Discrediting Regulation: from George Stigler to Tyson’s Fraud-Free Carbon Tax Fantasy

By William K. Black
(Cross posted at Benzinga.com)

Laura D’Andrea Tyson (President Clinton’s principal economist) has written an ode to a “carbon tax” that does not acknowledge a single disadvantage or substantive (as opposed to political) concern with such a tax.  A carbon tax can have advantages, but her article oversells the idea and ignores the severe concerns about such a tax.  Her article demonstrates why the Clinton administration’s anti-regulatory and fiscal policies helped sow the seeds of ongoing financial disaster.  (The Bush administration watered and fertilized those seeds and we all reaped the whirlwind.)

Tyson’s framing of the issue misses entirely the real concerns about relying on a carbon tax to prevent global climate change.

“If you dispute the overwhelming scientific consensus about man-made climate change and the role of fossil fuel emissions, you should probably stop reading now. Evidence is unlikely to affect your opinions.

But if you accept this consensus, you should know that economists across the political spectrum agree that a carbon tax is the most effective way to discourage carbon consumption and lower the risks of catastrophic climate changes.”

Let’s review the bidding to this point: Tyson’s policy argument is that there are zero substantive difficulties to a carbon tax and there is a consensus among Republican and Democratic neoclassical economists that we should adopt a carbon tax.  That is supposed to reassure the reader, at least readers who have forgotten anti-regulatory consensus among neoclassical economists that produced the epidemics of accounting control fraud that drove our last three financial disasters and the pro-austerity consensus among European neoclassical economists that caused the gratuitous second Great Depression in the European periphery (and a recession throughout most of the Eurozone).

This is the first in a series of articles discussing the perils of relying on neoclassical theory to generate effective regulation.  I will return to Tyson and her claim that a carbon tax is the optimal response to global climate change.  My route back to explaining why Republican and Democratic neoclassical economists tend to share an anti-regulatory consensus requires me to explain first how that consensus emerged and endured even though the resultant policies have often proved disastrous.  I have explained in two prior articles the horrific consequences of the Democratic Party’s variant of this consensus – the Reinventing Government effort under the Clinton/Gore administration.  I drew heavily on these articles in writing this series of columns.

Tyson was an enthusiastic, uncritical proponent of the administration’s Reinvention movement.

Three successive financial crises driven by epidemics of accounting control fraud have not caused neoclassical economists to take control fraud seriously.  Like Tyson when it comes to recommending the carbon tax, neoclassical economists continue to implicitly assume that control fraud out of existence when they develop their models and policy recommendations.  This often leads to failure, but rarely to any fundamental reappraisal of neoclassical dogmas.

There is an “overwhelming scientific consensus” among those who study elite white-collar frauds that control frauds are critical drivers of our recurrent, intensifying financial crises.  I could paraphrase Tyson:

“If you dispute the overwhelming scientific consensus about [control fraud], you should probably stop reading now. Evidence is unlikely to affect your opinions.”

My approach, however, is more relentlessly optimistic.  Despite decades of evidence to the contrary I continue to hope that neoclassical economists will one day become familiar with the relevant criminology literature and incorporate control frauds into economics.  Of course, that is a subversive hope because the implications of control fraud for economic theory are so revolutionary that were they to incorporate control fraud into economics they would be developing a post-neoclassical school of economics.  I specifically invite neoclassical economists to continue to read this and other columns.

Neoclassical Economists’ Implicit Assumption that “Control Fraud” is Trivial

I chose to discuss Tyson’s recent ode to the Carbon Tax as a means of providing a concrete example that allows me to illustrate the harm to the world caused by neoclassical economists’ refusal to take “control fraud” seriously.  This article continues my series of columns on Nobel Laureates in economics whose work has led to repeated predictive failures and the harmful policies that have created the criminogenic environments that drive our recurrent, intensifying financial crises and other maladies.  Neoclassical economists’ typical approach is to implicitly assume that such frauds cannot occur. I show why this long-falsified assumption explains why neoclassical economists assume that markets are naturally self-correcting and that regulation is not simply unnecessary but counter-productive.

