The 2016 Nobel Prize in economics was jointly awarded to Oliver Hart and Bengt Holmström on Monday for their shared contributions to our understanding of contract theory. Taken together, the work of Hart and Holmström has allowed all of us to understand more clearly what a “good” contract might look like – even when both parties face an uncertain future.
The economics prize is not one of the original awards endowed by Alfred Nobel. Instead, the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel” – its official name – is funded by the Bank of Sweden, although, like the other prizes, it is conferred by the Royal Swedish Academy of Sciences.
This year’s prize, valued at just under $1 million, is shared by Hart and Holmström. Hart was born in London in 1948, earned his Ph.D. at Princeton, and currently serves on the economics faculty at Harvard. Born in Helsinki one year later, Professor Holmström received his doctoral degree from Stanford, and now works in the economics department at MIT.
Most of Professor Hart’s work has dealt with “principal-agent problems.” These arise out of information asymmetries: instances in which one party, the “agent,” is charged with carrying out the wishes of its overseer, the “principal,” though the agent knows more about its own behavior than the principal. Stated another way, principal-agent problems are characterized by an overseer who is not, in fact, all-seeing. In such cases the principal and agent do not share complete information about the behavior and effort of the agent: Thus, information is asymmetrical between the parties, with the agent holding the informational upper hand.
In such cases, it makes sense for the principal to structure its contracts with an agent in a way that renders the incentives of all parties compatible. Otherwise, the agent will serve two masters, serving his own interests first while merely appeasing the principal.
Professor Holmström formalized this notion in his informativeness principle, which states that any good contract between principal and agent will tie the agent’s incentives to any observable measures of agent performance that are known to be linked to the unobservable behavior of the agent. Such contracts thereby align the incentives of both principal and agent.
The informativeness principle is exemplified in all kinds of contracts. It’s why salespeople are frequently paid on commission rather than on an hourly or salaried basis: the principal (the firm) does well when the agent (the salesperson) carries out the wishes of the principal (selling the principal’s wares). It’s also why some laborers are paid according to their accumulated piecework each day. And it’s why the boards of large corporations offer stock options to their CEOs: If the company grows in value while a given CEO is at the helm, then in the future that CEO will be able to purchase high-value shares of the company – value he helped create – at a bargain price.
While these examples help illustrate the power of the informativeness principle, not every principal is capable of designing the ideal contract. Consider the recent scandal at Wells Fargo, where employees “sold” new products to existing customers – without their knowledge – in order to reach sales quotas. According to one former employee, “I faced the threat of being fired if I didn’t meet their unreasonable sales quotas every day.”
As the Wells Fargo example illustrates, contracting in the real world is rarely ideal. In fact, it can be utterly confounding – especially if the institutional environment changes during the course of a contract’s term. Professor Hart’s work examines such incomplete contracts: the portion of contract theory that comes to grip with the fact that no contract can spell out every contingency that may or may not happen in an uncertain future. For example, even a beginning finance student can lay out the gist of whether a particular firm should finance a project by borrowing or by selling shares of stock in the company. But firms operate in the real world, and firms and their funders cannot know how their relationships might be affected by future events. This fact highlights the indispensability of conscientious employees at every level of a firm. If perfect contracts are impossible, then a sound moral compass must fill in the gaps to prevent unethical practices from systematically permeating a company, as it seemed to happen in the Wells Fargo case.
In recent years Professor Hart has turned his attention to another economic problem with a moral dimension: relationships among principals and agents in financial markets, and the question of who might be worth bailing out in the event of another banking collapse. In a recent NBER working paper, Hart and his University of Chicago co-author Luigi Zingales argue that large, diversified financial institutions are far more capable of handling risk than their depositors: you and I could lose our savings if our bank fails, but banks have better information about their own risk levels then we depositors do, and they also have the wherewithal to protect themselves from risk.
The authors conclude that those in the most fragile positions – you and I – are in more immediate need of being rescued than banks are. In fact, you and I are especially fragile, because we rely on what we presume to be low-risk investments – our bank deposits – to address our most immediate liquidity needs. When we drive through the ATM and make a deposit, or make a direct deposit on payday, we are not acting as venture capitalists. Instead we put our money in banks so we can later buy milk, gasoline, and baseball tickets. Given this reality, they write, “The optimal fiscal response to such a shock is to help people, not banks.”
So why are banks – especially big ones – so bad at managing risk? Because we bail them out, of course, but also because the incentives of both the bank’s managers and the bank’s shareholders are compatible: both want high returns, so managers take on excessive risk.
In a 2010 piece published in National Affairs, Hart and Zingales propose tossing out the too-big-to-fail philosophy that creates incentives for bad behavior on the part of banks, and replacing it with “a better way to judge and restrain that risk, but without placing undue constraints on economic growth and the freedom of the market. Of course, balancing these two crucial yet seemingly divergent aims will be no small feat.”
No small feat, indeed. But one that would go a long way toward rescuing people from bad banks, rather than rescuing the bad banks from themselves.