Coase Call

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President Bush is worried about the economy—and for good reason. The last time things were this bad this close to a presidential election, Jimmy Carter wound up walking down Pennsylvania Avenue holding Rosalynn's hand. Not a pretty picture.

Unfortunately, Bush is stuck. Except for pressuring the Federal Reserve to cut interest rates, there just isn't much he or anyone else can do in the short run. And the Fed, fearing inflation, has called it quits on slashing rates.

The president does have one factor on his side: Americans don't really trust the Democrats with the economy any more than they trust him. What George Bush needs isn't voodoo, it's vision—specifically, a vision of how the economy works. People don't expect a 15-point domestic agenda; if they did, Paul Tsongas would be the Democratic front-runner or Michael Dukakis would be president. People would just like some coherence.

And Bush definitely lacks that. Consider his opening campaign fundraiser. Speaking to his fellow Texans, he railed against attempts to regulate business, then bragged about his two greatest domestic achievements—the Clean Air Act and the Americans with Disabilities Act. These laws are the most intrusive, expensive, onerous pieces of legislation to come out of Congress in years. They will be dragging down the economy long after this recession has passed. And Bush is damned proud of them.

Repealing acts so wrapped in virtue is next to impossible, at least in the near future. But a coherent George Bush might avoid such mistakes in the future.

Before he hits the campaign trail, then, the president might want to hit the books—specifically, a slim and subtle volume for which Ronald Coase was awarded this year's Nobel Memorial Prize in economics. The Firm, the Market, and the Law is the world according to Coase; understanding that world is a good way to bring some coherence to economic policy making.

Coase's world is not the easily manipulated realm of "blackboard economics," in which "all the information needed is assumed to be available and the teacher plays all the parts. He fixes prices, imposes taxes, and distributes subsidies (on the blackboard) to promote the general welfare." In blackboard economics, everything is neat and tidy, all consequences clear, all transactions as frictionless as a body falling through theoretical space.

Blackboard economics is useful. It can quantify the cost of eliminating the last 1 percent of air pollution. It can suggest how much less of something you'll get if you tax it. Such calculations are important, but a tad too neat.

Coase's world, by contrast, is messy, not unlike the real world. It is, above all, a world of transaction costs: "In order to carry out a market transaction, it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on."

Consider the fundamental question Coase raised back in 1937: Why are there firms? Coase suggests that people try to avoid repeating the same transaction over and over again. This is particularly true for services. Finding the right person, hammering out a deal, making sure the job is done when and how you need it—all these transaction costs are so high that it's often easier and cheaper to hire someone on a (relatively) long-term basis. Thus are firms born.

Since 1937, other economists have offered their own theories, some building on Coase, others contradicting him. What these theories have in common is that they don't treat the economy as a blackboard—wise advice for policy makers, as well. Indeed, Coase's complicated and costly world has interesting implications for government policy:

1. Watch out for escalating transaction costs. Transaction costs signal some sort of underlying problem. In some cases, it's no big deal; you hire a real-estate agent because you don't know the market—a problem, but not a serious one. Rapidly rising transaction costs, however, are often a danger sign.

Take lawyers. If they're handling wills and incorporations, they're probably nothing to worry about. But if more and more lawyers are spending more and more time writing lawsuit-deterring warning labels to stick on ladders, something is awry. The same old transaction—selling a ladder—is getting more and more expensive. The lawyers aren't the problem; the lawsuits are. And if the problem becomes too big, as it did in civil aviation, the transaction cost becomes infinite. No amount of lawyering could protect small-plane makers from losing lawsuits, regardless of fault. So they just stopped making planes.

The same principle applies elsewhere. If more and more people hire accountants to help them do their taxes, the tax system may be too complex. If companies expand their personnel departments to comply with federal rules, the transaction—hiring people—hasn't changed, but its cost is rising.

2. The employment "wedge" is dangerous. The wedge is supply-side terminology for government-imposed costs, whether created through taxes or regulations. It includes the "dead-weight loss" of blackboard economics—the cost, for instance, of Social Security taxes.

But it also encompasses important transaction costs—regulations that affect the search for employees, negotiations between firms and employees, and the supervision of employees once they're hired. Requiring firms to provide certain benefits imposes new transaction costs over and above the obvious expense. Similarly, forcing firms to prove they're not discriminating—the issue in the new Civil Rights Act—raises recruiting costs and allows potential litigants to continually renegotiate their contracts.

Policies that make hiring increasingly cumbersome—and employee relationships increasingly encumbered—will eventually tip firms back into contracting out for services. Interestingly, this has been the trend for the last decade or two.

3. Increase flexibility and you strengthen the economy. Give people more leeway to make their own contracts, and they'll find ways to reduce transaction costs—and other costs, too. Trucking deregulation saved up to $90 billion a year and let U.S. companies adopt the lean inventory-management techniques of the Japanese. Companies could locate and bargain with truckers more efficiently; that, in turn, made transactions with suppliers less expensive. Policy makers (and presidential candidates) who want to pump up economic growth ought to look not merely for headline-grabbing tax cuts but also for ways to make economic transactions easier.

Thinking about transaction costs means thinking about transactions—about how people really do business with one another. That is helpful in and of itself, especially if you inhabit the blackboard jungle of Washington, D.C.

NEXT: The State of Taxes

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