Stigler and “The” Economic Theory of Regulation

In this article I primarily explain why George Stigler’s work on information and regulation, particularly the concept of regulatory capture, the subjects the prize committee primarily cited in explaining its award of the Nobel Prize in economics to Stigler in 1982, has captured the neoclassical economics profession and produced the destructive anti-regulatory policies that have added greatly to the criminogenic nature of finance and driven our recurrent, intensifying financial crises.  One of the terrible ironies is that Stigler’s views have led to the self-fulfilling prophecy of regulatory capture by encouraging a mechanism (the regulatory competition in laxity) and a dogma that has led to placing anti-regulators in charge of regulatory agencies under both Democratic and Republican administrations.

Stigler’s explanation of why the standard economic assumptions about perfect, cost-free information were absurd and produced recurrent predictive failures logically should have led to the opposite policies.  Once economists were forced to deal with the fact that information was invariably imperfect fraud was possible.  If fraud was possible then most of the neoclassical models were falsified.  If control fraud was possible then regulation became critical to the success of markets in a manner that neoclassical economists had long ignored.  Regulators were the “regulatory cops on the beat” essential to the proper functioning of markets.  The regulation v. market dichotomy was exposed as a false dichotomy where the purpose of regulation was to prevent fraud.  The proven ability of the CEOs leading control frauds to create “Gresham’s” dynamics in order to suborn private sector “controls” and pervert them into the most valuable fraud allies meant that regulators offered unique possibilities to prevent, detect, and punish frauds because only the regulators could not be hired or fired by the CEOs leading the control frauds.

Neoclassical economists, including Stigler, did not follow this logical path opened by recognizing the importance of imperfect information.  Instead, they went the opposite direction and formed a consensus that attacked regulation as the central enemy that needed to be crushed.  The further irony is that just as regulation had become overwhelmingly oriented to advanced purposes such as environmental regulation that were proving immensely successful Stigler ‘s primary claim to fame became attacking price cap regulation in competitive industries such as trucking and passenger aviation that was already rapidly being phased out as he wrote.

Stigler argued that firms in somewhat competitive industries wished to form cartels, but that cartels were quickly destroyed by the incentive of the members to cheat on their output quotas and the fact that agreements to function as a cartel were unenforceable.  Stigler claimed that the “fact” (fiction) that cartels promptly collapsed led them to seek regulation so that they could “capture” it.  Under U.S. law, a firm that does not compete on price because its regulator sets its prices is immune from an antitrust claim even if it conspired to create a regulatory system for the express purpose of creating a legal cartel.  A regulator can inspect for violations of the cartel agreement and punish any firm that cheats on its production quota.  The regulator can also ban entry of new firms into the industry.  Regulation could create the perfect U.S. cartel.

Stigler, unfortunately, generalized from this single, fast-declining context of rate cap regulation in industries that could be competitive to regulation generally.  Stigler entitled his autobiography: “Memoirs of an Unregulated Economist” (1988).  He felt that his most important work was his attack on regulation.

Stigler did not simply generalize inappropriately to all regulation even though his cartel arguments against regulation were inapplicable to most forms of regulation.  In his Prize lecture he described his theory about one, disappearing form of regulation as “the economic theory of regulation” rather than “an economic theory of regulation.”

The bipartisan support among neoclassical economists for Stigler’s theory

Tyson’s ode to the carbon tax is particularly useful as an illustrative device about the harm caused by Stigler’s theories because of the influence they had on neoclassical economics and neoclassical economists like Tyson.  The Wall Street wing of the Democratic Party, which has dominated the Party for over twenty years, rejoiced at Stigler’s claims that regulation was the paramount problem rather than being part of the solution.  The Carter administration got rid of the principal federal price cap regulatory systems that once governed airlines (CAB) and trucking (ICC).  Tyson played a major role in the Clinton administration and was a vibrant, uncritical apologist for the administration’s “Reinventing Government” effort that devastated financial regulation and began to set the stage for the accounting control fraud epidemics that drove the Enron-era and ongoing financial crises.

Tyson’s uncritical ode to the carbon tax is revealing because it repeats the central mistakes generated by Stigler’s fervent anti-regulatory dogmas that captured both Democratic and Republican neoclassical economists and politicians.  Those dogmas have not been reexamined even though they blew up the financial world and caused catastrophic damage.  Stigler’s anti-regulatory dogmas continue to capture the Clintonians and their policy recommendations even though the policies generated by his theories constitute among the most spectacular failures in modern history.  Senator Clinton’s renewed run for the presidential nomination makes the Clintonian’s continued embrace of neoclassical nostrums a matter of immediate concern.

