Financiers and the Coase Theorem
all about reducing transaction costs
Finance is like advertising in that it does not directly produce anything, leading many people to think the sector is too large and that its professionals are paid too much. Keynes saw the rentier (investor) as a useless parasite, and exchanges as pointless exercises in people predicting what other people predicted, as opposed to the sober long-run thinking provided by his high-minded friends and colleagues. Joan Robinson wrote that 'where enterprise leads, finance follows,' a parasitic profession. This financial animus is reflected in many writings by Nobel Laureates James Tobin, Joe Stiglitz, and Paul Krugman.
Current developed countries like the US, UK, Canada, and Iceland have Finance, Insurance, and Real Estate (FIRE) sectors of around 20% of GDP. Haiti's FIRE share of GDP is around 10%. Developed countries employ about 2% of their workforce in agriculture, compared to 50% in India and African countries. No one thinks the financial sector directly leads to growth the way many (wrongly) think aggregate capital does, but by itself, there’s a benign positive correlation between the proportion of indirect labor to total output.
Good Institutions & Norms Reduce Tx Costs
It's helpful to know why flourishing economies require relatively more indirect labor to better focus on how they can become a drag on economic growth. The key is the Coase Theorem, which showed that regardless of who owns what, if transaction costs are zero, resources will be allocated optimally. Oblivious to transaction costs, JS Mill thought that the distribution of wealth was independent of its production, and for most of the 20th century, economic growth models depended solely on capital, labor, and an exogenous technology factor.1
Most economists use the Coase Theorem to justify addressing their favorite externality, such as climate change. This is because the original Coase theorem presented an externality as what needed fixing (fires caused by train sparks). However, Coase's key point was that transaction costs are crucially important in generating optimal outcomes, as otherwise every society would converge to the same productivity once exposed to the latest science and technologies. Clearly this is not true, as Western countries have sent trillions of dollars to underdeveloped countries focusing on physical and human capital, without significant improvement.
The Coase Theorem inspired Douglass North to focus on why it is so difficult for poor countries to become rich. His Nobel prize-winning research focused on how institutions and norms reduce transaction costs, and highlights the computational irreducibility of economic growth (he didn't have a simple model like Bob Solow). In his theory, capital accumulation and educational expansion are largely effects of open-access institutions, not independent causal factors. Institutions, laws, and norms that promote growth exist in a context that makes exogenous changes detrimental, because they are optimized to a local maximum, maintaining the existing level of productivity. Moving away from a local maximum makes things worse.
How Institutions Help Growth
Dysfunctional economies are run like the Cosa Nostra crime syndicate. Political and economic power is concentrated in the hands of elites who maintain order through privileged access to resources, organizations, and rents. In economics, rents are like monopoly profits, extra income earned by a factor of production above its opportunity cost—i.e., more than what is needed to incentivize its supply. The norms that support this order are personal: loyalty, patronage, reciprocity, and hierarchy. They prevent destructive anarchy but also limit impersonal exchange and broader participation in politics and markets. Mafia bosses cooperate to preserve the system that rewards them, which in turn keeps the social order stable but impoverished, the ultimate bad equilibrium we see in failed states across the world, and some American cities.
Prosperous economies are characterized by broad, impersonal entry into economic and political organizations—anyone who meets minimal criteria can participate. Complex exchange requires coordination. As output and specialization grow, the web of transactions multiplies. Legal systems, financial services, accountants, auditors, and regulators exist precisely because they lower transaction costs by having clear contracts, impartial judges, monitors, and enforcement. Legal codes should generate predictable outcomes, and political institutions must constrain elites from rewriting rules for their own gain. Accounting standards, disclosure requirements, and press freedom reduce asymmetric information rents.
Complex exchange raises the demand for rule-setting, contract enforcement, monitoring, and information services. Courts, regulators, banks, accountants, and auditors all require skilled labor. Just as specialized physical tasks increase the productivity of needle makers, institutional specialization lowers transaction costs, which enables still finer specialization in production. Without supporting institutions, the transaction costs would explode. In high-productivity economies like the US, this translates into a much larger share of indirect labor compared to developing countries, where labor remains concentrated in direct production.
