That’s all for today, as Oliver Hart and Bengt Holmstrom enjoy a busy day of congratulations and celebrations.
Here’s our news story about today’s prize winners:
Thanks for reading and commenting. GW
Harvard’s Dani Rodrik tweets:
The Hart-Holmstrom prize is very well deserved. A quintessential Nobel awarded for fundamental tools of analysis used in many applications.
— Dani Rodrik (@rodrikdani) October 10, 2016
Hart and Holmstrom’s work may sound a little dry -- all that talk about CEO pay, insurance contracts and privatisations.
But their contract theory work is key to understanding some contentious issues.
Our economics editor, Larry Elliott, explains:
Take the question of how executives should be rewarded. Pay packages tend to be a mix of basic salary, bonuses and share options, with the aim of getting the best of those running companies.
The best sort of contract, according to the work pioneered by Holmström is one that provides the right balance of risk and incentives. It encourages top staff to innovate without being reckless.
A package weighted towards bonuses might be fine for a younger executive with ambitions to be promoted. It might be less good for a chief executive approaching retirement, who might be given the green light to take risky decisions safe in the knowledge that someone else will have to clear up the mess if they go wrong.
Holmström clearly thinks companies have not been paying enough attention to his work. After hearing he was a joint winner of this year’s prize, he said he thought bonuses were “extraordinarily high” and the contracts too complicated....
Here’s Larry’s full piece:
Although Hart and Holmstrom clearly merit today’s award, their success means that the Nobel prize for economics has only ever been won by one women – Elinor Ostrom, in 2009.
One day there will be another female Nobel prizewinner in economics to join Elinor Ostrom.
— Jill Priluck (@jillpriluck) October 10, 2016
Associated Press have published more quotes from Bengt Holmstrom today:
Speaking to reporters in Stockholm by telephone, Holmstrom said he felt very lucky and grateful.
“I certainly did not expect it, at least at this time, so I was very surprised and very happy, of course,” he said.
In the 1970s Holmstrom showed how a principal, for example a company’s shareholders, should design an optimal contract for an agent, like the CEO. His “informativeness principle” showed how the contract should link the agent’s pay to information relevant to his or her performance, carefully weighing risks against incentives, the academy said.
Holmstrom said his incentive to study contract theory came before he was an academic, when he was working for a company in the 1970s that tried to use computers to figure how to make strategic plans.
“That’s when I realized that the issue wasn’t really about the difficulty of coming up with the best plans,” he said. “The bigger issue was also to create incentives for people to give the right information that is needed for these plans and incentivize them in general.”
As well as the glory (and sudden interest in their research work) Oliver Hart and Bengt Holmstrom will share 8 million kronor, or about $930,000.
Paul Krugman, the US economist honoured in 2008, has warmly welcomed Hart and Holmstrom to the Nobel prize winner’s club:
Hart and Holmstrom so obviously deserving that my first thought was "didn't they have it already?" https://t.co/tdr52WYU3y
— Paul Krugman (@paulkrugman) October 10, 2016
Economist Justin Wolfers, professor at the University of Michigan, has also hailed the news:
Oliver Hart and Bengt Holmstrom win a long overdue Nobel Prize for founding the field of Contrat Theory. An unarguably splendid pick.
— Justin Wolfers (@JustinWolfers) October 10, 2016
While the Economist’s Stan Pignal is struck that Oliver Hart moved from the UK to the US in the 1980s
Eeesh yet another Nobel that goes to a bright Brit who has had to move to America to further career.
— Stanley Pignal (@spignal) October 10, 2016
Updated
Here’s an excellent explainer about Hart and Holmstrom’s work:
Contract Theory
The Academy also explain how Holmstrom pioneered the early research into executive pay:
A central result, published separately and independently by Bengt Holmström and Steven Shavell in 1979, is that 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).
A related result is that the harder it is to observe the manager’s effort – perhaps due to many distorting factors blurring the relationship between her effort and the company’s performance – the less the manager’s pay should be based on performance. In industries with high risk, payment should thus be relatively more biased towards a fixed salary, while in more stable environments it should be more biased towards a performance measure.
How Nobel prize winner shows failings of private prisons
Oliver Hart’s research work has included a damning assessment of America’s private prisons.
He shows that the pressure to cut costs is too great, leading to unacceptable drops in quality. At the core is the issue of ‘incomplete contracts’ -- the fact that contracts aren’t detailed enough to cover every nitty-gritty point.