Stigler’s Dogmatic Assault on Regulation

The irony is that the harm that Stigler did through his assault on the legitimacy of regulation began with work on the economics of information that, if economists made explicit assumptions about control fraud, could have produced an understanding of the unique advantages regulation can contribute to making markets honest, efficient, and effective.  Instead, he betrayed the logic of his findings on the economics of information by again, implicitly, assuming control fraud out of existence.  Stigler became the neoclassical commander-in-chief of the assault on regulation.  He waged a multi-front war against regulation and he was spectacularly successful in enlisting a consensus among neoclassical economists as his allies.  His war on regulation struck a chord with the ideology of a large number of neoclassical economists who distrust and fear even democratic governments.  As I discuss below, Stigler’s anti-regulatory policies were at first unpersuasive to even many conservative Republican politicians.  Today, however, his anti-regulatory views are shared enthusiastically by most neoclassical economists. Virtually all conservative politicians embrace Stigler’s anti-regulatory views (they only want to regulate bedrooms and school rooms, but not boardrooms).  The remarkable aspect of Stigler’s work is not how completely it has captured the Wall Street wing of the Democratic Party (that was inevitable), but at how completely the Wall Street wing has captured that Party’s candidates for national office.

Stigler’s regulatory capture theory (and James Buchanan’s “public choice” theory) purported to explain regulatory and political decisions under the assumption that public officials maximized their personal interests rather than the interests of the public.  Political science, of course, had long since dispensed with any view that public officials simply maximized the public interest.  Rather than adopting political science theories that discussed the mixed and variable determinants of the actions of public officials, Stigler and Buchanan asserted crude models that assumed that the sole determinant of public official’s actions was maximizing their self-interest.

Even under Stigler’s and Buchanan’s ultra-reductionist models it immediately became apparent that the models were indeterminate because there was no way of knowing what a public official’s “self-interest” was and what behavior it would predict.  Public officials might choose to work for EPA because they cared about the environment.  (Neoclassical economists have been inconsistent in calling such behavior “self-interested” v. “altruistic.”  Labeling those who help others “self-interested” because the individual feels good when helping others turns “self-interest” into a circular label that cannot be falsified.)  A government official might also advance her career by developing a reputation for disinterested, independent actions on behalf of the public.

It is ironic that Stigler and Buchanan’s anti-governmental theories were so widely accepted by economists.  First, the experts in government, political scientists and public administration scholars, overwhelmingly thought Stigler’s model was embarrassingly bad.

Second, regulation was changing radically in America as Stigler’s theory became dominant among economists.  I have noted that the particular variant of regulation that Stigler primarily criticized was fast fading, but the new form of regulation was surging – and the support for the new agencies was often bipartisan.  The CDC was created in 1946 under President Truman.  The Uniform Commercial Code (particularly Article 9 – secured transactions) was proposed in 1952 and adopted with typically minor variants by every State.  While most people do not think of this as “regulation” it is one of the most important forms of financial regulation at the state level.  The NTSB was created in 1967 under President Lyndon Johnson.  OSHA, the EPA, and NOAA were created in 1970 by President Nixon.  The Mine Enforcement and Safety Administration was created in 1973 under President Nixon and its successor agency (with greatly enhanced powers) in 1977 under President Carter.  The Consumer Product Safety Commission was created in 1972 under President Nixon.  None of these agencies was created in order to produce a legalized cartel.

Third, Stigler and Buchanan’s theories shared a feature – the entities driving the public sector failures they asserted were ubiquitous were often those with the greatest political power – private firms and wealthy individuals.  Stigler and Buchanan assumed that these entities were motivated solely by self-interest and had no ethical restraints.  Their assumption about the lack of ethical restraints was typically implicit.  But if private entities are immoral “rent-seekers” eager to suborn public officials to betray the public the obvious inference was that they would frequently engage in control fraud even absent a “Gresham’s” dynamic.  Control frauds, however, do create a Gresham’s dynamic and that can produce endemic fraud.  Indeed, under Stigler and Buchanan’s assumptions it would produce universal control fraud.  Once one assumes that self-interest drives behavior and that greed is unrestrained by ethics fraud becomes the central problem – and regulation becomes an essential part of the answer.  Unfortunately, neoclassical economists, numbed by over 50 years of implicitly assuming control fraud out of existence, continued to have no useful experience, expertise, or theories for recognizing or dealing with control fraud.

