Quotes of the Day: Ronald Coase on Economic Theory

Yesterday, proponents of free markets commemorated the 102nd birthday of the distinguished Nobel prize winner and University of Chicago Ronald Coase.

I will sharing snippets of his precious wisdom

But a theory is not like an airline or bus timetable.  We are not interested simply in the accuracy of its predictions.  A theory also serves as a base for thinking.  It helps us to understand what is going on by enabling us to organize our thoughts.  Faced with a choice between a theory which predicts well but gives us little insight into how the system works and one which gives us this insight but predicts badly, I would choose the latter, and I am inclined to think that most economists would do the same.

The above quote has been lifted from Café Hayek’s Don Boudreaux, which is from pages 16-17 of Ronald Coase‘s 1994 collection, Essays on Economics and Economists; specifically, it’s from Coase’s 1981 G. Warren Nutter Lecture in Political Economy, entitled “How Should Economists Choose?”

The point is what really matters is the soundness of the theory rather than its predictability which serves as consequence. For instance, unsound economic theories implemented through social policies may produce the desired effects over the interim...but at a tremendous price or at the expense of the future; look no further than today's lingering crisis in the developed world, which has been a product of the crucible of manifold interventionism via inflationism (boom bust cycles), welfare-warfare state, debt based consumption policies, cronyism and politicization of economic opportunities.

Importantly, theories can be manipulated to suit certain ends, particularly political ends for the benefit of vested interest groups.

This has been one of the recent admonitions of Mr. Coase at the Harvard Business Review (hat tip Prof Mark Thornton)

Economics thus becomes a convenient instrument the state uses to manage the economy, rather than a tool the public turns to for enlightenment about how the economy operates. But because it is no longer firmly grounded in systematic empirical investigation of the working of the economy, it is hardly up to the task. During most of human history, households and tribes largely lived on their own subsistence economy; their connections to one another and the outside world were tenuous and intermittent. This changed completely with the rise of the commercial society. Today, a modern market economy with its ever-finer division of labor depends on a constantly expanding network of trade. It requires an intricate web of social institutions to coordinate the working of markets and firms across various boundaries. At a time when the modern economy is becoming increasingly institutions-intensive, the reduction of economics to price theory is troubling enough. It is suicidal for the field to slide into a hard science of choice, ignoring the influences of society, history, culture, and politics on the working of the economy.

(bold mine)

The bottom line is that simplification of a complex world expressed through political means will likely have dire effects on the economy in the fullness of time.

China’s Road to Capitalism Lacks the Knowledge Revolution

A narrative of China’s path to progress according to Nobel laureate Professor Ronald Coase and Professor Ning Wang at the Wall Street Journal,

China's road to capitalism was forged by two movements. One was orchestrated by Beijing; its self-proclaimed goal being to turn China into a "modern, powerful socialist country." The other, more important, one was the gross product of what we like to call "marginal revolutions." It involved a concatenation of grass-roots movements and local initiatives.

While the state-led reform focused on enhancing the incentives of state-owned enterprises, the marginal revolutions brought private entrepreneurship and market forces back to China. Private farming, for example, was secretly engaged in by starving peasants when it was still banned by Beijing. Rural industrialization was spearheaded by township and village enterprises that operated outside state control. Private sectors emerged in cities when self-employment was allowed to cope with rising unemployment. Foreign direct investment and labor markets were first confined to Special Economic Zones.

Well, China’s road to capitalism has been half baked as it requires a very important factor that has been amiss: allowing ideas to have sex as Matt Ridley would call it.

Professors Coase and Wang adds,

In the years to come, China will continue to forge its own path, but it needs to address its lack of a marketplace for ideas if it hopes to continue to prosper. An unrestricted flow of ideas is a precondition for the growth of knowledge, the most critical factor in any innovative and sustainable economy. "Made in China" is now found everywhere in the world. But few Western consumers remember any Chinese brand names. The British Industrial Revolution two centuries ago introduced many new products and created new industries. China's industrial revolution is far less innovative.

The active exchange of thoughts and information also offers an indispensable foundation for social harmony. It is not a panacea; nothing can free us once and for all from ignorance and falsehood. But the free flow of ideas engenders repeated criticism and continuous improvement. It also cultivates respect and tolerance, which are effective antidotes to the bigotry and false doctrines that can threaten the foundation of any society.

When China started reforming itself more than three decades ago, Deng rightly stressed the "emancipation of the mind" as a prerequisite. But that has yet to happen. It's time for China to embrace not just the market, but the marketplace of ideas. This will help not just China reach its full potential, but the world as well.

China’s fundamental problems emanates from the still top-down command and control political system which has been running a head on collision course with the snowballing forces of ‘marginal revolutions’ or grassroots economic movement via entrepreneurs.

A knowledge revolution would be incompatible with the incumbent centralized structure of governance, which has underpinned the continued restrictive policies on “free flow of ideas”.

A communist society depends on the conformity of behavior, ideas and actions with those of the political authorities, mainly enforced through coercion and indoctrination, whereas a knowledge revolution will democratize and produce diversity of ideas, opinions and actions channeled through a market economy.

And a society founded on a knowledge revolution would, thus, undermine the privileges of those currently in power.

Yet having to unleash the forces of capitalism would mean substantial changes to China’s political system.

Yet the jury is out on how China’s politicians will deal with such monumental adjustment process, which I expect to be turbulent, along with the response of the average Chinese. And such transition will be accompanied by a national financial and economic crisis as ramification to the recent marco (top-down) economic policies, the impact of which would also diffuse into politics.

Current events have already been manifesting signs of such tempestuous adjustment process.

Interesting times indeed.