Ronald Coase famously began his article on the nature of firms by asking a novel and fundamental question: Why do we have firms in the first place? Why does anyone go through the trouble of organizing as a company instead of working individually?
Coase, who died at the age of 102 on Labor Day, was easily one of the most influential economic thinkers of the past 100 years. Perhaps ever. His focus was on how companies and markets really work, particularly in light of ubiquitous barriers to free and open exchanges.
So perhaps we should look to Coase for an explanation of our recent unpleasantness in the financial sector. What can Coase's teachings tell us about the structure of the financial system, the rise of shadow banking, the financial crisis and its aftermath? As far as I can tell, no one has really explored these questions.
But let's start with the Coasian basics, which means imagining a world without firms. Glen Fox once described this world in a Cato Institute paper on Coase:
Adam Smith's pin factory could operate as follows. One person could dig ore out of the ground and sell it to someone with a wagon and a horse. That person, in turn, could cart the ore to a port where they could be sold to a ship owner. The ship owner could sail to some other port and sell the ore to a smelter. The smelter could sell steel to a person who manufactures wire, the wire manufacturer could sell wire to someone who specializes in cutting wire to pin-like lengths. These pieces of wire could be sold to someone who sharpens one end to a point. This process could continue up to final delivery of pins to end-users.
From a certain perspective, this system looks highly efficient. After all, there would be constant market feedback, with information from prices flowing in at every step of production. So why don't we live in the world of universal independent contractors?
Coase's answer was that the constant bargaining necessary under such a system increased transaction costs.
Firms are organized to reduce these transaction costs by establishing ongoing relationships among owners of the factors of production. The pin factory vertically integrates at least some parts of the production—perhaps the cutting and the sharpening.
Exactly how much gets integrated into a single firm depends on the size of the transaction costs that can be avoided and the costs downsides of integration. Those costs include the possibility that managers will make mistakes because they lack market information about the pricing of inputs.
Very little attention has been paid, as far as I can tell, to how Coase's theory applies to both traditional banking and the rise of the shadow banking system. That's an odd gap in our thinking about banks, especially considering how influential Coase's theory of the firm has been in so many other areas.