Fourth, neoclassical economists attempted to turn the intense, perverse incentives of unrestrained greed into an indictment of the public sector and a testament to the private sector.  They made two claims about the private sector.  The first was the one made by Adam Smith’s paradox of the butcher and the baker in 1776.  Bernard Mandeville made the case for greed in The Fable of the Bees or Private Vices, Publick Benefits (1732), which even praised fraud.  The classical theory was that greed is what makes firms reliable.  The merchant’s interest in maximizing his income causes the butcher and the baker to provide superior products.

Adam Smith recognized the “agency” problems could pervert “the invisible hand.”  The CEO of a corporation could be an unfaithful agent maximizing his self-interest at the expense of his principals (the shareholders).  Smith believed that the broadly-held corporation was inherently dangerous.  Accounting control fraud is the ultimate in unfaithful agents.  Given the domination of our economy by publicly-held corporations, neoclassical economists felt that they had to find a way to assert that the private sector would solve the agency problem without government intervention.

The neoclassical solution was “agency cost theory.”  I have discussed this in my series of articles on the work of Roger Myerson, Nobel Laureate in Economics in 2007.  Agency cost theory assumed that the shareholders paid a cost to induce their principal agent (the CEO) to act as if he were interested in maximizing his principal’s interests.  (I have explained why, even if this were true, the results could be horrific for the forms of control fraud other than accounting control fraud.  Accounting control frauds loot the creditors and shareholders in order to benefit the CEO, but the other forms of control fraud benefit the shareholders at the expense of the customer, the employees, and the general public.)  The neoclassical agency cost theorists were often vague on what the “cost” was, how it was paid, and how it prevented even accounting control fraud.  They made it sound like there was the equivalent of a parking meter somewhere that would ensure that the CEO did not loot the firm as long as the shareholders made sure there that they put enough coins in the meter.

Eventually, as I explained in my Myerson columns, the agency cost theorists settled on modern executive compensation as the optimal solution.  “Performance pay” purportedly “aligned” the interests of the CEO and the shareholders.  I have explained why it actually further misaligns those interests in practice in many firms.  Together with Stigler’s successful war on regulation, modern executive compensation produced the vastly more criminogenic environment that produces the epidemics of accounting control fraud that drive our recurrent, intensifying financial crises.  I have explained why modern executive compensation causes accounting control fraud to produce a “Gresham’s” dynamic that did not formerly exist.  Accounting control fraud creates fictional gains and real losses.  Prior to modern executive compensation the “rational” response of a bank’s controlling officers to a competitor making bad loans pursuant to the fraud “recipe” for a lender would be joy – soon we will have one fewer competitors.  Because accounting control fraud is a “sure thing” guaranteed to report record (albeit fictional) income in the near term it also maximizes “performance pay.”  The CFO who reports mediocre income because he refuses to follow the fraud recipe has a very real fear that he may be fired after a single bad quarter that leads to the CEO being denied a bonus.

Neoclassical economists implicitly assumed fraud out of existence to reach their claims that “private market discipline” and the “alignment” of the CEO’s interests with those of the shareholders produced “efficient markets” and ended agency problems (albeit at the agency “cost” of making CEOs extraordinarily wealthy and politically dominant).  Neoclassical economists studiously ignore the radical implications for our economy and Nation of those extraordinary agency costs.  I will discuss the failures of the “efficient market hypothesis” – the foundation of “modern finance” in future columns discussing the Nobel awards in that category.  For present purposes, the key is that neoclassical economists assumed that “markets” were “self-correcting.”  Even if problems arose they would be fleeting and minor – and the self-correction would take place without any governmental role.  Indeed, neoclassical economists argued that only government “interference” in the markets could make markets fail and delay them from self-correcting.

Conversely, neoclassical economists used Buchanan and Stigler’s theories to argue that the government had no analogous self-correcting features because it lacked (1) market discipline, (2) the discipline of bankruptcy, and (3) pay systems tied to performance.

Self-correcting markets, the regulatory “race to the bottom,” and crises

Fifth, the neoclassical consensus was that government was uniquely prone to error and lacked any effective self-correcting feature.  The key, therefore, was to eliminate regulation.  Neoclassical economists love to consider (some) incentive systems and they quickly devised the optimal means of cutting regulation, supervision, enforcement, and prosecutions – create a regulatory “competition in laxity” (also known as a “race to the bottom”).  To most people, both phrases have pejorative connotations, but not to neoclassical economists.  They wrote articles using the phrases and praising the competition.