The Royal Swedish Academy say:
Another application of Hart’s theory of incomplete contracts concerns the division between the private and public sectors. Should providers of public services, such as schools, hospitals, and prisons, be privately-owned or not? According to the theory, this depends on the nature of non-contractible investments. Suppose a manager who runs a welfare-service facility can make two types of investment: some improve quality, while others reduce cost at the expense of quality. Additionally, suppose that such investments are difficult to specify in a contract. If the government owns the facility and employs a manager to run it, the manager will have little incentive to provide either type of investment, since the government cannot credibly promise to reward these efforts. If a private contractor provides the service, incentives for investing in both quality and cost reduction are stronger. A 1997 article by Hart, together with Andrei Shleifer and Robert Vishny, showed that incentives for cost reduction are typically too strong. The desirability of privatisation therefore depends on the trade-off between cost reduction and quality. In their article, Hart and his co-authors were particularly concerned about private prisons. Federal authorities in the United States are in fact ending the use of private prisons, partly because – according to a recently released U.S. Department of Justice report – conditions in privately-run prisons are worse than those in publicly-run prisons.
The Official Announcement
The event in Stockholm has now wrapped up, so let’s recap with the official announcement:
The Prize in Economic Sciences 2016
The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016 to
Oliver Hart
Harvard University, Cambridge, MA, USA
and
Bengt Holmström
Massachusetts Institute of Technology, Cambridge, MA, USA
“for their contributions to contract theory”
The long and the short of contracts
Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.
Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.
In the late 1970s, Bengt Holmström demonstrated how a principal (e.g., a company’s shareholders) should design an optimal contract for an agent (the company’s CEO), whose action is partly unobserved by the principal. Holmström’s informativeness principle stated precisely how this contract should link the agent’s pay to performance-relevant information. Using the basic principal-agent model, he showed how the optimal contract carefully weighs risks against incentives. In later work, Holmström generalised these results to more realistic settings, namely: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can free-ride on the efforts of others.
In the mid-1980s, Oliver Hart made fundamental contri-butions to a new branch of contract theory that deals with the important case of incomplete contracts. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: which party to the contract should be entitled to make decisions in which circumstances? Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law. His research provides us with new theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned.
Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.
Updated
Contracts really, really matter, says one of our new Nobel laureates:
From interview today with Oliver Hart, 2016 Laureate in Economic Sci: #NobelPrize pic.twitter.com/5W5TUM0hTZ
— The Nobel Prize (@NobelPrize) October 10, 2016
Here are some practical examples of the issues which Hart and Holmström’s work can help answer:
Contract theory: Should providers of public services, such as schools, hospitals, or prisons, be publicly or privately owned? #NobelPrize
— The Nobel Prize (@NobelPrize) October 10, 2016
Contract theory: Should teachers, healthcare workers, and prison guards be paid fixed salaries or should their pay be performance-based?
— The Nobel Prize (@NobelPrize) October 10, 2016
Contract theory: To what extent should managers be paid through bonus programmes or stock options? #NobelPrize
— The Nobel Prize (@NobelPrize) October 10, 2016
Oliver Hart has revealed that he was lying in bed, wondering if his chance had gone, when the phone burst deliciously into life....
“I woke at about 4:40 and was wondering whether it was getting too late for it to be this year, but then fortunately the phone rang” O. Hart
— The Nobel Prize (@NobelPrize) October 10, 2016
“My first action was to hug my wife, wake up my younger son ... and I actually spoke to my fellow Laureate” Oliver Hart #NobelPrize
— The Nobel Prize (@NobelPrize) October 10, 2016
Here’s the official tweet:
BREAKING 2016 Prize in Economic Sci. to Oliver Hart @Harvard & Bengt Holmström @MIT “for their contributions to contract theory” #NobelPrize pic.twitter.com/xosZ27WVee
— The Nobel Prize (@NobelPrize) October 10, 2016
Q: Did you ever expect to win this prize?
Bengt Holmstrom says that other people have talked about it, but he certainly did not expect it.
Nobel winner: CEO contracts are too complicated
An excited Bengt Holmström is on the phone now.
He confirms that he feels very happy about having his life’s work recognised today.
Asked what he makes of large bonuses awarded under modern-day contracts (a key part of his research), Bengt Holmström said
“My personal view is they are too complicated today”.
Taking questions from reporters, Bengt Holmström also said he felt “very lucky and very grateful” to the prize committee, to his family and to his colleagues.
He’s now taking questions in Swedish too....
In summary, Hart and Holmstrom have given us the tools to accurately examine contracts and see if people, governments and businesses are getting good deals:
Oliver Hart’s work has examined the issue of privatising public services -- and how governments can achieve high quality and low costs.
Government ownership of key services can create ‘weak incentives, but is private ownership better?
According to Hart’s work, it depends on:
- the extent to which cost reductions hurt quality
- the important of “non-contractible” innovation
- competition between providers.
It’s an area of economics called “incomplete contracts” -- addressing the fact that agreements often don’ specify actions and payments for all possible contingencies
Updated
Bengt Holmstrom’s work includes the thorny issue of executive pay.
The Swedish Academy are explaining that it examines the issue of overpaying a CEO just for being ‘lucky’ (ie, if the oil price doubles).
