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2016 economics Nobels a timely teaching moment

Ed Lotterman: Real World Economics
Ed Lotterman: Real World Economics

It was perfectly timed. On a Monday, Oliver Hart and Bengt Holmstrom were awarded the 2016 Nobel Prize in economics. Two days later, Wells Fargo CEO John Stumpf resigned. The whole debacle at his bank perfectly illustrates issues on which Hart and Holmstrom worked. It is rare that an economics Nobel offers such a timely teaching moment.

The Nobel announcement blandly refers to Hart’s and Holmstrom’s work on “contracts.” One wonders exactly that means. Smart-phone or rental-car contracts? Tangentially, maybe, but the crux of their work involves incentives to solve what economists call “principal-agent problems,” especially in employment.

Such problems arise when someone with the most fundamental stake in an enterprise — the “principal” — employs someone else to run it — the “agent.” How does one structure rewards and penalties to best motivate the agent to manage things for the best interests of the principal?

This question arises in several ways with Wells Fargo.

The basic principals in a corporation are the shareholders. They are the “residual claimants” who ultimately gain or lose from the business.

Executives such as Stumpf are the agents. He was hired to run the corporation day to day. His motivation differs from that of the owners, not least in their time horizon and willingness to bear risk.

If incentives are wrong, agents may manage for short-term unsustainable profits knowing that they can exit before the bust. Or they may seek “heads I win, tails the stockholders lose” ventures.

Obviously, if CEOs were on straight salary, there would be little incentive for innovation and prudent risk-taking. There would be no carrot for superior performance and firing would be the only stick. But alternative incentives are not as simple as, say, putting salespeople on commission.

This problem with corporations is not new. Adam Smith described it in 1776. Corporations then were rare, because each required a specific act of Parliament. Most businesses were sole proprietorships or partnerships. Smith argued that, because of differences in incentives between owners and hired managers, corporations would never be as efficient as proprietorships.

However, large global ventures such as the Dutch and British East India Cos. were beyond the resources of an individual or a few partners. The risks were great. Joint-stock corporations often were the best solution, despite incentive problems. This now is true given the scale of modern businesses, such as Wells Fargo with 236,000 employees.

Principal-agent problems go beyond stockholder-executive relations. How to best motivate employees, regardless of the size or legal organization of a business? Nonprofits face the same challenges. So do governments. Why did some Catholic clergy betray the lay believers who are the Church?

Why should the average person care? If you don’t own bank stock, have not contributed to some college or charity, or are merely a nonvictimized Wells Fargo customer, how do incentive problems hurt you?

The answer is that incentive problems, such as externalities, monopoly power or external costs, are ways markets “fail.” They waste resources and society is poorer.

Despite researchers like these laureates, such problems remain ubiquitous. President Eisenhower warned of the military-industrial complex decades ago, but arms procurement inefficiencies remain endemic. Some 5,500 U.S. sugar producers still raise sugar prices for 330 million sugar consumers.

Incentive problems are not limited to CEOs. The Wells Fargo retail banking executive responsible for incentives caused the fraud while retaining many millions of dollars in compensation. The 5,300 employees blamed by Wells Fargo’s top managers and fired were motivated by those incentives, which implicitly wielded the stick of job loss.

But defrauding customers certainly did not advance the long-term interests of their employers, shareholders or even Stumpf. Indeed, Wells Fargo has since lost some high-profile government accounts; its stock price is down about 10 percent since it agreed to a $185 million civil fine and, prior to retiring, Stumpf forfeited $41 million in stock awards.

Skeptics may ask why, if incentive problems remain so common, two academics should be rewarded for such research. After all, the increasingly complex compensation programs for corporate executives are themselves based in part on work Holmstrom embarked on decades ago. Might his insights even be part of the problem? Did we have better corporate governance back in the 1950s, when executive compensation was much simpler and the term “principal-agent problem” had not even been coined?

I think not. The fact that deeper insights don’t immediately solve problems does not mean scholarly investigation wastes resources. Skilled doctors bled a dying George Washington more than a century after Robert Hooke pioneered research into the circulatory system. Perhaps the cholesterol meds I have taken for 15 years contributed to cataracts in both my eyes. Yet over my lifetime, medical research has made our lives tremendously better.

So this is a good award. It again highlights an ongoing and fruitful renaissance in microeconomics, the study of resource allocation at the level of individuals, families, companies and other organizations.

Parenthetically, given the national debate over immigration, one should note that both of these economists were born abroad, as were four of the seven laureates in the “hard sciences.” Through this year, 31 of the 78 Nobels won by U.S. scholars since 2000 have gone to immigrants, and many of the others did graduate work here.

Despite some questioning the greatness of our country, in scholarship, it continues to dominate the world. Part of that is due to how we structure incentives for research. The upshot is that we are all better off, though many do not appreciate it.

St. Paul economist and writer Edward Lotterman can be reached at boise@edlotterman.com.

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