Coase was right – the one graph version

I recently came across two indices, which are measuring two on the surface unrelated things – property rights and environmental standards across different countries.

However, anybody who ever read Ronald Coase would know that according to Coase the best way to manage externalities (read pollution) is to have well-defined property rights. Note I am simplifying Coase’s message a lot here, but nonetheless this is basically at the core of what some have called Free Market Environmentalism.

The first index is the International Property Rights Index (IPRI) published by the Property Rights Alliance. The IPRI rank different countries according to the level of protection of property rights.

The second index is the Environmental Performance Index (EPI), which “ranks how well countries perform on high-priority environmental issues in two broad policy areas: protection of human health from environmental harm and protection of ecosystems.” EPI “is a joint project between the Yale Center for Environmental Law & Policy (YCELP) and the Center for International Earth Science Information Network (CIESIN) at Columbia University, in collaboration with the World Economic Forum and support from the Samuel Family Foundation and the McCall MacBain Foundation. “

This is what we get when we plot the two indices against each other.

Coase

So there you go. The one graph version of Free Market Environmentalism – if you are concerned about the environment you should really primarily concern yourself about the protection of property rights…Unfortunately that is unlikely to be on the mind of most of the policy makers who are meeting in Paris these days to discuss global climate change.

PS you can find the data here.

Update: Some have suggested that this is a spurious correlation caused by the fact that high environmental standards and the level of protection of property rights both are positively correlated with income levels. That is partly right, BUT not fully right. I have tested this by estimating EPI as a function of BOTH property right and GDP/capita. Even doing this property rights comes out as being a (very) significant determinate of environmental standards. A high GDP is not enough – property rights need to be protected as well.

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Property rights and banking crisis – towards a “Financial Constitution”

I just found a great paper – “A Coasean Approach to Bank Resolution Policy in the Eurozone” – on banking resolution by Gregory Connor and Brian O’Kelly. Here is the abstract:

“The Eurozone needs a bank resolution regime that can work across seventeen independent nations of diverse sizes with varying levels of financial development, limited fiscal co- responsibility, and with systemic instability induced by quick and low-cost deposit transfers across borders. We advocate a Coasean approach to bank resolution policy in the Eurozone, which emphasises clear and consistent contracts and makes explicit the public ownership of the externality costs of bank distress. A variety of resolution mechanisms are compared including bank debt holder bail-in, prompt corrective action, and contingent convertible bonds. We argue that the “dilute-in” of bank debt holders via contingent convertibility provides a clearer and simpler Coasean bargain for the Eurozone than the more conventional alternatives of debt holder bail-in or prompt corrective action.”

I found the paper as I was searching the internet for papers on banking regulation and property rights theory. If we fundamentally want to understand banking crisis we should understand incentives and property rights.

Who owns “profits” and “liability”? Who will be paying the bills? The banks’ owners, the clients, the employees, the bank management or the taxpayers? If property rights are badly defined or there are incentive conflicts we will get banking troubles.

In that sense banking crisis is a constitutional economics problem. Therefore, we cannot really understand banking crisis by just looking at specific issues such as how much capital or liquidity banks should hold. We need to understand the overall incentives facing all players in the “banking game” – owners, clients, employees, bank managements, regulators and politicians.

Inspired by Peter Boettke’s and Daniel Smith’s for a “Quest for Robust Political Economy” of monetary policy we could say we need a “Robust Political Economy of Financial Regulation”. I believe that Connor’s and O’Kelly’s paper contributes to this.

Another paper that helps use get a better understanding of the political economy of financial regulation and crisis is Josh Hendrickson’s new paper “Contingent Liability, Capital Requirements, and Financial Reform” (forthcoming in Cato Journal). Here is the abstract:

“Recently, it has been argued that banks hold an insufficient amount of capital. Put differently, banks issue too much debt relative to equity. This claim is particularly important because, all else equal, lower levels of capital put banks at greater risk of insolvency. As a result, some have advocated imposing capital requirements on banks. However, even if one accepts the proposition that banks hold too little capital, it does not neces- sarily follow that the correct policy response is to force banks to hold more capital. An alternative to higher capital requirements is a system in which banks have contingent liability. Under contingent liability, shareholders are liable for at least some portion of depositor losses. This alternative is not unprecedented. Historical evidence from the United States and elsewhere suggest that banks with contingent liability have more desirable charac- teristics than those with limited liability and that depositors tend to pre- fer contingent liability when given the choice. Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.”

Lets just take the last sentence once again – “Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.” 

Hence, if we want to “design” good banking regulation we fundamentally need a property rights perspective or even in a broader sense a “Financial Constitution” in the spirit of James Buchanan’s “Monetary Constitution”.

Concluding, yes we might learn something about banking crisis and banking regulation by studying finance theory, but we will probably learn a lot more by studying Law and Economics and Public Choice Theory.

Related posts:

“Fragile by design” – the political causes of banking crisis
Beating the Iron Law of Public Choice – a reply to Peter Boettke

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