Consider simple property rights to land. Ambiguities will arise in boundaries, resource claims, water rights, or communal land. In poor countries, governments often lack the administrative capacity to measure and document consistently. To trade property, buyers need reliable information about who owns what, liens, and encumbrances. The ambiguities becomes more challenging applied to contractual duties. Creating rules, and then monitoring, judging, and enforcing those rules impartially requires good institutions and norms.
An extreme example of how institutions directly impact economic efficiency by reducing transaction costs is the decimation of pirates. Piracy declined significantly around 1720, as navies refocused on hunting down pirates after being distracted by the War of the Spanish Succession. This allowed merchant ships to reduce their armaments (e.g., fewer cannons and armed crew members), freeing up space for more cargo and reducing insurance costs. This made trade more profitable and encouraged further investment in shipping and related technologies. The establishment of secure property rights and enforcement mechanisms was a critical driver of subsequent economic prosperity, and had a great precedent. In 67 BC, the Roman Senate granted Pompey the Great authority over the entire Mediterranean and resources including 500 ships, 120,000 soldiers, and 5,000 cavalry. In a 3-month campaign that captured 800 ships and destroyed 120 pirate bases, he effectively eradicated large-scale piracy in the Mediterranean for centuries.
How Institutions Impede Growth
Elites often oppose clear property rights because they remove opportunities for rent extraction. For example, informal or overlapping claims let officials demand bribes or allow rulers to reassign land opportunistically. In dysfunctional economies, public enforcement is patchy, selective, or corrupt. Private enforcement (clans, mafias) can substitute, but at a high social cost. Attempts to impose modern institutions onto developing economies often backfires because elites resist losing rents or capture new ones, worsening conditions instead of improving them.
As an example, since the 1960s Kenya, Tanzania, and Ghana have repeatedly tried to introduce formal land titling to replace or overlay customary tenure systems. Instead of unleashing capital, programs often increased conflict by creating overlapping claims between customary and formal titles. It favored elites: politically connected individuals who knew how to grab land by registering titles ahead of communities. It undermined trust because local communities preferred customary enforcement (chiefs, councils) to courts that often favored those with personal connections in the government. Land markets and credit are still backward.
Without impartial enforcement institutions, formal titles created more uncertainty, not less. Elites used the formal system to concentrate rents, making the country less productive. The costs of measurement, enforcement, and political contestation overwhelmed the potential transaction-cost savings.
Eternal Battle
Elite rent-seeking pressure is constant. Left unchecked, corporate or institutional rent-seeking create transaction costs that stifle competition. Instead of making property rights transparent and contract enforcement efficient, lawyers, regulators, and courts can multiply procedural hurdles, creating opportunities for fee extraction. Compliance costs can be enacted to create rents for a new protected class. Politicians and lawyers can create new stakeholders that require payoffs, such as groups claiming connection to indigenous tribes, advocates for endangered species, or new protected classes. Banks and financiers may engage in regulator quid pro quos, and encourage large regulatory fixed costs that act as a moat against potential competitors. Regulators need regulators ad infinitum. The resulting social dynamics are not the basis for what growth theorists refer to as an ergodic process, which is why there are no laws in economic growth rates, only ephemeral trends.
There have been several periods where great civilizations have collapsed. They likely succumbed to endogenous corruption within their institutions as opposed to exogenous forces like earthquakes and climate change.
Great Pyramids at Giza circa 2580 BC
No one knows how they made these, but it's as if they were sufficiently advanced to make a moon landing.
Minoans circa 1700 BC
Palaces on Crete had indoor plumbing. They used a script, Linear A, that is still undeciphered.
Bronze Age collapse circa 1100 BC
The Sea Peoples destroyed the Hittites (Anatolia), Mycenean Greece, Levantine port cities, and decimated the Egyptians. This led to what the ancient Greeks called The dark ages.
Fall of the Roman Empire circa 476 AD
We don't have much economic data on these earlier collapses (we don't even know who the marauding Sea People were!). However, after the fall of Rome, the devastation is clear. Sophisticated industry vanished. The widespread production and use of baked roof tiles ceased; post-Roman structures reverted to thatch or other perishable materials. Coinage became rare, often limited to high-value gold coins used by elites for limited purposes like storing wealth or paying soldiers, not for daily market trade. Major urban centers saw their populated areas contract dramatically (Rome's population peaked at 1 million in 200 AD, falling to 20k in 700 AD). Cattle stature shrank back below pre-Roman size. By the 7th century, even kings lived in conditions that would have been considered impoverished by the standards of a mid-level Roman provincial farmer from centuries earlier.
