tbs eFM Highlights

Interview with Bengt Holmstrom

tbs eFM This Morning interviews the legend, Bengt Holmstrom 2016.10.17

[The Best Incentive, No Incentive]

Turning the world of economics on it’s head, Bengt Holmstrom along with Oliver Hart received the Nobel Prize in Economics for their research into incentivised contracts and how they really work in the real world.

So in amongst all the different prizes that have been handed out in recent weeks we now have the pleasure of catching up on the line with professor Bengt Holmstrom from Finland, a US based scholar who has been awarded jointly with professor Oliver Hart from Britain the Nobel Economics Prize for their research into real life contracts. Good morning to you, first of all from Seoul. It’s great to have you on the line.

-Good to hear you.

And, I mean obviously your day job is working at MIT Department of Economics, this subject is very familiar to you, but this research goes back decades, doesn’t it? You looked into contracts, the way they’re structured, can you tell us what was so ground-breaking that drew the Nobel Economics Prize’s attention?

-Well, it is correct that this is work that was done, you know, in the late 70’s, 80’s, 90’s and these were times when people started getting interested in the role of information in economic decision making and how to treat, you know among other things, contracts and what kind of incentive they provide and so on. And this is not the first prize in incentive contracting but it is the first prize perhaps focusing on what’s called contract theory, which deals with incentivising people to do things right.

I mean some of that borrows from common sense, doesn’t it? How do you take the common sense idea that, you know, if I want to get a job done I give someone a contract to perform and I try to make sure the contract is as appealing as possible to suit both parties? How do you take that further, that idea?

-Yes, it’s very important to understand that there are two stages of a model, if you want to apply it, you know, there’s a part of this stage which is about trying to understand why contacts look the way they do in reality, and this was new. You know, the traditional economic theory just assumed that if we write a contract and then it’s enforced the way it is and that’s what happens, that’s what’s written in the contract. This theory takes into account the fact that you don’t know the same information as the other side and so on so it’s much more complicated in that sense to even study the question of quality and conceptual issues. But some of the, when you do models, you do want them to be giving obvious answers to obvious questions. So, you know, some of it seems to the outside as obvious because partly there’s a sense that the model is sensible one. And the model is like a conversation partner; you want it to answer in a sensible way to simple questions. You know, so if I give you stronger incentives do you want it to provide, the person to work more or do more closely what you want and so on. So that, I would say that there are a couple of things in my book that matter, there are other things that work that Oliver was very significant, discoveries that he made. In my book, the key thing was to understand exactly what information is relevant for contracting? And a lot of people at the time I wrote my thing thought that you know, if it gets very noisy the information it becomes irrelevant. But to make matters simple in some sense I showed that that’s not the right way to think about it. And it turns out that it’s always relevant, or most of the time relevant and when it’s not relevant it’s for a very different reason than they used to think. It led to relative performance evaluation, there’s a lot of people who think it’s natural but even there there’s a question of how you weigh the different measure that reflect relevance and the logic of why relative performance evaluation matters. And it is about filtering out information that is relevant, that’s the basic idea. And sometimes in order to filter out information that’s irrelevant you need to bring in information that is not directly related to what I’m doing but it just filters out the noise. So that was the first step and I stop here because I will explain the second step which is much bigger than this, but it was a way of getting started.

Firstly, at this point I’d like to ask about the legal implications for this, whether this empowers workers when they go into contracts, because sometimes here in Korea we hear red flags go up when you talk about performance related pay. In fact, it’s the workers themselves who protest against those sorts of deals.