In another wonderful irony, a category in which the committee that selects the Nobel Laureates in economics excels, Stigler was awarded the Prize in 1982 just as his praise for deregulation and the resultant competition in laxity was sowing the seeds of disaster that would lead to the savings and loan (S&L) debacle.

Stigler also lived to see the failure of Enron, which kicked off the Enron-era’s string of failures brought on by an epidemic of accounting control fraud.  Stigler died before “WorldCon” collapsed so he did live to see the full scope of the accounting control fraud in that era’s crisis.

In 1982, Federal Home Loan Bank Board (Bank Board) Chairman Richard (“Dick”) Pratt drafted the deregulation bill that was enacted as the Garn-St Germain Act.  Pratt was a neoclassical economist.  He relied on a simple economic study that looked at which State’s S&Ls reported the highest income.  Texas came out on top because of the boom in oil prices and because of widespread accounting control fraud.  Pratt and his economists implicitly assumed that fraud could not exist.  They loved the fact that Texas had the weakest S&L regulation in the nation, so they attributed the higher reported income of Texas S&Ls to deregulation and used that State’s deregulation as the model for “the Pratt bill.”

Pratt added a sweetener to his bill, however, to fuel the competition in laxity.  If you switched from a state to a federal charter the Bank Board and the Garn-St Germain Act would “preempt” certain state laws (e.g., those banning “due on sale” mortgage clauses.  Hundreds of S&Ls applied to change their charters.  “Preemption” is a doctrine that arises from the Constitution’s “supremacy clause” and that posed a grave danger to state legislators used to receiving large contributions from state-chartered S&Ls.  If the S&Ls switched to a federal charter the state legislature could no longer help or hurt them.  If the state legislature can neither help nor hurt your bank the incentive to make political contributions disappears.  California S&Ls (which had greater assets than California banks in that era) made these facts of life abundantly clear to the California legislators and they responded by adopting the Nolan Act.  The Nolan Act allowed a California-chartered S&L to put 100% of its assets in any kind of investment approved by the California Commissioner – and he was soon in business with Charles Keating, the most notorious leader of an S&L control fraud.  The California Commissioner began approving an average of a new S&L charter every business day to a newly formed S&L.  The new entrants were overwhelmingly financially troubled real estate developers.  (Every real estate developer’s sweetest dream is to own a bank.)  The California Commissioner did not reject a single charter application.

Texas responded to the Garn-St Germain and Nolan Acts by further weakening its regulation of S&Ls.  Its Commissioner was sleeping with prostitutes provided by the Nation’s second most notorious control fraud – Don Dixon’s Vernon Savings.  We called it “Vermin” Savings.  Texas and California “won” the regulatory race to the bottom.  S&Ls in those two states caused over 60% of the total losses in the debacle.  By encouraging and even, in the case of Pratt and Alan Greenspan, deliberately creating a regulatory race to the bottom Stigler and the neoclassical economists created a self-fulfilling prophecy of regulatory failure.  One cannot have rampant deregulation and the appointment of regulatory leaders chosen because they believe the neoclassical nostrums that control fraud cannot occur, that markets are self-correcting, and that regulation is the problem without making the environment highly criminogenic.  It is vain to think such leaders will identify and act vigorously against control fraud when they believe that it is akin to UFOs.

George Akerlof (Nobel Laureate in 2001) co-authored the classic economics article on “accounting control fraud” with Paul Romer in 1993 entitled “Looting: The Economic Underworld of Bankruptcy for Profit.”  They made the definitive warnings about the dangers of economists ignoring fraud and praised the regulators for promptly recognizing and combating the S&L fraud epidemic.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).

“[M]any economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4-5).

The National Commission on Financial Institution Reform, Recovery and Enforcement reported in 1993 that:

“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization” (NCFIRRE 1993).

Stigler’s Restatement of the Coase Theorem

Sixth, Stigler compounded his anti-regulatory motif by misinterpreting the work of Ronald Coase, who became a Nobel Laureate in economics in 1991.  The so-called “Coase Theorem” taught in economics is almost always Stigler’s reformulation of Coase’s work on transaction costs.  Coase sought to demonstrate the importance of transaction costs, and the weaknesses in neoclassical economic thought introduced by assuming away transaction costs, in many fashions.  His most famous application of transaction costs was to argue that transaction costs explained why firms exist and why firms, rather than markets, conduct most of the business dealings in the world.  Coase found it bizarre that economists worshipped a neoclassical model that could not explain, and therefore ignored, the principal mode of business (the firm).

