Nobel economics prize winners' work unlocks issues around executive pay
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Version 0 of 1. It sounds the driest of subjects, but the Nobel prize-winning work of Oliver Hart and Bengt Holmström on the theory of contracts is key to understanding some of the most contentious political issues of the age. 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. Hart has specialised in what are known as incomplete contracts – where, for example, there is an agreement to deliver a service but it is impossible to specify precisely how this should be done. This matters because there are two, often conflicting, forces at work when a government decides whether it should run its own services or privatise them: improvements to quality and cost reduction. Hart’s work shows that if the government’s main priority is to improve quality it should retain control, since private providers usually have too strong an incentive to cut costs. This can result in an unacceptable drop in quality. One example cited by Hart was the US prison system, where a paper written almost two decades ago expressed concern about those in private hands. The US government now accepts that conditions in privately run prisons are significantly worse than those that are publicly owned and has decided to end their use. |