And tying bonuses to profits can also backfire, if it encourages short-term thinking.
[given CEO pay has spiralled ahead of workers’ pay in recent years, perhaps we should all pay closer attention to Holmstrom’s work...]
Who are Hart and Holmström?
Britain can celebrate today’s award, as Oliver Hart was born in London.
He’s spent his academic career in America, though, and is the Andrew E. Furer Professor of Economics at Harvard University.
Harvard say that:
Hart works mainly on contract theory, the theory of the firm, corporate finance, and law and economics. His research centers on the roles that ownership structure and contractual arrangements play in the governance and boundaries of corporations.
Bengt Holmstrom was born in Finland, but has also been based in the US. He’s currently the Paul A. Samuelson Professor of Economics at Massachusetts Institute of Technology, who call him a:
..microeconomic theorist, best known for his research on the theory of contracting and incentives especially as applied to the theory of the firm, to corporate governance and to liquidity problems in financial crises.
Hart and Holmstrom’s work is basically about balancing the needs, and demands, of the people or organisations who agree a contract.
It’s all about “risks versus incentives” - the ‘principle agent problem’. (Ie, if you have fire insurance, why do you care if it burns down).
The Acadamy are explaining that Oliver Hart and Bengt Holmström’s work focuses on contracts such as insurance claims, salaries, property rights, etc.
This may not sound terribly exciting, but this work is crucial for understanding the modern economy.
Oliver Hart and Bengt Holmström win the Nobel Prize
Goran Hansson, secretary general of the Royal Swedish Academy of Sciences, is announcing the winner now...
This year’s prize is going to....
Oliver Hart of Harvard, and Bengt Holmström of MIT for their contributions to contract theory.
The Academy says:
“(Their work) lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.”
Updated
You can watch today’s announcement at the top of this blog (or there’s a web feed here)
The Sveriges Riksbank Prize in Economic Sciences has even been criticised by one former winner.
Friedrich von Hayek, the Austrian/British economist whose work found favour with many right-wing politicians, argued that the award could give economists too much authority:
Hayek on the economics Nobel (that isn't really a Nobel I know I know) https://t.co/6uEdB8xjnK pic.twitter.com/E1ZPlzMoKQ
— Soumaya Keynes (@SoumayaKeynes) October 9, 2016
(that’s via The Economist’s Soumaya Keynes, whose relative John Maynard Keynes never scooped this award (as he died before it was created).
Updated
People are gathering at the Royal Swedish Academy of Sciences in Stockholm, ready for the official announcement:
Who might win this year's award?
Guessing Nobel Prize winners is devilishly tough, but the shortlist of possible winners includes:
-
Olivier Blanchard, former top economist at the International Monetary Fund, for his work on improving economic models
-
Edward Lazear, of Stanford University, for his work on using employee incentives to improve productivity.
-
Marc Melitz, professor of political economy at Harvard, for his work on free trade.
There are more details here:
Yes, we know it's not a real Nobel prize.....
Good morning. Let’s get one thing out of the way first…
The #NobelPrize for economics will be announced today around noon. pic.twitter.com/VhRPhuhIdF
— Maxime Sbaihi (@MxSba) October 10, 2016
Yes, it’s the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, not one of the ‘proper’ Nobel prizes which were dished out last week.
But it’s still the biggest prize in Economics, awarded to illustrious names such as John Hicks, Jan Tinbergen, John Nash, and Joseph Stiglitz.
It’s also a controversial award.
Economics can sometimes feel like maths for argumentative people, but critics argue that its proponents aren’t ‘proper scientists’, as they’re trying to understand social behaviour not physical laws.
Anthropologist Joris Luyendijk argued last year that putting economics on a pedestal leads to trouble…
The problem is not so much that there is a Nobel prize in economics, but that there are no equivalent prizes in psychology, sociology, anthropology. Economics, this seems to say, is not a social science but an exact one, like physics or chemistry – a distinction that not only encourages hubris among economists but also changes the way we think about the economy.
A Nobel prize in economics implies that the human world operates much like the physical world: that it can be described and understood in neutral terms, and that it lends itself to modelling, like chemical reactions or the movement of the stars. It creates the impression that economists are not in the business of constructing inherently imperfect theories, but of discovering timeless truths.
It’s a fair point….
…but if we’ve learned one thing since the 2008 financial crisis broke, it’s that the world needs a better grasp of the economic mechanisms that underpin society.
And some Sveriges Riksbank Prize winners have made very significant contributions; from Nash’s work on game theory to Jean Tirole’s research into market power, and how to regulate big businesses.
And last year’s winner, Angus Deaton, was rightly recognised for his work charting global developments in health, wellbeing and inequality.
The announcement is due around 11.45am in Sweden, or 10.45am in the UK....
Updated