-Yes, so that’s the second part, the question is why is there so much work that isn’t performance based? And that’s where my book is relevant, especially is relevant showing that when you have a situation where people, these early models were about incentivising a particular task or job or action really. And then what we worked on was what happens when people can do many different things. So that was the first step and then you can get to a situation where if you on one hand need to for instance bring – you want your worker to sort of make sure that the reputation of the firm is growing or at least maintained, on the other hand you want the worker to work very hard to say produce short term results, these are inconsistent with each other. And therefore, you know, if you are really worried about reputation, say or, environmental issues which are very hard to measure but you are worried about them that downstream somewhere, five years from now six years from now some bad things will happen, you know, environmental consequences then the best way and almost the only way to provide incentive for that is to not provide incentives for current performance and then structure instead – and this is very critical – then structure instead the task in such a matter that even though they don’t have any incentive these people will still do a good job. Now one has to realize that people, it’s not like people do nothing if you don’t provide them incentive. So it is about realizing that a lot of the incentive issues don’t have to do with whether they work hard or don’t work hard but whether they work smartly and on the right things. So this was a big shift in the theory of incentives, to align it better with reality and that I would say is one of the major contributions by this, and most of the work we’ve done. And (that is) understanding that sometimes the best incentive is no incentive and that leaves then to a reset the instruments, you know, realizing that one of the, that actually firms in some sense are in the business of not providing very strong market wide consensus. So this movement towards you know, saying that we have to incentivise people who are inside the firm and provide priority incentives in some instances it’s very misguided. And I don’t know if you have followed the Wells Fargo case, you know, the scandals from Wells Fargo, but that’s a good illustration of it. They were incentivised to create new accounts and new products and have customers buy the products and initially it worked very well because there were customers wanted it but then they forced upon customers products that they didn’t want and then eventually, they just created customers, products that were actually just fictitious.

Well the Wells Fargo case is certainly something that our listeners can look into further, because we are so short on time I had to ask you and I need to get your thoughts during our own interview on what you said in a press conference after winning this prize. You talked about owner management and you used the family management of Korean conglomerates as an example, is that a fundamentally flawed model in the modern age?

-I don’t recall that I said that, most of the things you see are not flawed, I don’t believe in the thought that, you know somehow Korea could have systematically for decades done a flawed model. I can’t believe that…

It’s a very top-down model, I didn’t say you said that, I’m just asking if it’s flawed, in your opinion? If we need to get away from this conglomerate structure because we have a lot of young people who can’t even get contracts.

-I would not position myself ever, my interest is in understanding why did you do that, it’s therefore a doctor, you know, I first want to diagnose why are you doing that, why is this happening? Because my premise is that there’s a good reason why you are doing it, good in the sense of there’s a reason; good reason a rational reason in some sense. Now that reason may be connected to a wrong objective or a narrow objective or maybe not a desirable social objective but narrowly good for this conglomerate or whatever. That we can fix, but to believe that people could systematically make mistakes, big mistakes, I’m not, that’s not part of the economics I’m doing.

Now I understand, but what was your purpose then of highlighting the Korean system at the press conference?

-Well, I think the reason it was we probably didn’t have capital markets at the time in Finland, so we didn’t have – and we still don’t have – very well working capital markets in the sense of the US. In fact, the US capital market is shrinking right now, that is the stock market. Half of the stocks on the New York stock exchange have been delisted because of regulations, because the stock market is more expensive than it used to be, backlashes, corporate governance is so intense that it’s just not worthwhile being on the stock market. So you know, the reason the Koreans, and I’m guessing because I haven’t studied you at all, but it is because you didn’t have a very functional stock market and you used internal capital markets and it made perfectly good sense. Now, as the world is changing and you want capital from abroad, you want a broader resharing and information flow into Korea, then that model may not be sensible anymore, but it’s not that you did stupid things. I mean Korea is a very successful in the history of economics, I mean economic development. So you have a fabulous example of how you can grow fast out of a failure – Finland by the way is the same. Finland was very poor, you know, seventy years ago, it’s a miracle really. And South Korea is a miracle. So it would be stupid for an economist to say that it was a stupid system that brought you that kind of miracle.

No. I mean it’s just with specific reference to you contract expertise, as you mentioned it’s not something that you’ve gone into yourself but clearly we have a problem right now with the way that the economy is structured; the top down approach with what some people view as not necessarily the fairest system and not necessarily the fairest contracts. But maybe that’s something that you can look into in the future professor Holmstrom, we’ve got to leave it there. Thank you so much for taking the time to speak with us.

-Thank you. Bye bye.

Professor Bengt Holmstrom at MIT Department of Economics. You can get in touch with us right now, you can send us a message via Facebook by searching tbs eFM This Morning.