The good news about the next societal collapse is that Amish life is not bad! Their rejection of private car ownership is primarily a social and cultural choice rather than a belief that automobiles are inherently heretical, aimed at preserving community cohesion, family ties, and their distinct identity. They do not have electricity, but they have strong families and communities. The bad news is that reverting to Amish technology implies a drastic reduction in the population across the globe. Billions will die.
How do we know when bureaucrats go bad?
Employment in developed countries FIRE sector is historically high, but there are good reasons to think this is OK. A complex economy needs more people focused on reducing transaction costs, facilitating complex transactions that would have been impossible 50 years ago. In 1958, Leonard Read wrote the essay, ‘I, Pencil,’ which outlined the incredibly diverse set of companies needed to create a pencil: wood, graphite, ammonium hydroxide, brass, rapeseed oil, etc. A modern smartphone contains screen, processors, camera, modem, memory, batteries, gyroscopes, speakers, each of which relies on more complexity than a pencil. Managing this supply chain would be impossible without innumerable specialists making sure quality and payments are as anticipated.
There are also good reasons to be concerned about the devotion of our institutional elites to impartially legislate, monitor, and enforce laws that foster competition and individual liberty. The fall of the Soviet Union discredited socialism as a desirable goal, as it was all broken eggs and no omelet. Progressives pivoted to co-opting large corporations using the pretext of saving the environment, social justice, and lately COVID and sundry misinformation. Thus, in the 60s or 80s, corporate CEOs favored Republicans by 80-90%, while in recent elections, most large publicly traded companies, which are all heavily regulated, supported the Democrats that dominate government bureaucracies and law schools, and the academic journal that attempt to justify Democratic policies as ‘science,’ which they hope people will conflate with ‘truth.’ I can imagine a future where typing ‘crony capitalism’ into Google search will lower your social credit score; ‘is crony capitalism fascist’ will freeze your bank account.
Existential risks justify non-democratic policies, as when the Biden administration covertly suppressed speech on social media to combat misinformation. When rules are not transparent, insiders create rents, and competition is reduced. Colleges and corporations have explicit policies favoring certain classes of people. When individuals are not judged impartially, rents are created and can be bought and sold.
The key is the ability of institutions to enforce rules impartially, protect property rights, and lower transaction costs so that markets and organizations can flourish. Good norms and institutions do this reliably, which allows private actors to invest and plan. Dysfunction norms and institutions, by contrast, add uncertainty and work to protect or create rents.
The dysfunctional financiers at IndyMac and Countrywide were ultimately washed out by the 2008 financial cleanse. A bigger problem are bureaucracies that are not transparent, where there is no potential for bankruptcy, and where only a handful of people are ever fired for poor performance. The massive increase in compliance employment in financial institutions, and the ability of regulators to use powers justified by the crisis that regulators encouraged, is most distressing, because their bottom line is vague (social justice?), justifying whimsical enforcement.2
Internal battles within complex societies are eternal, as the Book of Judges highlights. Good times produce complacency and corruption. We should be grateful for all the modern conveniences that our great-grandparents would have found amazing. In the long run, I'm sure eventually the bad bureaucrats will win well before ChatGPT's SkyNet awakens, but I want to see that day kicked down the road until my kids die peacefully of old age.
The key is not the size of these various institutions, but their transparency. Do they generally speak in cliches that indicate no thought, only the desire not to reveal what they are really doing? Do they have any effective checks and balances? Is their objective vague enough to prevent evaluation? Do they explicitly reject individualism, and thus impartiality? The distinguishing characteristic of a dysfunctional bureaucrat is that they lie, because rents they seek depend on partiality that would not generate democratic support. The above can be difficult to monitor and police, but detecting lies is relatively straightforward. Exposing and firing bureaucrats who lie is a good social norm.
Later growth models tried to make technology endogenous by assuming it was a function of research and development, a self-serving argument if there ever was one.
Lower loan requirements aligned with lending targets to low-income neighborhoods targets. Hitting these targets was necessary to get approval for acquisitions, so those that did not expand lending to low income areas where taken over. Regulators could not, and did not, discourage the elimination of down-payment or income minimums; they aided and abetted the decline in underwriting standards.
Banger