The Coase Dividend

Essay. The economist, Ronald Coase (December 29, 1910 to September 3, 2013), passed away on Tuesday, September 3, at the age of 102. By his own description, he was an intrepid economist who fruitfully engaged economics as a study of law and anthropology for which the economic allocation of scarce resources was but an appendix and, to this day, is itself a scarce resource as issues of ownership are far more decisive in the allocation and use of resources than their production or quantities.

It was only by happenstance – not the centrepiece of economics – that we came across a pivotal observation of Mr. Coase that tells us what economics is really about:

“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 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. These operations are often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost.” – Ronald H. Coase, 1960, The Problem of Social Cost, Journal of Law and Economics.

Economics is about us
Divina Commedia
Dante Alighieri c. 1308

In other words, economics is about us and how we deal with one another, and it is only in the context and substance of such dealings that we might become aware of investment risk – the possibility that we might not get our money, or trade, back, and if we do, it might buy less of what we need, or want, then than it does now.

Mr. Coase addressed this problem of investment risk in the theory of the firm (Coase 1937) but it is only recently (and unknown to Mr. Coase) that the author has found a way to calculate it within the demonstrated societal norms of risk aversion and bargaining practice and the result has consequences.

One of its consequences is the “Separation Theorem” that generalizes James Tobin’s work on “investor behaviour towards risk” (1958) to the capital markets of both equities and bonds.

The Separation Theorem also generalizes the Capital Assets Pricing Model (CAPM) and Modern Portfolio Theory (MPT) because it can be shown that the market itself always separates into a portfolio of assets that behaves like a “risk free” bond (which we call (B)) and its exact complement which behaves like an equity (N) and is dominated by investor uncertainty.

It is also obvious (as above) that “risk” is not volatility but the possibility that we might not get a non-negative real rate of return on our investment and an “investment” is not the purchase of a debt or an ownership interest in a “thing”, but it is the “purchase of risk” and, as such, there is a “price of risk” which must be paid, one way or another.

Postscript

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