It couldn’t have been more perfectly timed. On Monday of last week, the Nobel Foundation announced the award of the 2016 prize for economics to Oliver Hart and Bengt Holmstrom. On Wednesday, John Stumpf, the Wells Fargo CEO, who had taken halfhearted responsibility for a years-long account scandal at his bank, announced his retirement — effective immediately. The whole debacle in the bank he headed is a perfect illustration of the issues Hart and Holmstrom worked on. It is rare that an economics Nobel offers such a timely teaching moment.
However, it would be hard to tell this from the Nobel announcement, which blandly refers to Hart’s and Holmstrom’s work on “contracts.” One may well wonder just what these contracts involve. Cellphones or rental cars, perhaps? Tangentially, perhaps, yes, but the crux of the prize-winning 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 activity or enterprise — the “principal” — must employ someone else to carry that activity out — the “agent.” How do we structure a set of rewards and penalties that best motivate the hired agent to manage the enterprise for the best interests of the principal?
This question arises in several ways in the Wells Fargo example. The most basic principals in a corporation are the shareholders. They are the owners, the “residual claimants” who ultimately gain or lose from their stake in the business. Executives like Stumpf are the agents. Despite his considerable stock options and leadership of the board, Stumpf essentially was hired to run the corporation on a day-to-day basis on behalf of the shareholders. His motivation differs from that of the owners, not least in their time horizon and willingness and ability to bear risk.
If incentives are wrong, agents may manage for short-term unsustainable profits knowing that they can exit before the bust comes. Or they may take on risky “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 the 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 in “The Wealth of Nations.” Corporations in Smith’s world were rare because each required a specific authorizing act from Parliament. Most businesses were sole proprietorships or partnerships. Smith argued that, because of the difference in incentives between owners and hired managers, management of corporations would never be as efficient as that of proprietorships.
However, large global ventures such as the Dutch and British East India Cos. were beyond the resources of an individual or set of proprietors. And the risks might be great. So there were situations where a joint-stock corporation was the best solution, despite the incentive problems. This is particularly true given the scale of modern businesses, like that of Wells Fargo with its 236,000 employees.
Principal-agent problems go beyond stockholder-executives relations. How can one best motivate employees, regardless of the size or legal organization of a business? Nonprofits face the same challenges even if the principals are an ill-defined “constituency” rather than share owners. So do governments that exist to serve the citizenry. Why did some Catholic clergy betray the best interests of the lay believers who are the Church? Why have prominent colleges been hit with financial scandals? Why do special interest groups have so much power at many levels of government?
Other than the last, which affects everyone, why should the average person care? If you don’t own bank stock or have not contributed to a particular college or charity, or if you are merely a nonvictimized Wells Fargo customer, how does the existence of incentive problems affect you?
The answer is that incentive problems, like externalities, monopoly power or external costs, are a way in which markets may “fail.” By that, we mean they cause resources to be wasted and society as a whole to be poorer than if they were not present.
Despite the efforts of researchers like the 2016 laureates, such problems remain ubiquitous. President Dwight Eisenhower warned of the dangers of the military-industrial complex 60 years ago, but inefficiency in arms procurement remains endemic. Some 5,500 U.S. sugar producers still raise sugar prices for 330 million sugar consumers.
Note also that incentive problems are not limited to CEOs. The Wells Fargo retail banking executive directly responsible for the sales incentives resulting in the false-account scandal has retired while retaining tens of millions in compensation (though she has agreed to forfeit $19 million). The 5,300 employees blamed by Wells Fargo’s top managers and thus 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 Sept. 8, the day it agreed to a $185 million civil fine to settle the issue for the time-being; and prior to retiring, Stumpf agreed to forfeit $41 million in stock awards; he retires with no severance package.
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 perhaps 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. And perhaps the cholesterol meds I have taken for 15 years contributed to me getting cataracts in both eyes. Yet even over my lifetime, medical research has made our lives tremendously better.
So this is a good award. It again highlights an ongoing 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.