960, Coase invaded the holy sanctuary
of the neo-classicists, the University of Chicago, hoping to convince
them that economists could do better than that - could help explain
economic behavior in a way that would improve society. He applied
his idea of transaction costs to law and regulation, and argued
before Milton Friedman and George Stigler and other leading economists
that government regulation and legal liability were unconscious
efforts to overcome transaction costs for certain types of transactions,
such as accidents and pollution. But the regulations themselves
generated so many transaction costs that in many cases doing nothing
at all would produce a better result. To find out how much law and
regulation was optimal required a better understanding, once again,
of the costs.
As the story has been told, the initial vote on Coase's heresy was
20 to 1 against, but after three hours of argument, he had convinced
everyone in the room. The essay that summarized this radical idea,
"The Problem of Social Cost," was published in 1960, the
second publication cited in 1991 by the Nobel Committee.
Coase hoped his elegant proof would finally get economists working
on the real problem at hand - the systematic identification and
elimination of transaction costs from the economy, which he believed
would make most government regulation - which he viewed as the least
efficient mechanism for solving market failures - unnecessary. Ironically,
all he did was make economics more esoteric. Rather than lower themselves
to the kind of empirical case-based research that was common in
other social sciences, economists simply dispose of Coase as an
opening footnote. They continue to "assume a frictionless economy"
because such an assumption is necessary for the math to work.
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But
Coase (who took up residence not at the University of Chicago's
economics department, where he remained unwelcome despite his dinner-party
success, but at its law school) didn't want economists to assume
anything - he wanted them to eliminate the friction, that is, the
transaction costs. He grew increasingly frustrated with his colleagues,
and in particular with their pretense of scientific superiority,
much of it based on statistical models applied to incomplete government
data. He dismissed Milton Friedman and much of modern economic analysis
in 1981 by observing, "If you torture the data enough, nature
will always confess."
If that was all economists could do, Coase decided, then he was
no economist. When he awarded the Nobel Prize in 1991, Coase began
his acceptance speech on a note of despair. "In my long life
I have known some great economists," he told the Committee,
"but I have never counted myself among their number nor walked
in their company."
Data About Data
Look at your personal financial portfolio and it is easy to sympathize
with Coase's frustration. The "rational" stock market
still booms and busts. Cyclical industries still overexpand and
overcontract. Efforts at creating a rational global economy that
would maximize everyone's welfare are met with rioting mobs. Poor
Alan Greenspan reads every tea leaf he can find and still goes to
bed at night wondering if he cut rates too soon or too late, too
much or too little, or even if it makes an iota of different in
any case. While most economists fiddle with their formulas, Rome
(or rather Genoa) is burning. Without a better understanding of
the nature of transaction costs, we'll never be able to predict
- let alone improve - what seem to be the most basic elements of
economic behavior.
It seems obvious enough that information technology is improving
productivity and reducing transaction costs. But we know so little
about the activities it is making more productive, and where the
transaction costs are in the first place, it's impossible to predict
how new applications will work their magic--and therefore how to
capture the savings in the form of new profits. For radical new
products and services, as we have learned over the last few years,
estimating the financial impact of innovation is pure guesswork,
or worse.
Information technology has and continues to give us more and more
data, but we have no data about the data. Coase's pleas since 1937
only become more poignant over time. A few years ago, Coase gave
up on economics and started a new movement which he called the International
Society for New Institutional Economics. ISNIE's goal is to
solve, once and for all, the problem of transaction costs, and in
the process expose just how little value there is to economic analysis
of the last few hundred years. "While theorists are very welcome,"
he wrote in an open invitation to economists to join ISNIE, "the
main emphasis is empirical."
Seventy years after he first tried to prod economists into action,
perhaps the most remarkable thing about Coase is that he can still
be so gentle with them.
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