The neoclassical models that drove Coase to distraction typically assumed (implicitly) that firms did not exist.  Stigler asserted that economics was the only social science worthy of the name “science,” but neoclassical economics has demonstrated a remarkable ability to resist even the most basic prerequisite of science – avoiding models premised on unstated and indefensible assumptions.

Coase’s other principal application was his argument that in a world without transaction costs, i.e., a world that he was trying to emphasize did not and could not exist, the implications of the nature and assignment of property rights became curious.  Coase proposed that in such a world as long as there was a complete assignment of all conceivable property rights to specific persons, no matter how unfair and unprincipled that assignment might be; economic efficiency would be maintained.   By assigning all conceivable property rights externalities such as pollution would be internalized.

Coase had in mind unique forms of property rights we do not normally consider.  One variant was a right to pollute without any limits or liability.  The counterpart of this would be the property right not to be polluted.  Similarly, we could make Fred or Mary the owner of the world’s fish.  Fred would maximize the long-term value of cod or old growth redwoods.  Mary, who had the right never to suffer pollution, would license manufacturers to permit a level of pollution specified in the license.  The markets would ensure that the optimal level of pollution was licensed.  Coase assumed that the court systems could enforce each of these contracts, even in the case of salt water fish that are not confined to any single nation’s waters.  Under his model, it takes a navy to raise a school of fish – and that navy is assumed to be cost-free.  Again, Coase’s point was that assuming away transaction costs led to absurd predictions in neoclassical economic models.

Coase’s argument about the implications of a (fictional) world in which there were no transaction costs captured the U. Chicago faculty in a famous presentation.  I will explain in a future column several flaws in Coase’s presentation that the U. Chicago faculty missed:  Coase implicitly assumed that control fraud could not occur, ignored extortion, and ignored power.  He assumed rationality and very long-term perspectives and ignored irreversibility.  The real importance of these obvious limitations in Coase’s work is that they reveal the limitations of the U. Chicago faculty repeatedly introduced by their implicit assumptions.

The limitations in Coase’s depiction of a world without transaction costs have little real world application because Coase’s central point was that such a world cannot exist.  No one who understands Coase’s work could propose giving Fred or Mary ownership of the world’s fish or the absolute right to pollute (or to be free from pollution).  Stigler, however, reinterpreted Coase’s work through what he labeled “the Coase Theorem.”  Coase explained in his Prize lecture:

“What I showed in that article, as I thought, was that in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximise wealth and this irrespective of the initial assignment of rights. This is the infamous Coase Theorem, named and formulated by Stigler, although it is based on work of mine. Stigler argues that the Coase Theorem follows from the standard assumptions of economic theory. Its logic cannot be questioned, only its domain. I do not disagree with Stigler. However, I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs.”

Stigler’s version of Coase buried Coase’s central message and implied the opposite.  Stigler claimed externalities were possible only because of a failure to assign property rights.  Governmental programs, particularly regulation, aimed at limiting negative externalities or making goods and services with high positive externalities more available were inherently misdirected away from what Stigler asserted was the true cause of the purported externality.  By warping Coase’s work, which logically supports the necessity of regulation, Stigler has led a generation of economists to be trained that regulation is not needed to deal with externalities.  Stigler’s message was that if we simply give the wealthy even greater property rights over the environment and the explicit right to pollute the markets will provide optimal environmental and economic outcomes.  Coase should be appalled, but I will explain in future columns his more ambiguous response to Stigler’s perversion of his work into “the Coase Theorem.”

The interaction between Coase and Stigler illustrates how neoclassical economists see “elegance” and support for their devotions to “the market” in the fact that when their models assume away economic reality they assume away the problems posed by economic reality.  I will show in a future column that the “logic” is assailable and that Stigler’s claim that “only its domain” can be “questioned” is bizarre when Coase’s point was that the true domain of the neoclassical models that assumed that transaction costs did not exist was the null set.  Yes, the “only” limitation of the neoclassical models is that according to Coase the models are never correct.  Stigler labeled the neoclassical exercise in tautological assumptions/predictions a sterling example of unassailable “logic.”  Logicians must shake their heads in disbelief whenever they read neoclassical economists’ claims about the logic of their models.


Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @williamkblack


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