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The greatest economist who never wrote out an equation died last week at the age of 102. Ronald Coase of the University of Chicago, who showed how individuals and firms in the private market can do a better job at most things than government regulators, wrote less than any other Nobel laureate in economics but accomplished more than most of them.
In 2004, I arranged a special sort of tribute to Coase in the form of a credit risk model monogrammed for him: Credit Option-Adjusted Spread, or “COAS,” with a portfolio system called Lighthouse. More on that below.
As students of economics and, now, readers of obituaries know, British economist Coase introduced the concept of transaction costs into economic parlance. Firms exist, he argued, because the individuals who comprise the firm – the production workers, the salesmen, the typists in the office pool, and the janitor – would have to spend too much time searching for work if they all worked freelance. By collaborating in a firm together they are assured of steady work.
Another Coasian insight stemmed from his work for the Federal Communications Commission on the assignment to broadcasters of radio frequencies. Rather than charge a fee, the FCC should treat broadcast rights as property and auction them to whoever wanted to buy and trade them. If two stations broadcast on the same frequency, moreover, the more profitable station would pay the less profitable one to desist. Without heavy-handed government intervention, private factors would arrive in many cases at a mutually advantageous solution.
One of his most elegant observations concerned the prevalence of private lighthouses in 18th-century England.  Economists had claimed that lighthouses proved why government investment is indispensable: no single shipowner would incur the expense to build one while his competitors got a free ride. In fact, Coase pointed out, shipowners frequently combined to build lighthouses despite some inevitable free riding. Private lighthouses flourished until the British government took them over.
That was the inspiration for a business strategy at Bank of America, where I headed fixed income research from 2002 to 2005. We would provide a credit model that used market observables. This implementation of Contingent Claims Analysis had the advantage of incorporating signals from liquid markets (equity and equity options. It improved the tool kit available to credit investors. The default-risk signals generated by the model we named “COAS” at the obligor level were then considered in the context of correlation in a credit portfolio. The portfolio model then allocated the tail risk of spread widening (which translated into default in the extreme case) among the elements of the portfolio.
Bank of America Securities built these analytical tools in order to serve the customers of the securities business (including internal risk managers at Bank of America), but with a broader agenda: it was our intention to create a market-based standard for risk measurement in structured product that would make it impossible to game the ratings system, and thus establish market confidence in structured product. Although free riders would take advantage of our work, the improvement in risk managers would benefit the bank. I described the effort in a 2012 article for Journal of Applied Corporate Finance.
No such thing happened, for a simple reason: Wall Street and the main ratings agencies – Standard & Poor’s, Moody’s and Fitch – found it more advantageous to use the older black box ratings methodology because it was easier to game. The gaming was most outrageous in subprime mortgages, where the conventional models said whatever the issuers wanted them to say, but the same sort of chicanery was endemic in credit markets as well.
The private lighthouse model in credit risk analysis never was adopted, and in 2008 most of the ships ended up on the rocks. That benefited no-one, certainly not the bankers whose bonuses were paid in the stock of banks whose price crashed miserably.
Why aren’t more private lighthouses built? There are many reasons, but one of them, I believe, is a flaw in Coase’s model of the firm. With the Internet, search costs are a fraction of what they used to be. A small business or a self-employed service provider can reach the world with a few hundred dollars’ outlay. Angie’s List allows contracts access to a broad universe of customers. EBay allows individuals to participate in a vast emporium of goods and maximize prices on items that would have been impossible to sell beforehand. LinkedIn provides profiles and recommendations of a large number of professionals.
While search costs have fallen by a huge margin, large firms are more entrenched than ever. Startups have vanished from the American economic scene. The great age of disruption innovation launched by the Reagan economic reforms appears to have passed. The American economy has turned into the corporate equivalent of a real life Jurassic Park, dominated by dinosaurs.
Surely that is the opposite of what Coase would have been expected: with minimal search costs, large firms should have lost traction rather than gained it. Something else must be at work.
I have an alternate theory of the firm, namely that large firms exist to protect mediocrity – from the lunatics and conmen on one hand, and disruptive innovators on the other. An entrepreneur, my former partner Jude Wanniski liked to say, is a fellow who walks into your office wearing a propeller beanie and carrying a perpetual-motion machine convinced that he’s going to be a trillionaire. Ex ante it’s hard to tell the loonies from the real thing. For every Thomas Edison there are a hundred candidates for commitment to state mental health facilities.
Most people don’t like disruption. They want to acquire a skill, work reasonable hours, secure reasonable pay, watch television in the evening and play golf or whatever on the weekends. They don’t look deeply into the matters that concern them and are content to do what other people in their position do. If they are diligent, reliable, well-mannered and polite, they are just the sort of folk that the human relations types at corporations prefer. Without a way to socialize, train and employ such people the world would come to a halt, because they make up the vast majority. And that is the great contribution of corporations to social welfare: they find ways to make mediocre people useful.
By training, supervising and deploying the great mediocre mass, corporations earn the trust of consumers who are equally mediocre. Consumers want reliable and predictable products that do not challenge their tastes, habits, and skills. Corporations spend most of their research and development funds ascertaining these tastes and habits and designing products that conform to them.
If they do their job properly, they prevent the supply chain from substituting anti-freeze for corn syrup or talcum for milk power. Unfortunately, corporations also do a good job of extirpating the sort of people who get bored with such products and attempt to do something new. Those people often become entrepreneurs and attempt to challenge the system.
Such challenges are not always beneficial. During the 1990s, the dot.com bubble proceeded on the unstated premise that the future of the US economy lay in downloading music and watching pornography. Innovation chased youth culture down the wrong rabbit hole.
Corporations do not innovate well, and economies die without innovation. Disruptive entrepreneurs destroy corporations who have done their job of cultivating mediocrity a bit too long, and create new corporations that, in turn, will cultivate their own sort of mediocrity.
Sometimes this goes haywire, as the US financial industry did during the 2000s. Left to its own devices, the financial industry created the sort of product that mediocre customers thought they wanted, namely AAA-rated securities. No-one needs imagination to own AAA’s. Unfortunately, the financial engineers put the financial equivalent of anti-freeze into the corn syrup and poisoned the financial system. In the mediocre culture of corporations, advancement is attained by making your numbers and hoping that when a suppurating mass of toxic waste finally explodes it will do so on someone else’s watch, long after you have been promoted.
Mediocrity can under special circumstances become a Petri dish for the incubation of some dangerous problems. The advent of financial engineering introduced a predator into the system against which mediocrity had no natural defenses. In the financial industry, at least, the mediocre became corrupt: millions of homeowners lied on mortgage applications, and tens of thousands of bank employees encouraged or at least countenanced the lies, both serious crimes under American law.
Ronald Coase taught us a great deal about how markets could do a better job of ordering economic life than government regulation. But we should keep in mind that markets are never better than the people who trade in them.
1. Coase, Ronald H (1974), “The Lighthouse in Economics,”Journal of Law and Economics17(2): 357376,doi:10.1086/466796