Bengt Holmström, Nobel Laureate

Again, I’ll be refreshing this post throughout the morning, keep on hitting refresh.  Here is Bengt Holmström’s home page, which includes a CV, short biography, and links to research papers.  Here is his Wikipedia page.  He has taught for a long time at MIT, was born in Finland, and is one of the most famous and influential economists in the field of contracts and industrial organization.  Here is the Swedish summary.  Here is a video explanation.  This is a nice short bio of how he was influenced by his private sector experience, recommended, not just the usual take on him.

One key question he has considered is when incentives should be high-powered or when they should be more blunt.  It is now well known that you get what you pay for; see Alex’s excellent summary on this and related points.

His most famous paper is his 1979 “Moral Hazard and Observability.”  What are the optimal sharing rules when the principal can observe outcomes but not efforts or inputs?  And how might those sharing rules lead to a less than optimal result?  This is probably the most elegant and most influential statement of how direct incentives and insurance value in a contract can conflict and hinder efficiency.  A simple example — what about deductibles in a health insurance contract?  Yes, they do encourage the customer to internalize the value of staying in better health.  But they also limit the insurance value of a contract.  That a first best outcome will not be created in this situation was part of what Holmstrom showed, and he showed it in a relatively tractable way.

If you are thinking about CEO compensation, you might turn to the work of Holmström,  the Swedes have a good summary of this paper and point:

…an optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken. This informativeness principle does not merely say that payments should depend on outcomes that can be affected by agents. For example, suppose the agent is a manager whose actions influence her own firm’s share price, but not share prices of other firms. Does that mean that the manager’s pay should depend only on her firm’s share price? The answer is no. Since share prices reflect other factors in the economy – outside the manager’s control – simply linking compensation to the firm’s share price will reward the manager for good luck and punish her for bad luck. It is better to link the manager’s pay to her firm’s share price relative to those of other, similar firms (such as those in the same industry).

That is again a result about how incentives and insurance interact.  When do you pay based on perceived effort, and when on the basis of observed outcomes, such as profits or share price?  Holmström has been the number one theorist in helping to address issues of this kind.

“Moral Hazard in Teams,”1982, is a very famous and influential paper, here is the working paper version.  Holmström showed that the optimal incentive scheme has to consider time consistency.  Sometimes good incentive schemes impose penalties on the workers/agents to get them to work harder.  But let’s say you had a worker-owned and worker-run firm.  If the workers fail, will the workers/owner impose punishments on themselves?  Maybe not.  Thus in a fairly general class of situations you need an outside residual claimant to impose and receive the penalty.  This is Holmström trying to justify one feature of the capitalist system against socialists and Marxists.

A Fine Theorem has an excellent post on his work.

Managerial Incentive Problems: A Dynamic Perspective” is another goodie, this one from 1999.  The key point is that repeated interactions, for instance with a manager, can make incentive problems worse rather than better.  The more the shareholders monitor a manager, for instance, and the more that is over a longer period of time, perhaps the manager has a greater incentive to manipulate signals of value.  When are career incentives beneficial or harmful?  This paper is the starting point in thinking through this problem.  Here is one of the possible traps: if a worker fully reveals his or her quality to the boss, the boss will use that information to capture more surplus from the worker.  So many workers don’t let on just how talented they are, so they can slack more, rather than being caught up in the dragnet of a ‘super-efficient” incentives scheme.  I have long found this to be a very important paper, it is probably my favorite by Holmström.

This 1994 investigation, based on personnel data from within firms, is actually way ahead of its time in terms of empirical methods.  It is certainly known but he never received full credit for it.

Holmström and Hart together have a very nice piece surveying the theory of contracts and theories of the firm.  With John Roberts, he has a very nice (and highly readable!) survey of economic work on theories of the boundary of the firm, recommended on the field more generally.  Not his most famous piece, but if you are looking in the applied direction, here is his survey piece with Steven Kaplan on mergers.

With Jean Tirole has has a 1997 paper “Financial Intermediation, Loanable Funds, and the Real Sector.”  This was an important precursor of the later point about how collateral constraints really can matter.  Firms and banks should be well-capitalized!  This piece was significantly influenced by the Nordic financial crises of the 1990s and it was prescient regarding later events in the United States and elsewhere.

His liquidity-based asset pricing model, with Jean Tirole, did not in its published form “take off” in the world of finance, but it is an excellent and important piece, worth revisiting as part of the puzzle of why the world has so many super-low interest rates today.

Holmström has since written much more about banking and agency problems.  His very latest piece is on banks as secret keepers, and it tries to model and explain the fundamental nature of banking and its fixed value liabilities.  Here is his piece on why financial panics are so likely to involve debt.  With Jean Tirole, he wrote a well-known paper on why government supply of liquidity services sometimes may be justified.

Here is his 2003 survey paper, with Steven Kaplan, on what is right and wrong in U.S. corporate governance.  It is a more applied side than what you often see from him.  The piece claims that, even in light of the scandals of that time, American corporate governance is not broken and will probably become better yet, though it could stand some improvement, including on the regulatory side.  Overall I view his co-authorships with Kaplan as suggesting that his overall stance toward corporations is more influenced by Chicago-style thinking than is oftetn the case at MIT.  Read his defense of asset securitization for instance.

Congratulations to Bengt Holmström!


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